UPDATE 1/31/2011:

Contestants Summary:

- 31 Spec-listers contributed to the 2011 Investment Contest with "specific" recommendations.

- Average 4 recommendations per person (mean of 4.2, median and mode of 4) came in.

- 6 contestants gave only 1 recommendation, 3 gave only 2 and thus 9 out of the total 31 have NOT given the minimum 3 recommendations needed as per the Rules clarified by Ken Drees.

- The Hall of Fame entry for the largest number of ideas (did someone say diversification?) is from Tim Melvin, close on whose heels are J. T. Holley with 11 and Ken Drees with 10.

- The most creatively expressed entry of course has come from Rocky Humbert.

- At this moment 17 out of 31 contestants are in positive performance territory, 14 are in negative performance territory.

- Barring a major outlier of a 112.90% loss on the Option Strategy of Phil McDonnell (not accounting for the margin required for short options, but just taking the ratio of initial cash inflow to outflow):

- Average of all Individual contestant returns is -2.54% and the Standard Deviation of returns achieved by all contestants is 5.39.

- Biggest Gainer at this point is Jared Albert (with his all in single stock bet on REFR) with a 22.87% gain. The only contestant a Z score greater than 2 ( His is actually 4.72 !!)

- Biggest Loser at this point (barring the Giga-leveraged position of Mr. McDonnell) is Ken Drees at -10.36% with a Z Score that is at -1.45.

- Wildcards have not been accounted for as at this point, with wide
deviations of recommendations from the rules specified by most. While 9
participants have less than 3 recommendations, those with more than 4
include several who have not chosen to specify which 3 are their primary recommends. Without clarity on a universal measurability wildcard accounting is on hold. Those making more than 1 recommendations would find that their aggregate average return is derived by taking a sum of returns of individual positions divided by the number of recommends. Unless specified by any person that positions are taken in a specific ratio its equal sums invested approach.

Contracts Summary:

- A total of 109 contracts are utilized by the contestants across bonds, equity indices (Nikkei, Kenyan Stocks included too!), commodities, currencies and individual stock positions.

- The ratio of Shorts to Longs across all recommendations, irrespective of the type of contract (call, put, bearish ETF etc.) is 4 SELL orders Vs 9 Buy Orders. Not inferring that this list is more used to pressing the Buy Button. Just an occurence on this instance.

- The Average Return, so far, on the 109 contracts utilized is -1.26% with a Standard Deviation of 12.42%. Median Return is 0.39% and the mode of Returns of all contracts used is 0.

- The Highest Return is on MICRON TECH at 28.09, if one does not account for the July 2011 Put 25 strike on SLV utilized by Phil McDonnell.

- The Lowest Return is on IPTV at -50%, if one does not account for the Jan 2012 Call 40 Strike on SLV utilized by Phil McDonnell.

- Only Two contracts are having a greater than 2 z score and only 3 contracts are having a less than -2 Z score.

Victor Niederhoffer wrote:

One is constantly amazed at the sagacity in their fields of our fellow specs. My goodness, there's hardly a field that one of us doesn't know about from my own hard ball squash rackets to the space advertising or our President, from surfing to astronomy. We certainly have a wide range.

May I suggest without violating our mandate that we consider our best sagacities as to the best ways to make a profit in the next year of 2011.

My best trades always start with assuming that whatever didn't work the most last year will work the best this year, and whatever worked the best last year will work the worst this year. I'd be bullish on bonds and bearish on stocks, bullish on Japan and bearish on US stocks.

I'd bet against the banks because Ron Paul is going to be watching them and the cronies in the institutions will not be able to transfer as much resources as they've given them in the past 2 years which has to be much greater in value than their total market value.

I keep wondering what investments I should make based on the hobo's visit and I guess it has to be generic drugs and foods.

What ideas do you have for 2011 that might be profitable? To make it interesting I'll give a prize of 2500 to the best forecast, based on results as of the end of 2011.

David Hillman writes: 

"I do know that a sagging Market keeps my units from being full."

One would suggest it is a sagging 'economy' contributing to vacancy, not a sagging 'market'. There is a difference. 

Ken Drees, appointed moderator of the contest, clearly states the new rules of the game:

 1. Submissions for contest entries must be made on the last two days of 2010, December 30th or 31st.
2. Entries need to be labeled in subject line as "2011 contest investment prediction picks" or something very close so that we know this is your official entry.
3. Entries need 3 predictions and 1 wildcard trade prediction (anything goes on the wildcard).

4. Extra predictions may be submitted and will be judged as extra credit. This will not detract from the main predictions and may or may not be judged at all.

5. Extra predictions will be looked on as bravado– if you've got it then flaunt it. It may pay off or you may give the judge a sour palate.

The desire to have entries coming in at years end is to ensure that you have the best data as to year end 2010 and that you don't ignite someone else to your wisdom.

Market direction picks are wanted:

Examples: 30 year treasury yield will fall to 3% in 2011, S&P 500 will hit "x" by June, and then by "y" by December 2011.

The more exact your prediction is, the more weight will be given. The more exact your prediction, the more weight you will receive if right and thus the more weight you will receive if wrong. If you predict that copper will hit 5.00 dollars in 2011 and it does you will be given a great score, if you say that copper will hit 5.00 dollars in march and then it will decline to4.35 and so forth you will be judged all along that prediction and will receive extra weight good or bad. You decide on how detailed your submission is structured.

Will you try to be precise (maybe foolhardy) and go for the glory? Or will you play it safe and not stand out from the crowd? It is a doubled edged sword so its best to be the one handed market prognosticator and make your best predictions. Pretend these predictions are some pearls that you would give to a close friend or relative. You may actually help a speclister to make some money by giving up a pearl, if that speclister so desires to act upon a contest–G-d help him or her.

Markets can be currency, stocks, bonds, commodities, etc. Single stock picks can be given for the one wildcard trade prediction. If you give multiple stock picks for the wildcard then they will all be judged and in the spirit of giving a friend a pearl–lets make it "the best of the best, not one of six".

All judgments are the Chair's. The Chair will make final determination of the winner. Entries received with less than 3 market predictions will not be considered. Entries received without a wildcard will be considered.The spirit of the contest is "Give us something we can use".

Bill Rafter adds: 

Suggestion for contest:

"Static" entry: A collection of up to 10 assets which will be entered on the initial date (say 12/31/2010) and will be unaltered until the end data (i.e. 12/31/2011). The assets could be a compilation of longs and shorts, or could have the 10 slots entirely filled with one asset (e.g. gold). The assets could also be a yield and a fixed rate; that is one could go long the 10-year yield and short a fixed yield such as 3 percent. This latter item will accommodate those who want to enter a prediction but are unsure which asset to enter as many are unfamiliar with the various bond coupons.

"Rebalanced" entry: A collection of up to 10 assets which will be rebalanced on the last trading day of each month. Although the assets will remain unchanged, their percentage of the portfolio will change. This is to accommodate those risk-averse entrants employing a mean-reversion strategy.

Both Static and Rebalanced entries will be judged on a reward-to-risk basis. That is, the return achieved at the end of the year, divided by the maximum drawdown (percentage) one had to endure to achieve that return.

Not sure how to handle other prognostications such as "Famous female singer revealed to be man." But I doubt such entries have financial benefits.

I'm willing to be an arbiter who would do the rebalancing if necessary. I am not willing to prove or disprove the alleged cross-dressers.

Ralph Vince writes:

A very low volume bar on the weekly (likely, the first of two consecutive) after a respectable run-up, the backdrop of rates having risen in recent weeks, breadth having topped out and receding - and a lunar eclipse on the very night of the Winter Solstice.

If I were a Roman General I would take that as a sign to sit for next few months and do nothing.

I'm going to sit and do nothing.

Sounds like an interim top in an otherwise bullish, long-term backdrop.

Gordon Haave writes: 

 My three predictions:

Gold/ silver ratio falls below 25 Kenyan stock market outperforms US by more than 10%

Dollar ends 10% stronger compared to euro

All are actionable predictions.

Steve Ellison writes:

I did many regressions looking for factors that might predict a year-ahead return for the S&P 500. A few factors are at extreme values at the end of 2010.

The US 10-year Treasury bond yield at 3.37% is the second-lowest end-of year yield in the last 50 years. The S&P 500 contract is in backwardation with the front contract at a 0.4% premium to the next contract back, the second highest year-end premium in the 29 years of the futures.

Unfortunately, neither of those factors has much correlation with the price change in the S&P 500 the following year. Here are a few that do.

The yield curve (10-year yield minus 3-month yield) is in the top 10% of its last 50 year-end values. In the last 30 years, the yield curve has been positively correlated with year-ahead changes in the S&P 500, with a t score of 2.17 and an R squared of 0.143.

The US unemployment rate at 9.8% is the third highest in the past 60 years. In the last 30 years, the unemployment rate has been positively correlated with year-ahead changes in the S&P 500, with a t score of 0.90 and an R squared of 0.028.

In a variation of the technique used by the Yale permabear, I calculated the S&P 500 earnings/price ratio using 5-year trailing earnings. I get an annualized earnings yield of 4.6%. In the last 18 years, this ratio has been positively correlated with year-ahead changes in the S&P 500, with a t score of 0.92 and an R squared of

Finally, there is a negative correlation between the 30-year S&P 500 change and the year-ahead change, with a t score of -2.28 and an R squared of 0.094. The S&P 500 index price is 9.27 times its price of 30 years ago. The median year-end price in the last 52 years was 6.65 times the price 30 years earlier.

Using the predicted values from each of the regressions, and weighting the predictions by the R squared values, I get an overall prediction for an 11.8% increase in the S&P 500 in 2011. With an 11.8% increase, SPY would close 2011 at 140.52.

Factor                  Prediction      t       N    R sq
US Treasury yield curve      1.162    2.17      30   0.143
30-year change               1.052   -2.28      52   0.094
Trailing 5-year E/P          1.104    0.92      18   0.050
US unemployment rate         1.153    0.90      30   0.028

Weighted total               1.118
SPY 12/30/10               125.72
Predicted SPY 12/30/11     140.52

Jan-Petter Janssen writes: 

PREDICTION I - The Inconvenient Truth The poorest one or two billion on this planet have had enough of increasing food prices. Riots and civil unrest force governments to ban exports, and they start importing at any cost. World trade collapses. Manufacturers of farm equipment will do extremely well. Buy the most undervalued producer you can find. My bet is
* Kverneland (Yahoo: KVE.OL). NOK 6.50 per share today. At least NOK 30 on Dec 31th 2011.

PREDICTION II - The Ultimate Bubble The US and many EU nations hold enormous gold reserves. E.g. both Italy and France hold the equivalent of the annual world production. The gold meme changes from an inflation hedge / return to the gold standard to (a potential) over-supply from the selling of indebted nations. I don't see the bubble bursting quite yet, but
* Short gold if it hits $2,000 per ounce and buy back at $400.

PREDICTION III - The Status Quo Asia's ace is cheap labor. The US' recent winning card is cheap energy through natural gas. This will not change in 2011. Henry Hub Feb 2011 currently trades at $4.34 per MMBtu. Feb 2012 is at $5.14. I would
* Short the Feb 2012 contract and buy back on the last trading day of 2011.

Vince Fulco predicts:

 This is strictly an old school, fundamental equity call as my crystal ball for the indices 12 months out is necessarily foggy. My recommendation is BP equity primarily for the reasons I gave earlier in the year on June 5th (stock closed Friday, June 4th @ $37.16, currently $43.53). It faced a hellish downdraft post my mention for consideration, primarily due to the intensification of news flow and legal unknowns (Rocky articulated these well). Also although the capital structure arb boys savaged the equity (to 28ish!), it is up nicely to year's end if one held on and averaged in with wide scales given the heightened vol.

Additional points/guesstimates are:

1) If 2010 was annus horribilis, 2011 with be annus recuperato. A chastened mgmt who have articulated they'll run things more conservatively will have a lot to prove to stakeholders.

2) Dividend to be re-instated to some level probably by the end of the second quarter. I am guessing $1.00 annualized per ADS as a start (or
2.29%), this should bring in the index hugging funds with mandates for only holding dividend payers. There is a small chance for a 1x special dividend later in the year.

3) Crude continues to be in a state of significant profitability for the majors in the short term. It would appear finding costs are creeping however.

4) The lawsuits and additional recoveries to be extracted from the settlement fund and company directly have very long tails, on the order of 10 years.

5) The company seems fully committed to sloughing off tertiary assets to build up its liquid balance sheet. Debt to total capital remains relatively low and manageable.

6) The stock remains at a significant discount to its better-of breed peers (EV/normalized EBITDA, Cash Flow, etc) and rightly so but I am betting the discount should narrow back to near historical levels.

Potential negatives:

1) The company and govt have been vastly understating the remaining fuel amounts and effects. Release of independent data intensifies demands for a much larger payout by the company closer to the highest end estimates of $50-80B.

2) It experiences another similar event of smaller magnitude which continues to sully the company's weakened reputation.

3) China admits to and begins to fear rampant inflation, puts the kabosh to the (global) economy and crude has a meaningful decline the likes of which we haven't seen in a few years.

4) Congress freaks at a >$100-120 price for crude and actually institutes an "excess profits" tax. Less likely with the GOP coming in.

A buy at this level would be for an unleveraged, diversified, longer term acct which I have it in. However, I am willing to hold the full year or +30% total return (including special dividend) from the closing price of $43.53 @ 12/30/10, whichever comes first. Like a good sellside recommendation, I believe the stock has downside of around 20% (don't they all when recommended!?!) where I would consider another long entry depending on circumstances (not pertinent to the contest).

Mr. Albert enters: 

 Single pick stock ticker is REFR

The only way this gold chain wearing day trader has a chance against all the right tail brain power on the list is with one high risk/high reward put it all on red kind of micro cap.

Basic story is this company owns all the patents to what will become the standard for switchable glazings (SPD smart glass). It's taken roughly 50 years of development to get a commercialized product, and next year Mercedes will almost without doubt use SPD in the 2012 SLK (press launch 1/29/11 public launch at the Geneva auto show in march 2011).

Once MB validate the tech, mass adoption and revenues will follow etc and this 'show me' stock will rocket to the moon.

Dan Grossman writes:

Trying to comply with and adapt the complex contest rules (which most others don't seem to be following in any event) to my areas of stock market interest:

1. The S&P will be down in the 1st qtr, and at some point in the qtr will fall at least

2. For takeover investors: GENZ will (finally) make a deal to be acquired in the 1st qtr for a value of at least $80; and AMRN after completion of its ANCHOR trial will make a deal to be acquired for a price of at least $8.

3. For conservative investors: Low multiple small caps HELE and DFG will be up a combined average of 20% by the end of the year.

For my single stock pick, I am something of a johnny-one-note: MNTA will be up lots during the year — if I have to pick a specific amount, I'd say at least 70%. (My prior legal predictions on this stock have proved correct but the stock price has not appropriately reflected same.)

Finally, if I win the contest (which I think is fairly likely), I will donate the prize to a free market or libertarian charity. I don't see why Victor should have to subsidize this distinguished group that could all well afford an contest entrance fee to more equitably finance the prize.

Best to all for the New Year,


Gary Rogan writes:

 1. S&P 500 will rise 3% by April and then fall 12% from the peak by the end of the year.
2. 30 year treasury yields will rise to 5% by March and 6% by year end.
3. Gold will hit 1450 by April, will fall to 1100 by September and rise to 1550 by year end.

Wildcard: Short Netflix.

Jack Tierney, President of the Old Speculator's Club, writes: 

Equal Amounts in:

TBT (short long bonds)
YCS (short Yen)
GRU (Long Grains - heavy on wheat)
CHK (Long NG - takeover)

(Wild Card)
BONXF.PK or BTR.V (Long junior gold)

12/30 closing prices (in order):


Bill Rafter writes:

Two entries:

Buy: FXP and IRWD

Hold for the entire year.

William Weaver writes:

 For Returns: Long XIV January 21st through year end

For Return/Risk: Long XIV*.30 and Long VXZ*.70 from close today

I hope everyone has enjoyed a very merry holiday season, and to all I wish a wonderful New Year.



Ken Drees writes:

Yes, they have been going up, but I am going contrary contrary here and going with the trends.

1. Silver: buy day 1 of trading at any price via the following vehicles: paas, slw, exk, hl –25% each for 100% When silver hits 39/ounce, sell 10% of holdings, when silver hits 44/ounce sell 30% of holdings, when silver hits 49 sell 60%–hold rest (divide into 4 parts) and sell each tranche every 5 dollars up till gone–54/oz, 59, 64, 69.

2. Buy GDXJ day 1 (junior gold miner etf)—rotation down from majors to juniors with a positive gold backdrop. HOLD ALL YEAR.

3. USO. Buy day 1 then do—sell 25% at 119/bbl oil, sell 80% at 148/bbl, sell whats left at 179/bbl or 139/bbl (whichever comes first after 148)


Happy New Year!

Ken Drees———keepin it real.

Sam Eisenstadt forecasts:

My forecast for the S&P 500 for the year ending Dec 31, 2011;

S&P 500       1410

Anton Johnson writes: 

Equal amounts allocated to:

EDZ Short moc 1-21-2011, buy to cover at 50% gain, or moc 12/30/2011

VXX Short moc 1-21-2011, buy to cover moc 12/30/2011

UBT Short moo 1-3-2011, buy to cover moc 12/30/2011

Scott Brooks picks: 


Evenly between the 4 (25% each)

Sushil Kedia predicts:


1) Gold
2) Copper
3) Japanese Yen

30% moves approximately in each, within 2011.

Rocky Humbert writes:

(There was no mention nor requirement that my 2011 prediction had to be in English. Here is my submission.) … Happy New Year, Rocky

Sa aking mahal na kaibigan: Sa haba ng 2010, ako na ibinigay ng ilang mga ideya trading na nagtrabaho sa labas magnificently, at ng ilang mga ideya na hindi na kaya malaki. May ay wala nakapagtataka tungkol sa isang hula taon dulo, at kung ikaw ay maaaring isalin ito talata, ikaw ay malamang na gawin ang mas mahusay na paggawa ng iyong sariling pananaliksik kaysa sa pakikinig sa mga kalokohan na ako at ang iba pa ay magbigay. Ang susi sa tagumpay sa 2011 ay ang parehong bilang ito ay palaging (tulad ng ipinaliwanag sa pamamagitan ng G. Ed Seykota), sa makatuwid: 1) Trade sa mga kalakaran. 2) Ride winners at losers hiwa. 3) Pamahalaan ang panganib. 4) Panatilihin ang isip at diwa malinaw. Upang kung saan gusto ko idagdag, fundamentals talaga bagay, at kung ito ay hindi magkaroon ng kahulugan, ito ay hindi magkaroon ng kahulugan, at diyan ay wala lalo na pinakinabangang tungkol sa pagiging isang contrarian bilang ang pinagkasunduan ay karaniwang karapatan maliban sa paggawa sa mga puntos. (Tandaan na ito ay pinagkasunduan na ang araw ay babangon na bukas, na quote Seth Klarman!) Pagbati para sa isang malusog na masaya at pinakinabangang 2011, at siguraduhin na basahin kung saan ako magsulat sa Ingles ngunit ang aking mga saloobin ay walang malinaw kaysa talata na ito, ngunit inaasahan namin na ito ay mas kapaki-pakinabang.

Dylan Distasio comments: 

Gawin mo magsalita tagalog?

Gary Rogan writes:

After a worthy challenge, Mr. Rogan is now also a master of Google Translate, and a discoverer of an exciting fact that Google Translate calls Tagalog "Filipino". This was a difficult obstacle for Mr. Rogan to overcome, but he persevered and here's Rocky's prediction in English (sort of):

My dear friend: Over the course of 2010, I provided some trading ideas worked out magnificently, and some ideas that are not so great. There is nothing magical about a forecast year end, and if you can translate this paragraph, you will probably do better doing your own research rather than listening to the nonsense that I and others will give. The key to success in 2011 is the same as it always has (as explained by Mr. Ed Seykota), namely: 1) Trade with the trend.

2) Ride cut winners and losers. 3) Manage risk. 4) Keep the mind and spirit clear. To which I would add, fundamentals really matter, and if it does not make sense, it does not make sense, and there is nothing particularly profitable about being a contrarian as the consensus is usually right but turning points. (Note that it is agreed that the sun will rise tomorrow, to quote Seth Klarman) Best wishes for a happy healthy and profitable 2011, and be sure to read which I write in English but my attitude is nothing clearer than this paragraph, but hopefully it is more useful.

Tim Melvin writes:

Ah the years end prediction exercise. It is of course a mostly useless exercise since not a one of us can predict what shocks, positive or negative, the world and the markets could see in 2011. I find it crack up laugh out loud funny that some pundits come out and offer up earnings estimates, GDP growth assumptions and interest rate guesses to give a precise level for the year end S&P 500 price. You might as well numbers out of a bag and rearrange them by lottery to come up with a year end number. In a world where we are fighting two wars, a hostile government holds the majority of our debt and several sovereign nations continually teeter on the edge of oblivion it's pretty much ridiculous to assume what could happen in the year ahead. Having said that, as my son's favorite WWE wrestler when he was a little guy used to say "It's time to play the game!"

Ill start with bonds. I have owned puts on the long term treasury market for two years now. I gave some back in 2010 after a huge gain in 2009 but am still slightly ahead. Ill roll the position forward and buy January 2012 puts and stay short. When I look at bods I hear some folks talking about rising basic commodity prices and worrying about inflation. They are of course correct. This is happening. I hear some other really smart folks talking of weak real estate, high jobless rates and the potential for falling back into recession. Naturally, they are also exactly correct. So I will predict the one thing no one else is. We are on the verge of good old fashioned 1970s style stagflation. Commodity and basic needs prices will accelerate as QE2 has at least stimulated demand form emerging markets by allowing these wonderful credits to borrow money cheaper than a school teacher with a 750 FICO score. Binds go lower as rates spike. Our economy and balance sheet are a mess and we have governments run by men in tin hats lecturing us on fiscal responsibility. How low will they go Tim? How the hell do I know? I just think they go lower by enough for me to profit.

 Nor can I tell you where the stock market will go this year. I suspect we have had it too good for too long for no reason so I think we get at least one spectacular gut wrenching, vomit inducing sell off during the year. Much as lower than expected profits exposed the silly valuations of the new paradigm stocks I think that the darling group, retail , will spark a sell-off in the stock market this year. Sales will be up a little bit but except for Tiffany's (TIF) and that ilk margins are horrific. Discounting started early this holiday and grew from there. They will get steeper now that that Santa Claus has given back my credit card and returned to the great white north. The earnings season will see a lot of missed estimates and lowered forecasts and that could well pop the bubble. Once it starts the HFT boys and girls should make sure it goes lower than anyone expects.

Here's the thing about my prediction. It is no better than anyone else's. In other words I am talking my book and predicting what I hope will happen. Having learned this lesson over the years I have learned that when it comes to market timing and market direction I am probably the dumbest guy in the room. Because of that I have trained myself to always buy the stuff that's too cheap not to own and hold it regardless. After the rally since September truly cheap stuff is a little scarce on the ground but I have found enough to be about 40% long going into the year. I have a watch list as long as a taller persons right arm but most of it hover above truly cheap.

Here is what I own going into the year and think is still cheap enough to buy. I like Winn Dixie (WINN). The grocery business sucks right now. Wal mart has crushed margins industry wide. That aside WINN trades at 60% of tangible book value and at some point their 514 stores in the Southeast will attract attention from investors. A takeover here would be less than shocking. I will add Presidential Life (PLFE) to the list. This stock is also at 60% of tangible book and I expect to see a lot of M&A activity in the insurance sector this year and this should raise valuations across the board. I like Miller Petroleum (MILL) with their drilling presence in Alaska and the shale field soft Tennessee. This one trades at 70% of tangible book. Ill add Imperial Sugar (IPSU), Syms (SYMS) and Micron tech (MU) and Avatar Holdings (AVTR) to my list of cheapies and move on for now.

I am going to start building my small bank portfolio this year. Eventually this group becomes the F-you walk away money trade of the decade. As real estate losses work through the balance sheet and some measure of stability returns to the financial system, perhaps toward the end of the year the small baileys savings and loan type banks should start to recover. We will also see a mind blowing M&A wave as larger banks look to gain not just market share but healthy assets to put on the books. Right now these names trade at a fraction of tangible book value. They will reach a multiple of that in a recovery or takeover scenario. Right now I own shares of Shore Bancshares (SHBI), a local bank trading at 80% of book value and a reasonably healthy loan portfolio. I have some other mini microcap banks as well that shall remain my little secret and not used to figure how my predictions work out. I mention them because if you have a mini micro bank in your community you should go meet then bankers, review the books and consider investing if it trades below the magical tangible book value and has excess capital. Flagstar Bancorp(FBC) is my super long shot undated call option n the economy and real estate markets.

I will also play the thrift conversion game heavily this year. With the elimination of the Office of Thrift Services under the new financial regulation many of the benefits of being a private or mutual thrift are going away. There are a ton of mutual savings banks that will now convert to publicly traded banks. A lot of these deals will be priced below the pro forma book value that is created by adding all that lovely IPO cash to the balance sheet without a corresponding increase in the shares outstanding. Right now I have Fox Chase Bancorp (FXCB) and Capital Federal Financial(CFFN). There will be more. Deals are happening every day right now and again I would keep an eye out for local deals that you can take advantage of in the next few months.

I also think that 2011 will be the year of the activist investor. These folks took a beating since 2007 but this should be their year. There is a ton of cash on corporate balance sheets but lots of underperformance in the current economic environment. We will see activist drive takeovers, restructures, and special dividends this year in my opinion. Recent filings of interest include strong activist positions in Surmodics(SRDX), SeaChange International (SEAC), and Energy Solutions. Tracking activist portfolios and 13D filings should be a very profitable activity in 2011.

I have been looking at some interesting new stuff with options as well I am not going to give most of it away just yet but I ll give you one stimulated by a recent list discussion. H and R Black is highly likely to go into a private equity portfolio next year. Management has made every mistake you can make and the loss of RALs is a big problem for the company. However the brand has real value. I do not want town the stock just yet but I like the idea of selling the January 2012 at $.70 to $.75. If you cash secure the put it's a 10% or so return if the stock stays above the strike. If it falls below I' ll be happy to own the stock with a 6 handle net. Back in 2008 everyone anticipated a huge default wave to hit the high yield market. Thanks to federal stimulus money pumping programs it did not happen. However in the spirit of sell the dog food the dog will eat a given moment the hedge fund world raised an enormous amount od distressed debt money. Thanks to this high yield spreads are far too low. CCC paper in particular is priced at absurd levels. These things trade like money good paper and much of it is not. Extend and pretend has helped but if the economy stays weak and interest rates rise rolling over the tsunami f paper due over the next few years becomes nigh onto impossible. I am going take small position in puts on the various high yield ETFs. If I am right they will explode when that market implodes. Continuing to talk my book I hope this happens. Among my nightly prayers is "Please God just one more two year period of asset rich companies with current payments having bonds trade below recovery value and I promise not to piss the money away this time. Amen.

PS. If you add in risk arbitrage spreads of 30% annualized returns along with this I would not object. Love, Tim.

I can't tell you what the markets will do. I do know that I want to own some safe and cheap stocks, some well capitalized small banks trading below book and participate in activist situation. I will be under invested in equities going into the year hoping my watch list becomes my buy list in market stumble. I will have put positions on long T-Bonds and high yield hoping for a large asymmetrical payoff.

Other than that I am clueless.

Kim Zussman comments: 

Does anyone else think this year is harder than usual to forecast? Is it better now to forecast based on market fundamentals or mass psychology? We are at a two year high in stocks, after a huge rally off the '09 bottom that followed through this year. One can make compelling arguments for next year to decline (best case scenarios already discounted, prior big declines followed by others, volatility low, house prices still too high, FED out of tools, gov debt/gdp, Roubini says so, benefits to wall st not main st, persistent high unemployment, Year-to-year there is no significant relationship, but there is a weak down tendency after two consecutive up years. ). And compelling arguments for up as well (crash-fears cooling, short MA's > long MA's, retail investors and much cash still on sidelines, tax-cut extended, employee social security lowered, earnings increasing, GDP increasing, Tepper and Goldman say so, FED herding into risk assets, benefits to wall st not main st, employment starting to increase).

Is the level of government market-intervention effective, sustainable, or really that unusual? The FED looks to be avoiding Japan-style deflation at all costs, and has a better tool in the dollar. A bond yields decline would help growth and reduce deflation risk. Increasing yields would be expected with increasing inflation; bad for growth but welcomed by retiring boomers looking for fixed income. Will Obamacare be challenged or defanged by states or in the supreme court? Will 2011 be the year of the muni-bubble pop?

A ball of confusion!

4 picks in equal proportion:

long XLV (health care etf; underperformed last year)

long CMF (Cali muni bond fund; fears over-wrought, investors still need tax-free yield)

short GLD (looks like a bubble and who needs gold anyway)

short IEF (7-10Y treasuries; near multi-year high/QE2 is weaker than vigilantism)

Alan Millhone writes:

 Hello everyone,

I note discussion over the rules etc. Then you have a fellow like myself who has never bought or sold through the Market a single share.

For myself I will stick with what I know a little something. No, not Checkers —

Rental property. I have some empty units and beginning to rent one or two of late to increase my bottom line.

I will not venture into areas I know little or nothing and will stay the course in 2011 with what I am comfortable.

Happy New Year and good health,



Jay Pasch predicts: 

2010 will close below SP futures 1255.

Buy-and-holders will be sorely disappointed as 2011 presents itself as a whip-saw year.

99% of the bullish prognosticators will eat crow except for the few lonely that called for a tempered intra-year high of ~ SPX 1300.

SPX will test 1130 by April 15 with a new recovery high as high as 1300 by the end of July.

SPX 1300 will fail with new 2011 low of 1050 before ending the year right about where it started.

The Midwest will continue to supply the country with good-natured humble stock, relatively speaking.

Chris Tucker enters: 

Buy and Hold


Wildcard:  Buy and Hold AVAV

Gibbons Burke comments: 

Mr. Ed Seykota once outlined for me the four essential rules of trading:

1) The trend is your friend (till it bends when it ends.)

2) Ride your winners.

3) Cut your losses short.

4) Keep the size of your bet small.

Then there are the "special" rules:

5) Follow all the rules.

and for masters of the game:

6) Know when to break rule #5

A prosperous and joy-filled New Year to everyone.



John Floyd writes:

In no particular order with target prices to be reached at some point in 2011:

1) Short the Australian Dollar:current 1.0220, target price .8000

2) Short the Euro: current 1.3375, target price 1.00

3) Short European Bank Stocks, can use BEBANKS index: current 107.40, target 70

A Mr. Krisrock predicts: 

 1…housing will continue to lag…no matter what can be done…and with it unemployment will remain

2…bonds will outperform as republicans will make cutting spending the first attack they make…QE 2 will be replaced by QE3

3…with every economist in the world bullish, stocks will underperform…

4…commodities are peaking ….

Laurel Kenner predicts: 

After having made monkeys of those luminaries who shorted Treasuries last year, the market in 2011 has had its laugh and will finally carry out the long-anticipated plunge in bond prices.

Short the 30-year bond futures and cover at 80.

Pete Earle writes:

All picks are for 'all year' (open first trading day/close last trading day).

1. Long EUR/USD
2. Short gold (GLD)

MMR (McMoran Exploration Corp)
HDIX (Home Diagnostics Inc)
TUES (Tuesday Morning Corp)

PBP (Powershares S&P500 Buy-Write ETF)
NIB (iPath DJ-UBS Cocoa ETF)
KG (King Pharmaceuticals)

Happy New Year to all,

Pete Earle

Paolo Pezzutti enters: 

If I may humbly add my 2 cents:

- bearish on S&P: 900 in dec
- crisis in Europe will bring EURUSD down to 1.15
- gold will remain a safe have haven: up to 1500
- big winner: natural gas to 8

J.T Holley contributes: 


The Market Mistress so eloquently must come first and foremost. Just as daily historical stats point to betting on the "unchanged" so is my S&P 500 trade for calendar year 2011. Straddle the Mistress Day 1. My choice for own reasons with whatever leverage is suitable for pain thresholds is a quasi straddle. 100% Long and 50% Short in whatever instrument you choose. If instrument allows more leverage, first take away 50% of the 50% Short at suitable time and add to the depreciated/hopefully still less than 100% Long. Feel free to add to the Long at this discretionary point if it suits you. At the next occasion that is discretionary take away remaining Short side of Quasi Straddle, buckle up, and go Long whatever % Long that your instrument or brokerage allows till the end of 2011. Take note and use the historical annual standard deviation of the S&P 500 as a rudder or North Star, and throw in the quarterly standard deviation for testing. I think the ambiguity of the current situation will make the next 200-300 trading days of data collection highly important, more so than prior, but will probably yield results that produce just the same results whatever the Power Magnification of the Microscope.

Long the U.S. Dollar. Don't bother with the rest of the world and concern yourself with which of the few other Socialist-minded Country currencies to short. Just Long the U.S. Dollar on Day 1 of 2011. Keep it simple and specialize in only the Long of the U.S. Dollar. Cataclysmic Economic Nuclear Winter ain't gonna happen. When the Pastor preaches only on the Armageddon and passes the plate while at the pulpit there is only one thing that happens eventually - the Parish dwindles and the plate stops getting filled. The Dollar will bend as has, but won't break or at least I ain't bettin' on such.

Ala Mr. Melvin, Short any investment vehicle you like that contains the words or numerals "perpetual maturity", "zero coupon" and "20-30yr maturity" in their respective regulated descriptions, that were issued in times of yore. Unfortunately it doesn't work like a light switch with the timing, remember it's more like air going into a balloon or a slow motion see-saw. We always want profits initially and now and it just doesn't work that way it seems in speculation. Also, a side hedge is to start initially looking at any financial institution that begins, dabbles, originates and gains high margin fees from 50-100 year home loans or Zero-Coupon Home Loans if such start to make their way Stateside. The Gummit is done with this infusion and cheer leading. They are in protection mode, their profit was made. Now the savy financial engineers that are left or upcoming will continue to find ways to get the masses to think they "Own" homes while actually renting them. Think Car Industry '90-'06 with. Japan did it with their Notes and I'm sure some like-minded MBA's are baiting/pushing the envelopes now in board rooms across the U.S. with their profitability and ROI models, probably have ditched the Projector and have all around the cherry table with IPads watching their presentation. This will ultimately I feel humbly be the end of the Mortgage Interest Deduction as it will be dwindled down to a moot point and won't any longer be the leading tax deduction that it was created to so-called help.


Short Gold, Short it, Short it more. Take all of your emotions and historical supply and demand factors out of the equation, just look at the historical standard deviation and how far right it is and think of Buzz Lightyear in Toy Story and when he thought he was actually flying and the look on his face at apex realization. That plus continue doing a study on Google Searches and the number of hits on "stolen gold", "stolen jewelery", and Google Google side Ads for "We buy Gold". I don't own gold jewelery, and have surrendered the only gold piece that I ever wore, but if I was still wearing it I'd be mighty weary of those that would be willing to chop a finger off to obtain. That ain't my fear, that's more their greed.

Long lithium related or raw if such. Technology demands such going forward.


Long Natural Gas. Trading Day 1 till last trading day of the year. The historic "cheap" price in the minds of wannabe's will cause it to be leveraged long and oft with increasing volume regardless of the supply. Demand will follow, Pickens sowed the seeds and paid the price workin' the mule while plowin'. De-regulation on the supply side of commercial business statements is still in its infancy and will continue, politics will not beat out free markets going into the future.

Long Crude and look to see the round 150 broken in years to come while China invents, perfects, and sees the utility in the Nuclear fueled tanker.

Long LED, solar, and wind generation related with tiny % positions. Green makes since, its here to stay and become high margined profitable businesses.


Short Sugar. Sorry Mr. Bow Tie. Monsanto has you Beet! That being stated, the substitute has arrived and genetically altered "Roundup Ready" is here to stay no matter what the Legislative Luddite Agrarians try, deny, or attempt. With that said, Long MON. It is way more than a seed company. It is more a pharmaceutical engineer and will bring down the obesity ridden words Corn Syrup eventually as well. Russia and Ireland will make sure of this with their attitudes of profit legally or illegally.

Prepare to long in late 2011 the commercialized marijuana and its manufacturing, distribution companies that need to expand profitability from its declining tobacco. Altria can't wait, neither can Monsanto. It isn't a moral issue any longer, it's a financial profit one. We get the joke, or choke? If the Gummit doesn't see what substitutes that K2 are doing and the legal hassles of such and what is going on in Lisbon then they need to have an economic lesson or two. It will be a compromise between the Commercial Adjective Definition Agrarians and Gummit for tax purposes with the Green theme continuing and lobbying.

Short Coffee, but just the 1st Qtr of 2011. Sorry Seattle. I will also state that there will exist a higher profit margin substitute for the gas combustible engine than a substitute for caffeine laden coffee.

Sex and Speculation:

Look to see go public in 2011 with whatever investment bank that does such trying their best to be anonymous. Are their any investment banks around? This Boxxx will make Red Box blush and Apple TV's box envious. IPTV and all related should be a category that should be Longed in 2011 it is here to stay and is in it's infancy. Way too many puns could be developed from this statement. Yes, I know fellas the fyre boxxx is 6"'s X 7"'s.


This is one category to always go Long. I have vastly improved my guitar playin' in '10 and will do so in '11. AAPL still has the edge and few rivals are even gaining market share and its still a buy on dips, sell on highs empirically counted. They finally realized that .99 cents wasn't cutting it and .69 cents was more appropriate for those that have bought Led Zeppelin IV songs on LP, 8-track, cassette, and CD over the course of their lives. Also, I believe technology has a better shot at profitably bringing music back into public schools than the Federal or State Gummits ever will.


Long - Your mind. Double down on this Day 1 of 2011. It's the most capable, profitable thing you have going for you. I just learned this after the last 36 months.

Long - Counting, you need it now more than ever. It's as important as capitalism.

Long - Being humble, it's intangible but if quantified has a STD of 4 if not higher.

Long - Common Sense.

Long - Our Children. The media is starting to question if their education is priceless, when it is, but not in their context or jam.

Short - Politics. It isn't a spectator sport and it has been made to be such.

Short - Fear, it is way way been played out. Test anything out there if you like. I have. It is prevalent still and disbelief is rampant.

Long - Greed, but don't be greedy just profitable. Wall Street: Money Never Sleeps was the pilot fish.

I had to end on a Long note.

Happy New Year's Specs. Thanks to all for support over the last four years. I finally realized that it ain't about being right or wrong, just profitable in all endeavors. Too many losses led to this, pain felt after lookin' within, and countin' ones character results with pen/paper.

Russ Sears writes:

 For my entry to the contest, I will stick with the stocks ETF, and the index markets and avoid individual stocks, and the bonds and interest rates. This entry was thrown together rather quickly, not at all an acceptable level if it was real money. This entry is meant to show my personal biases and familiarity, rather than my investment regiment. I am largely talking my personal book.

Therefore, in the spirit of the contest , as well as the rules I will expose my line of thinking but only put numbers on actual entry predictions. Finally, if my caveats are not warning enough, I will comment on how a prediction or contest entry differs from any real investment. I would make or have made.

The USA number one new product export will continue to be the exportation of inflation. The printing of dollars will continue to have unintended consequences than its intended effect on the national economy but have an effect on the global economy.. Such monetary policy will hit areas with the most potential for growth: the emerging markets of China and India. In these economies, that spends over half their income on food, food will continue to rise. This appears to be a position opposite the Chairs starting point prediction of reversal of last year's trends.

Likewise, the demand for precious metals such as gold and silver will not wane as these are the poor man's hedge against food cost. It may be overkill for the advanced economies to horde the necessities and load up on precious metals Yet, unlike the 70's the US/ European economy no longer controls gold and silver a paradigm shift in thinking that perhaps the simple statistician that uses weighted averages and the geocentric economist have missed. So I believe those entries shorting gold or silver will be largely disappointed. However in a nod to the chair's wisdom, I will not pick metals directly as an entry. Last year's surprise is seldom this year's media darling. However, the trend can continue and gold could have a good year. The exception to the reversal rule seems to be with bubbles which gain a momentum of their own, apart from the fundamentals. The media has a natural sympathy in suggesting a return to the drama of he 70's, the stagflation dilemma, ,and propelling an indicator of doom. With the media's and the Fed's befuddled backing perhaps the "exception" is to be expected. But I certainly don't see metal's impending collapse nor its continued performance.

The stability or even elevated food prices will have some big effects on the heartland.

1. For my trend is your friend pick: Rather than buy directly into a agriculture commodity based index like DBA, I am suggesting you buy an equity agriculture based ETF like CRBA year end price at 77.50. I am suggesting that this ETF do not need to have commodities produce a stellar year, but simply need more confirmation that commodity price have established a higher long term floor. Individually I own several of these stocks and my wife family are farmers and landowners (for full disclosure purposes not to suggest I know anything about the agriculture business) Price of farmland is raising, due to low rates, GSE available credit, high grain prices due to high demand from China/India, ethanol substitution of oil A more direct investment in agriculture stability would be farmland. Farmers are buying tractors, best seeds and fertilizers of course, but will this accelerate. Being wrong on my core theme of stable to rising food/commodity price will ruin this trade. Therefore any real trade would do due diligence on individual stocks, and put a trailing floor. And be sensitive to higher volatility in commodities as well as a appropriate entry and exit level.

2. For the long term negative alpha, short term strength trade: I am going with airlines and FAA at 49.42 at year end. There seems to be finally some ability to pass cost through to the consumer, will it hold?

3. For the comeback of the year trade XHB: (the homebuilders ETF), bounces back with 25% return. While the overbuilding and vacancy rates in many high population density areas will continue to drag the home makes down, the new demand from the heartland for high end houses will rise that is this is I am suggesting that the homebuilders index is a good play for housing regionally decoupling from the national index. And much of what was said about the trading of agriculture ETF, also apply to this ETF. However, while I consider this a "surprise", the surprise is that this ETF does not have a negative alpha or slightly positive. This is in-line with my S&P 500 prediction below. Therefore unless you want volatility, simply buying the S&P Vanguard fund would probably be wiser. Or simply hold these inline to the index.

4. For the S&P Index itself I would go with the Vanguard 500 Fund as my vehicle VFINXF, and predict it will end 2011 at $145.03, this is 25% + the dividend. This is largely due to how I believe the economy will react this year. 

5. For my wild card regional banks EFT, greater than IAT > 37.50 by end 2011…

Yanki Onen writes:

 I would like to thank all for sharing their insights and wisdom. As we all know and reminded time to time, how unforgiven could the market Mistress be. We also know how nurturing and giving it could be. Time to time i had my share of falls and rises. Everytime I fall, I pick your book turn couple of pages to get my fix then scroll through articles in DSpecs seeking wisdom and a flash of light. It never fails, before you know, back to the races. I have all of you to thank for that.

Now the ideas;

-This year's lagger next year's winner CSCO

Go long Jan 2012 20 Puts @ 2.63 Go long CSCO @ 19.55 Being long the put gives you the leverage and protection for a whole year, to give the stock time to make a move.

You could own 100,000 shares for $263K with portfolio margin ! Sooner the stock moves the more you make (time decay)

-Sell contango Buy backwardation

You could never go wrong if you accept the truth, Index funds always roll and specs dont take physical delivery. This cant be more true in Cotton.

Right before Index roll dates (it is widely published) sell front month buy back month especially when it is giving you almost -30 to do so Sell March CT Buy July CT pyramid this trade untill the roll date (sometime at the end of Jan or begining of Feb) when they are almost done rolling(watch the shift in open interest) close out and Buy May CT sell July CT wait patiently for it to play it out again untill the next roll.

- Leveraged ETFs suckers play!

Two ways to play this one out if you could borrow and sell short, short both FAZ and FAS equal $ amounts since the trade is neutral, execute this trade almost free of margin. One thing is for sure to stay even long after we are gone is volatility and triple leveraged products melt under volatility!

If you cant borrow the shares execute the trade using Jan 12 options to open synthetic short positions. This trade works with time and patience!

Vic, thanks again for providing a platform to listen and to be heard.


Yanki Onen

Phil McDonnell writes: 

When investing one should consider a diversified portfolio. But in a contest the best strategy is just to go for it. After all you have to be number one.

With that thought in mind I am going to bet it all on Silver using derivatives on the ETF SLV.

SLV closed at 30.18 on Friday.

Buy Jan 2013 40 call for 3.45.
Sell Jan 2012 40 call at 1.80.
Sell Jul 25 put at 1.15.

Net debit is .50.

Exit strategy: close out entire position if SLV ETF reaches a price of 40 or better. If 40 is not reached then exit on 2/31/2011 at the close.

George Parkanyi entered:

For what it's worth, the Great White North weighs in ….
3 Markets equally weighted - 3 stages each (if rules allow) - all trades front months
3 JAN 2011
BUY NAT GAS at open

BUY SILVER at open

BUY CORN at open
28 FEB 2011 (Reverse Positions)
SELL and then SHORT NAT GAS at open

SELL and then SHORT SILVER at open

SELL and then SHORT CORN at open
1 AUG 2011 (Reverse Positions)
COVER and then BUY NAT GAS at open

COVER and then BUY SILVER at open

COVER and then BUY CORN at open
Hold all positions to the end of the year

3 JAN BUY PLATINUM and hold to end of year.


. Markets to unexpectedly carry through in New Year despite correction fears.

. Spain/Ireland debt roll issues - Europe/Euro in general- will be in the news in Q1/Q2

- markets will correct sharply in late Q1 through Q2 (interest rates will be rising)

. Markets will kick in again in Q3 & Q4 with strong finish on more/earlier QE in both Europe and US - hard assets will remain in favour; corn & platinum shortages; cooling trend & economic recovery to favour nat gas

. Also assuming seasonals will perform more or less according to stats

If rules do not allow directional changes; then go long NAT GAS, SILVER, and CORN on 1 AUG 2011 (cash until then); wild card trade the same.

Gratuitous/pointless prediction: At least two European countries will drop out of Euro in 2011 (at least announce it) and go back to their own currency. 

Marlowe Cassetti enters:

FXE - Currency Shares Euro Trust

XLE - Energy Select

BAL - iPath Dow Jones-AIG Cotton Total Return Sub-Index

GDXJ - Market Vectors Junior Gold Miners

AMJ - JPMorgan Alerian MLP Index ETN

Wild Card:


VNM - Market Vectors Vietnam ETF

Kim Zussman entered: 

long XLV (health care etf; underperformed last year)
long CMF (Cali muni bond fund; fears over-wrought, investors still
need tax-free yield)
short GLD (looks like a bubble and who needs gold anyway)
short IEF (7-10Y treasuries; near multi-year high/QE2 is weaker than



Apropos of this derivative-centric world, I'll never forget the first time I was asked, "what might happen if there were a crash UP?"

Bill Rafter writes:

There were "up crashes". During the flash crash in May there were some thinly traded ETFs that had big range days with the activity being on the upside. I believe that was because they were involved in some long/short strategies such that when the holder dumped the long side, he covered the short ETF driving it up. 



 Let me call this a literary digression so as not to run afoul of the prohibition on political proselytization:

Perhaps what I am about to say will appear strange to you gentlemen, socialists, progressives, humanitarians as you are, but I never worry about my neighbor, I never try to protect society which does not protect me – indeed, I might add, which generally takes no heed of me except to do me harm – and, since I hold them low in my esteem and remain neutral towards them, I believe that society and my neighbor are in my debt.

Spoken by the title character of The Count of Monte Cristo. Chapter XV The Breakfast.

Stefan Jovanovich writes: 

Dumas the elder and Auguste Maquet were probably the most successful literary collaboration ever. Maquet was a prodigy of historical study; he was a professor at the Lycee Charlemagne at age 18! He did the historical research, plot outlines and character sketches– what Hollywood would call treatments– and Dumas wrote the scripts. They were also a wonderfully sensible division of labor. Dumas who was already a celebrity was the name author; Maquet and he split the royalties. Maquet was a much better investor. He died rich.  Dumas– in the great tradition of spendthrift geniuses– was always on the edge of bankruptcy.

The back story for the Count, who is really Dumas himself, is that Dumas and his son (Traviata is based on the son's play) both suffered scorn, sarcasm and insult for being what would now be called "black". The Count's view of "society" is very much that of the outsider looking in. "Life itself is an exile. The way home is not the way back." (Colin Wilson)



 Payroll tax receipts are a very good surrogate for jobs. The data is daily with a 1-day lag. It is reported by the Treasury rather than the BLS, and is NEVER revised. It does have the disadvantage of being presented raw rather than seasonally-adjusted, a fact which keeps many from considering the data. The series tends to lead the unemployment numbers (which are the opposite side of the coin) by some four to five weeks. All of the above is a repeat announcement. Now the news: At this time the growth/slope of that data is decidedly negative, almost to the point of being scary in our opinion. This is not what we expected and put it out as a word of caution. Of course, remember that the economy is not the market.

Scott Brooks adds:

Two anecdotal observations:

1. My insurance brokerage clients and insurance industry clients are reporting that their workers comp premiums are down and not coming up.

My small business clients that are hiring are reporting that they are having a very difficult time hiring at the lower end of the pay scale. They simply can't compete with unemployment benefits that are paid for doing absolutely nothing. People would rather earn slightly less money without the hassle or expense associated with actually working.



 I read an article "How Venice Rigged The First, and Worst, Global Financial Collapse" by Paul Gallagher. Whaddya think?

Bill Rafter summarizes:

Skimming the article one gets the opinion that the author blames most of the 14 Century economic failures on Venetian bankers rather than on the Black Death. 

Victor Niederhoffer writes:

We must hear from Stefan on this subject to get the truth, the whole truth and nothing but. 

Stefan Jovanovich commentates:

I am feeling damn near invincible this morning having had Susan's corn meal and flour drop bisquits for breakfast (also the 10-year old boy cat's favorites) so I am going to pretend that this opinion offers what Vic requested– "the truth, the whole truth and nothing but the truth". I have read Charles Lane's book , and I do know something about the period because my own faith comes closer to what is now called the Eastern Church than any other Christian sect; and I have always been curious about its fate. As Bill tactfully suggests, perhaps Black Death had something to do with the decline in European population that the essayist blames on those awful Italian bankers. The later Crusades and the mere Hundred Years war (which, together, had relative costs greater than WW II and the Cold War combined) may also have played a part. Blaming the bankers for the decline in food production that began around 1300 also seems more than a bit of a stretch. The farmers themselves thought that the end of the Medieval Warm Period was a more likely cause.

The author is right: there was a credit bubble. But like our most recent ones the bubble rose out of a dramatic reduction in the real prices for the things people lived by (computing for the tech bubble, household and home improvement goods from Asia for the consumer/real estate bubble). The rise of the Italian city-state bankers came from the dramatic declines in the costs of transportation and protein. (Archaeologists are finding that around 1100 Europe relatively suddenly went from eating freshwater fish to cod and other salt-water species.) These changes came from developments in naval technology and an outbreak of relative peace. The Italian bankers couldn't have been able to cheat poor King Edward if they hadn't had the means of getting themselves and their gold to London and back quickly without risk of having the Vikings waylay them.

The bubble continued and then broke because events moved against people and then as now, the bankers kept their mansions but most of them lost the better part of their fortunes.The essay assumes that there was ONE GIANT FINANCIAL VILLAIN without which the rise of benevolent national governments would have continued and everyone would have lived in peace and prosperity. This essayist blames the Venetians; others have blamed (who else?) the Jews. What is indisputable is that the bankers kept better books and minted more honest coin than the governments they lent to. How that allowed them to "control the Mongol Empire" and switch legal tender from gold to silver and back again remains unexplained. But, then, so does the modern notion that the Great Depression and the rise of the Nazis were mostly a function of the New York Fed's misadventures with the money supply.

The costs in blood and treasure of WW I, the influenza epidemic and the Tokyo fire and earthquake and the Mississippi Flood of 1927 were entirely incidental. What made people stretch so far for yield that they were willing to invest in match monopolies in the 1920s is the same cause that brought people to do serial refinances with the Bardi, Peruzzi and Venetian banks. Events had left most of them without the incomes they had come to expect so they borrowed and risked more and hoped to make it back when the weather changed and they won the next war.

Phil McDonnell adds:

I have to side with Bill Rafter on this. Arguably the Bubonic Plague may have begun in Europe when the Mongol Golden Horde laid siege to the nearby Genoan city of Kaffa in 1345. The siege was only broken when the Mongols were too badly stricken with the plague and forced to go home. Within a couple of years one third of Europe had died.

I think Plague and Mongols invaders would have a strong chilling effect on trade. Conversely, a banking panic cannot cause the Plague.

Steve Ellison comments: 

One of my pet peeves is the overuse of impenetrable equations in
peer-reviewed finance publications (and I think I'm pretty good at math;
I can still occasionally help my son with his calculus homework). To
cite a recent example, it would not seem to require calculus to explain
that spending on durable goods falls faster in a recession than other

Russ Sears replies:

Mr. Falkenstein's argument should be applied to all modeling, not just economic modeling. Even in a field with time tested product pricing models as actuarial science, I have found time after time that to truly add value, you must ask "where is the model blind spots?" People drove a convey of trucks through the MBS model's blind spot in pricing and ratings. And if left to their own devices FASB mark to market models would have driven all of us to a great depression. As I said at the time, (see A modest Proposal to the SEC)

They were blind to a liquid assets that can quickly turn illiquid and have huge liquidity premium on a mark to market model.Exploit the loopholes, and if nobody ask if this is simply a blind spot that you are exploiting, you will look great on paper like AIGFP… for awhile…until it become apparent that your resource allocation has a divide by zero error in it.

Modeling and regulatory modeling in particular, have replaced the central planner of the failed communist system.



The professor's wifeOne wonders if anyone out there saw any activities that bore the badges and emblems of inappropriate behavior out there today so that one can maintain my side of the discourse with Mr. Humbert. One noted a strong weakness in the last minute. Could that be the interference with the advantages of the closing prices of JPM and GOOG announcements from the flexes? Or was it more likely yet another wife (or significant other) of a professor from an ivy league university just using her knowingness for her hedge fund as in the free market reform expenditures they conduited, monopolized and discharged their debts in court thereto? Any help you can give me in this continuing discussion so that I can hold my own with my friendly adversary who apparently sees the best in all his former bosses and their colleagues would be appreciated.

Rocky Humbert states his position:

I am not an adversary of The Chair (friendly or otherwise). I simply question why, if the game is as rigged as he suggests, does he continue to participate– especially when more than 70% of the daily volume is attributable to high-frequency computer-generated algorithmic activity– which by its very nature must be a zero sum game. 

Nigel Davies writes:

I think someone will continue professional participation in a game as long as one believes that money can be made. Now there was always cheating in chess tournaments via the throwing of games for prize money and/or title norms, but this didn't stop the better players making money, especially because tournaments had external sponsorship.

But what happened after the Berlin Wall came down is that the bus loads of former Soviets both flooded the market and simultaneously increased the amount of cheating. All but 'elite', non bus-loaded chess events lost their prestige (and thus their external sponsorship) and forced the early retirement of 'professionals' starting with the relatively unsuccessful and gradually working upwards.

Could such a phenomena happen with markets? Very possibly, as once the game starts to get rigged and randomised the weaker pros plus passing wannabes will get driven out, reducing liquidity and making it harder for those who are left to remain. They might not feel the effect at first but the game would become increasingly unplayable.

In this light some early protestations about rigging are sensible as they just might help stop the rot. The creaking gate tends to get oiled and all that.

Nick White responds:

Re: "why bother?"

For myself at least, I would argue that it's a bit like in football.

A running back tries to get through the line and the secondary to make the play and score….most of the time he will get flattened or maybe gain small yardage. Every now and then he'll get creamed, or worse, fumble it to concede a TD to the other side. But - the opportunity to score comes from trying to find that little crease in the D to break into daylight. And so it is with us.

To know where those creases may open up on a given play, the player needs to study the film, know the schemes, know the players they're up against and the tells those players give out ( I recently watched an "America's Game" NFL film about the Patriots; on the other side of the ball, one of the coaches remarked how much they were looking forward to defending against a particular OL because this linesman gave up, without fail, whether their play was going to be a run or a pass by the stance he took at the line: if he was in a two-point, i think it was for the run, and three-point stance for the pass.)

So, there it is….it can be a tough game to play against the ebb and flow of noise; no one doubts that. But the key seems to be (no matter your trading stripe) to put yourself in the best position to find a crease, know the circumstances under which they are likely to occur– and then nail it for all it's worth.

Rocky Humbert adds:

But extending the metaphor, The Chair seems to be suggesting that (1) the referee is corrupt; (2) the other team's blockers are carrying brass knuckles; (3) the clock runs faster when you have ball possession; and worst of all, the Professor's Wife paid off the laundry guy to not-wash-out the bleach from your jock strap. Shall we still play a game?

(It didn't end so well for Mathew Broderick.)

Nick White writes:

I'm no conspiracy theorist. Maybe there's collusion and coercement. Maybe there isn't. I'll never know. I console myself that if I stick to my plans, I hopefully won't have much reason to care. I can only play my game, and (like you, Chair and others) play it staunchly by the rules.

I'm just pragmatic about the potential for shenanigans where there is a competition and money is the prize. To build in some redundancy into my bold assertions I'll try and give some allowance for 1-3. Four is more problematic…that's just going to hurt.

With the current running of the Tour de France, I'm sure there is much we can learn about systematic cheating and cover-ups.

Bill Rafter adds:

The fix or edge was always so, and is so now, but the markets and players have changed.

Many moons ago when my partner and I were active commodities traders (before they were called futures) we made a lot of money in certain markets. Our favorite venues were eggs, cocoa, bean oil and meal. For some strange reason we had the ability to ascertain the fix, but only in those markets. What interested us what that the egg market was clearly a rigged game, but the bean products seemed to be the essence of fair markets. Also of interest was that we could not get any edge in other obviously fixed markets such as bellies (and a tip of the hat to a certain former and future flexions cattle broker and her signiflexiant other). In the case of eggs we had strong evidence that it was the delivery particulars, and delivery also seemed to have an effect on the other markets we could play favorably. Delivery is very much the bailiwick of those in the know.

Fast-forwarding to today's equity markets we suspect that HFT is having a strong effect. Overall share volume had dropped precipitously from the highs of several years ago. It has recently returned to a decent level. But how much of that recent volume increase/recovery is HFT? If it is, then some part of the activity beyond 1-minute bars (or 5-minute bars) is going to be inefficient. For HFT should make the market more efficient in the shortest run, but ignores the forest for the trees.

We ourselves like the presence of HFT as it tends to give us better executions. And we prefer that the giants (e.g. Giant Squid) play in that shortest time frame. Someone has to take over the specialist functions, and better it be the well-capitalized firms. But anyone trying to compete in that time slot is going to have a lot of competition. And should one of the giants discover an opportunity in which THEY had limited, if any, big player competition, watch out. That is, a giant with the room to run a table most certainly will. And if the giant has a dealer at every table, sooner or later one is going to present such an opportunity. That in theory could have happened under the specialist system, but the specialists were constrained from doing so. No such constraint is in place now. The bailiwick of those in the know at this time is the HFT universe. Expect to be taxed by the bailiff.



1. Can anyone come up with ANY justification for retail parties' engagement in High Frequency Trading?

Russ Herrold writes:

Sure. First would you mind please:

1. Carefully defining: High Frequency Trading

2. Explain if you consider the taking of profit from a market to constitute an adequate 'justification'.

Bill Rafter writes:

Let me deal with them in reverse order:

If a market is inefficient such that a profit can be made by doing a trade to capitalize upon the inefficiency, the trade performs the simultaneous jobs of creating liquidity and reducing inefficiency (and making a profit).

Given that, it makes no difference whether the trading is high frequency or not high frequency.

By the way, I have no dog in this hunt, being a long-only equities trader who tends to hold for a minimum of 2 days.



Inigo v. WestleyThe Princess Bride Swordfight Scene shows a gentlemen's prelude, and how concealed ambidexterity can be a secret weapon, but can also backfire.

You will see Inigo Montoya very chivalrously allowing the Dread Pirate Roberts, aka Westley, to catch his breath after scaling a sheer cliff wall before beginning their swordfight.

Then as concealed ambidexterity is applied and revealed by both fencers one after another, the tables turn and turn yet again. But really the chivalrous Spaniard's eventual loss was sealed the moment he allowed Westley to clamber up over the cliff edge.

Chivalry, malevolence or (unjustified) pride in one's abilities?

Chris Tucker adds:

"The Princess Bride" is a movie that Aubrey simply must see. I love this movie; so do my kids. We find ourselves quoting Inigo at work frequently. "I do notta suppose you coulda speed things up?" or "I'm going to do him left-handed" or "You know what a hurry we're in!" or "It's the only way I can be satisfied" or "Inconceivable!" or "You keep on using that word. I do notta think it means what you think it means." Mandy Patinkin is priceless!

Bill Rafter adds:

"Never try to outwit a Sicilian," and "Do I have to get a new giant?"

Russ Sears writes:

My high school aged daughter tells me it is quoted all the time around her clique. Quoting it is the inside joke/ litmus test for those with verbal IQ versus those clueless.



The currently available data for M2, a slightly broad definition of money supply, show continued restrictive behavior. That restriction may be caused by the Fed, or it may simply be a lack of willingness of banks to lend. Regardless, the outcome means that inflation is not a risk in the foreseeable future. If anything the risk is for deflation if this continues.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy



the matrixRead this article on Random Matrix Theory: the deep law that shapes our reality.

Bill Rafter comments: 

This is a good intro article. I appreciated this part:

But when Bouchaud's team applied Marcenko's and Pastur's mathematics, they got a surprise. They found that only a few of these apparent correlations can be considered real, in the sense that they really stood out from what would be expected by chance alone. Their results show that inflation is predictable only one month in advance. Look ahead two months and the mathematics shows no predictability at all. "Adding more data just doesn't lead to more predictability as some economists would hope," says Bouchaud. 



 Here is a useful index of physical commerce in the U.S.

Bill Rafter reviews it:

That is interesting–an index based upon diesel purchases by long-haul trucks. They show you the charts, and to a small extent they are interactive, but there does not seem to be any back data available. If they want any recognition, they should put the data out there so the number crunchers can have a go at it. If it's worthwhile, the number crunchers will make it highly desirable.

It has certain distinct advantages:

It's based on thousands of real free-market transactions and not surveys.

Generally not revised.

Monthly with a two-week lag.

Has the potential to be more frequent with even less lag. Note U.S. treasury tax data is daily with a 1-day lag.

Because it is gathered (and presumably binned) locally, it could be used to track cross-border movements. There's not a whole lot of forex risk between USD, peso and C$, but the near-port area transactions could be of use with overseas forex risk.

Potential problems:

Long-haul truckers are very efficient in their avoidance of expensive diesel, taxes of which are state-based. So there's some potential for distortion.



Suddenly my "buy" list has a large number of companies which have never graced the list before. They are property and casualty insurers. Although they have sufficient capitalization, their volumes are too small for me to get involved. Does anyone know why they would be in favor?

Dan Grossman writes:

B RVolumes too small for you to get involved… You must be quite a heavy hitter, trading millions of shares.

I don't know what you mean by in favor, but because the insurance companies held mostly bonds, including mortgage bonds no one knew the value of, they were beaten down to very low levels, below book value, PE multiples of four or five. Now bond valuations are normalizing, and I guess the insurance stocks are returning to reasonable levels.

Scott Brooks writes:

I deal a bit in the insurance world and I have to say that this baffles me. Insurance brokerage firms that I deal with are hurting big time. Premiums are down as small businesses (which insurance brokerage firms have as clients) continue to layoff, not hire, and generally decrease payroll.

Maybe their revenues are down, but their margins are looking better, but I find that hard to believe since every P&C guy I know is busting his butt to bring on as many new clients as possible and bidding as low as possible to "buy" the business. The problem is that their competitors are doing the same to them.

Vince Fulco comments:

A few I follow remain at a healthy discount to book value (WTM, CNA) and I've been wondering when the rising tide would lift these ships–  since other industries are being given the benefit of the doubt that conditions are normalizing — and when would some of them get credit for adequate portfolio management and improving pricing and underwriting activity. Loosely speaking, a properly running P&C company can trade from .9-1.3x book and when the punch bowl really overflows, multiples of 1.5-1.8x are possible. Still plenty of room vs. normalized valuations. Why it has taken the crowd until now to really start bidding them up, I remain puzzled particularly vs. underlying corporate performance. It would seem the investors wanted to wait the half life of the bond portfolios to ensure no more problems as most run short duration portfolios.

Secondarily, there had been concerns within the industry about six months back that the Obama administration would go after the Bermuda-domiciled ones doing biz in the US for a bigger tax bite. That seems to have fallen by the wayside for now. Talking my book as I've owned WTM off and on for the last seven years.

Ken Drees adds:

The big question is since these insurance companies were screwed by their debt holdings, took writeoffs and have muddled through — some with Tarp but most P&C did not get Tarp — where do these companies park their cash now? They used to make money in the derivative leverage through the bond kingdom — outside of normal operational gains through underwriting. What is the risk of their holdings now? I don't see many stock buy backs from these guys and I don't see dividend rates that have gone up — both factors here would show that companies would rather pay out earnings or reinvest in themselves. Will they be able to ring the registers as normal through the bond markets? 

Kim Zussman replies:

At a recent lecture by a business law attorney, the take-away message was "everyone needs business practices liability insurance." He went through a litany of litigations; violations of overtime laws, rest-breaks, bonuses not being factored into overtime calculations, performance reviews, extensive paper-trailing, s_xual harassment (including a married doctor who had relations with a woman six times before hiring her, then continuing to pursue her on the job).

In an environment of increasing regulation/litigation, empowerment of little old ladies in lieu of rich guys, and increasing taxes, the deductible expense of increasing insurance coverage could make sense — even though lining pockets of bureaucrats and their legal co-conspirators.

Phil McDonnell asks:

Vince, I have a question. For CNA the ratio of receivables to revenue is about 100%, for wtm it is about 75% (by eye). That would correspond to 12 and 9 months worth of receivables they are owed by their customers. Are their customers really the slowest payers in the world or am I missing something? 

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Vince Fulco responds:

Not sure where you are looking but the largest receivables on the balance sheet from the last few years relates to business they've reinsured with others. WTM management is generally more risk averse than their peers and is inclined to cede segments of their business to better define their upside/downside. These arrangements have truing up terms, conditions and times which make the receivables ratio more lumpy than an ordinary industrial concern. The mix of biz between them and CNA is probably another factor.

If you are speaking specifically to 'insurance and reinsurance premiums receivable', they've been 21-22ish% of revenues for the last few years. I have no specific answer for that but it doesn't seem out of line if we think of the balance sheet as a point in time.



Painting by Rubens

The yogis say our true nature is joy.  When we're laughing and truly having fun, perhaps that's when we're most being ourselves - and not the product of something else. G.P.

It is easy to be jocular and personable when things are going well, but you get to see who you really are when things are going badly. The energy required to maintain interpersonal facade is redirected toward survival. The market is a very good mirror. And a very bad one.

Bill Rafter adds:

Who you really are is very much like a stock in Portfolio Theory. The good side is the rate of return, but most compare that with the additional information of the standard deviation of the returns.

Similarly a person should be measured along the same lines. The person who is happy go lucky most of the time but occasionally has bouts of violent anger is not as desirable a friend as one who is relatively constant but with lesser high points.

Each person responds differently to stimulus. And as with stocks it is the bad side that is most important. Someone who is in a funk for a long time has the risk of getting clinically depressed, with physiological damage to the synapses.

Ken Drees comments:

I always liked the saying that "not all great companies are great stocks". Forgot who coined that one–maybe from the Livermore books that I have read. Meaning that the stock of the good company may not act or behave well for speculation. In general, it is interesting how stocks are given human qualities by specs.

Alex Castaldo replies:

Forget about Livermore. The first to warn about confusing good companies and good stocks was the late Peter Bernstein in the Harvard Business Review in 1956.  The idea was followed up by many people, including Solt and Statman (1989) and most recently Richard Bernstein .  

Kim Zussman generalizes and extends:

Galton weighed in on this, with five big personality traits: Openness, Conscientiousness, Extroversion, Agreeableness, and Neuroticism (OCEAN) In modern times, add Yeswecannyness, Islamocapitalist, and Amelanotaxophile.



parabolaAn interesting and scholarly article on basketball angles and spins in the Washington Post, kindly sent my way by Dan Grossman of Florida, indicates that physics calculations show that the angle with which a shot is thrown influences its accuracy. The gist is that the higher the arc, the greater then chances it will go through. Also, the higher the height the ball is launched from, the greater the margin of error on the shot, and the greater the success. Taking one thing with another, a launch angle of between 45 degrees and 55 degrees seems best.

Angles have played a big role in stock market technical analysis. The most influential angles are those derived from the work of W. D. Gann who believed that when price breaks through an angle of 30, 45 or 60 degrees from a previous low to previous high, a continuation in direction of the break through was possible. As to how to compute the previous low or high, where it should start, where it should end, and what the time scale should be — why, that's why there are 1.4 milion entries on the subject of Gann angles with most concluding that they have been superceded by more sophisticated tools in these days of modern computers.

Being one to believe that taking the pencil to paper might help to find regularities, I computed some subsequent prices moves for the last 15 years for daily, weekly, and monthly prices. I looked at the angle between the two last moves of an index. For monthly prices, I looked at the subsequent moves following the moves in the previous two months. For example I looked at the moves in January and February to predict March. For weekly moves, I looked at the two previous weeks to predict the third week. For exampe the first and second week of the month to predict the third. For daily moves, I looked at the previous two days to predict the third. For example, Monday and Tuesday to predict Wednesday. The angles formed could be computed by using trigometric identities to compute the adjacent angles and noting that the sum of the three angles is 180 degrees. Here are the results:               

subsequent period   prior     previous    expectations   number of obs

monthly                    +         +                       4                53

monthly                    +         -                      -4                 41

monthly                     -         +                      7                 40

monthly                     -          -                      -6                33                                                                                                              

weekly                      +         +                      -2               185

weekly                      +         -                       4                186

weekly                       -         +                      -3               189

weekly                       -         -                        1               147          

daily                        +         +                      -0.7             952

daily                        +         -                       -0.5             898

daily                        -         +                        0                904

daily                         -       -                          1    744                                                                                                          

The many regularities that this table reveals are a good start to find angles that are useful for success in shooting for profits in markets. 

Bill Rafter offers:

If there is some mystical or otherwise relationship of price to time, it would perforce need to dictate the scale of the price charts for any angles to describe that relationship. In earlier times graphs and charts were drawn in pencil on standard graph paper, such as 10 x 10 to the inch. If everyone kept the same charts in the same scale, an argument can be made (i.e. the self-fulfilling prophesy) for various angles, Gann or otherwise. However the person who used a scale not similar (in the geometric sense of the word) to the standard scale would have different points of intersection with respect to the same angles as the standard scale. Fast-forward to today and we find computers rescaling charts to fit on the visual page to the extent that no longer is there a standard scale. So at the very least, there can no longer be a self-fulfilling prophesy. Whether there is a price-time relationship, I do not know. But the next time I see Master Yoda I will ask him.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy

Jim Sogi writes:

 One of the problems is asymmetry. Contrary to symmetry theory, the markets are not symmetrical. It makes the Gann ideas or other symmetrical equations inaccurate. This includes normal distributions.

Sushil Kedia comments:

A few years ago Mr. Sogi had written a review of a book from a publisher in Australia providing co-ordinate geometry treatments of the Mathematics of the Divine Ratio. The Chair and Dr. Castaldo too have written about the applications of polar co-ordinates to transforming prices to study appropriately, thereon. Perhaps a number of ideas from that book could be applied to produce suitable transforms and then fitments to the effect of say treating the rate of drift as equivalent to an angle of zero or one would provide perhaps some worthy examinations of the other standard angles as 1/3rd or 2/3rds (pi/12 or pi/6) etc.

Jim Sogi replies:

Why is it that the last few weeks, the price followed an upper and lower line so well as moving mechanically upward? It has kind of broken that recently, but it seems more than random things the mind puts together like a taking patterns out of random dots. I've graphed random series and seen the so called trends, but they don't seem as linear. And it seems to continue for days and weeks.

On the subject of the negative time idea Rocky talked about earlier, and since it's spring now, a look at our Gregorian calendar shows the inaccuracies in the counting system. Assume as a mind experiment that the market operates on absolute time. Given an inaccurate Gregorian system, at times the measurement of absolute time might appear to jump or reverse at various adjustment points. See the wikipedia entry on Julian Day Calculation and on the accuracy of Gregorian Calendars.

Pitt T. Maner III writes:

John WoodenThe discussion on shooting angles in basketball reminded me of one of John Wooden's favorite ideas which is to use the backboard or "glass".

Within days of implementation of this new 'back' board, players found that they could gauge the angle and use this new tool to their advantage to make shots. The problem today is that players have either forgotten or never learned its full advantage. Arguably the most successful coach of his era and probably of all time, UCLA Hall of Fame Coach John Wooden was renowned for teaching his players to use the glass both in the post and especially off of fast break transition. Coach Wooden's teams won 9 straight NCAA Titles (10 in 11 years) a feat unparallel before or since in collegiate basketball. Coach Wooden believed that if his players practiced making 5-10 foot bank shots at the 45 degree angle off the break and could make them at a rate of about 75-80% these shots were nearly as good as getting a lay-up. For those young players that missed the opportunity to see the great UCLA teams they were almost always successful in transition. Probably the single greatest scoring performance ever in an NCAA Championship Game was by UCLA's Bill Walton’s 21 for 22 field goal shooting performance against Memphis in the 1973 title game. Bill Walton’s' patented move was the up and under using the glass.

I have found that it is possible to use the target square on the backboard to advantage when shooting free throws and banking shots in instead of trying to get a "swoosh" each time. Having a visual target behind the "bucket" seems to help.

Banking in shots, however, is probably best used (like Wooden suggests) when shooting from the sides in basketball. Wooden believed in playing percentages and when a basketball hits the backboard it has almost a "second" chance of going in as opposed to hitting the front or side of the rim or completely overshooting or undershooting the mark. I think the coach would have preferred a sure layup over a dunk any day—and how many times has one seen a sure dunk pop out when thrown down with too much force when a layup would have scored two.

Not quite sure what a market analogy would be for a backboard–perhaps some type of straddle where you can make money on the continuation of the angle in either direction?At any rate one of the fun aspects of the NCAA basketball tournament is getting a chance to see various styles of play and the leveraging of seemingly higher risk approaches. The Cornell–Kentucky game on Thursday night, for instance, if it stays close, could be an example of excellent, confident outside shooting and defense vs. more pure interior power, younger talent and athleticism (and good outside shooting too). But as they say, you can "live and die by the 3-pt. shot".



It happened.

For the first time in over two years the year-on-year growth in payroll tax receipts is positive. That is, the somewhat less negative jobs news that has been circulating is not phony. In the past we anecdotally observed some identical anomalies in both these data and the BLS jobs data, and the BLS anomalies lagged the Payroll Tax data by about five weeks. That makes us believe that no matter what happens to future payroll taxes, the BLS numbers will be positive for the next month or so. Certain politicians will take credit for it, and there will be a bullish tone to the stock market.

N.B. We do not use these data to trade the stock market, but think they're valuable nonetheless.



For what it's worth, here are representations of the velocity of money, which is defined as the nominal gross national product divided by the money stock.Velocity tends to tank in a recession and recover thereafter.

Ken Drees replies:

Since arrow mzm = s&p, money base is non confirmation? Should not all three walk together?



I'm looking for some new/better ideas on how to calculate the vig in ETFs, versus the vig in futures, versus the vig in the physical.

Bill Rafter replies:

Not all ETFs are taxed identically. Specifically the inflation-averse would be warned that GLD is set up as a grantor trust and not as a 1940 Act fund. Profits in GLD are taxed as collectibles.

This points out that "structure matters". For example if you own an ETN (note) rather than an ETF (fund) you are subject to counterparty risk. Some people have chosen to gloss over the distinctions and refer to them all as ETPs (products), and that homogenizing tends to mask the counterparty risk. For example, LEH had issued a few ETNs whose owners are now waiting in line with all of LEH's other creditors. Barclays is the counterparty on INP (ETN representing India), which presumably would be okay. But why take the chance when you can buy EPI, the Wisdom Tree offering which is a true ETF?

How do you find these things out? Read the prospectus, something very few do anymore.

Nick White writes:

Deep and mysterious are the secrets that one can behold if they are willing to brave the legalese, break out pad and paper and delve into these sometimes fantastically structured products.

Rocky Humbert comments:

There were/are a whole load of those ETNs out there — additionally, the IRS issued a ruling about a year ago that changed the tax treatments for the currency ETNs. Currently, some of the narrower futures are under scrutiny by the IRS, and some foreign (unregulated) futures don't qualify for Section 1256 at all. Another example of the hazards of the ETFs are also the changing CFTC rules regarding position limits — which caused the UNG and USO to diverge from their NAV. At one point the UNG was trading at a 19% premium to NAV. If one is short the ETF, one cannot redeem the position, so there is no theoretical limit on how far the premium could go. In contrast, if you buy the ETF at a discount, you can always redeem it and close the arbitrage to the underlying. 



There is a very big "shoot the moon" increase in the Base.

Bud Conrad comments:

Here is a chart from St Louis Fed of Monetary base

Bill Rafter adds:

Terse: a big increase in money stock (money supply). That would normally tend to be inflationary, but BSB just yesterday told us there is no inflation. (And he was correct.) Typically the Base tends to grow at an exponential rate in the low single digits. However with the banking rescue programs there was an astounding 100+ percent increase from Sept 08 to Jan 09, and another big increase from Aug 09 to Dec 09, and now we are at it again.

The reason there has not been inflation is that this expansion has not gone anywhere beyond the (big) banks. If you look at other versions of the money stock such as M2, you see that there has been no such increase. In fact, M2 has been showing contraction relative to its long-term target. It will be most interesting to see the M2 numbers to be released today. A big increase in M2 would make the case that inflation is finally coming. No increase in M2 would state that we are just getting more of the same, specifically that the Fed has been putting money out to the big banks (at zero interest) and then allowing them to simply leave that money on deposit with the Fed (at interest). This process is just a subsidy to the banks.

The important question to me now is why the latest increase? Are the banks in further trouble? Does this anticipate more trouble, say with commercial real estate?

Given the colossal increase in the Base, some of it will bleed through to M2, which probably explains the current increase. However note that M2 is still below its long-term growth rate (what I call the fit or target), so effectively practice (as opposed to policy) continues to be restrictive.

At some point "somethin's gotta give": The Fed could start taking down the Base. They probably will just reverse the policy of paying interest on deposits left with the Fed. At that point the banks will return much of their borrowings back to the Fed. Some of them may not, and choose to start pushing commercial loans out the door. Then you will start to see increases in M2 and the earlier increase in the Base will become inflation. That at present is the only reason why I watch this data.

Mick St. Amour comments:

Bill, this proves my theory that fed is fighting deflationary forces given contraction in lending and collapse in monetary velocity. Given we are in balance sheet recession, reflation of assets/collateral values is main goal of central banks everywhere. It is key to stoking animal spirits in the markets and in real economy. I suspect this provides tailwind for asset classes such as equities and commodities.

Rudolf Hauser comments:

It might be worthwhile to remind readers of what the demand for money is in a non-inflationary economy. It is the amount of money people in the aggregate wish to hold (emphasis on hold, not spend) plus that needed for transition in transactions (the amount involved that is held up by the clearing process) in an environment of just real growth or decline. That applies to both high-powered money (the monetary base) and measures such as M2. If that amount is not provided banks will attempt to increase reserves by reducing investments and loans. Paying interest on reserves increases the banks demand for reserves (excess reserves), as does increased caution on their part. You will only get M2 to grow if banks are more aggressive in investing and lending. Since there are no longer reserve requirements on (M2-M1) all of the reserves related to this are excess reserves. If the Fed were to stop paying interest on reserves a bank could profit from such reserves by buying 3 month or probably even 1 month Treasury bills as long as the return were in excess of their processing costs since the reserves used to buy those securities is zero percent financing. But to buy treasures they have to pay the buyer, which increases bank deposits, i.e., M2 (and M3). The banks cannot drain total reserves from the system– only the Fed can do that. If the Fed wants to keep excess reserves from being used it can discourage that use by raising the interest rate it pays on excess reserves. To repeat, lowering that interest rate only leads to more rapid monetary creation-something that I suggested would be desirable here to accelerate M2 growth to a rate that does not drive us into another economic down-leg in a few quarters from now.



Dr Rafter

There is an upcoming article in TAS&C (April 2010) by David G. Hawkins that deals with modifying Price Volume Trend Indicator, a 1980 variation of Granville's OBV indicator. The article is chart-based rather than statistics-based, but there are a number of talented readers who could correct that, should they wish. The article references two contributions to TAS&C by Larry Williams (2000 and 2004). What is interesting to us is that he overlays a linear-scaled indicator onto a log-scaled price, recognizing that most indicators behave linearly while equity prices do not. We had long noted that, but never thought of superimposing the one chart onto the other.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy



Volume, from Jim Sogi

February 2, 2010 | 2 Comments

Interesting drop in volume on today's up move in ES:

2010-02-01, 1896011
2010-01-29, 3068079
2010-01-28, 3052088
2010-01-27, 2634603
2010-01-26, 2449263
2010-01-25, 2080292

The old TA theory is that an up move on low volume is weak, and a down move on increasing volume is strong, but it doesn't prove out scientifically.

Sushil Kedia comments:

A homegrown theory I developed borrowing on the Chair's applications of the concept of struggle to markets interprets volume as a struggle for price discovery. Extending this with memetics, a higher volume indicating a higher struggle for price discovery meme implies an ongoing persistence of the meme. So, within any time frames or patterns or noise, if you perceive a meme then interpreting lower volume as lesser struggle tilting towards consonance and thus implying a fading meme comes by. This way of looking at price and volume relationships does lead to several testable ideas getting the gut feel closer to science.

Bill Rafter writes:

The only use we have found for volume is as a surrogate metric for volatility. Indeed S&P volume and VIX have very interesting relationships. However the standard TA mantras that  (a) volume “confirms” price and (b) volume-weighting indicators makes them better, have not been confirmable.

Here is an excellent graphic I prepared relevant to volume.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy

Kim Zussman writes:

Here's another check. SPY daily returns (c-c), with volume traded, 1993-present, were used to check for big up days = >+1% (0.01). Then calculated relative volume (RV) as:

(today's volume) / (average volume prior 5 days)

Then compared next day's return for two cases; if it followed a big up day which had low RV (RV<0.8) or a big up with high RV (RV>1.3):

t-Test: Two-Sample Assuming Equal Variances

                       low RV      hi RV
Mean               0.0010    -0.0015
Variance          0.0002    0.0002
Observations        151    146

Pooled Variance    0.0002
Hypothesized Mean Difference    0.0000
df    295
t Stat    1.5263
P(T<=t) one-tail    0.0640
t Critical one-tail    1.6500
P(T<=t) two-tail    0.1280
t Critical two-tail    1.9680



(Caveat: easier said than done)

SPY monthly returns (1993-present, with div) were checked for a normalized proxy of intra-month range = (H-L)/C. The series was then ranked by range, along with corresponding monthly returns. These monthly returns were multiplied for the entire 17 year period, which gives a total return of 3.35 ($100 became $335). This was then repeated after successively skipping first the highest range month, then second, all the way to skipping the highest 100 range months. This allowed evaluation of the effect of being "out of market" on final compounded return - whether or not the high range months were up or down.

The graph below shows the effect. Cpd return is the green line, which rapidly increases by skipping (and investing in "cash" = multiplicative return of 1.00) the highest range several months, and continues to outperform B/H up to 100 months skipped. Range of skipped months is plotted in red; for scale on this graph multiplied X10 (eg, range of 0.34 shows as 3.4).

Here are the compound returns, successively skipping the top 20 range months, with dates:

Date             ret       H-L/C     CPD
10/01/08    0.83    0.34    3.35
11/03/08    0.93    0.29    4.01
07/01/02    0.92    0.24    4.31
09/04/01    0.92    0.21    4.68
03/02/09    1.08    0.20    5.10
02/02/09    0.89    0.19    4.70
08/03/98    0.86    0.18    5.27
09/02/08    0.91    0.17    6.14
01/02/09    0.92    0.17    6.77
10/01/98    1.08    0.17    7.38
03/01/01    0.94    0.17    6.83
10/01/02    1.08    0.16    7.23
10/01/97    0.98    0.15    6.68
01/02/08    0.94    0.15    6.85
09/03/02    0.90    0.15    7.29
08/01/02    1.01    0.15    8.14
04/02/01    1.09    0.14    8.09
03/01/00    1.10    0.14    7.45
04/03/00    0.96    0.14    6.79

In fitting with decline = volatility, only 6/20 biggest range months were up.

Steve Ellison writes:

Using Dr. Zussman's results as a starting point, since I am not very good at determining the monthly range before the month begins, I checked what would happen if one skipped the month after a month with a high range. SPY total return including dividends from the end of 1993 to the end of 2009 was 3.14, for an average monthly return of 1.0060. If one held cash in all months following a month in the top 10% of ranges to date, and held SPY in all other months, total return would have been 1.98, with 140 months in the market and 52 months out. Average monthly return would have been 1.0049.

Since the end of August 2007, however, the average monthly return following a month with a range in the top 10% of historical values has been 0.9707, while the average monthly return of other months has been 0.9992. Thus, substantially all the losses of the last two years occurred in months following months of very high ranges.


 Month ending   H-L/C   H-L/C Position Return

    9/30/2008    0.18    0.13     in     0.9058
   10/31/2008    0.35    0.13    out   0.8349
   11/28/2008    0.30    0.14    out   0.9303
   12/31/2008    0.12    0.14    out   1.0098
    1/30/2009    0.18    0.14     in     0.9179
    2/27/2009    0.19    0.14    out    0.8925
    3/31/2009    0.21    0.14    out    1.0833
    4/30/2009    0.12    0.14    out    1.0993
    5/29/2009    0.08    0.13     in     1.0585
    6/30/2009    0.08    0.13     in     0.9993
    7/31/2009    0.13    0.14     in     1.0746
    8/31/2009    0.06    0.14     in     1.0370
    9/30/2009    0.08    0.15     in     1.0354
   10/30/2009    0.08    0.14     in    0.9809
   11/30/2009    0.08    0.15     in    1.0615
   12/31/2009    0.04    0.16     in    1.0191

Rocky Humbert asks:

Is this study and its results more than a reflection that (historically) a higher VIX → lower return?

Bill Rafter comments:

VIX is simply one form of volatility. It is logical to assume that some of the other forms may lead VIX, and that those may be causative and have predictive value. If they have predictive value for VIX and VIX is coincidental with declining equities, then you have something on which to build.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy



I have recently been exposed to the wiles of many a con man. I wonder what revisiting the subject of the techniques of the big con could teach us about the current situation in the markets. I think of such things as leaving the victims fearful of claiming restitution at the end, and the imprimatur of the respected elder at the beginning. What is missing to the layman is the degree of complicity of the victim. What do you think?

Scott Brooks responds :

High level cons: Con men seem to prey on issues that the Victim has, at least, a peripheral knowledge of or experience in. This allows a con to speak to the Victim and use words and situations that the Victim can relate too.

The key to this is it allows the Con to mix in just enough truth to get the Victim to agree with the con on some points, thus showing that Victim that the Con knows what he is talking about, as well as add an air of expertise to the Con's resume. The "truth" that Con mixes in are the "white swans" that the Mark so desperately wants to see.

This is a Con's ultimate fantasy, because the Mark will then do most of the work to build up the Con's resume in his own mind as the Mark see's a world swirling in white swans and purposefully ignores the black swans.

The con shows some small and perfectly plausible area/idea that has not yet been exploited (the exploitation point or EP). If the Con can build up Mark's confidence in him by supporting the exploitation point with some sort of 3rd party reliable material, then the Mark will further build up the Con's "Cred's" in his own mind. Even if the 3rd party material is only tangentially related, it will be viewed as more white swans by the Mark.

The Con will then play up the profit potential of the EP and get the Mark very excited. When he plays it up, he has to be careful not play it up too much……..his figures have to be appealing, but can not sound, "too good to be true". If the Con is smart, he will then "play down" the profit potential that he just built up to show that he's not some "pie in the sky"over seller and that he has a reasonable outlook on the profit potential….i.e. "Now, I know those numbers are exciting, but let's look at the downside….." He then shows what appears to be a reasonable low end profit potential.

The Con will then spring the trap…..and spring it with a sense of urgency.The con will usually request a reasonable amount of money that the Mark won't have any trouble accessing and can quickly write a check for….BUT…..the money will be needed within a short period of time…usually right there on the spot. If the Mark balks, the Con will back off and let the Mark tell him when he can have the money available. Lets say the Mark says that he can get the money to the Con on Wednesday. The Con will usually make a reasonable request and say, "I can only hold out until Tuesday. So can I get it on Tuesday instead of Wednesday"

The Con will then usually say something like, "Okay, great, let's do it on Tuesday. Now the banks don't post any deposits after noon for that day, so I need to make deposit before noon on Tuesday.Can I come by at 10 am on Tuesday?" The Con will then usually treat the Mark to lunch to pick his brain about the Mark's idea's about how to move this forward and solicit any advice the Mark can give, based on his extensive knowledge of (whatever the Mark has extensive knowledge of) and how it might apply to the EP (which the Mark has a peripheral knowledge of). More meetings will be scheduled to go over "details" between now and the day the check is to be picked up so the Mark will feel involved and and excited about the opportunity. At these meetings, the Con will play to Mark's ego and let the Mark brag to the Con that he has lots of money…and the Con will then drop very subtle hints that more money may be needed in the future. By now, the Mark feels very good about the Con and feels that they are closely bonded due to this "insider secret" that they both share. The Mark will want to enhance this feeling of closeness as it is the "white swan" in their relationship and allows the Mark to ignore the "black swans" that he needs to be seeking that are sometimes screaming but often whispering,"you're being conned". When the Con picks up the check on Tuesday morning, he arrives a little early, gets the check and has a refresher "rah, rah" meeting with the Mark and gets the Mark even more excited…..the Con will usually have some"extra" good news about the EP that has just come to his attention and it will likely involve some sort of 3rd party expert saying something that is related (usually in a very tangential manner) to the EP that the Con displaying the Mark on.

The Con will then return as many times as he can to get more and more money from the Mark, always playing to the emotions of the Mark. Even if the Mark begins to have doubts, he'll not want to waste all the money he's put into the EP so the Con will be able to get money from the Mark even after the doubts begin (the mind of the Mark says "I know I'm $200k into this thing,so investing another $20k is not that big of a deal if we can pull this off.Heck all good things take time and are little harder than we initially expect"). This goes on until the Con can't get anymore. There are many more steps and an infinite number of variations on the"Con/Mark" relationship. But many of those relationships contain most of the factors that I've listed above. 

Bill Rafter comments :

Bill RafterIf one were to tell “others” (i.e. not in our immediate circle of market watchers) that the market was pulling a con on us, they would think us more than a little paranoid. However if the market is the digested knowledge (and emotions) of its collected population, then thinking of it as sentient is not too absurd. Once we have accepted that, however, it’s a fine line between what comes after and paranoia. What is the first concern of a sentient being? Self-preservation. Now for a market to keep itself alive, it can never allow any one participant to gain such an advantage that the participant wins all the money. Should the latter happen, the market would be destroyed. Thus the market’s future existence depends on its not letting anyone get an insurmountable advantage. Consequently, there can never be a “Holy Grail” or flawless indicator. Perfection in trading can only be defined in statistical rather than absolute terms. Once you realize that you find it easier to live with your mistakes.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy

Alston Mabry comments :

In considering the elements of a con one is inevitably drawn to the rich genre of American Movies, which for the most part have glorified the con man. David Mamet gets a lot out of the con. See:

1 House of Games

2 Homicide

3 Heist

4 The Spanish Prisoner

5 Spartan

6 Redbelt



B RafterAs previously mentioned, we track three monetary aggregates and their deviation from target (based on a historical fit).

The triptych presented here is the progression from the Base to MZM to M2 reflecting a decrease of Fed control and concomitant increase in shadow banking control.  (N.B. I have shortened the charts to get them on the same page.)  The progression also shows that the Base is extremely expansionary while M2 is actually restrictive.  That is, Money Supply as defined by M2 is restrictive in the current depression.  The liquidity provided by the Fed is not filtering out to the population at large but being used to rebuild bank balance sheets.

This scenario (assuming it persists) has implications for recovery and inflation.  That is (in our opinion) neither is likely to happen soon.  But you can draw your own conclusions.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy

Vince Fulco adds:

As a additional resource, this Fed paper delves quite clearly into why excess reserves are not necessarily inflationary both due to their composition and interest payment policies created specifically for the post-crisis period.

Why Are Banks Holding So Many Excess Reserves? [PDF, 380kb]
Todd Keister and James McAndrews
Federal Reserve Bank of New York Staff Reports, no. 380, July 2009



The Fed has the most control over the Monetary Base, less control over MZM and even less over M2.  Interestingly the Base has doubled with the Fed’s activities, but those activities have had a much reduced effect on MZM and almost negligible effect on M2.  This means that the extra money is being held on deposit by the banks (helping their bottom lines).  With no bank-lending-created expansion of money, any inflationary or bubble argument is diminished.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy

Steve Ellison recalls:

I feel like I have seen this movie before. In the early 1990s the banking system was in trouble, and the Fed's actions were considered ineffective — "pushing on a string". The next phase was the jobless recovery, in which Bill Clinton was elected on the platform of "it's the economy, stupid" 18 months after GDP growth turned positive. As late as the fall of 1993, Barron's ran a cover story on efforts to rescue homeowners with negative equity. This entire period was a great time to own stocks. It wasn't until the economy was unmistakably strong that the stock market ran into trouble in 1994.

Bill Rafter adds a picture to his comment:

I refer you to this graphic that will illustrate the point.

As you will see, M2 is below its target rate of growth. That’s contraction from a monetary policy standpoint. That means no inflation.

What would happen if there was an increase in bank-lending-created money? Well, what do you get when you increase a fiat money stock without an increase in goods and services? Increases in prices; loss of confidence in the currency.



PhilAAA rated bonds are the best corporate bonds available. BAA represent a somewhat riskier class of such bonds. So, using St. Louis Fed data monthly (series AAA and BAA) it might be instructive to look at the yield spread between the two bonds versus the monthly returns of the Dow Jones average. The yield spread was calculated as BAA - AAA yield from 1928 to the present. The spread is currently near historically high levels and thus seems especially relevant now. One way to think of the yield spread is as a measure of fear in the bond market or as a measure of the current availability of credit to riskier corporations.

The following correlations are for the yield spread lagged n months ago. Zero lag is the concurrent relationship. To be significant at the 5% level, two tailed with n =1000 the correlations should be above 6.2%.
Lag    correlation
12     0.054331609
11     0.060955747
10     0.05292927
9      0.039778526
8      0.035184767
7      0.01231181
6      0.000377968
5      0.004196862
4      0.008836528
3      0.027029827
2      0.043577867
1      0.030773782
0     -0.03036919

But what is interesting is that they are all positive at the various lags. In other words if there is a credit crunch indicated by a larger yield spread, then stocks subsequently go up. This is not what one would have expected.

Suppose one were able to obtain a newspaper for the yield spread over the next 12 months (in the future). Well the correlations between the Dow and the future yield spreads were as follows:

Lag   Correlation
1    -0.112798121
2    -0.126495119
3    -0.124710641
4    -0.096857777
5    -0.107535598
6    -0.112776958
7    -0.117648043
8    -0.10364356
9    -0.117856956
10    -0.134941986
11    -0.137242692
12    -0.148479036

They are all negative and statistically significant. Again not what was expected.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Charles Pennington asks:

Is this summary correct:

1) High (or rising?) yield spread predicts excess positive returns for stocks in the future, though not statistically significant and 2) Rising stocks predicts narrower than average yield spreads in the future?

If so, then why would you find item 2 to be "not what was expected"? I would have expected that rising stock prices would lead to lower yield spreads, as you observe.

Also, it sounds like you've used "levels" rather than "moves" for the yield spread. I would think that the yield spread is something that moves around on a fairly slow time scale, and that there would be a lot of serial correlation in its level from month to month. That would explain why the second set of 12 numbers are all about the same.

Phil McDonnell responds:

Your first and second points are correct.

It has long been held as common wisdom on Wall St. that yield spreads indicate credit conditions, and that widening spreads predict stock market problems. In this case stocks seem to predict yield spreads. As always you make a good point. I did use levels in the yield spread only, percent changes in the Dow. It is probably worth looking at the changes as well.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Bill Rafter adds:

This number was down to a -349 and has now risen to -259. Above -270 it took out the post-LEH, post-TARP periods, meaning that the credit problems associated with those events have been rendered old-news by recent behavior. It's nice corroborative information but not actionable, in my opinion.

More important than this is that the "dumb" money is still short, and still shorting the rally.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy



 On February 1st, Cassandra picks up the Wall Street Journal outside her door and discovers that it is the paper for March 1st, one month in the future. She does not know what to do with it, and no one believes her story, so she simply saves the paper. The next day, February 2nd, the paper dated March 2nd appears. This continues unabated. Come March 1st Cassandra checks the actual stock prices and sure enough they all match the prices in her originally-delivered paper. Likewise with all of the subsequent newspapers.

Soon Cassandra puts a PC to use and starts ranking stocks on their average 1-month growth rates based on this perfect knowledge. She then partitions her available capital into 21 tranches and each day purchases in equal values the 200 stocks of the Russell 3000 expected (actually "guaranteed") to do the best over the next 21 market days (1 calendar month). This partitioning eliminates any start-date bias. The returns she achieves are the best possible for a buy-and-hold strategy over that time frame. After all, it is the result of perfect look-ahead bias. Returns for this, the control group from 2001 through 2008, are a not-surprising 25.53 times her capital per year.

John B says, if you give a trader any system, no matter how good, in half an hour he will have modified it in an attempt to improve it. This is true even when perfect foresight is present, and Cassandra succumbs to her curiosity. You see, Cassandra is uncomfortable with the decision to buy-and-ignore. And she is correct to be uncomfortable. She has this constant stream of excellent information, albeit for later periods. It has to be worth something, according to information theory. And Cassandra's intuition is legendary.

Cassandra alters her trading in that she will now only hold her positions for 15 days instead of 21 days. She does this without knowing in advance what the prices will be 15 days after her purchases. When Cassie sells the portfolio on day 15, she will then purchase another 200 stocks based on their next 21-day forecast. Now of course, she is investing with sub-perfect knowledge, because she does not know the price of those stocks on day 15. She is using knowledge farther in the future to trade for a date shorter in the future. Intuitively it would seem unlikely that she could tinker her way to a better return than the perfect portfolio. But she can, and does so repeatedly. Strategy A beats Strategy B, where Strategy A consists of more-frequent forecasting and trading with sub-perfect knowledge, and Strategy B consists of less-frequent activity with perfect knowledge. The 15-day recast produces 39.52 times her capital per annum, about half-again better than the control.

Encouraged by the success of active investment management over a seemingly-unbeatable investment, Cassandra shortens up even more. She still forecasts 21 days ahead on the basis of the newspapers, but she only holds 10 days, or half the forecast period. This produces a whopping 138.53 times her capital per year. Recasting every 5 days produces 56.62 times her capital annually, less than 10 days, but greater than 15 days or the control period of 21 days.

Additionally, these experiences were not limited to monthly forecasting. Trying to further game the system, Cassandra subscribed to Investor's Business Daily, which arrived always a calendar quarter ahead. Her control group 63-day (quarterly) returns were 5 times capital each year. But reducing the holding period to 2 months increased it to 12 times, and reducing it to one month produced returns of 10 times. From 5 days out to the forecasted time in both the monthly and quarterly scenarios, the improvements were universal. Furthermore, extending the holding periods beyond the forecast period was universally worse. This is also true for different rate of return ranking processes. That is, it works identically whether one uses exact rates of change or regression rates of change.


There are two possible explanations for the increased profitability. The least obvious factor would be portfolio rebalancing of an entire portfolio every time new positions are taken. Indeed, rebalancing tremendously adds profitability and the more frequent the better. However in this study rebalancing was excluded for any unchanged holdings. In this study new positions would have had an equal value allocation, and existing positions were left alone to grow or decline in value, unchanged in size until liquidated. Thus with rebalancing absent, there can only be one explanation - that more frequent forecasting is more profitable, even better than some forms of perfect knowledge.

What About Risk?

Increasing profits without consideration of risk is foolhardy. It is worth noting as an aside that perfect knowledge does not always produce profits in every period. This is a long-only strategy in which Cassandra is purchasing the top-200 ranked stocks. There are some periods when virtually all stocks decline, or at least when the average return of the top-200 is negative. Thus we must consider the dark side of investing.

One of the distinct advantages of more frequent analysis and forecasting is that losses get cut earlier, providing damage control. Given the inclusion of risk into the equation, shortened time horizons become exceedingly obvious in the role of risk reduction. Recasting our 21-day forecast every 15 days produced an annual return of 39 times one's money, but at the risk of a 30 percent decline in capital. At 10 days the returns were 138 times, but with a 47 percent drawdown. At 5 days, the returns were 56 times, but the maximum drawdown was only 14 percent. Thus 5 days had a reward-to-risk ratio of 391, compared to 292 for 10 days and 127 for 15 days. The monotone progression makes the point. And it is confirmed in the quarterly data as well; the risk-adjusted rewards are improved by ever shorter forecasting periods.

What Are the Practical Applications?

Here we see a situation in which our investor has perfect future knowledge and yet she is absolutely advantaged by re-evaluating her decisions with increasing frequency. This is essentially a conflict of two mutually-exclusive ideas. On the one hand, perfect knowledge has to win, and indeed it will over that exact period. However it is also intuitive that more-frequent information would be beneficial, if one is willing to shorten the trading period. And here we have evidence of the latter's success over a perfectly-chosen portfolio. If active management can improve a portfolio chosen with perfect foresight, surely logic dictates its value on a sub-perfect portfolio. That would have to be proven, but any of those results would be dependent upon a particular investment or trading program. The beauty of this particular study is that it is program-independent. The clear lesson from this is that any financial advisor who tells you to buy an investment and ignore interim news or market action is repeating some time-honored advice that is clearly and profoundly wrong. The buy-and-ignore strategy only works if you or the advice provider is unable or unwilling to devote more time to your investment analysis. Clearly lack of perpetual investment diligence applies to many investors and advice providers, but the costs of that ignorance or intransigence are generally dismissed.

The purpose here is not to suggest a specific trading frequency, but only to suggest that the trading frequency should be a shorter number of days than the forecasting horizon. Over time there will certainly be sweet spots, and one should not assume those to be constant. Some traders will argue that they trade without making any forecasts. However, every trading decision is at least an implied forecast.

Technicians of course practice their craft with increasing analysis frequency, and they should gain comfort with these results. But some technicians also look at less frequent data, and this work should provoke caution in that regard.

Some fundamental analysts would argue that it is not possible to increase the frequency of analysis. Assuming the fundamental variable of Earnings (released quarterly), that would be true. However the Price/Earnings ratio is available daily, albeit based partly on a quarterly number. Greenblatt ("The Little Book That Beats the Market") uses only two ratios as inputs: Return on Capital and Earnings Yield, and produces daily recommendations. Likewise Haugen ("The Inefficient Stock Market") uses approximately 70 inputs (several of which are technical) very frequently despite the fact of some of their precursor variables are only available quarterly.

Furthermore, the rationale for frequent use of fundamental information is abetted by the blurring of the definitions as to what constitutes technical versus fundamental information. Something we have learned as a result of the recent market declines is that at least one of the major credit rating agencies (S & P) reevaluates its company ratings partly on the basis of a company's stock price performance. A big drop in the stock price might earn that company a downgraded rating. Thus daily priced-based activities (a technical factor) become part of the fundamentals of that stock.

What Prompted This Research?

With so many things to be studied, why spend time on such a seemingly esoteric idea? Well, it's not so esoteric. In our research we had attempted to look at longer time horizons, as we wanted to hold our positions longer. The investment community has sold its customers on the concept that more frequent analysis/increased trading must be bad for the investor. The government effectively limits more frequent trading for IRA accounts, although it is allowed for qualified pension plans. Consequently we started crippling our research to make it equal to "industry practice". Every time we did that we experienced declining results. That of course suggested that targeting separate time frames for forecasting and trading could be advantageous to any trading program.

Research Notes

To eliminate survivor bias our list of the Russell 3000 stocks from 2001 through 2008 consists of about 4200 stocks, the difference being those deceased, merged or otherwise eliminated. The constituents were obtained directly from Russell.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy

Jim Sogi comments:

Absolutely fascinating. The reduction of risk seems to be a main factor as the rate of variance goes down faster than the decline in profits. Is there a sweet spot for maximum risk/reward, or would it go down to the vig as the timeframe shortens? An exercise for the reader?

Charles Pennington comments:

I know it's problematic to use the word "obvious" in mathematics, but isn't this obvious? The un-updated predictions are partly about the past, not the future, and to that extent they don't help you as much as the updated predictions would.

Bill Rafter responds:

Bill RLots of things are obvious and still ignored. And sometimes seasoned professional traders do the exact opposite of what is obvious.

We learned quite a lot from that research and altered our trading process –with definite benefits. Specifically what we did was to have different time periods for our forecasts and trading, and that was not obvious to us at first.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy

George Parkanyi writes:

I did a lot of research on re-balancing fixed names packaged into groups of six, trading on the relative price movement against each other over fixed time intervals. I settled on 4 months as "pretty good". The other major variable you need to consider besides the time frame is the volatility. The wider and faster the swings, the more you can compact your re-balancing time frame. The challenge is try to catch as many smaller interim fluctuations as possible but not to sell your winners too soon or to average down on your losers too soon when the stocks are in big moves.

In my research I ran a large batch of tests keeping the time frame constant but varying the volatility range of the randomly seeded stock simulator I developed. I ran a whole bunch of tests using my simple re-allocation algorithm at different volatility bands within which I allowed my "stocks" to fluctuate. These tests generated an average annual compounding increment over buy-and-hold, that, as you might expect, increased with volatility.

What was encouraging, is that the outperformance generated by the simulated data used in the periodic reallocations matched testing I did on real stock data. Theory was confirmed by reality. You can seriously beat indexing (over the long run) with this type of active re-allocation methodology. The trick is to re-allocate individual securities (index components) against each other, not whole asset classes or indices, which are already smoothed out and much less volatile because they are, by definition, averages.

I've published the re-balancing methodology on my blog if anyone's interested — it's not a long read, and easy to digest, but too long for an email or single blog post. The links to the 3 segments are the first three in the blogroll column under the My Portfolio heading.



CurveHow can we avoid curve fitting when designing a trading strategy? Are there any solid parameters one can use as guide? It seems very easy to adjust the trading signals to the data. This leads to a perfect backtested system - and a tomorrow's crash. What is the line that tells apart perfect trading strategy optimization from curve fitting? The worry is to arrive to a model that explains everything and predicts nothing. (And a further question: What is the NATURE of the predictive value of a system? What - philosophically speaking - confer to a model it's ability to predict future market behavior?)

James Sogi writes:

KISS. Keep parameters simple and robust.

Newton Linchen replies:

You have to agree that it's easier said than done. There is always the desire to "improve" results, to avoid drawdown, to boost profitability…

Is there a "wise speculator's" to-do list on, for example, how many parameters does a system requires/accepts (can handle)?

Nigel Davies offers:

Here's an offbeat view:

Curve fitting isn't the only problem, there's also the issue of whether one takes into account contrary evidence. And there will usually be some kind of contrary evidence, unless and until a feeding frenzy occurs (i.e a segment of market participants start to lose their heads).

So for me the whole thing boils down to inner mental balance and harmony - when someone is under stress or has certain personality issues, they're going to find a way to fit some curves somehow. On the other those who are relaxed (even when the external situation is very difficult) and have stable characters will tend towards objectivity even in the most trying circumstances.

I think this way of seeing things provides a couple of important insights: a) True non randomness will tend to occur when most market participants are highly emotional. b) A good way to avoid curve fitting is to work on someone's ability to withstand stress - if they want to improve they should try green vegetables, good water and maybe some form of yoga, meditation or martial art (tai chi and yiquan are certainly good).

Newton Linchen replies:

The word that I found most important in your e-mail was "objectivity".

I kind of agree with the rest, but, I'm referring most to the curve fitting while developing trading ideas, not when trading them. That's why a scale to measure curve fitting (if it was possible at all) is in order: from what point curve fitting enters the modeling data process?

And, what would be the chess player point of view in this issue?

Nigel Davies replies:

Well what we chess players do is essentially try to destroy our own ideas because if we don't then our opponents will. In the midst of this process 'hope' is the enemy, and unless you're on top of your game he can appear in all sorts of situations. And this despite our best intentions.

Markets don't function in the same way as chess opponents; they act more as a mirror for our own flaws (mainly hope) rather than a malevolent force that's there to do you in. So the requirement to falsify doesn't seem quite so urgent, especially when one is winning game with a particular 'system'.

Out of sample testing can help simulate the process of falsification but not with the same level of paranoia, and also what's built into it is an assumption that the effect is stable.

This brings me to the other difference between chess and markets; the former offers a stable platform on which to experiment and test ones ideas, the latter only has moments of stability. How long will they last? Who knows. But I suspect that subliminal knowledge about the out of sample data may play a part in system construction, not to mention the fact that other people may be doing the same kind of thing and thus competing for the entrees.

An interesting experiment might be to see how the real time application of a system compares to the out of sample test. I hypothesize that it will be worse, much worse.

Kim Zussman adds:

Markets demonstrate repeating patterns over irregularly spaced intervals. It's one thing to find those patterns in the current regime, but how to determine when your precious pattern has failed vs. simply statistical noise?

The answers given here before include money-management and control analysis.

But if you manage your money so carefully as to not go bust when the patterns do, on the whole can you make money (beyond, say, B/H, net of vig, opportunity cost, day job)?

If control analysis and similar quantitative methods work, why aren't engineers rich? (OK some are, but more lawyers are and they don't understand this stuff)

The point will be made that systematic approaches fail, because all patterns get uncovered and you need to be alert to this, and adapt faster and bolder than other agents competing for mating rights. Which should result in certain runners at the top of the distribution (of smarts, guts, determination, etc) far out-distancing the pack.

And it seems there are such, in the infinitesimally small proportion predicted by the curve.

That is curve fitting.

Legacy Daily observes:

"I hypothesize that it will be worse, much worse." If it was so easy, I doubt this discussion would be taking place.

I think human judgment (+ the emotional balance Nigel mentions) are the elements that make multiple regression statistical analysis work. I am skeptical that past price history of a security can predict its future price action but not as skeptical that past relationships between multiple correlated markets (variables) can hold true in the future. The number of independent variables that you use to explain your dependent variable, which variables to choose, how to lag them, and interpretation of the result (why are the numbers saying what they are saying and the historical version of the same) among other decisions are based on so many human decisions that I doubt any system can accurately perpetually predict anything. Even if it could, the force (impact) of the system itself would skew the results rendering the original analysis, premises, and decisions invalid. I have heard of "learning" systems but I haven't had an opportunity to experiment with a model that is able to choose independent variables as the cycles change.

The system has two advantages over us the humans. It takes emotion out of the picture and it can perform many computations quickly. If one gives it any more credit than that, one learns some painful lessons sooner or later. The solution many people implement is "money management" techniques to cut losses short and let the winners take care of themselves (which again are based on judgment). I am sure there are studies out there that try to determine the impact of quantitative models on the markets. Perhaps fading those models by a contra model may yield more positive (dare I say predictable) results…

One last comment, check out how a system generates random numbers (if haven't already looked into this). While the number appears random to us, it is anything but random, unless the generator is based on external random phenomena.

Bill Rafter adds:

Research to identify a universal truth to be used going either forward or backward (out of sample or in-sample) is not curvefitting. An example of that might be the implications of higher levels of implied volatility to future asset price levels.

Research of past data to identify a specific value to be used going forward (out of sample) is not curvefitting, but used backward (in-sample) is curvefitting. If you think of the latter as look-ahead bias it becomes a little more clear. Optimization would clearly count as curvefitting.

Sometimes (usually because of insufficient history) you have no ability to divide your data into two tranches – one for identifying values and the second for testing. In such a case you had best limit your research to identifying universal truths rather than specific values.

Scott Brooks comments:

If the past is not a good measure of today and we only use the present data, then isn't that really just short term trend following? As has been said on this list many times, trend following works great until it doesn't. Therefore, using today's data doesn't really work either.

Phil McDonnell comments:

Curve fitting is one of those things market researchers try NOT to do. But as Mr. Linchen suggests, it is difficult to know when we are approaching the slippery slope of curve fitting. What is curve fitting and what is wrong with it?

A simple example of curve fitting may help. Suppose we had two variables that could not possibly have any predictive value. Call them x1 and x2. They are random numbers. Then let's use them to 'predict' two days worth of market changes m. We have the following table:

m x1 x2
+4 2 1
+20 8 6

Can our random numbers predict the market with a model like this? In fact they can. We know this because we can set up 2 simultaneous equations in two unknowns and solve it. The basic equation is:

m = a * x1 + b * x2

The solution is a = 1 and b = 2. You can check this by back substituting. Multiply x1 by 1 and add two times x2 and each time it appears to give you a correct answer for m. The reason is that it is almost always possible (*) to solve two equations in two unknowns.

So this gives us one rule to consider when we are fitting. The rule is: Never fit n data points with n parameters.

The reason is because you will generally get a 'too good to be true' fit as Larry Williams suggests. This rule generalizes. For example best practices include getting much more data than the number of parameters you are trying to fit. There is a statistical concept called degrees of freedom involved here.

Degrees of freedom is how much wiggle room there is in your model. Each variable you add is a chance for your model to wiggle to better fit the data. The rule of thumb is that you take the number of data points you have and subtract the number of variables. Another way to say this is the number of data points should be MUCH more than the number of fitted parameters.

It is also good to mention that the number of parameters can be tricky to understand. Looking at intraday patterns a parameter could be something like today's high was lower than yesterday's high. Even though it is a true false criteria it is still an independent variable. Choice of the length of a moving average is a parameter. Whether one is above or below is another parameter. Some people use thresholds in moving average systems. Each is a parameter. Adding a second moving average may add four more parameters and the comparison between the two
averages yet another. In a system involving a 200 day and 50 day
average that showed 10 buy sell signals it might have as many as 10 parameters and thus be nearly useless.

Steve Ellison mentioned the two sample data technique. Basically you can fit your model on one data set and then use the same parameters to test out of sample. What you cannot do is refit the model or system parameters to the new data.

Another caveat here is the data mining slippery slope. This means you need to keep track of how many other variables you tried and rejected. This is also called the multiple comparison problem. It can be as insidious as trying to know how many variables someone else tried before coming up with their idea. For example how many parameters did Welles Wilder try before coming up with his 14 day RSI index? There is no way 14 was his first and only guess.

Another bad practice is when you have a system that has picked say 20 profitable trades and you look for rules to weed out those pesky few bad trades to get the perfect system. If you find yourself adding a rule or variable to rule out one or two trades you are well into data mining territory.

Bruno's suggestion to use the BIC or AIC is a good one. If one is doing a multiple regression one should look at the individual t stats for the coefficients AND look at the F test for the overall quality of the fit. Any variables with t-stats that are not above 2 should be tossed. Also an variables which are highly correlated with each other, the weaker one should be tossed.

George Parkanyi reminds us:

Yeah but you guys are forgetting that without curve-fitting we never would have invented the bra.

Say, has anybody got any experience with vertical drop fitting? I just back-tested some oil data and …

Larry Williams writes:

If it looks like it works real well it is curve fitting.

Newton Linchen reiterates:

 my point is: what is the degree of system optimization that turns into curve fitting? In other words, how one is able to recognize curve fitting while modeling data? Perhaps returns too good to believe?

What I mean is to get a general rule that would tell: "Hey, man, from THIS point on you are curve fitting, so step back!"

Steve Ellison proffers:

I learned from Dr. McDonnell to divide the data into two halves and do the curve fitting on only the first half of the data, then test a strategy that looks good on the second half of the data.

Yishen Kuik writes:

The usual out of sample testing says, take price series data, break it into 2, optimize on the 1st piece, test on the 2nd piece, see if you still get a good result.

If you get a bad result you know you've curve fitted. If you get a good result, you know you have something that works.

But what if you get a mildly good result? Then what do you "know" ?

Jim Sogi adds:

This reminds me of the three blind men each touching one part of the elephant and describing what the elephant was like. Quants are often like the blind men, each touching say the 90's bull run tranche, others sampling recent data, others sample the whole. Each has their own description of the market, which like the blind men, are all wrong.

The most important data tranche is the most recent as that is what the current cycle is. You want your trades to work there. Don't try make the reality fit the model.

Also, why not break it into 3 pieces and have 2 out of sample pieces to test it on.

We can go further. If each discreet trade is of limited length, then why not slice up the price series into 100 pieces, reassemble all the odd numbered time slices chronologically into sample A, the even ones into sample B.

Then optimize on sample A and test on sample B. This can address to some degree concerns about regime shifts that might differently characterize your two samples in a simple break of the data.




 1. Tax savings to the shareholder.  The shareholder receiving those dividends must pay taxes on them at a fairly high rate, and in that tax year.  If alternatively the corp uses that cash to repurchase its own shares on the open market or otherwise, the overhanging supply of shares decreases resulting in a higher price for all shares.  Thus the shareholder experiences a capital gain, which historically has been taxed at a lower rate.  Thus his after-tax return increases.  And he can choose the tax year.  Taxes deferred are taxes denied.

2. The shareholder receives the dividend at a time not determined by himself, and the odds are that it is not the most desirable time for him to receive that payment.  If the shareholder wants some cash, he can sell some shares when it is convenient and/or necessary for him to do so.  If you want some annoying experience with dividends, buy some HOLDERS (an early/anachronistic version of ETFs).  You will get dividend announcements several times a week and your accountant will be delighted with all of the work you have given him.

3. (Opinion) Corps that have cash available to pay dividends are not efficient investors of the capital entrusted to them.  By giving the shareholder a dividend they are saying effectively, "we do not have any good investment ideas; take the money because you probably can do better."  This is not to suggest that all corps should be acquirers of other companies, but they could put some money in R&D to either enlarge share or reduce expenses in the future.  And R&D expenses are tax deductible.

4. (Opinion) The payment of dividends is a public relations game to get investors to hold the stock for long periods.  The process lulls investors into not reevaluating their investment options as regularly or often as they should, which is not in the shareholder's best interest.  (N.B. That opinion is different from what the "buy and ignore" crowd will tell you.)

Thank YOU for your service to our country.

Stefan Jovanovich comments:

I think the point about the taxation of dividends belongs to an earlier time.  The taxable portfolios of individual investors (as opposed to IRAs, SIMPLE IRAs, 401(k)s, etc.) are not a significant part of the overall market.  Most of the shares owned are in the hands of tax-exempt institutions.  Most of the taxable investors are corporations; because of the dividends received exclusion their effective tax-rate on payouts from other corporations is - at most - 15%.  I would hardly want to quarrel with Bill's maths, but it could be argued that the advantage of having a cash payout diminished a 15% by tax could be a better return than allowing corporate management to hold on to the cash and then use it to speculate in their own company's securities.  There are very few Henry Singletons.

George Parkanyi adds:

The dividends-are-bad argument misses the point that dividends are not always static, and when companies keep increasing them regularly, after a while you can be earning a very high yield on your original investment in addition to the capital appreciation.  Companies can also squander money, and perhaps paying a dividend is a better choice than overpaying for some acquisition that blows up.  Dividends can also be good indicators of value where your primary objective is capital appreciation.  Look around you now.

I also would be careful using generalizations like "hope for the buy and hold crowd", implying they are a bunch of bovine followers.  A lot of people have gotten rich by holding on to companies that have grown and dramatically appreciated in value.  In addition to the appreciation, there are tax-deferral and transaction cost avoidance benefits.  In fact, it takes a LOT of discipline to be that patient, especially if you follow the markets regularly.

As for dividend-paying stocks, they're just another useful tool - not for everyone, but for many - in the arsenal of investment vehicles available to traders and investors.  Personally I think that quality companies paying dividends are going to rocket off the bottom first when things turn around because of the yield support and recognition of value, and many of us will be lamenting "How did I miss _________ at 6%?"

Phil McDonnell replies:

Dividends can be an important part of returns.  Most studies of long term stock market returns show that re-investment of dividends accounts for about half of the long term return.  So in the long term they are very important.

In the short term they may be less important.  If a stock pays a dividend of $.50 then it will probably drop and average of $.50 on the day it goes ex-dividend.  So there would seem to be no apparent gain.  But if the dividends are reinvested in the stock the investor is buying the stock a little bit cheaper after the ex-dividend event.

Added to this are the benefits of dollar cost averaging. Specifically when the stock is generally at a low price more shares are purchased with the dividend.  When the stock is high fewer shares are purchased with that same dividend.  Over time this leads to an average price per share that is below the average price of the stock during the same period.

In looking at yields and total returns it is important to look at how the reporting institution does its calculation.  You would think that this is not important and that people like S&P report things on a consistent basis.  A good case in point is that the S&P index is a cap weighted index.  Big cap stocks like IBM, GE and XOM get far more weight than their smaller brethren.  But when S&P reports the earnings for the index, bizarrely, they do not use cap weighting.  The earnings are equal weighted.  Thus an earnings to index level comparison for the S&P is completely meaningless.  An example is that S&P calculates the equal weighted reported earnings as negative for the first time in history.  But if they were cap weighted the earnings would be positive.  If the operating earnings were reported on a cap weighted basis they would be 80% higher than the equal weighted earnings that S&P actually reports.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008



 Here is a funny rowing story with a market lesson. This is how the story was told to me; most assuredly some of it had been embellished. I take responsibility for the market-related comments:

In the sport of rowing there are eight different boats that are raced, five of which the rowers have one oar each. That’s called sweep rowing, as opposed to sculling, in which the rowers have two oars each. In the case of sweep rowing, the rowers are traditionally stacked alternatively on opposite sides: port, starboard, port, etc. In fact, prior to the early 1960s that was always the case. Here is a stylized diagram.

In Europe there are many rowing clubs, some of which are affiliated with companies. Just as an American company may sponsor a softball team, some European companies sponsor rowing teams. Such was the case with Moto Guzzi, a renowned maker of motorcycles and scooters located near Lake Como in northern Italy. In the early 60s the rowing club affiliated with Moto Guzzi had the Italian champion “straight four”, also known as a “four-without-coxswain” or “4-”. Each type of boat has a crew that could be typecast to fit it perfectly. A straight four is a beautiful boat that combines grace, speed and power, whereas some boats are best populated by refrigerators. (Aside: how do they steer without a coxswain? One of the rowers’ shoes is attached to a rudder.) These guys were good – very good. And they were soon to compete in the European Championships (the de-facto world championships) in Luzern.

After having traveled to a regional regatta, the crew was supposed to take the boat off the trailer and attach the riggers prior to the coach showing up and a practice. The riggers are the extensions outside the boat that hold the oarlocks – the boats themselves being very narrow for speed (lower resistance). Just horsing around the guys rigged the boat “wrong”. That is, instead of it being starboard, port, starboard, port, they rigged it port, starboard, starboard, port. Well, the coach was not amused, and said something like, “Okay you clowns; now you are going to have to row it that way. And we are doing a time trial, and if I don’t like your time, you’ll do it over until I do.” That’s what coaches typically say.

Well, they row the boat and had no difficulty with the different rig. During the time trial, they clock their best time ever. What happened? The coach knew he was out of his league, so he went down to see the mechanical engineers at Moto Guzzi and explained his problem. They immediately identified the effect as the “sum of the moments”, which I will illustrate below. But let’s first get back to the story.

The crew goes to Luzern, takes the boat off the trailer and starts rigging it “wrong”. Everyone who sees it howls. You can just hear the competitor comments now, “Hey, those crazy Italians don’t even know how to rig a boat. No sense worrying about them.” Well, you know what happens – the guys win the European Championships to everyone’s surprise. That style of rigging is subsequently referred to as “Italian Rigging” and has begotten all sorts of new rigs.

The thing to consider is that rowing has been around as a sport for a long time. For instance, the oldest intercollegiate athletic event in the U.S. is the Harvard-Yale boat race. But no one ever thought to try rigging a boat differently. An accidental event changes everything. Worse is that this watershed event occurred over 40 years ago, and still there are coaches in the sport who have no idea as to why someone would rig a boat differently. The worst are the typical coaches of college freshman, where most rowers get their introduction. You constantly hear expressions like, "Riggin, schmiggin, we just row."

Investment analysis is the same way. Too many people are stuck in ways that are unproductive. The analysts refuse to learn or to consider anything different. They don't read, experiment or learn. And the legal system is there to punish any experimental attempts that might underperform, albeit temporary. Anything learned becomes dogma no matter how bogus. Forgive me, but this reminds me of Markowitz, CAPM, etc.

Here’s why the rigging works: When you pull an oar (particularly a sweep), you not only move the boat ahead, but you pull the boat around to the opposite side (“pinch” the boat). The port rowers pull the boat to starboard, and vice-versa. So now think of a teeter-totter or see-saw, where the farther away one is from the fulcrum the more effect a given unit of power exerts. Where’s the fulcrum in a boat? The only thing under a boat’s hull is its fin to keep it from side slipping. That fin in most boats is about one person-length aft of the guy in the stern, and it is the fulcrum, albeit a weak one. So the guy in the stern is 1 unit away, the next guy 2 units, etc. If you add up the units you will find that the sides are equal in Italian rig, and are unequal otherwise. If everyone pulls with equal speed and force (highly unlikely), then the traditionally rigged boat will veer to one side, and the Italian rigged boat will not. The more course corrections that have to be made, the more drag exerted by the rudder. Hence the Italian rigged boat wins.

Rigging is one of those things that can make a big difference at the higher levels of the sport. However at lower levels of the sport the reason most crews lose is not rigging, so most coaches ignore it, and worse, do not bother to learn about it. I venture to say 95 percent of the boats never get their riggers adjusted after they are put on the boat initially. Yet not only can riggers be moved from seat to seat, but are fully adjustable in most other ways: height off the water, pitch, spread from the keel, etc. With choppy water, a little extra height off the water helps.

The style of rigging where two seats are on the same side is also called “in buckets.” Not sure why. But it is also possible to rig an 8-oared boat with 3 buckets, which is also balanced according to the sum of the moments, but has a distinct advantage for teaching novices. One problem with novices is that they “crab” or get the oar caught in the water, which plants their oar handle in the back of the person in front of them. Ouch. The pain could be lessened if eights were rigged in full buckets (P, S, S, P, P, S, S, P – for Port and Starboard) because of where the oar handle hits. Why novice coaches do not do this baffles me. I believe coaches think that rowing in buckets is more challenging that rowing a standard-rigged boat. Trust me, it takes about 30 seconds for a rower to adjust to it.

Oars used to be symmetric (tulip shaped). Now they have been improved (asymmetric and hatchet shaped) to really lock on to the water. The asymmetry also self-corrects for putting it in the water undersquared (crabbing). Note that the oars are not supposed to move thru the water – the boat moves thru the water. But with the old tulip (Macon) blades there was a certain amount of slippage. Now there is less. This has been the cause of an increase in lower back injuries. Something has to “give”, since there is less slippage when the oar is planted, that now becomes the lower back. The solution is to buy oars that have more spring to them, but you will find that only the oldtimers do that. The kids use stiff oars and have back injuries. Old rich guys cannot afford back injuries.

If you are coaching a crew and have the luxury of lots of boats, get them out of eights and into small boats. “People who know how to row, row small boats.” Also, the number one determinant of racing speed is stroke rate (strokes per minute). But your crew has to be in shape and skilled to row at high rates.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy



 It seems that to be a trader these days you must have a PhD in Math. Actually how much math does a trader need?

I've been struggling with math since childhood, and I'm taking statistics personal classes right now. Recently Victor told me that I would only have had to count Galton's way and that would be enough. It seems to be easy to immerse yourself in deep math and forget about what the markets really are.

I know this lecture is from last year, but Soros has a good point when saying that the statistic models available fail to consider the role of uncertainty. When you are too much leveraged and the event goes too many standard deviations, you know you’re in trouble. Take a look at:

George Soros at MIT and

Quantitative Trading, an excellent blog on quants by Ernest Chan. His latest post:

This Quebec pension fund lost some $25 billion due to non-bank asset-backed commercial paper (ABCP). Their Value-at-Risk (VaR) model did not take into account liquidity risk. As usual, the quants got the blame. But can someone tell me a better way to value risk than to run historical simulations? Can we really build risk models on disasters we have not seen before and cannot imagine will happen?

The replies to the post were most illuminating:

quarterback said…

"Nassim Taleb's ”Fooled by Randomness” is a must read. Simply we don't live in a Gaussian world.”

Paul Teetor said…

"The NY Times recently quoted Taleb as saying, “VaR is like an airbag that works all the time, except when you have an accident.” I think that’s a perfect characterization.Can we prepare for what we have not seen? The folks in the insurance business have faced this problem for centuries. Some actuaries use Extreme Value Theory, and I’ve often wondered if the finance world needs to look more closely at that. Are the quants to blame for VaR’s short-comings? Sort of. I ran the VaR reports for previous employer — who got wiped out. In retrospect, I should have been telling everyone, “These numbers do not mean what you think they mean.” That was my error.”

Bill Rafter replies:

Dr RafterYou do not need an advanced degree in mathematics to be a successful trader. What you need firstly is the ability to think for yourself and secondly the ability to do research in a scientific manner. Regarding statistics, what you need to know is that one event is not significant, and that your highest return will not be your average return. Those are common mistakes of novices.

Most “quants” are employed in “risk” work. That is, they are given tasks such as, “assuming you have a certain profit, how do you protect it?” Or, “given a certain alpha, how do you make it portable?” Perhaps the best-known quant made his money by finding an anomaly in the contract specs of a certain futures market and then exploiting that. Those points suggest that your efforts at profitable trading should not be concentrated in the risk area. Instead they should be directed towards generating that profit or alpha that the supervisors assume is inherently there.

Let me pose a scenario: Suppose you had perfect knowledge that the broad market was going to rise, what stocks would you buy? The standard philosophy is that you would buy the ones with the highest beta, because they should go up the most. For the most part you would be disappointed, because those with the highest beta (i.e. past beta) would be the most volatile, as past volatility is equated with subsequent bearish performance. Don’t take my word for it; there are lots of academic articles saying the same thing.

Also — and this is important — would you rather trade an efficient market or an inefficient one? Obviously the latter, so do not waste your time with the efficient ones. Oh, but the risk guys love the efficient markets. Yeah, but the risk guys do not make money.

Let me give you our experience. We screen for risk early in our selection process, and never look at it again. We never use stops, which we feel simply provide certainty in losses. Except in the odd times when we are in bills, we never buy one asset because we cannot predict one asset well. On the contrary, our success rate in predicting baskets of assets is better, so we stick to that. Of course they are baskets where the early screening was on a risk-adjusted basis, but with no other attention being paid to risk. I am not suggesting that ours is the only way or the best way; only that it is a profitable method that does not hold the risk mavens up as gods.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy



bookWhat is most troubling to me about the current situation in the financial markets is the global backlash against the "free" market and what is perceived as capitalism in general. Your average person is so angry right now, and it seems almost inevitable that anything related to the financial markets is going to be torn down and rebuilt in a nationalized or internationalized shell of its former self. Forget the amount of damage that has been done in dollar terms during this decline (easier said then done for some including myself); the real damage is that the image of America's version of market based economies may have been tarnished beyond repair. I hope this is an overly pessimistic view of where we are headed. I have a six month old that I would like to see prosper as she grows; I just can't help but wonder what damage will be wrought by the powers that be with the backing of an angry mob.

I found the below passage from The Road to Serfdom particularly relevant to the $700 billion package handed to Paulson and the Treasury Dept:

What is promised to us as the Road to Freedom is in fact the Highroad to Servitude. For it is not difficult to see what must be the consequences when democracy embarks upon a course of planning. The goal of the planning will be described by some such vague term as "the general welfare." There will be no real agreement as to the ends to be attained, and the effect of the people's agreeing that there must be central planning, without agreeing on the ends, will be rather as if a group of people were to commit themselves to take a journey together without agreeing where they want to go: with the result that they may all have to make a journey which most of them do not want at all.

Democratic assemblies cannot function as planning agencies. They cannot produce agreement on everything — the whole direction of the resources of the nation-for the number of possible courses of action will be legion. Even if a congress could, by proceeding step by step and compromising at each point, agree on some scheme, it would certainly in the end satisfy nobody.

To draw up an economic plan in this fashion is even less possible than, for instance, successfully to plan a military campaign by democratic procedure. As in strategy it would become inevitable to delegate the task to experts. And even if, by this expedient, a democracy should succeed in planning every sector of economic activity, it would still have to face the problem of integrating these separate plans into a unitary whole. There will be a stronger and stronger demand that some board or some single individual should be given power to act on their own responsibility. The cry for an economic dictator is a characteristic stage in the movement toward planning. Thus the legislative body will be reduced to choosing the persons who are to have practically absolute power. The whole system will tend toward that kind of dictatorship in which the head of the government is position by popular vote, but where he has all the powers at his command to make certain that the vote will go in the direction he desires. Planning leads to dictatorship because dictatorship is the most effective instrument of coercion and, as such, essential if central planning on a large scale is to be possible. There is no justification for the widespread belief that, so long as power is conferred by democratic procedure, it cannot be arbitrary; it is not the source of power which prevents it from being arbitrary; to be free from dictatorial qualities, the power must also be limited. A true "dictatorship of the proletariat," even if democratic in form, if it undertook centrally to direct the economic system, would probably destroy personal freedom as completely as any autocracy has ever done.

Source: Illustrated Road to Serfdom.

Bill Rafter adds:

"I see the Fed, the Treasury, the SEC, long ranks of the new oppressors who have risen on the destruction of the old, perishing by this retributive instrument, before it shall cease out of its present use. I see a beautiful city and a brilliant people rising from this abyss, and, in their struggles to be truly free, in their triumphs and defeats, through long years to come, I see the evil of this time and of the previous time of which this is the natural birth, gradually making expiation for itself and wearing out."

My apologies to Charles Dickens (Tale of Two Cities, last chapter, spoken by Sidney Carton)



LarryCan stops depress returns? You bet, and that's a problem if you have a perfect system.

If you don't have such an approach — and feel it might be to your advantage — to not wipe out your account (been there done that, it is depressing) then stops of some sort are the only tool at a trader's disposal.

[A blog referenced by a reader] so stupid and upsets me so much — geez these guys will insure their house but not protect a trade… it takes only one — just one — trade to kill you; the loser you held.

Happy trails to all.

Dr. Williams is the author of The Right Stock at The Right Time, Wiley, 2003

Bill Rafter replies:

Dr RafterPermit me to play Devil's Advocate, and in the process insert philosophy into the exercise of making money.

Some people use stops because they cannot decide when a trade has gone bad. That is, they admit that they cannot forecast the future of that trade, so they put a stop on it, solely to save money (or so they think). However the very act of doing so is in fact a forecast. Thus the conflict: they know they cannot successfully forecast, but they forecast anyway.

Other people use stops and place them at particular points specifically because they know that statistically if the price goes to point A, the odds are very small that it will revert.

My contention is that the latter person will be successful and the former will not. Thus I encourage those who use stops to question themselves as to the reason for the stop.

Our own situation is illustrative of knowing your weaknesses and circumnavigating around them. We know that we cannot forecast individual asset prices. We get reminded of that daily. Consequently we never use stops. We can however forecast the outcome of a basket of assets with some reliability. Many have been the times where we lost say 20% in an individual stock, but redemption has been found in the basket.

Dr. Rafter is the author of The Moving Trend, TASC, 2002



Dr RafterI purchased and have read Shinya's book. The early chapters were interesting, but further reading produced disappointment.

At some point he mentions chimpanzees and how their colons are clear of problems because they are vegetarians. At that point I lost some respect because he obviously does not know about chimps being huge meat eaters. It is actually pigmy chimps or bonobos that are vegetarians, and not normal chimpanzees. Scientists aren't supposed to make mistakes like that. Just like traders are not supposed to confuse General Motors with General Mills.

He believes that judicious control of enzymes are the answer. He makes several references to chewing one’s food fifty times to promote the salivary glands to produce enzymes. And he mentions that fruit is a good source of enzymes, but he never mentions where to enhance one’s supply of enzymes. I only know casually that papaya and pineapple contain digestive enzymes (I’ve used them in food preparation). I would have expected that such an expert would have elaborated on that, but he doesn’t even mention it.

From the first few chapters one gets the idea that he is going to be very scientific, but then nothing happens. Maybe his ideas are correct. Because of his experience he could have been a most credible proponent. Consider the concepts, but don’t waste your money on the book.

Steve Leslie extends:

I am sure Shinya's book is a credible book and I hope it works out for you. If on the other hand you wish to look elsewhere, I suggest you study the life of Jack Lalanne, an American icon in the field of fitness and nutrition. You may have seen him on TV representing his juicer. This follows in the path of the original Juice Man. This product was promoted by infomercial by the man with the gray furry eyebrows some years back. Jack Lalanne had the original show on television titled The Jack Lalanne Show which ran from 1951 to 1985. This is the longest running show on exercise ever in the history of television. He founded a string of health clubs that he eventually sold to Bally Total Fitness. He invented a weight and pulley system and was the inventor of the Smith machine. His feats of strength are accomplishments of Herculean proportion. At age 70 he swam 1.5 miles handcuffed and shackled towing 70 boats with 70 people in Long Beach Harbor en route to the Queen Mary. He once held the world record for pushups, doing 1033 pushups in 23 minutes. He performed this on the TV show You Asked For It. Jack is now 93 years young, still active with a thriving business, and exercises every day. If you want to study someone and utilize his advice, I suggest you go to Jack Lalanne.



Motor HomeLunched today with a couple that owns an extra nice motor home. In the past they have made several nice trips in it. Today they commented that they have a upcoming trip to their son's home in Jacksonville, FL and will take the car instead. The motor home has a one hundred gallon tank and diesel fuel to fill it is $4.17 per gallon! They indicated they will use the motor home 'some' this Summer for 'shorter' trips. I am sure the motor home industry is hurting as a result of fuel costs.

Bill Rafter remarks:

I tried to short some WGO (Winnebago) recently and could not borrow the stock.

Ken Smith writes:

Motor homes are a common approach to living on the cheap. Not too cheap, though. One can own the vehicle but must rent space in a trailer park, pay for hookups to water, sewer, electricity, phone. KOA provides free wireless Internet, has beautiful grounds, swimming pool, small store on premises with dry food stocks.

A sizable population has always lived in trailer parks; KOA is not representative of such housing. I would stay at KOA for extended periods of time; could live there nicely for total living expense of $1000 a month. But I am not a bachelor — can't make this decision autocratically.

Can live on California Coast, near Smith River, Crescent City, beautiful setting. Just give up high living, settle down to quiet, simple life style. Ride around the area on your bicycle. Fish on the river, surf on the ocean.



 Another way to look at changes in volatility (increase/decrease in price swings per unit time) is to view it as having a typical overall move in price but with the time scale expanding and contracting. This might offer some additional insights, for example point and figure charts by ignoring time also ignore volatility. So if you test these they'll produce a quite different set of patterns which are essentially 'volatility blind.'

Sushil Kedia replies:

A filtration process such as Point & Figure is essentially based on defining one's tolerance for noise in the price series. The box size achieves that. Point & Figure is the only method in Technical Analysis to not plot the time axis. It is perhaps the only method of looking at prices which has a nature similar to the time/distance equivalence in Einsteinian physics. There perhaps is a case for finding a congruence in defining a unit of time for a particular security based on a certain standard movement in its price.

Bill Rafter explains:

Point & Figure purports to separate "signal" from "noise" and discard the latter. Every time you run data through a filter, you eliminate both some signal and some noise.  The short-term data that you assume to be all noise contain substantial signal.  Thus, it is illogical to assume that you will improve results by discarding information.  Further, and most-importantly, we applied Point & Figure filtering to all of our trading methodologies and the degradation of results was universal.

Phil McDonnell expands:

PhilThe Grand Master poses an interesting question and Mr. Kedia wisely suggested an analogy to Einstein's relativity theory. There is much to be learned from these ideas.

Suppose we have two assets which substitute for each other in investment portfolios. For example they might be stocks (s) and bonds (b). Given that there is only a constant supply of funds (m) available for these two investments we can posit that their combined value would be equal to:

m ~= ( s^2 + b^2 )^.5

The above is essentially the equation of a circle of radius m. One possible flaw is that the market for s may be much smaller than the market for b. Thus a given fixed disinvestment from b might move s by considerably more. Our model would therefore no longer be a circle. Without loss of generality we can assume the fixed quantity m to be 1 (100% of all the money). Then we have:

1 = ( s^2 / a^2 + b^2 / d^2 )^.5

where a and d are two constants of proportionality which relate to how quickly the two markets move. Thus each market now has its own ease of movement parameter in this new elliptical model.

One of the key properties of the theory of relativity is that as one approaches the speed of light both time and space are distorted. In particular the Lorentz transformation governs this process and is given by:

gamma = 1 / ( 1 - v^2 / c^2 ) ^ .5

where v is the velocity of the spaceship and c is the speed of light. This represents the transformation in the x direction which we shall assume is the direction of acceleration. Referring back to the elliptical model formula above we see that the one dimensional form looks remarkably similar to the denominator of the Lorentz transform (gamma).

Qualitatively such a model would be consistent with the Davies/Kedia conjectures. Time would slow down as the market moved faster. Magnitude in the price direction would dilate as well as a function of velocity.

Having a theoretical model of the market is all very nice but unless the market follows it then it is useless. To test this a study was done of the above stock to bond relationship using SPY and TLT ETFs. Fitting the parameters a and d to past data one finds that the constants were 200 and 100 respectively. Then the fitted model was compared to the actual past history of SPY and TLT and found to provide very good agreement. Perhaps we may look at these constants as the speed of financial information (light) in the stock and bond medium respectively.





Adi Schnytzer concurs:

It's time the world learnt how data collection functions. These numbers are produced by turkeys who never ask whether their numbers make sense. And to think that markets respond to them!

Bill Rafter adds:

Lots of the data put out are also seasonally adjusted. One of my big peeves is that the data monkeys who work for the gummint do not know how to properly do the seasonally adjustment. As a result there are a lot of bad data out there. The real problem comes when the bad data are released, and everyone follows them. In other words, perception becomes reality. You (having the good data) have to follow the bad data also, at least until some time elapses and the whole thing gets corrected. So you have to watch against being too clever for your own good.

Jason Thompson reveals:

I've developed a localized index of inflation that is actually reflective of folks' consumption baskets. It includes taxes, insurance, education, and healthcare in more accurate weights. It has shown me how far off the CPI has been versus reality since at least 2002.  The spread has consistently grown! This local inflation measure focuses on prices in the Chicagoland area and so would be best compared with CPI-U. Further, the resolution is quarterly not monthly. The inflation measure for Q1 2008 will likely show an increase of 8.6% YoY.



NervousBack in my apprentice days in the wheat pit, a wizened old guy took me under his wing. Since he had been trading successfully since the late 1930s, I was all ears. One of the anecdotal statements he made to me was that "Nervous markets always close lower." I've remembered that sage bit of wisdom for all of these years, and have followed that advice with reasonable success. Lately, I've been wondering if there was a way to quantify that statement, or if anyone in this group can lead me in the right direction. I'd like to see what the numbers and percentages of nervous markets really are.
One might ask, "What is a nervous market?" The only answer is that I can't define a nervous market, but that I know one when I see it.

Bill Rafter replies:

There has been some work done relating volatility to subsequent price behavior. Volatility (depending on how it is defined) may agree with your description of nervousness. Generally the premise is that volatility is bearish, which would be in agreement with what the wizened old guy told you.

There are many definitions of volatility. My suggestion is to look at measures other than 1-day rates of change. Earlier this year I asked around for other measures of volatility, and got approximately 20 variations. Additionally, there are “handmaidens” of volatility, such as institutional holdings.

Jim Sogi adds:

Vic and Laurel recently hypothesized that afternoons closer to the low of the day in S&P could be thought of as you say "nervous." I've also been playing around with NYSE declining volume. Today 857k. Fairly nervous. Over 1m down before the end of the day is very nervous.

Phil McDonnell remarks:

"Volatility is bearish" requires considerable qualification. In my ruminations the results have generally shown that rising volatility is bearish on a contemporaneous basis and over the short run. However high levels of volatility can be quite bullish. It is important to define what volatility we are talking about.

Victor Niederhoffer investigates:

VictorMost definitions of nervousness refer to trembling, quivering, and agitation. I thought I would look at some qualitites of markets that seem to be of that nature. I started with markets that were up at the open, down at 11 am, up at 1pm and down at 3 pm. I found 17 cases since 1999 in the S&P futures, and nine of them went down from 3 pm to the close, with an expected move of three points. Such moves occur about twice a year. I found that a similar gyration, but down at 2 pm rather than 3 pm, which happened eight times since 1999, to be visited with four up from 2 pm as of the close and four down. I found eight cases of the first pattern in bonds, and the next day was 50-50 up with an expectation of four ticks up. In general, I would say that there is not much evidence that a quivering market with numerous crossovers to the down side is bearish. In another study, I found 22 cases since 1999 where the market was up at open, down at 10 am, up at 11 am, and down at noon. Eight of these occured in 2007. Thus, the market appears to be gyrating more frequently in a way most people would get nervous about if it were their limbs or sinews. Seven of the 12 cases showed a rise from noon to the close. Thus, nervous stock markets, defined in this way, did not show any non-random predictive tendencies, although the jury is out as to whether the market shows an inordinate tendency to tremble between hours.

Vincent Andres adds:

One classical way to proceed would be to have someone provide : 100 examples of nervous/non-nervous/"don't know", status markets. (Maybe more than those three classes). Each example being the price series and the graph. Of course, it's possible to ask several people to do the classification.

Some counting would probably teach things, hopefully reveal possible clusters in the appropriate measure space. Well used, tools like neural nets (many NNs are nothing else than stat learners) may be of use here. However, there is a preprocessing to be done on the price series before feeding the counter … and this will often be the clue. (Some ideas have been provided in this thread).

It is however quite a painful job, and requires a rigorous methodology. And even if classification succeeds, it's only a piece of the job. As  P.McDonnell said, nervous => bearish is not a 100% sure implication. And markets are dynamic, not well-defined, etc.



 The Monetary Base continues to indicate restrictive monetary policy, whereas MZM indicates an accommodative monetary policy. That is not a conundrum as long as one leads the other, and several posts here have demonstrated that MZM leads the BASE.

Heres our current 2-cents worth: The BASE is presently some 6.5 percent below what we refer to as its target. More on that in a minute. MZM is 3.8 percent above its target. Both of those are big numbers. In fact, the BASE has never been this far below its target since the data started. If the BASE were the only tool we had, we'd be very pessimistic right now about the economy. But since we know that MZM leads the BASE, theres less to be concerned about.

How do we arrive at the target? We simply imagine that the Fed knows what it is doing, and has a target rate in mind. All we do then is fit the most appropriate mathematical line to the data. In our opinion that line is a parabola. We could also take a log of the data and then fit a straight line to the logged data. We will leave that to others for another day.

Heres the BASE , and here is MZM .

There are many other relationships that can be hypothesized. This chart looks at smoothed t-bill rates of change vis-a-vis the BASE.



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.



 MZM Chart

This graph shows moonshot one-year growth of Money of Zero Maturity, a proxy for money supply.

Jeremy Smith adds:

In contrast to this, the year-over-year change in the real Monetary Base has been negative lately.

Bill Rafter explains: 

Yes, Monetary Base growth is still hugely negative. But George is also correct that MZM growth is hugely positive. The missing connection is lag. MZM significantly leads Monetary Base.



I need a new/different perspective. Can anyone recommend a few stocks (not indices) that have met the following criteria: The stock was originally not volatile, but then became volatile for at least some time. Use whatever definition you want for "volatile". Any time frame is okay. I need only a few examples. I'm just testing some new algorithms.



Niels BohrWhat theory exactly do I test, and how is it put together on the basis of history? In the physical sciences, the answer is, ironically enough, often gut feeling and intuition. Bohr's "crazy" ideas about atoms are an example. That is what makes counting so difficult: What the heck do I count? Statistics and econometrics are fabulous tools, but applying them to forecasting is tough!

Rod Fitzsimmons Frey adds:

I agree that is the crux of the issue. The inductive leap that all scientists must make is a mystery that is not itself explained by science. Francis Bacon, who convinced me to ditch philosophy and take up engineering, hand-waved it away by putting a philosopher-king at the head of the rational, scientific state, with all the other citizens scurrying about gathering data to test the hypotheses that he came up with.

Nigel Davies remarks:

The reason a chess player should practice analysing positions is in order to cultivate intuition. Many players wrongly believe that the idea is to find specific improvements from specific positions, but they rarely get the opportunity to spring their cooks.

I have come to believe that the same role is played by counting for traders, that the main goal should be to cultivate understanding and awareness rather than devise specific trades. And one can find many other examples in difficult human endeavours, such as the importance of kata to the martial artist.

Bill Rafter explains:

Bill RafterThe answer to "what to test?" is "everything."  You try to break everything down to its smallest components and test each.  You keep records and their summaries on everything.  If you learn of something new, you have to go back and test everything again using that new method.

Suppose you know with certainty that the market is headed up in the near future.  A simple and intuitive strategy would be to buy the high beta stocks.  But testing that strategy would prove you wrong.  You cannot know that unless you test.  Okay, now let's consider the reverse:  you know with certainty that the market is headed down.  What about selling the highest beta stocks?  Test and you will find out.

One of the big topics now is volatility.  How do most people define volatility?  Are there any other ways to define volatility?  Is there any symmetry to the various definitions of volatility?  That is, does it work the same way in up days/weeks as it does in down days/weeks?  If you define volatility as one-day rates of change, the answer is affirmative.  But not so with other definitions.

Most researchers make the mistake of testing their ideas against "the market".  Well, the market is just the average.  You are not going to find any leading indicators by looking at the average.  So let's say that instead of looking at the S&P 500, you do your research on the 10 Sectors.  The results are different.  So then you drill down a little more to the 24 Industry Groups, and then to the 60+ Industries. If you are "on to something" you will find that the results get better with additional focus.  Your universe is the same 500 stocks, but you are no longer averaging to mediocrity.  Note that I didn't say this was technical or fundamental research; it's just research rather than intuition.

Most people do research badly.   Let me give some examples. (1) One of the major data suppliers (50,000 subscribers) gives its users the ability to construct their own portfolios.  That's important, as you may just want to work with stocks of companies with positive cash flow.  However a call to the support department of that data supplier will inform you that virtually none of their subscribers make their own portfolios. (2) The research software platform with the highest number of users does not even allow users to construct their own portfolios.  They give them pre-constructed portfolios of the S&P, Russell, Dow, etc. Take it or leave it.  (3) One of the leading (at least by reputation) institutional and retail providers of fundamental research allows its users to screen stocks on the basis of certain factors.  Their screening tool does not work correctly; giving the wrong results.  It's been that way for the two years that we have had a comp account.  No one has fixed it, most likely because no one has noticed.  We noticed, but of course we're not going to tell them.

So if flocks of "counters" or "quants" did poorly in the recent selloff, it may not be because counting or quant research is a flawed concept. It may because the researchers are not giving an honest day's work for their pay.  They are pretending to do research.  Their version of the scientific method is shoddy at best.  But that's okay.  To be a consistent winner, you need a supply of losers.

David Lamb writes:

"What to test" brings to mind the passages on counting in Vic and Laurel's books. In one, Artie, Vic's father, was writing on a yellow pad of paper while he was watching handball players. Upon a completion of a point Artie would notate: OTWK (off the wall killer); KW (killer, winner); DW (drive killer); A (ace); AW (angle winner). He was trying to calculate "the chances of winning the next point after runs of winning and losing points of different magnitudes."

And Dr. Rafter's comments on not testing ideas against the market, due to the market's being average, if further demonstrated by Artie's note taking during handball matches. He wasn't watching average players, he was watching a particular "sector" of players. In this case it was the best players.



One of the reports of the Israeli intrusion into Syrian airspace mentioned that the Syrians fired missiles at the intruders, who then used jamming devices to befuddle the missiles. Now don't blame this on Syrian incompetence in operating the missile batteries, as the Russians were in Syria operating them. We know this as the Russian military advised Israel not to bomb the missile batteries as there were Russians present.

I believe this was a test of the jamming techniques. The Russians had sold those missiles to Syria as well as identical ones to Iran. If the jamming worked against the missiles in Syria, the same jamming will also work in Iran. So the question now is: who is going to intrude into Iranian airspace?



OysterIn the US, those oysters along the Katrina coast are some of the sweetest and largest found. But here in the southern Chesapeake, which has the best oysters on the East Coast, those found on the Middle Peninsula are even sweeter, almost like butter. However, don't expect to find the best on a plane to NYC — waterman keep their best for local customers, as most in the cities have no idea how a good oyster tastes.  We have to call a tug captain named Puddin', who is about 400 pounds, and he'll send a diver down by a bridge support to get some of the really large ones in return for beer money. If you want the best, come down to the Urbanna Oyster Festival on the first weekend in November you'll be very pleased. On the Eastern Shore, the Chincoteague oyster is a saltier (brinier) lad with a taste that some NYC critics prefer, but in oysters (and music) it gets personal after a while.  I've been along the NW and NE coasts and those oysters taste like seaweed to me.

Alan Millhone adds:

A few years ago we stayed in Blainville with our French-Canadian friends Jean-Claude and Joelle. One day with the tide out Jean-Claude took me, my wife Vickie and our oldest grandson David out oyster hunting. The law there is that any oysters on the outside of the oyster cages were free for the taking by anyone. We waded into the soft seabed and collected a bucket of fresh live oysters. Jean-Claude and I shucked the oysters while Vickie and Joelle prepared a clear sauce for them. I prefer a hot sauce — but, when in Rome! They were great. Nice memories.

Bill Rafter advises:

Always go to a real oyster bar, where you can watch the staff shucking the oysters. Watch for a while (not just five minutes), ask questions and then tip the guy when you're done. Note that they can enter the oyster from either the bill end or the hinge end. If you are going to shuck them yourself, don't buy many, as you will probably give up. I like using an awl and entering from the hinge end. Avoid using a hammer and smashing the bill end to gain entry. The shells are quite brittle if hit that way and you will be picking the bits of shell out of your mouth.

You may want to try clams first, as they are considerably easier to open, but not as interesting. Do not waste money buying a "clam knife" which has a sturdy handle and a really dull blade. A paring knife with a sharp blade is best. Little Neck clams are small, tasty and considerably easier to open than Top Necks or Cherrystones.

At home: If you have access to clean salt water, get a bucket full and put the critters in there for several hours. As they have been shut up for hours or days in a cooler, they have been defecating in their shells. A couple hours in salt water and they will clean themselves. After you dump the water you will be most glad you did. You don't want to ingest that stuff.

Frequently, clams and oysters are sold at bayfront shacks. Most people are put off by that, but if the shack does of volume, patronize it. If you are coming to Long Beach Island NJ, there's such a place on Bay avenue in Manahawkin.



 Muir Woods is 500 acres of coastal redwood forest, twelve miles north of San Francisco, and is a setting that is relatively unchanged over the last 50 million years. The trees in Muir Woods are the oldest living things on earth, and having visited the woods recently I have been thinking of what lessons they might hold for markets and for life. My thoughts on the subject have been helped by reading the following books: Muir Woods by James Morley, Life in an Old Growth Forest by Valerie Rapp, Trees by Roland Ennos.

Lesson One: While from a distance, all the trees look very similar, up close they are each different, showing the effects of fires, exposure to light, roots damaged or spared by floods, wind, storms, landslides, disease, and predation from insects. Many of the current trees have lived since the times of the Vikings. If only the trees could tell their story of what they have seen and witnessed, and what adaptations they have had to make to prosper, we could learn so much about the past present and future.

Looking at an individual stock or a market at a point in time, without regard to the major events that have shaped it leaves much information out of the mix that could be used to project the future.

Lesson Two: The forest thrives and benefits after many seemingly disastrous events. Fires clear the underbrush. Dead trees still standing provide cover for much flora and fauna. Trees contain so much water that there is still much biomass left when they die, and they contain the nutrients and moisture that other plants or fungi need for survival. This situation is called a biological legacy by the scientists, but is just known as a gift by the laymen.

The number of, the amount of time in between, and the extent of watershed declines that the market has witnessed in the last year, as well as the resilience of the market to these declines, is a good measure of the health of a system. It is often good for future growth, to see decimated parts of the market landscape, such as the US real estate sector which has currently taken it on the chin, or the Saudi Arabian market that is down 75%.

Lesson Three: A strong root structure is key. The roots of the redwood trees often stretch horizontally 30 yards from the center of the tree, and they can be as much as one foot in diameter. They mix with the roots of neighboring trees which provides greater strength to all. Seedlings also sprout from the roots, so the same sources are used for multiple outputs. If the tree is unfortunate enough to die, the roots can produce more trees of the same genetic material. The roots of the redwood tree are remarkable in that they are not deep, but they stretch so far horizontally, allowing the tree to grow in different conditions.

The importance of roots to the coastal redwoods leads me to consider the functions of the roots of a company — the sources of capital necessary to build its infrastructure. The money reaches the various divisions of the company and is turned into profits which are then circulated back to the trunk.

Lesson Four: Being tall keeps out competition and gets more light. The choice that a tree makes to invest its energy in upwards growth, and raise its canopy above that of its competitors, is apparently a very successful one in nature, because the different genera of trees, cones,cycloids, hardwoods, have all come to it independently. The redwood trees are able to reach the sun above any competition, and they are able to shade out and prevent any other trees that need sun for growth.

The big companies, those that say have a share price above $100, or a market value above 25 billion, have an advantage over the smaller ones. They are not as subject to dying, yet they have the ability to shed many older divisions to help their earnings statements along. They also do not have to worry as much about random shocks from the environment that might level smaller companies.

I hypothesize that the returns of companies that have a price above $100 is higher than the returns from average companies, and that their volatility is less. Also, that markets at higher levels are less volatile than those at lower levels.

Lesson Five: Trees depend on other flora and fauna.The diversity of the flora that help the basic functions of the tree provides resilience in case of disaster. The ground of Muir Woods is covered by sorrel which retains the moisture and nutrients necessary for the redwoods to grow during the dry summers. The roots of the tree are dependent on lichens that help them get water and nitrogen. Mites helps to recycle a fallen tree by eating the rotting wood, and chewing the litter that falls on the forest floor, and voles living in the canopy spread the fungi that the trees need for survival.

The health of a individual market or stock component, like GE, is dependent on the health of its environment. The healthiest market environments are those that have witnessed many varieties of stress and strain, and exposures to good and bad news.

Conclusion: There are many other lessons that I have learned from Muir Woods, like building a strong bark resistant to insects rather than growing leaves immediately, shading out your competitors, thinking long term, sending your leaves out on strong branches, and changing with the seasons. I can think of no better place in the world than Muir Woods to visit with a view to improving the quality of one's trading or living.

Charles Sorkin writes:

The slopes of White Mountain Peak are home to the ancient bristlecone pine forest, which contains the oldest living things on earth. Such trees are perhaps the reductio ad absurdum of adaptation, making do with diminished oxygen, extremely harsh weather, few nutrients, and highly alkaline rock/soil matrix in which to sink modest roots. The Methuselah of this grove is in excess of 4000 years old, and I'm sure they offer their own lessons. 

Bill Rafter adds: 

Redwoods need an exceptional amount of water to prosper. The rainfall in northern California is not always up to that requirement. However the height of the redwood comes to the rescue. Moisture in the atmosphere collects on the high leaves and the tree creates its own rainfall. 

Steve Ellison notes: 

Cook, Sillett, Jennings, and Davis, writing in Nature in 2004, estimated the maximum feasible height of a tree at about 130 meters (the tallest redwood is about 112 meters). "As trees grow taller, increasing leaf water stress due to gravity and path length resistance may ultimately limit leaf expansion and photosynthesis".

Adam Robinson adds: 

Those interested in the seminal work on Chair's musings might want to pursue Thompson's On Growth and Form, written nearly a century ago, I believe the first attempt to analyze biological phenomena quantitatively.

Also, re: Chair's Lesson 2 on resilience of a system, one of the ironies forest rangers learned was that their attempts to put out any and all forest fires resulted in a huge buildup of flammable undergrowth, so that the inevitable fires, when they finally occurred, were uncontrollable conflagrations. A sobering thought for the Fed and other market interventionists.

Which thought reminds me, apropos of Chair's point on the cataclysmic decline in the Saudi market, the Saudi market, perhaps for religious reasons, lacks mechanisms for short selling (I believe), so that market lacks the ability to "incorporate" divergent opinion, so the inevitable buildup of selling pressures, when finally vented, is massive and uncontrollable. 

Steve Ellison remarks:

Adam makes an excellent point that one should keep in mind the next time the Challenger, Gray, and Christmas layoff report is in the news. The process of decomposition, the breaking apart of complex organisms into simple components that can be used by other organisms, is very important in biology. Similarly, business failures and layoffs move people from performing work that customers or employers do not want to activities that add more value. 

James Sogi writes: 

Today's quiet market at recent highs are like the lofty tree tops of the forest. The tree tops seem to know where the top levels are and it takes some extra energy and exposure to extra risk to break above the tree tops. The boughs and branches are slender and sway up there.

Sept CME SP Futures

The quiet growth pushed upwards to make new incremental highs and an incremental daily gain. As with trees and plants, the upward growth of markets is always incremental, but steady. The rate of growth varies with the climate, the weather and season. The transactions approaching the top are always a good study of dynamics. There are many buys at the very top, hopeful buyers either hoping for the breakout, or seeing the new high as a sign of further gains.

These buyers have been rewarded in the past few years of benign climate, good weather, and rich soils. As with slender reeds, rapid growth is not sturdy and might suffer damage, breakage, wind, insects. Sometimes the boughs break, but with a strong organism, the branches grow back. The gains seem stronger and more protected when supported by steady and sold growth rather than thin shoots shooting upward.

Study of the rings in old trees can give much information about weather patterns in past years and relate to tree growth. It is a worthwhile study. The strongest moves in the market seem to be the steady marches upward, grinding, growing slowly but steadily upward. Even bamboo can crack through the strongest concrete. It’s hard to believe how tall the redwoods can grow. My friend has tree climbers, and we go up trees on these ropes. It feels pretty high up there, but is actually safe. We usually don't go out on limbs.

In the markets, as in the wild, it is always good to see the forest, not just the trees.

Russell Sears writes: 

The giant trees are made of mostly dead wood in the center. The incredible heavy lifting of water is even more amazing when you consider, it is just the outer layer, just under the bark. The efficiency and simplicity is reminiscent of the invisible hand of the market. The part that is growing or expanding sustains the whole tree while the dead wood just lends support. 



Regarding short interest as posted by Bloomberg, has this been tested? That IWM short interest being the highest, is that an indication for buying since a squeeze is possible. How would this be tested?

Bill Rafter replies: 

We have done considerable testing of short interest data. I am on vacation and must speak anecdotally, but let me give our generalizations. The results suggested that half the time the shorts were dead right and the other half they were dead wrong. Very little middle ground. An exceptionally large SI value had no particular significance. That is, it gave no edge to the trader to pick subsequent direction.

Our research was attempting to approach the data differently from the way Phil Erlanger approaches it. Erlanger first identifies market direction, and then looks for possible short squeezes that will extend a rally to a more substantial level. Since we found no edge doing it our way, we have to conclude that until shown otherwise, Erlanger's approach was valid. We did find that it took a long time for short interest to be covered. That is, the rally durations were substantial as to both price and time. The shorts were slow to believe they were wrong. Sell-offs of stocks with high short interest tended to be less substantial as to both price and time.

One might simply conclude that drops occur fast and rallies take longer, and that the SI figures were of no significance at all. We disagree. That is, we think SI is certainly a contributing factor. It may not be a meal, but it certainly is seasoning.

We also watch and calculate some other sentiment indicators, including a price-based intra-day sentiment value. Looking at subsequent market performance with it is identical to what we learned from observing and testing SI: Sentiment indicators have an extending effect when they are wrong and a moderating effect when they are correct. 

David Wren-Hardin writes:

In this case, you have to think about what IWM is. Most of the time when people short a company, they do so because they think it isn't very good, that it should be priced lower. IWM, however, isn't a company. It's an ETF tied to the Russell 2000 index. So now you have to ask "Why would someone sell this?"

Some sellers, I'm sure, think the Russell should be lower, and happily sell IWM. But others might just be doing it as a hedge. If you wanted to hedge your Russell 2000 exposure with a basket of stocks, getting clean fills would be a nightmare, as would tracking the 1900+ individual names, most of which trade by appointment. You think it's hard to borrow IWM, try borrowing some of these tiny names. But with IWM, you can get the entire index in one shot. One can even spin a tale that if people are selling IWM against a net long exposure, that the IWM short interest is, in fact, a reflection of overall long sentiment.

The other thing to consider is that you can't look at short-interest in IWM purely in terms of percentage short vs. amount out there. An ETF is created when someone hands the trust the complete basket of stocks, getting the ETF in return. Now, IWM may be short equal to the float of all the stocks in the index, but more likely, given the basket example I used above, it's simply a pain in the rear to assemble complete baskets of stock and turn them into more ETFs. 



 I have been researching on the web how to teach children to dream. What is left out is how to develop a passion for life when dreams fail to develop. I suspect their father's example is the best teacher.

John Floyd writes: 

I am looking for recommendations for children’s books. I would like to include the right mix of education, capitalism, logic, reason, imagination, and individuality among other things. A few books and stories that I have found, and the kids enjoy: Jonathan Livingston Seagull, Thidwick the Big Hearted Moose, An Airplane is Born, and The Little Prince.  

Scott Brooks adds: 

As much as we push education in our home, we've had a dickens of time getting our children to read outside of school. Finally last year, my oldest daughter got into reading the Goose Bumps series. She loves them and needs no prodding to read up on them.

My youngest son somehow got into reading the Star Wars books. He doesn't read them religiously, but will read outside of class if given a little reminder. Interestingly, I bought him a book on bullets at the Quality Deer Management Association national convention in Chattanooga last week and he's been perusing it almost everyday. He's 8 years old and it's way above his level, but he seems fascinated by it. He had his home school teacher read it with him and explain the more difficult parts to him.

For my 12-year-old, we've had to use a different tactic. He doesn't read unless we push him to do it. However, he's really into the markets and learning about investing. So he reads stuff on the net about companies he's thinking of buying and watches and reads investing information.

I guess the key is to immerse your kids in reading and let them find what they like. When I was kid, I'd read one or two Hardy Boys book's a week. I tried to get my kids into them, but to no avail. Keep searching to help your kids find something that they like. There have been a lot of good books recommended here (and I'm saving this thread for future reference for my kids and their home school).

Many of these books are important and are one's that I'll have the kids read as part of their school work assignments (whether they want to or not). But the biggest thing that I've searched for is, how do I instill in them a love for reading a thirst for knowledge? I can't do that by forcing books on them. Sure, I can help them to learn important lessons by requiring that they read certain books. But what I really want to see is them sitting down curled up with a book reading it because they want to. I believe that should be goal! 

From Bill Humbert: 

One of my children was a reading-avoider. My goal was to get the kid reading and I happened to see the movie League of Their Own in which the Madonna character teaches the non-literate character to read by using trashy novels. I believe the quote was something like, Who cares? She’s reading isn’t she? It’s a scene we always laugh at.

Well, I didn’t use trashy novels, but I did use comic books. We started with the superhero genre and then I gradually slipped in the newer version of the old Classic Comics. For certain works I also acquired Books on Tape, which is more useful than listening to the radio in the car and it gave the child a general understanding of the work.

Since the brain stores different types of input in different locations, this child had an advantage over the children who only had read say Homer’s Odyssey. The child had the pictures from the Classic Comics, the audio from Books on Tape and the printed word itself. After a while the child started to excel in those classes. And only then did the overall desire to read take over. I think it was like a pump that needed to be primed.

Get the child reading. "What" does not matter. If the child finds that useful and desired knowledge comes from reading, eventually that child will take to the books. But you have to prime the pump by starting with something that they want to read, which is not always what we want them to read. 

Larry Williams adds:

When I wanted my kids to read a book I was reading I told them they probably should not read it — that it was too adult for them. A cheap trick, I know, but they pick up those books like a brown trout seeing a grasshopper in August.

Nat Stewart writes:

My parents did much to foster my love of reading. In early grade school I would go with my mother to the local library, where I was allowed to pick any books I wanted for that week. I quickly fell in love with the selection of children's books that focused on biographies of America's great heroes. My particular favorites where books on:

1. Thomas Jefferson
2. Thomas Edison
3. George Washington
4. Paul Revere
5. John Paul Jones
6. George Washington
7. Davey Crockett
8. Henry Ford
9. Daniel Boone
10. the Wright brothers

I loved these books! The children's books focus on a narrative of struggle, adventure, and heroism, ingenuity, and are often historically accurate enough to prove very educational. I remember reading them late into the night, hoping no one notice that I had my light on long past the official bed time.

My parents also spent a good deal of time reading to me. My favorites included books about King Author and Nights of the Round Table, "Little House on the Prairie" books, and The Chronicles of Narnia.

Let a kid explore the library and pick favorites. Provide enough options so that reading can become an adventure rather than a chore. Spend some time reading to them over summer vacation. 

From  Bill Rafter:

 We all remember our trips to the library. However that cannot be replicated today. The libraries simply cannot compete with television and the Internet either with content or "wow" factor. The answer to the problem will be in using the new technology not avoiding it. Television, even the good stuff like National Geographic or Ken Burn's "Civil War", is still second-rate because it's passive. The Internet is active, and thus has more potential as a learning tool.

Games can be very helpful. One that had particularly helped me (both myself and subsequently my children) was Scrabble. After a street game of "boxball" we would dig out the Scrabble board while we cooled down. Those games got very competitive to the extent that several of us kids started doing research on words by randomly reading the dictionary. Scrabble also required you use arithmetic to keep score.

My favorite Scrabble word was "ennui," as it cleaned out your collection of accumulated poor-value tiles. It also led to challenges, which led to another turn and more points. While researching through the dictionary I stumbled upon the word "eunuch", which also had good Scrabble possibilities. Being in 6th grade, I didn't care what it meant, but kept a mental file for future use.

Well somehow I got into a name-calling event in the schoolyard with a girl and called her a eunuch. She had no idea what it meant, but the teacher Sister Mary Hatchetface was in earshot and she most certainly knew. The next thing that happened was that I was in the principal's office (Sister Jane Battleaxe). My father was summoned. He was a Philadelphia policeman, and he happened to be in uniform.

So there I was in the Holy of Holies with the two nuns in their penguin uniforms and Dad in his, trying to learn what trashy literature I was reading. The revelation that it was the dictionary left them with no solution.

Ahhh, the ability to stick it to authority…priceless. 



I wonder if "covering shorts" is a more predominant activity on Fridays than going long. And I wonder what method could test this. We see this today in debt markets for home builders' bonds, covered shorts, but not long buyers.

Bill Rafter adds: 

I don't have any proof, just a feeling that you would find Fridays to be mean-reverting, or reversing the Monday to Thursday action. But most of my feelings are wrong, which is why it's important to do the testing.

Craig Mee writes:

Climatic selling at its best late in the week saw the markets rates and equity finally break into a gallop and suck in some big ones after months in a slow well control trot. With so much energy now exerted, it looks like Phar Lap, will now look to please the crowd and not the punters. 



 The Chair recently mentioned Point and Figure, and advised that he was reading Tom Dorsey's book on the subject. I'm not sure if that was a recommendation. It won't hurt anyone to read Dorsey. There is another popular author on P&F, whose work I do not recommend.

Others have commented on the plethora of Dorsey followers. I have seen that also, but what has surprised me is that the institutional following of Dorsey is quite large.

There are substantial differences in Point and Figure methodologies that bear noting, particularly to anyone doing statistical/quantitative testing.

Dorsey uses a 3-box reversal. That means that to reverse direction, three boxes are needed, whereas continuing in the same direction requires only one box. That has the quality of making his version of P&F asymmetrical. Before you decide whether or not you like that, consider the following:

If your box reversals are symmetric, then P&F becomes strictly a non-linear filter. The smaller you make the box sizes, the more the P&F filtering of the data will converge to the price. For example, if your box height were the minimum tic, then the P&F filter would be almost identical to the price. (It would be identical unless the market went sideways.) But with the asymmetrical/classic/Dorsey version, reducing the box size changes the chart. But it never converges to the price. You will have to decide if that's the type of filter you want.

Dorsey also has box sizes that adjust to price, but only at certain intervals (like at $20). That creates some problems if the price fluctuates around the appointed level. However, the point is well taken that if the price doubles the box size probably should also, so there should be a better method of adjusting box sizes. John Bollinger had done that by defining Bollinger Boxes as a function of price.

I'm not sure John wants his formula out there, so I won't give it. But it does dynamically adjust box sizes. The values they provide are good ones for most stock prices. The only problem with that formula is that it is poorly defined for values below one.

Now you might question why I am looking at "penny stocks", and the answer is that I am not. But consider that if it makes sense to P&F filter prices, then it might make sense to do that with indicators, oscillators, or whatever. That's where the occasional values below one come into play.



 In an article by Bruno Dupire of Bloomberg titled "Optimal Process Approximation: Application to Delta Hedging and Technical Analysis" (July 7, 2005), he looks at price changes irrespective of time. I cannot speak for him, but in reading the article, I had the distinct impression that Mr. Dupire was unaware that he was really describing point and figure filtering. That's believable, as I doubt he would read the P&F literature, since it is considerably beneath him. I also doubt that anyone who is seriously into P&F would read Dupire. Most of the P&F crowd are unaware that P&F is a non-linear, adaptive (and in some cases asymmetric) filter.

In our shop we have done lots of work with filtering data. Universally we have found that using P&F techniques create unnecessary lag. I say unnecessary, as there are other filters that do not distort, and yet do not create lag. So we were vexed by the time we wasted in researching P&F.

But, critically, we never researched the patterns of P&F. Then Vic and Laurel mentioned it, which got us thinking we may have dismissed P&F too soon. So we have recently embarked on creating a library of frequently-recurring patterns, and using those to deselect some of the stocks on our daily lists. That is, using P&F filtering on price data.

But P&F may have other possible beneficial uses. In many ways it is the opposite of a moving median. Whereas the median discriminates against an abrupt move, P&F immediately recognizes moves beyond a certain size and ignores periods of inactivity. That makes it extremely interesting, and for more than price.

Victor Niederhoffer remarks:

The probabilities that Dr. Rafter found are completely non-random and form the base for a simple model that can be tested against extensions for reductions of variation relative to hypotheses concluded. The positive sequence of length 12 in the Dow overrides the normal difficulties with drift and heightened chance of momentum due to starting out in each case nearer the next sequence than the reversal due to randomness. 

Paolo Pezzutti asks:

Is this true also if the number of observations is quite limited for every pattern?

Victor Niederhoffer explains:

The numbers can be tested with a broad brush, with a standard variance of expected number of observations for each classification. There's enough there for the simple model to be highly significant.



 "Couldn't you just buy a portfolio of stocks that outperformed random?" That question was posed over dinner by an individual investor who had never taken a statistics course and had no real idea of random. He also had no idea over how long one should compare the performances. But he held the belief that today's financial weather is a function of yesterday's financial weather, and in his own way was looking for a way to make it work. Individual investors believe in autocorrelation even if they don't know what it is; they do not believe in the random walk.

The question caught us off-guard because we did not know the answer. We had always compared performance to the market indices as the obvious benchmarks. We were not enamored with the idea, but as professionals we had no choice but to learn the answer.

We have taken the 500 largest capitalization stocks* and their 1-day rates of change. Then we have randomized the signs of those rates of change. For example, if stock A had a gain of 0.32 percent on a particular day, the study would for each observation randomly attribute that day's performance as a positive 0.32 percent or a negative 0.32 percent. Keeping the absolute value of the percentage change and randomizing the sign preserves the volatility of each particular stock.

We then produced 1,000 such random results for each of those stocks over the last 10 years.

Next, on a moving basis (with varying lookback periods) we compared the actual performance of each stock to its collection of random results. We then ranked each by the percentage of the actual above or below the random collection. For example, if at a given time, the actual performance of stock B was better than 850 of the 1,000 random runs, then stock B was given a ranking of 85. If, over the same period, stock C ranked 80, then stock B was deemed to be stronger than stock C. Thus the stocks were compared first to themselves and then to each other.

We then simulated trading results as follows: we purchased a collection of stocks that ranked highest on a given day, allocating funds equally. The collections varied from as few as 5 assets to as many as 50. There was no attempt to rebalance the portfolio. For example, if 3 stocks dropped off the list, then we simply divided up the sales proceeds equally to the 3 new stocks entering the list. This was to keep the strategy operationally possible. We know that total daily rebalancing is more profitable (we have tested it), but it requires transactions in every held asset every day that is onerous for all but a few professionals. The actual strategy seems simple, but is annoyingly time consuming because of the number of calculations involved.

There was no attempt to institute stops. Stocks were never "sold"; they were simply replaced. This avoided the toughest decision in investing: when to sell.

We performed this work over a number of "lookback" periods. In the link below we have illustrated results over a semi-annual period (126 market days). Since ranking over a lookback period is more reflective of the middle of the period, we were essentially comparing quarterly price performance, which we felt mimicked either actual or expected quarterly earnings performance.

If stock price behavior is random, the strategy will not perform well.

Our preference is to compare performance on a reward-to-risk ratio. That is, we take the average annual rate of return and divide that by the maximum drawdown over the period. The S&P 500 Index on a total return basis returned a 9.26 percent average annual rate of return and experienced a 47.41 percent peak-to-valley drawdown, thus its reward-to-risk ratio is .1953. However as you will see, the choice of performance yardstick is moot, as the results are totally one-sided.

Of the 46 collections studied, the average annual return was 27.39%, while the average maximum drawdown was 45.15%. The average reward-to-risk ratio of the collections was 0.6076. More importantly however, is that all of the collections bested the S&P. There was not one that underperformed the market.

Although the results are fairly uniform some vague generalities can be made, which will not be surprising: The fewer the number of assets chosen, the higher the return and more volatile the performance. The greater the number of assets chosen, the closer that performance will come to mimicking the overall market.

These are not enviable results, but they are significantly better than the market. This study raises the bar for asset rotators. Most compare their performances to a buy and hold strategy of the indices. However, now we would postulate that these are new benchmarks for an asset rotator to beat prior to claiming any expertise.


* The list included deceased stocks (e.g. Enron, Worldcom, etc.) to prevent survival bias. Thus at times the list consisted of more than 500 stocks.



Decades ago I had heard the quote, "There are three kinds of lies: lies, damned lies, and statistics," attributed to Mark Twain. Then a few years ago I read that Twain got it from Benjamin Disraeli. However just the other day I read it attributed to Thomas Carlyle. The three were contemporaries. Does anyone know the true originator?

Philip J. McDonnell replies: says Twain attributes it to Disraeli in Twain's autobiography. But claims the earliest known written reference is by Lord Leonard H. Courtney. The observation is made that Courtney's quote attributed the phrase to the "Wise Statesman" who may or may not be a specific person. 



"If You Think You Can Beat Buy and Hold, Try Looking at Taxes"

Standard and Poor's gives SP500 returns with and without dividends back to 1990. Here are the returns at year ends, without and with dividends:

date       1yr rt  total rt
12/1990 -0.066 -0.031
12/1991  0.263  0.305
12/1992  0.045  0.076
12/1993  0.071  0.101
12/1994 -0.015  0.013
12/1995  0.341  0.376
12/1996  0.203  0.230
12/1997  0.310  0.334
12/1998  0.267  0.286
12/1999  0.195  0.210
12/2000 -0.101 -0.091
12/2001 -0.130 -0.119
12/2002 -0.234 -0.221
12/2003  0.264  0.287
12/2004  0.090  0.109
12/2005  0.030  0.049
12/2006  0.136  0.158

Mr. B. Holder (BH) puts $100,000 into the SP500 index 1/1/90, reinvests dividends into the index at year end, and pays tax on dividends out of his salary as school janitor. BH sweeps into retardment 12/2006, and notices that without taxes his initial investment became $555,637, including reinvestment of $22,271 in dividends along the way.

For this exercise, let's assume that long-term capital gains and dividends are both taxed 20% (they are currently taxed less, have been taxed more in the past, and will no doubt be more in the future). When BH cashes out 12/06, he gets to contribute $91,128 and keeps

Also in 1990, recent refugee Natasha Otradeskaya (NO) plows $100,000 of hard stolen capital into a U.S. trading account. Like others from her country, NO has degrees in math, physics, and nuclear medicine, but unlike competitors in the US and A, does well enough with trading (after slippage, commissions, and opportunity costs) to exactly equal yearly SP500 returns including dividends. Exhausted after 16 years and 10^16 quantitative studies, she decides to look back at her results:

date      100000     P/L     tax        net
12/1990   96896   -3104       0
12/1991 126416  29520   7925  118491
12/1992 127526    1110    333  127193
12/1993 140004  12478   3743  136261
12/1994 138060   -1945        0  138060
12/1995 189939  51880 14980 174959
12/1996 215129  25190   7557 207572
12/1997 276825  61696 18509 258316
12/1998 332140  55315 16594 315546
12/1999 381941  49801 14940 367001
12/2000 333588 -48354        0 333588
12/2001 293938 -39650        0 293938
12/2002 228973 -64965        0 228973
12/2003 294665  65692        0 294665
12/2004 326724  32060        0 326724
12/2005 342770  16045        0 342770
12/2006 396907  54137   4490 392417 <<<<Final balance

NO trades full-time 100% of her account every year, and pays income tax of 30% on her gains (the calculation carries forward losses, which are balanced against future gains; which is the case for a trader who has no other income tax to offset capital losses. Note also that losses carried forward from 00-02 are not used up until 2006). Thus she is unable to reinvest what is lost to taxes, and these amounts do not compound.

In the end, BH cleans up: He gets paid an extra $72,093 for not doing studies or trading frequently, and uses it to order a new bride who happens to be NO's grand-niece from the old country.

J T Holley adds: 

The old gray mare ain't what she used to be. You can actually get no load low M&E annuities that aren't as bad as you would think. Most people think though that investing should be free and that one bp is too much.

Vanguard's isn't in the example above but its M&E is .20 basis points with a .10 basis point administration charge and the S&P 500 clone sub account is .44 expense, bringing the total to 74 beeps. Anyone counting this out remember that annuities are like mutual funds and take fees out daily on an annual basis.

I'll take the ordinary income later in life over the stg/ltg now and avoid Uncle Sam. Even with the 74 beep vig annually that is better than the taxable stg/ltg combination paying taxes now, that the S&P 500 tax toll can be annual. I like the compounding and pay later acting as a quasi spigot trust if you have enough time and persistence.

Steve is right though. There are tons of annuities that have a lot higher costs. The industry average is around 250 beeps in M&E and charges, but even these higher vigged charges show the tax deferral outperforming the pay as you go in a taxable account if you hold long enough to let it happen.

Also, annuities have a 10% penalty much like IRA's if you yank out before 59 ½, unless you 72T. I would recommend neither unless "liquidation" is really needed.

Mr. Sears might help us here. I'll defer all annuity and running knowledge to him.

Steve Leslie writes:

ETFs are not fairly new. Diamonds and Spiders have been around for a decade or more. And irrespective of their longevity if one's goal is to replicate an event using an ETF, what difference does it make how long they have been around? This is not Morningstar; as we know track records do not matter.

There is a big misunderstanding as to the elimination of estate tax law in 2010 and the questions surrounding it. The reason there is a gap in 2010 is that it is my understanding tax law cannot be written for more than 10 years. So it is clear that the next administration will rewrite the tax code. Who knows what they will come up with then?

There are some very low cost variable annuities which stripped down to the bare minimum may have an attractiveness. When I was a broker (sounds like my father) the lowest cost one we sold was the Nationwide Best of America. Still, be very careful that there are some pretty good back end charges if you redeem the annuity. I think there are some no load annuities with low M&E perhaps in the Vanguard family. M&E is mortality and expenses.

This is where all the hidden charges show up. You pay for that death benefit. And the charges are rarely below 1% and then you add management fees of the funds on top of that. The management fees can be higher in annuities if they are funds outside the annuities family of funds. You pay to play. And once again there is no stepped up cost basis on date of death. That is an extremely expensive thing to have the heirs have to face should that happen.

I still argue there is no perfect solution, however, ETFs stack up very well against no load index funds, in performance for expenses and after tax return ease of ownership and liquidity. One added thought; they are a heck of a lot easier to track the cost basis for reinvested dividends than mutual funds. You do not get average cost basis. First in first out, etc.

I am not sure about the dividends being left in cash as Mr. Sasmor suggests. I thought by definition they try to be as fully invested as possible. Not even open-end index mutual funds are fully invested at all times. They do by the mechanics of the machine have to keep some cash on hand. And in open ended mutual funds, when a run on liquidity happens they must sell stocks accordingly to handle redemptions. Whereas with closed end funds this does not happen. There may be times when closed end funds trade at a discount to the NAV. Open ended mutuals are marked to the market on the end of business. And purchases are restricted to last day's closing price.

Bill Rafter adds: 

Regularly I get an idea from an investment professional who typically does not do any quantitative research, but has a "hunch" that he thinks will work. More often than not the investment pro got the idea from some huckster. Investment professionals are really no different (nor less vulnerable) than the public at large. To keep the investment professional devoted to quality research, I have to disprove the cockamamie hunches, lest he wander off following outlandish ideas.

The latest is the "gravity idea" based on "celestial mechanics". Every good con job contains a certain amount of truth, and this one evokes Isaac Newton, Kepler, and some other luminaries. The celestial mechanics is BS to make the huckster sound important and establish him in an intellectual pecking order. I think this is something they teach in huckster school on the premise that the mark has to look up to the huckster.

The system the huckster is peddling is really just based on tides, which of course is a function of celestial mechanics. But neither the huckster nor the mark knows that. I can tell the huckster doesn't know that because he claims to use both the celestial cycles and the tides, which in his case is redundant.

The huckster uses tide schedules from a point in Delaware Bay. I cannot really find out why because all conversation has to go through the mark. Apparently the mark has told the huckster that he has had conversations with another one of his confidants (me) who is skeptical. This gets the huckster's back up: how dare the mark give any credibility to non-believers! Another lesson from huckster school: get indignant when challenged and threaten to cut off communications. The mark always wants what he cannot have.

The huckster really has the mark convinced. I try all sorts of arguments, like why we cannot find any evidence of these cycles using Fourier analysis. And if the idea were true, why isn't there more volatility during the "spring tides" when the earth is at perigee? However, I'm getting nowhere because the huckster has a track record with great performance. Of course there are reasons why he cannot show it, so no one has seen it.

Well I don't want to go searching for the Delaware Bay tide schedule. And since I live near the seashore, I have the Barnegat Light tide tables bookmarked on the PC. That data are neatly presented in a spreadsheet with the date and four columns representing the two daily high and low tides. The similarity with bar-chart data is overwhelming, so I copy the data, import it into my charting software and have it displayed as open, high, low and close. I send that chart back to the investment professional with my commentary that the highs on the 2nd of the month will be higher than the highs on the 16th, and the lows of the 23rd will be lower than the lows of the 9th.

At the end of the month the investment professional (i.e. the mark) gives me a call and tells me that my trading signals were right on target, and the gravity man (i.e. the huckster) complements me on having mastered the technique in such a short period of time. I know the trading signals did not work and I suspect that the huckster is now using me to validate his own importance. This must be another lesson from huckster class: if confronted with an outside challenge, turn the challenge around to support your own claims.

I have no choice but to have a personal meeting with the investment professional and show him exactly what I did, which takes about two minutes. He really doesn't want to believe me, but when he sees that my tidal signals did not work and then realizes that the gravity man is just playing him, I finally win him over.

Hey, anyone want to buy my gravity system?

Steve B. adds:

The con game is not so much about the con be it in financial services, health and beauty, or the red-hot real estate (mortgage) market. The con game is about the mark - the one who must get conned for the game to work. The con in this game has the advantage of instant feedback from the mark. The mark is spotted by the type of work he does, the kind of car he drives, his or her age. These are just general and to get specifics he needs to talk directly with the mark.

How is it that the con can come to know about us? We provide him the information via physics and other shamsters. But in this case we feel we are dealing with a respectable person and our guards are down. Basically, one starts with general statements and through feedback (verbal and body) the con figures out which of his general statements are specific to you.

We all have the desire to trust our fellow human and the con operates with this advantage. You may not always know when the con is on but if you feel the flattery (and a feeling you may miss the boat) then you may be a mark.

From Henry Gifford:

While it seems so many con games include some true physics in the story, the physics are usually redundant (as already mentioned) or not relevant. My favorite is energy-saving devices that incorporate the use of "bipolar" magnets. As all magnets have two poles, the statement is meaningless yet true. 



 The worst mistake in business is to get in over your head. Don't ever let yourself do it. The market will always be around. Do keep a lab notebook and hand records of all your trades. Try to do as much of your research by hand whenever you can, as it lets you see more things.

Always enumerate your entire computer output by trade so you'll see how it's doing over time and bunches. Try not to listen to smart people on a macro basis, as their views can be marginal and some are smarter than others. Only trade active markets.

Also, don't be afraid to give up on markets. Find a niche where you have an edge and do concentrate on it. I started out with about 10,000 under management. If you can make a little above average, you'll have all the business in the world.

Bill Rafter adds: 

The Chair is absolutely correct about keeping notes. And there is nothing as good as a lab notebook. But everything has the disadvantages of its advantages. I have found in both research and trading that the handwritten lab notebook is essential for thinking through ideas and theoretical problems. But it falls short in terms of practical research because your notes will essentially be anecdotal.

We have found that when researching a particular idea we get excited and may sometimes make manual research "runs" several times a minute. That's too fast to keep adequate handwritten notes. Additionally we may set up research to run thousands of variations overnight in an attempt to find the statistical "truth" of something. In such a case you must have a way of saving each result and sorting and comparing the whole lot. Anecdotal notation is not enough.

The same is true with trading. Every time you make a trade have the results saved according to the type of trade it was. The types are specific to you. Someone else might characterize them differently. The more information the better.

For both research and trading it's best if you create software to save your results. Have the results of each research run or trade stored in a text file, and then have the ability to plop the results of all such research and trades in an excel file for comparison. You may not be the smartest "natural" researcher or trader, but your documentation and filing system will enable you to avoid future mistakes.

Most people fail at the business of trading. Most people trade "anecdotally." My guess is that the Venn diagrams of these shows considerable overlap. As the demigod said, it's perspiration, not inspiration.

Hany Saad comments:

What is getting in over your head? Is leverage getting in over one's head? Is over leveraging? What is overleverage? should one be only trading on a 1 to 1 … 1 to 3, or use the maximum leverage possible? Should one diversify? if you are trading the stockmarket, is anything above 15 positions really necessary? Is anything above that even easily trackable by a manager?

It is unfortunate that the first advise seasoned managers offer you is to diversify. I believe this is the mistake managers make the most. They over-diversify and they lose track of the raison d'etre of their positions in the first place. Do not over-diversify.

On a side note, I am guilty of not following Vic's advise about hand studies. I only started after reading this post by simply putting down prices on graph paper, and let me tell you that the feeling you get out of the process is incredible. Things you would very easily miss by using the computer become clear to you. The only problem is that the process can be very time consuming, but not without its benefits. 

Alex Castaldo offers:

What is getting in over your head?

Really you don't know? We have some experts on this right here on the Spec-List. Or is it a rhetorical question?

What is over-leverage?

Ed Seykota has a good explanation on his web site. (I don't like Ed Seykota, BTW, too arrogant.) For a given expectation, as you increase leverage at some point the rate of return decreases. A hump shaped curve.

Should one diversify?

Let's not waste time on this; Markowitz already got the Nobel Prize for answering it.

If you are trading the stock market, is anything above 15 positions really necessary?

Do you think that Jim Simon or David Shaw have portfolios of fewer than 15 stocks?

Is anything above [15 stocks] even easily tractable by the manager?

With a computer you can keep track of 1500 stocks practically as easily as 15.

I believe this is the mistake managers do the most. They over-diversify.

Think of it from the Markowitz point of view. You have a quadratic program in terms of means, variances, and covariances, plus you add a constraint "no more than 15 stocks." Solve the QP. Now remove the constraint of only 15 stocks and solve the QP again. What happens to the rate of return? In all but pathological cases it increases (and it never decreases) by removing that constraint.

Think of it also from the Statarb point of view. You have an algorithm that successfully predicts stock excess returns. As long as the excess returns are greater than the transaction cost, you might as well include as many stocks as possible in the portfolio. By limiting the portfolio to 15 stocks you are leaving money on the table.

From Sushil Kedia:

The picture captioned Guru has some inspiring stories to tell. This particular snapshot shows Abhishek Bacchan - the current contender for the superstar slot in Bollywood. In this recent blockbuster titled Guru he is playing the role of Gurukant Desai - a pseudonym for Dhirubhai H Ambani - the biggest tycoon ever in Indian business.

The sea of umbrellas in the backdrop is a touching sense of cinematography and attempts to capture that historic moment when nearly two decades ago for the first time in India a Public Limited Company held its Annual General Meeting in a sports stadium for the first time. Mr. Ambani is credited to be the father of the raging equity cult in this nation. The lashing rains, it is said, did not dissuade a near histrionic crowd from dispersing. This picture thus has a story of a man, who was barely literate but had all the speculative and risk taking genetics to inspire milling crowds to supply capital.

Mr. Ambani was a rank outsider in the industrial club of post-independence India. The son of a village schoolteacher who resigned from secure employment to create the largest ever-industrial enterprise in India. The Reliance group of companies that he went onto create have had grown within twenty years of coming to life to be the largest market capitalization companies in their respective sectors, largest sales, largest profits, largest number of shareholders, largest everything.

The movie is a reasonably close depiction of many of his facets (and three hours can't be enough to justly portray the racing pace of two decades of growth). An ace natural speculator, his enterprises have continued to expand in ways very typical of a trader who pyramids correctly and manages risk. This movie depicts inspiringly enough for any trader how a rank outsider without any crutches of a business lineage or modern education applies commonsense, correct usage of the envelope and pencil device (hand-studies), intelligence and sheer diligence to beat the system at its own tracks.

Lores suggest that when Dhirubhai was working as a clerk for a commodity trader on the port of Aden at the age of sixteen, suddenly the town started discovering the trading prowess of the lad with acumen. A particular denomination of coins vanished gradually first and completely later out of circulation. The value of the silver content had gone higher than the nominal value of the coins. It is believed his first large wad of capital originated from this arbitrage. [Not shown in the movie though]

A ticklishly touching sequence from the movie shows that when the Futures exchange in Mumbai was shut down by the orders signed by a bureaucrat that described speculation as unproductive gambling, Guru / Dhirubhai hires a truck and dumps long and fat rolls of polyester yarn in the living room of this bureaucrat. The officer scared of a possible tarnishing of his reputation that others may think all this yarn is lying in his house asks him to remove it immediately. Dhirubhai walks off saying the only two ways the officer can dispose off the yarn is by either dumping it all in the sea or re-opening the exchange where it is possible to buy and sell. Perplexed for several days, the officer tracks Dhirubhai down over and orders the re-opening of the exchange turning the David a darling of the Goliaths.

If anyone is interested in figuring out how modern India's business structures operate, what is the "inside picture", what is to be not done and what must be done this is a must watch movie. For those purely interested in trading philosophies the ingenuity of the hero of this saga has continuous positive surprises. For a rise as meteoric as this in such short time, what is remarkable is that for all his aggression he clearly believed and lived inside out that, "the worst mistake in business is to get in over your head." He is more Aggressive and more humble than the competition and in equal measure.

Of the hundreds of popular Ambanisms one would in the present context mention these few:

"No one was ever issued an invitation to profits."

"If I have to salute a peon in someone's office to get past my objectives, it is part of my work to do so."

"Calamity is the origin of other opportunities."

"Think big, think fast, think ahead. Ideas are no one's monopoly."

Vic replies:

One of the greatest mysteries to me is how trading firms like the ones mentioned can garner over sized returns with short term activities, considering the massive bid asked spreads and exposure to the principles of ever changing cycles. Smart people I have known, like my first partner who was a champion bridge player as well as number one in M.A.A. comp., have never understand that whatever looks like it works is doomed to failure. Despite this, to his credit he was a buy and hold man with a reasonably positive view of the resilience of enterprise, and was thus able to participate in the drift of the 10,000 fold return per century.

On the other hand the firms mentioned are riddled by those who hate enterprise and would seem to favor things like long/short, making their inability to overcome the bid asked spread even more incredibly likely to me. But as they say, when I pose similar lacnunae against the sport-term owner, he is the one who owns the big teams and I am still a very small operator. I am a poster boy for how volatility and chronic bullishness can lead to disaster, as well as the butt of the mojo of the expert derivatives man who is so ready and able to take all my meager chips on the all too frequent black swan events.



 I believe hedge fund strategies will be new frontiers in the ETF market. As we are seeing ETFs move into more active strategies, we have already seen the beginning of this trend. The quantitative backdrop for evolution can be found in these articles by hedge fund Bridgewater, on selling beta as alfa and levering betas.

My prediction is that the increased accessibility will make it harder to prosper for hedge funds that are currently selling beta as alpha. In effect I see no reason why it couldn't soon be as easy to access some of these strategies as it is to trade the QQQQ today.

Gordon Haave writes:

Yes, but the whole point of the ability to replicate these funds is that you don't need the lockup, or at least not as much of one. One can short volatility without a 1-year lockup.

From Bill Rafter:

The largest portion of hedge fund money is employed in long-short. Long-short is highly liquid and highly scalable, and could easily endure a zero-day lockup. For example, we have a long-only (in theory, less liquid that long-short) large-cap program that has a zero-day lockup. One might ask why. Our answer is "marketing." Investors (particularly pros) are a lot less reluctant to give you money if they can get out on an instant's notice.

Lockups are really only necessary for strategies such as event-driven or distressed assets. The hedge fund industry mostly uses lockups to keep control of its assets. Recall how the recent ('06) Greenwich-based fund went guts-up and tried to manipulate its reports to shareholders to have the latter miss a redemption deadline.

Brian Haag adds:

If the funds are algorithmically managed, they are a short. Fixed systems die. If the funds are actively managed, they are a short. They will not attract the talent that 2/20 type arrangements will, and will thus be the mark at the table.

This whole "you can replicate any hedge fund strategy by adding beta and a few formulas" meme is no different from the "You can beat Wall Street at its own game!" type hucksterism so prevalent in the late 90s. It's just marketing crapola. While the base idea may be sound, that you don't have to get involved in hedge funds to receive average returns, so what? The only possible outperformance in products like these is relative to managers with subpar returns. It's all just another way for the industry to sell average performance.

Managers who do add alpha are very happy about this whole development. It's another source of edge. One needs to look no further than the "Goldman roll" in commodities to see an example.

Charles Sorkin adds:

I have been offered structured notes (intended to be re-offered to our customers) that pay interest based on the Tremont hedge fund indices. Depending on the degree of index participation desired, investors have the option to have total return floored at zero percent (principal guaranteed, like a bank note). Naturally, the secondary market for such a thing is limited, but it's still better than a hedge fund lock-up. Moreover, the issuer is generally an AA-rated large European bank.

Need to get more aggressive? Just buy 'em on margin…

Henrik Andersson adds:

Some of these structured products, which are particularly popular in Europe, are selling with a participation rate of 100% and no Asian etc. This is strange since it seems you get the put for free; but in these cases the cost of the option is most likely taken from the fees of the underlying funds.



Today I did a quick hand study to make a point and figure chart. I looked at swings of five or more points, only above an S&P futures level of 1400, and starting on the 15th of March. I defined a sequence as a plus plus (++) or minus minus (- -), a negative reversal as a plus followed by a minus (+-), and a positive reversal as a minus followed by a plus (-+).

There has been a nine long (++++++++++) positive sequence up to the 1450 level, then a negative sequence of three (- - - -) to 1434, and then a positive sequence of one (++) to close again at 1450 . There has since been a negative reversal of length one to bring us to 1439.

I hypotheize that the expectations after negative reversals of length 1 are negative. 

Bill Rafter writes: 

Two years ago we wrote some code to test Point and Figure data. Our goal was to quantify some of the anecdotal claims going around. We were predisposed to like the concept of running data through a P&F filter, as the resulting data is non-linear.

It is also asymmetric (it usually takes more points to reverse than to continue) and in the classic version, adaptive. We found that smoothing the data with all varieties of P&F filters did produce better results than obtained by using raw data, by reducing "noise."

However, it was vastly inferior to most other filters, mainly because the P&F process introduced additional lag. So, the dog hunts, but he doesn't hunt as well as the other dogs.

Sushil Kedia writes:

Dr. Rafter's post has invigorated the ever hungry mind. Without trying to pry any profitable filtering ideas from list members, one is curious to learn how to think of suitable filters.

What properties, in general, should one look for in including a particular filter or filtering system on the list of "need to test further or develop further?" And which attributes would help put the rest on the other list?

The more learned could help neophytes sharpen their thought and creativity tools to focus better. Thanks in advance.

Bill Rafter replies:

By filters we mean filtering the data, not spam filters for email, although the principle is the same: weeding the wheat from the chaff. By filtering we create a surrogate dataset. The goal is to create a dataset with all of the good attributes of your original and minus a few of the bad features of the original. We are of two opinions that are not necessarily mutually exclusive, but approaching it:

1. It is not a question of separating the short-term noise from a long-term signal, which is the general consensus. According to our research, the true signal is in what most refer to as the noise. That is the counter-intuitive point of view. A good example of this is illustrated where we break down the put-call ratio by wavelet de-noising, and then reassemble the shortest time frame components.

2. Opposing that is the fact that we have found that some minor smoothing universally improves our results. I suggest that you look at 3-period medians and 2-period exponentials for a start. Medians have some great advantages. I definitely recommend against midranges (daily or otherwise), although that's what many "experts" tout.

The consensus refers to filtering as smoothing. That's not always the case. Some filtering will result in data that seems to be more erratic or discontinuous. A fairly inclusive "course" on this can be found at one of our sites.



 About six months ago I posted my growth rate calculation of Federal Payroll Tax Withholding in the form of a chart   showing its past relation to the stock market. The information was shocking to me, and apparently to a few others. It showed that the U.S job growth was declining, as indicated by the real numbers - payroll taxes, not surveys. It's natural to think of declining job growth as a "job growth recession." That's what scared me - the "R" word.

All of my trading information was indicating a higher market, yet the R word had me in a state of apoplexy. Boy was I dumb! I ignored the obvious: When your economy is at full employment, it's impossible to have anything but a decline in job growth. That doesn't mean a decline in jobs - just in their rate of expansion. An economy in that situation does the obvious - outsource.

So before you throw in the towel, remember, we're at full employment. And also note that the job growth numbers have been coming back up.



 Chris Cooper wrote: "I am trying to determine what lessons I should learn about my trading during the past week of large moves in the markets."

If the objective is consistent profits (positive returns), how can this be accomplished under all market conditions?

Persisting stable drift, such as the 8-month period that ended last week, requires long exposure/leverage. But as recently demonstrated, this approach has risk that cannot be controlled while maintaining exposure.

Even more ironic is the plight of those who concluded that the 00-03 bear market was "a big one," which would continue as a rational correction of the prior irrationalities. Or the OMWPS (older white males with pony-tails) still holding PALM and EMC from their days as millionares circa 19 and 99.


Maybe the problem should be reframed: Consistent profits are illogical, because no one can anticipate 2/27's, 911s, nor 3/00s. (OK there were many who got one right; some got two, and even a few all 3. Just as magical as 9 heads in a row.)

The only state of risklessness is death. We reach for risk as we follow the path of the delusional Quixote in the moribund hunt for immortality.

Bill Rafter adds:

Depending on how one defines "consistent profits," they may be achievable to the extent that they are more frequent than random would dictate. We would suggest that the focus should be more on reducing the number or severity of periods of negative returns.

Our experience is as follows:

If your investment universe is large-cap stocks, you are going to be vulnerable to overall market declines. Your only escape is to find a tool/indicator that enables you to change your universe during those periods. Some sector rotation will work to the extent that you will be able to claim positive relative returns, but we don't call that "winning," although Wall Street generally does.

If your universe includes mid-cap, small-cap stocks, and foreign equities, you are going to be less vulnerable to overall declines, particularly if such declines occur over an extended period (e.g. 2000-03). But in a "whoosh" such as the market experienced last week, it is more likely that all will fall somewhat together until the panic subsides. If you can predict the whoosh, then good for you. But if you cannot, and your universe is equities, you must find some of those that will behave somewhat independent of the averages.

Brian J. Haag writes:

I've said this in response to various topics, but I will continue to beat the table on it:

The biggest reason so many people perceive increased correlations is because they look at everything in dollars. That's fine; but then they shouldn't be surprised when correlated moves happen. Any time you buy something for dollars, you are essentially selling dollars (or loaning them out, if you want to get all "swappy" about it). So if, after you have made your trade, people decide they like dollars more than your asset, you will lose. And sometimes they decide they want dollars more than just about anything else –and then almost everything goes down together.

It is extremely instructive when looking at a trade (even if you are relatively high-frequency) to price the asset in question in terms of other assets. For example, how much did US equities drop in terms of Euros? Or in terms of gold? It's not orthodox to think of long stocks/short gold as a hedged trade, but sometimes it is. The key is to have the trade on in the right amount and at the right time (of course, that's the key to every trade). But in any case the trade will have add a different kind of diversification, which is probably what you're really after. Call it a "correlation call."



 We do not use moving average systems*, but we do use approaches (e.g. sector rotation) that have lookback periods. One of the first things we did was to check all possible lookback periods. That research was not to find an optimal one, but to look for "sweet spots" and to hopefully identify the reason. We did find sweet spots for all parameters, and not just the lookback periods. The lookback sweet spots tended to cluster around very identifiable periods, like monthly, bi-monthly, quarterly, etc. Through an interesting approach we identified some of them as related to options exercises, and others as related to earnings releases. We subsequently theorized that since a large portion of the market followers are fundamentals-based and specifically earnings-based, it is quite logical for a momentum/velocity/acceleration-based ranking system to be successful with a quarterly lookback period. That is, what appears to be a technical system (i.e. price-based) is in reality a fundamental system.

One wonders why recent success would have any predictive capability. That's a fair question, and one we continually agonize over. However, let me use a sports analogy. (I hate to use sports analogies, as it usually alienates many women, although my wife would disagree.) Last years NCAA men's basketball champion was Florida. Forgetting their current performance, Florida was highly ranked at the beginning of the season. Why? Well because they had many returning players. Past successful expertise doesn't stop just because of an arbitrary end of the season. The same is true in investing. Long ago it was discovered that one of the reasons for mutual funds having a second year of good returns is that the stocks held in the first year continued to be held.

The above approach is fine, but requires repeated testing using continually-updated out-of-sample data. What we prefer is identifying a particular characteristic of the markets that is reflective of current conditions and using that characteristic to define and alter your lookback period. This makes your lookback period adaptive, and effectively negates the need for out-of-sample data.

* If forced to come up with a long-short strategy and in need of the short side system, we have found the best approach to be moving-average based. It won't make money either long or short, but will go nowhere and reduce the margins for the long positions. However, I don't think that's an endorsement of moving average strategies.



The current popular explanation for the market's persistent strength is "worldwide excess liquidity" (a la Sam Zell's singing Christmas card).

Under this view,

1) Where is all the excess liquidity coming from?

2) And why is there more liquidity being created now than in normal other good economic times?

Dan Grossman writes:

Maybe the world is awash in liquidity and maybe it isn't. But the central banks of the number 1 and number 2 economies are restrictive and have been that way for some time:

Jim Sogi writes:

 I am sure everyone has noticed that the market refuses to go down. Every time the bid pauses, after a small airdrop, buyers come back to bid it back in force. The liquidity is a tectonic event, like the movement of plates. Once put into motion by years of pump priming in the US, in Japan, in China, it is hard to hold back.

While the monetary authority is restrictive in its pronouncements, it is not necessarily so in practice, with low rates below short-term rates, which would cause liquidity to flow to equities under the Fed model. Typically, as with any political movement or group situation, once a consensus is created it is hard to change the direction and the momentum tends to overshoot the changing circumstances. It is a typical group dynamic caused by the difficulty of getting people to agree. And as with the gambler's being more certain once the bet is made, decisions become etched in stone and are hard to change. When currencies move, they tend to overshoot their mark. When risk is deemed to be low, the consensus continues even beyond the time and circumstances justify. Remember 1995? It seemed the market was really high then. But it shot up like crazy over the next five years.

Old metrics of liquidity such as M3 don't work. George and Phil mentioned the role of derivatives. Is there a way to measure the derivative market? What are the indicators? Currencies measure the relative strength of flows of capital, goods, and fiscal and monetary balances between nations, and are important measure to consider in a multivariate way similar to gold and commodities that reflect and predict equities.

Japan's new equity highs and yen lows reflect a political and economic dynamic of a growing economy with its monetary gear in reverse. Very odd. Both the US and Japan benefit from weak currencies against the Euroland, and despite the jawboning and posturing, the currencies stay low. The fiscal power is exercised by the Executive but the power, in theory, is in Congress. This is separate from the monetary power of the central banks. The two are related, but are not formally coordinated. The size of the currency markets surpasses equity and debt and is subject to intervention in scope beyond both.

As the floating fiat currencies mature, the competition between nations may become more intense. While liquidity is good, now, there is not much of a squeeze. Reading some of the old books, there were some tense moments when bars of gold had to be shipped from England to New York to keep things afloat. Benjamin Franklin argued for printing money to stimulate commerce. All nations have incentive to inflate their currencies to keep growth from falling back into recession. What happens when the confidence, rather than gold, that keeps the currencies afloat turns dark?

It's a very difficult issue to understand. Thanks all for your help.

Bud Conrad writes:

Nice charts. I appreciated your sharing them. I agree with your base point, and want to see if I understand the importance of this analysis.

A little more explanation would help me apply the observations. The red curve fit looks like it is at a higher rate for the Japanese. Can you give me your fit percentage annual growth for each? The size is hard to read on my small screen.

Do you have an explanation of the big drop in Japanese monetary base? I think there were shifts in the policy of the BOJ in May 2006, around going off the Zero Interest rate policy but I can't recall the actions taken. Would they fit though the Japanese end point were higher or lower than the US? Is the monetary base an important measure now that there is so much credit created outside the banking system that is not regulated, and for which there is no reserve requirement, and now people prefer paper money to credit cards?

From Bill Rafter:

U. S. Monetary Base is the combination of currency in circulation and deposits in Federal Reserve Banks. It is released bi-weekly in seasonally adjusted form by the St. Louis Fed. It is also released weekly in non-seasonally adjusted form. I can seasonally adjust the weekly data myself, but then I would be the only one with that data. Since much of market action is sentiment-based, it's best to see what everyone else is watching, so I use the default.  

The Base must grow at the rate of the population growth and economic growth or risk causing deflation. Thus in the long run the Base growth will be exponential with some positive and negative feedback influences. The best way to fit it would be with a parabola. That's what the red line represents. The software that I use (our own*) does that easily and produces the formula giving the growth rate. Off list, I will send you a text file with the base and parabolic fit numbers. What is absolutely amazing is that the fit is so perfect from inception. To me this means that there is a "natural" target for the Base. Whether the Fed admits to a target or not is inconsequential. One exists. Once you have acknowledged that, then it is a small step to say that growth in excess of the target is accommodative, and less than it is restrictive. The two spikes (Y2K and 9-11) prove that the Fed has control.

The Japanese Monetary Base numbers are available monthly. They consist of currency and deposits and are available raw and ARIMA adjusted. I used the latter in my chart. The Bank of Japan did have an inflation epiphany last May, when the numbers showed a huge contraction. Some have attributed the sell-off in our equities markets at that time to the BOJ action. Yes, the growth rate in the Japanese Base is considerably greater than that of the US. Please don't flame me for saying so, but I attribute that to (a) inexperience and (b) BOJ having less independence from the government than our own Fed does.

Credit is created outside the central bank infrastructure, but sooner or later, that money hits the banking system where it is recorded in the Base.

Note to members: I would be happy to produce additional information based on monetary numbers from other countries. Send me links. Europe would be particularly useful. Australia and Russia are probably just warts on the elephant's butt. China is a question mark. I assume that even the rural areas are somewhat dollar-influenced. I don't know how China's banking system works, but assume it is run by benign neglect. Therefore, a lot of what goes on there shows up in the U.S. numbers.

* To all: I have previously offered the software free to list users. That offer still holds. Just send me an email if you want a serial number.




 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. She 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? Standard & Poors does that work for us, and breaks down the overall market (that is, the S&P500) into 10 Sectors. They then 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 change 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). She then invests in those ranked first through fourth (25 percent in each), and maintains those holdings until the rankings change. How does she do? Not bad, it turns out.

From 1990 through 2006, which encompasses several types of market conditions, the overall market managed an eight 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 focus, major improvements can be achieved. If instead of ranking the top four of 10 Sectors, our savvy investor invests in a similar number (say the top 4, 5, or 6) of the 24 Industry Groups, she achieves a 13.12% compounded annual 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 she 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 she 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. But 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, it 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 she 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 her recent experience would suggest otherwise. And since timing can never be perfect, it is further likely that the equities she 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 four 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 surprising, the choice of 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 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 she 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.



 I heartily recommend the use of the compounded value of cash as a multidimensional tool. That is, one takes the daily 3-month bill rate and compounds it. (If you are looking at market days, it is the cumulative product of the 252nd root of 1 + the rate.)

I had previously illustrated how year-on-year changes of that data are an excellent indicator as to whether Fed policy is accommodative or restrictive. Now I recommend comparing that data as a benchmark to whatever else you are trading. The point is obvious: If whatever you are trading does not outperform cash (i.e., 3-month bills), then don't own it at that time; it's a dog!

Consider the broad market. Compare a buy-and-hold S&P to the strategy of switching to cash if the yearly growth (252 market days) of the cash is less than that of the S&P. Results of that daily strategy (4300+ days since 1989) are illustrated here:

This is not difficult, and the savings for the investor can be substantial. Ranking your other assets versus cash can be even more rewarding.



 The Monetary Base is composed of 2 items: currency and deposits in Fed banks. The two are an interesting combination. If you look at the spikes in Monetary Base, the first one (Y2K) is entirely due to currency. The second one (9/11) is entirely due to the Fed goosing the deposits. That points out that despite some opinions to the contrary, the Fed definitely has some control over the process. Which is to say that changes in Fed policy can have significant effect.

Deviation from the fit does not correlate well with bullish or bearish equities, just as high or low interest rates (unless excessively so) also do not correlate well. The equities markets can get used to a level of interest rates, but uncertainty or volatility of those rates can have a deleterious effect on the stock market. That is, it's not the level, but the volatility of the changes. Because there are not enough examples, however, the analysis must be considered anecdotal.

Regarding the Fed's policy, they were restrictive during the 1996-99 period. But the decision to be less restrictive after the combined Asian Contagion, Russian Bond default, and collapse of LTCM, really sent the stock market soaring.

I ask the rhetorical question that if the Fed should back off their restrictive policy, what will happen to the stock market? However, I believe it is unlikely that they would back off without a triggering event.



 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:

How Great Traders Make Millions in Up or Down Markets 

Does Trend Following Work On Stocks?

Interviews At RealWorld Trading

Why I Don't Believe in Trends

Briefly Speaking . . . 

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.

In 2D, the French author Jean-Paul Delahaye speaks about "effet rateau" (rake effect), here and here .

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. 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 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.

Victor replies:

 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

WN <-rnorm(1024);RW<-cumsum(WN);DELTAT<-1/252;

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:

Regression Statistics
Multiple R                0.6816
R Square                 0.4646
Adjusted R Square   0.4627
Standard Error        0.0066
Observations           0.1166

                    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,

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

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
             —–        —–
               9           10

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.




True learning comes from taking a new fact and conjoining it or juxtaposing it with something you already know. Some very good market research ideas come from diverse science fields such as chemistry and cosmology. Many of those ideas are counterintuitive at first inspection. "Accepted" market literature is replete with statements that cannot be proven false. At least reading about proofs in science gives one the general background to reject some of the bogus statements about the markets. A very good place to start is NewScientist magazine as a quick source for new scientific developments. Many of their articles are available free on their website.



Here is a visual comparison of the S&P vs. S&P total return with a 10% curve thrown in.

Dick Sears comments:

Thank you all very much for helping me find the data for the S&P 500 T.

I'm astonished to discover that what the press has been reporting all these years doesn't include dividends. It's not as if the difference is insignificant. In 2006, the S&P was up 15.79% with and 13.62% without, a difference of more than 200 basis points.

Over the last five years, the difference is more marked (in relative terms), 6.19% per annum vs. 4.32%.

By excluding dividends, the press makes the stock market appear less successful than it is. I'd chalk that up to its anti-business bias if I hadn't discovered how difficult it is to get the return including dividends. S&P does provide it, but not in real time, and probably only once a day and many hours after the market has closed.

For myself, I think I will simply remove the S&P from my GTI website. It doesn't have much meaning for tech stocks anyway.

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