201f Vinh Tu : Daily Speculations 213a 11558

# Chemistry and Markets, from Vinh Tu

Since the topic of chemistry/market analogies has come up, I'm reminded of something I noticed while studying economics. Anyone else notice some resemblance between stoichiometry and the Cobb-Douglas production function?

Stoichiometry and the reaction rate equation: r = k(T) * A^n * B^m

And the Cobb-Douglas production function: Y=AL^{\beta}K^\alpha

What kind of "chemical" reactions can we find in the markets?

Something like this?

An important difference with this "reaction" is that _p, which is price, fluctuates; whereas chemical reactions always have the same stoichiometry. So, are there any useful analogies?

### Nov

#### 28

November 28, 2012 | 4 Comments

First consideration, have a customer who is willing to pay. If you have that, you have a business. Without that, you have an idea and not a business.

Second, be willing to amend your plan(s) in whatever fashion in order to accomodate what the customer is looking for.

Third, don't listen to anyone–naysayers, govt regulators or other douchebags– just go, do it.

## Jeff Watson writes:

It might be advantageous to consider the possibility of finding a business near bankruptcy and doing a turn around. Failing businesses like pizza and bagel shops and others can often be bought turnkey for pennies on the dollar (the owner is selling equipment before the creditors can attach it), moved to a new location and turned around, or liquidated.

Plenty of people go into business without enough specific knowledge, capital, a business plan, proper help, quality product, or a realistic price list. They compound these mistakes by not watching their pennies, mismanaging inventory, having over optimistic, unrealistic expectations. They also might place too much trust in their employees and not notice what's going out the back door. Many don't realize that running a business is 24/7 and every small detail counts. I've seen small business owners who don't even know their raw material costs or how to figure a gross profit. I've also seen people go into business not knowing the size of the market which can be as deadly in a brick and mortar business as not knowing how much wheat is for sale at any given time.

A further note, speaking of gross profit, if I walk into a small business that is always disorganized, messy, poor sanitation, dirty windows, I would readily make a wager that the business also has a gross profit problem and probably much worse. I am always on the lookout for these types of opportunities, since being a silent partner in a properly managed turnaround situation can be very profitable. It's the ecology of the business world, just like in the markets…the strong eat the weak.

Ralph,

Re: your 1st consideration, I assume you just mean end market demand for whatever it is you are selling. If entrepreneurs waited for the end market demand to cover costs I would imagine the majority of businesses that exist today wouldn't.

## Ralph Vince writes:

I mean before you go to sell or market something, find at least one person who tells you, "yes I will buy THAT at THAT price," and tell them you;ll be back with it tomorrow, or whenever. But make the sale, whether you are selling vats of mustard or something that has never been sold before. If you are going to consult — don't go into the consulting business, get a customer to pay you for something. Now you are a consultant. Do not go into business and wait for a sale
– that's doing it backwards.

## Vince Fulco writes:

Ralph- the latest craze in the start up world of 20 year olds is developing a minimum viable product. MVP, which is the barest of bare bones app/site/product, gets customers to sign on and then one goes about building out the real infrastructure. Think of fake storefronts with no sides or back walls. Frankly, some of the truth stretching to get paying customers on board makes me conjure up carny barkers. Similar to the HF/FOF world, most experienced business people never, ever, ever want to be the 1st customer. How do you surmount that hurdle?

## Vinh Tu writes:

Look at Kickstarter. there's no pretense, really: people are pretty upfront about the fact that they're at a stage where it's mostly a webpage, maybe a prototype or half-baked product. And in some cases people are still willing to kick in the cash.

This is a good list for a quick and dirty website idea.

And throw in reveal.js for your funding/customer pitches.

# Flexionism of the Day, from Vinh Tu

July 13, 2011 | 1 Comment

If flexions inject money into a company, then the way to profit is to buy BEFORE the flexion money comes in, and sell immediately afterwards.

Why do investors expect profit? Because the borrowers need money. Generally, the greater the borrower's need, the higher the expected return to the investor. There is no reason to think that putting your money in after the flexions should be profitable. And it is not surprising that doing so is unprofitable.

Or am I misunderstanding the concept of flexion?

# NFL Football Statistical Study, from Charles Pennington

September 30, 2009 | 10 Comments

Evidence is accumulating that football, at least at the professional level, is causing dementia and other cognitive problems among retired players.

"..the Michigan researchers conducted a phone survey in late 2008 in which 1,063 retired players — those who participated from an original random list of 1,625 — were asked questions on a variety of health topics. Players had to have played at least three or four seasons to qualify. Questions were derived from the standard National Health Interview Survey so that rates could be compared with those previously collected from the general population, the report said.

"The Michigan researchers found that 6.1 percent of players age 50 and above reported that they had received a dementia-related diagnosis, five times higher than the cited national average of 1.2 percent. Men age 30 through 49, for whom the national average is 0.1 percent, showed a rate of 1.9 percent, or 19 times that of the general population.

"The paper itself questioned the reliability of using phone surveys to assess prevalence rates of diagnosed dementia, as did several experts in telephone interviews. For example, some of those affected might not be reachable; then again, N.F.L. players may have greater access to doctors to make the diagnosis, and so on."

The study already seems compelling. There could be some promising ways to test the idea further and learn more, such as measuring the dependence of cognitive problems on:

– years played
– self-reported number of diagnosed concussions over football career
– height and weight at retirement
– "safety" of position played, as rated by some independent source.
(e.g. punter and kicker would probably be rated safest)

Obviously this may cause some worries among high school and college players. One can hope that the problems don't really kick in until the play reaches the weight and speed level of the NFL.

## Victor Niederhoffer generalizes:

The study the Professor alluded to reinforces my long held belief that soccer is an evil sport, and the body is not meant to be banged up, especially the head, and that this causes early death and dementia. In addition to the heading shot, which must be involved on at least a third of all goals, I find soccer objectionable for my kids because kids with no other means of recreation or occupation play it from the day they are born, and by the time they compete with Americans who have to go to school and develop other interests, they are much too good for the Americans to compete against . Also, I hate that you can't play it without great effort after you graduate from college so it's not a life long source of recreation. My father Artie always said, whatever you do, don't let your kids play football. And I would add soccer and boxing.

## Jordan Neuman opines:

I always thought that the rise of soccer in the suburbs over the last generation was just an extension of liberal politics because everybody can play. If someone has no talent they just stick him on defense. (I am speaking of school kids, obviously at higher levels of play this does not apply.)

On the other hand when my kid is pitching, he is on the stage. When he is throwing good strikes it is beautiful. When he gets lit up you have to tip your hat to the hitter (also on his personal stage). I always thought all those volumes expended on "America is baseball" were wasted, and most are. But there is a reason that baseball is a uniquely American game.

## Ryan Carlson digresses to his favorite sport:

One of the many reasons why I find hockey to be such an honorable sport is that cheapshots and any unsportsmanlike conduct is dealt with through "the code" that such behavior has to be answered through fistfights. The code serves as a check and balance for problems to be addressed quickly and so liberties aren't taken when the ref is looking the other way. An entertaining book for those interested is The Code: The Unwritten Rules Of Fighting And Retaliation In The NHL

## Scott Brooks continues:

Having grown up a big St. Louis Blues fan and overall general hockey fan, I watched more than my fair share of hockey. We had season tickets to the Blues when I was growing up in the 1970s. My dad ate at a restaurant by his work that was frequently attended by Blues players. Dad was on first name basis with such greats as the Plager Brothers, Garry Unger, Bob Gassoff, Noel Picard, Chuck Lefley and many others.

Watching the dynamics of hockey growing up, it was clear that every team needed at least one good enforcer. This was the guy that would go out and beat up whoever on the the other team "breached protocol". If someone smashed into the Garry Unger (the Blues main scorer back in his day), he'd have to deal with one of the Plager Brother or (even worse for him), Bob Gassoff!

My father knew Plagers and Bob Gassoff and would tell me regular stories about what nice guys they were — but on the ice, holy cow! They were animals!

Pound for pound, there was no tougher, meaner group of hockey players ever to step on the ice than those Blues teams in the early/mid 1970s. The Plager Brothers were two of the toughest men ever to play in the NHL. And the best pure fighter to ever step on the ice was Bob Gassoff!

Bob Gassoff was the ultimate enforcer. Even the Plager Brothers — easily in the top 25 best fighters to ever step on the ice in the history of the NHL — would defer fights to their teammate Bob Gassoff.

Of course, there is always the image in my mind of the Blues going up into the stands fighting with the crowd in Philadelphia (a city known for its toughness).

And of course, there is ultimate showdown in the history of the NHL: Bob Gassoff vs. Tiger Williams as to who was the toughest man in the NHL. Both coaches agreed in advance to not let the players on the ice at the same time. But with around three seconds left in the game (and the game already won), there was a dead puck face off. The coaches put Gassoff and Williams on the ice at the same time. They lined up next to each other in the circle, looked directly into each others eyes, nodded to each other and proceeded to drop their gloves and go at it!

What a spectacle! After the fight, Bob Plager grabbed a bloodied Bob Gassoff and skated him around the ice holding his hand up like a referee does for the victorious prize fighter. Gassoff had won the ultimate hockey battle!

I think the markets would be a lot more interesting if we could have enforcers. If someone squeezes you out of your position too many times, you just send over your equivalent of Bob Gassoff to let him know he'd better not do that anymore!

## Stefan Jovanovich reassures:

The most important question to be asked about getting smacked in the head is "where?". The upper forehead and the forward peak of the skull can take a severe impact without any damage; the same blow to the temple will kill a person. There is no question that football players and professional boxers have problems with dementia from the repeated blows to the temple. Vinh Tu's beefy coach was an idiot and bully. The first lesson in learning how to head a ball is teaching the kid to watch the ball into his/her forehead, and the best way to teach that lesson is to have two kids soft-toss the ball back and forth, as if they were playing pepper.

There is very little risk of head injury in amateur boxing; if it is properly worn, the head gear protects the temples and the upper jaw – the two places where you can get hurt.

What is stupid about the design of football head gear are that the helmet is allowed to float; compare the design to military headgear where the webbing and the helmet are cross-braced so they move together.

## Tom Marks is skeptical:

A humble postulate: Nearly all orthopedic and neurological injuries related to professional sports stem from the fact that eons of evolution hardly designed the human body for the unique stresses these activities put on it.

Sports-related head and knee injuries aren't going away anytime soon, especially the latter. Somebody could design a more efficient helmet, but only nature could design a knee that could better withstand the unnatural rigors of playing running back in the NFL. And there's nothing hasty about nature. It tends to deliberate long and hard.

343d

# Strategies, from Jim Sogi

December 20, 2008 | 2 Comments

Looking back at the year, a down year, what type of strategies worked best? A different question is also, what type of strategies that worked before would have worked this year. All this should be tested of course a la Seattle Phil's methods, but generally, from a qualitative view, it seems that timing worked better than stock picking this year. Secondly, lower leverage seems to have produced better returns. This at first blush seems obvious in a downmarket, but could produce higher profits on profitable methods. A risk return matrix could quantify the sweet point, at least in retrospect, and might be used going forward when a regime is recognized by the pilot fishes' first appearance. The February 2nd outlier turned out to be that pilot fish and the introduction of the new high volatility regime. This last Friday was a low volatility day and volatility levels seem to be dropping. With 8% daily moves in equities, 2% moves in currencies and bonds, who needs leverage?

With the Madoff imbroglio in full bloom, due diligence, apparently sorely lacking, will make a big comeback. I've commented before on the beauty of the markets ability to make large deals in standardized forms without reams of paperwork and lawyers, but the wilt is on that bloom. Now you have to keep a daily eye on the values and balance sheets of the bank, broker, contractors, car repairman, so they don't go bust while holding your stuff. Witness Refco, Lehman, Madoff, Citigroup, WaMu et. al. No wonder there is no confidence. Perhaps some of these funds and banks should have had the lawyers and accountants take a look at these multi-billion dollar investments as they would will any other deal of this size. It shows that the Emperor had no clothes, and no one noticed.

Looking forward, the entire industry seems to be changing. The volumes are down leading to big fast moves. Many of the big Wall Street dinosaurs are dead, or dying. I think there will be opportunity from all this, like after the forest fires. Life leaps back. The ultimate slow mover, the government, will provide loads of opportunity. I started my career with the IRS. Fresh out of school I was handling huge deals, cutting my teeth. Typically a government worker is fresh out of school and will be assigned to run GM, or the entire banking system. The boss, the name, will be lunching on the private jet, but the person making the decisions will be a 23 year old kid, smart, no doubt, but still 23 years old. I, when 23, dealt with these old crafty 60 year old guys who made me feel just great, but no doubt made a great deal for their clients at the expense of the government interest.

Next year should be a good year. Just got to survive to see it!

## Vinh Tu writes:

It has been an interesting year. That fact timing worked better than stock picking is consistent with the factor analysis that says that beta is by far the most important factor. That lower leverage was better than higher leverage is also very interesting. In part this was due to optimal bet sizes going down as volatility went up. On the other hand, it was also related to the highly-leveraged ecosystem being over-crowded, and the deleveraging becoming a stampede.

# Home Supercomputing, from Marlowe Cassetti

I still remember picking up a copy of the June 1974 issue of Radio & Electronics Magazine and reading about the construction of a 8 bit Intel chip microcomputer with a full 128 bytes of memory. I had to have one and by October of that year I had on my desk a fully functioning home computer.

I suppose this was eventually going to happen, the common PC has now transformed into a supercomputer. And it is made by none other than Dell. Now the dream of scientists, engineers and even amateur rocket scientist may soon come true. I once mused that with a supercomputer one could conquer the stock market… we shall see. Or maybe put into motion another Long Term Capital Management?

## Vinh Tu writes:

Nvidia gave a seminar on this at Oxford e-research Center yesterday. CUDA looks very cool, and does indeed make massively parallel computing seem pretty usable to ordinary programmers. Also, the language is very close to OpenCL, so your algorithms and code should be transferable without too much effort. You can get started by using a fairly cheap Nvidia consumer graphics card with a model number that starts with at least an 8.

# Circular Definitions and Market Definitions, from Jeff Watson

December 7, 2008 | 3 Comments

I've always been intrigued by circular definitions, which are described as, the meanings of whatever is to be defined are found in the definition itself. Time is one of those constructs that might exist, but one would be hard pressed to find a definition of time that didn't have "time" included in the description. Many other circular definitions exist in the world, and many fundamental units such as the kilogram are best described by circular definitions. Circular definitions, sometimes paradoxical in nature, extend to other areas of nature and humanity with regularity. One would be hard pressed to define exchange without including some aspect, meaning, of exchange in the definition. I can't think of how one could define the meaning of the word trade, without having an element of the meaning of trade in the definition, Trade and exchange could even be used interchangeably Debt could be another term best described with a circular definition, as I'd be hard pressed to find a meaning that didn't include owing something in the definition. Value, as in monetary terms, is another construct that could best be described by a circular definition. Although it's a stretch, the word money, when stripped to it's essence is best described using a circular definition, as "medium of exchange" is still money. It seems that when you drill down to the essential things in science and nature, the building blocks, the things we take for granted, circular definitions pop up with increasing regularity. If fundamental units like time and mass cannot be described without resorting to circular definitions, then our entire bedrock of human knowledge, from the time of Aristotle, is laid on quicksand.

## Art Cooper writes:

The bedrock of human knowledge is in fact based on universal human experience in its broadest sense. Your criticism of circular definitions brings to mind Noam Chomsky's universal grammar, which relates to universal human experience. There is a universal human understanding of such fundamental concepts as time and mass, although there are cultural differences in the way such concepts are perceived.

For those who are inclined towards things computer-sciencey, the free MIT online book Structure and Interpretation of Computer Programs is great, and in particular I found the chapter and lectures on the "metacircular evaluator" to be mind-expanding.

## Vincent Andres writes:

from I. Prigogine
1. La Nouvelle alliance - avec Isabelle Stengers, 1986,
ISBN 2-0703-2324-2
2. Les lois du chaos (Le leggi del caos) - 1993, ISBN 2-0821-0220-3

I think 1. is : Prigogine, Ilya; Stengers, Isabelle (1984). Order out of Chaos: Man's new dialogue with nature. Flamingo. ISBN 0006541151. Unfortunately, I don't know if 2/ was translated in English.

Both books are clearly written (but not always easy). It appears I. Prigogine did a great work as a contemporaneous scientist. But in those books he also achieves a truly impressive history of science job. It's this sort of book you just regret to not have read earlier.

I'd like to hear about other good books/texts on the topic of time.

Time is a condition of increased entropy in the universe.

The usual meaning of 'circular definition' is when someone uses the word itself in an attempt to define the word. In order to understand such a definition one must already understand the word.

However this discussion has embraced a much wider interpretation of the word circular. If I understand correctly it is that a definition is equal to the thing itself. That is always true for every definition. A thing is equal to itself and by extension to its definition.

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

## Jim Sogi writes:

In Henri Poincare's time, there was great dispute over time, where the meridian would be and exactly what time was it? Two places could not agree on time without adequate communication and accurate clocks, neither of which were available back then.

Now time in data is still an interesting issue. Time in Europe, NY, Chicago, Tel Aviv, Japan… whose time is it and what time is it really? Whose framework will prevail. I think this is still contested daily and weekly now. If we take a holiday, does time stop? Who is moving the markets? There have been many big gaps when our markets are closed. Whose time is it?

45dd

# Portfolio Diversification, from Vinh Tu

December 5, 2008 | 5 Comments

I think one of the challenges in speculation is in deciding what data set to use, i.e  what part of the data do you include and exclude, whether it be by filtering for days that share similar characteristics, or by selecting a date range based on a known structural break. How do you decide what portion of history is relevant? And is it valid to use history to decide what portion of history is relevant? Jeff Watson's question is interesting: "what if you were paid to do the exact opposite of what history told you?" Historically, would this have been profitable? In a way, it would be a paradox if it had been. My feeling is that there may be some high-hanging fruit that exists as a premium for trading on smaller sample of data - i.e. lower statistical significance - but with correspondingly greater risk. At the limit, there is what Aaron Brown in his book The Poker Face of Wall Street called "unquantifiable risk". What is the difference between "unquantifiable risk" and mere hunch? Do unquantifiable risk situations exist? Are they truly unquantifiable? And if so, where does the edge come from?

## Nick White writes:

I think the real issue is determining the best method of adaptation to new circumstances. How does one free oneself from Pavlovian responses to old market relationships? How can we have courage to believe the data when it changes?

Every speculator's current predicament is to find a path through a new and unfamiliar environment; an environment where it seems that a great deal of what we have learned about markets — from the textbooks as well as from our own experiences — are, at least for the time being, essentially worthless.

Some of the most basic market microstructure foundations — things we take for granted every day in pricing and trading — have come under attack. Even the market-wide reliance on arbitrageurs to keep things reasonably orderly required the a priori assumption that there would always be the odd dollar or two of capital around to eliminate the anomaly… so much for that.

The ever-changing cycles have well and truly thrown us a curve-ball. More than ever, current market conditions - full of unprecedented anomalies and broken relationships as they are - require fresh thinking and an unrelenting dedication to pushing through proximate causes to find the ultimate ones.

So, as it relates to choice of data, the very fact that the market is a different beast post-September to its pre-September form means we have to be more wise in our data choice and analysis. The most stable relationships, instruments and markets have undergone seismic shifts in daily ranges and changes — the correlation shifts alone have been a wonder to observe. Yes, we have a very limited data set of ~70 observations — but, in this new environment, perhaps it is more risky NOT to use that new data set? Imagine you were out sailing on a sunny day — and, all of a sudden, conditions rapidly deteriorated from blue skies to hurricanes and enormous swells — would you continue to sail as though the conditions were still blue skies and a gentle breeze? Our heuristics have to match the conditions, not the other way around.

Having made that concession, so much now seems to be driven by market-exogenous factors. In that case, perhaps the best and most reliable data set of all — studies of human behaviors under stress and uncertainty — can supplement the lack of more numerous traditional observations. In other words, it seems like a good time to apply the appropriately-filtered qualitative data alongside the quantitative.

So much of this website is dedicated to the lessons we can learn from other fields. A recurrent theme is biology and evolution; surely now is the time for the greatest flexibility in strategy and tactics so that we can be amongst the quickest to successfully adapt to the new environment.

I'm sure there would be a great range of evolutionary examples that the more biology-savvy Specs could provide for inspiration…

# Herding, from James Sogi

Marketeers have been herding or stampeding recently. The NYSE up volume/down volume has been over 10:1 and over 1 million on one side. The days have been "trendy." Fish school and gazelles stampede for safety when under attack. Predators have to stand back or just pick off strays. Seems to be an effective survival type tactic. A question might be: when does the stampede start, and what triggers it?

## Vinh Tu writes:

Virtual birds form flocks, when each bird individually follows three rules:

1. Separation: steer to avoid crowding local flockmates.

2.
Alignment: steer towards the average heading of local flockmates.

3.
Cohesion: steer to move toward the average position of local flockmates.

Here's a nice demo.

I'm looking for other good demos, for other types of herding behaviour.

Similarly, traders can stampede and trend as each individually decides that there is a trend going on. An exogenous shock that triggers a buy signal for enough traders would be able to trigger the stampede.

In Australian and other bookmaker horse betting markets, herding is triggered by inside trades (plunges) and takes the odds lower than they the horse's true winning probability. This creates arbitrage opportunities. I have not yet gotten round to tote-only markets like the US or HK, but know that things there are more complicated by the absence of tradable updating prices. In the stock market, I'm sure it's also insiders or big money that triggers the herding and I hope to get around to this next year. Meanwhile, see A. Schnytzer and A. Snir, "Herding in Imperfect Markets with Inside Traders", Journal of Gambling Business and Economics, Volume 2, No. 2, 2008, 1-16. (available upon email request).

# Briefly Speaking, from Victor Niederhoffer

November 23, 2008 | 16 Comments

1. Walking east across 56th Street from 9th to 6th Avenues the other day, at 5:15 pm, I noted 50 cars parked there, with drivers in the drivers seat waiting, slumbering… It wasn't an invasion of the body snatchers. Just people waiting for the 'no parking till 6 pm' to pass. They save 15 bucks for the night at the cost of an hour or so, valuing their time at less than $15 an hour. I wonder what the implicit price of time is in various cities now as a function of the recent diminution in wealth and loss of jobs. Along the same lines, I recently received an offer from Icon which has a few hundred parking lots in NYC to park one's car on a monthly basis for$220 a month with "further discounts available" if you call. This might be a good way for the city and others to save money through obvious substitutions.

Fifteen dollars after tax translates to $22 or more pre-tax depending on the bracket. Moreover snoozing or reading have their own value, so the$15 could also be interpreted as the marginal difference in comfort between reading/napping in one's car versus doing the same in another environment. Nonetheless, the point remains: whether these people have anywhere better to be. Such Millhonian observations are enlightening and a reminder of the complexity of the economic system in which even the smallest actors are constantly performing economic calculations, the results of which feed into larger calculations.

I hope these people are reading some mentally enriching material, or at least taking power-naps or meditating, or somehow increasing their human capital, and that this is not complete deadweight loss.

2. At x pm every day, an announcement is made. The market moves to a level. The move is attributed to the announcement. The question is whether the move would have occurred regardless of the announcement. Also, whether the announcement was planned to make the move. For example, at 3:02 on 11/21, an announcement that the new Treasury Secretary was appointed occurred and the market moved up 6% in 59 minutes. Similarly at 3:10 last Friday, the announcement from the current Secretary that he believed everything was under control. The market set a new high and then dropped 6% in 50 minutes. We know that the news follows the price. Also, that the news is often now as "new" as we believe. The proverb comes to mind "the ____ will do what he can do." Also, the ephemeral nature of the news and those who know about it in advance. Is it fate or chance when such moves occur? And does the market do what it's going to do regardless? How would one approach this question and its tests and what insights can be drawn from such a traverse?

3. "The Game" between Harvard and Yale was won 10-0 with Yale limited to 90 yards. Yale previously had allowed just 95 points through 9 games. If the market can't be predicted, let us at least use the market to predict other things. Scores in baseball are always lower during bear markets. That's well known. Can we expect the same in basketball and such others as "What time is it, Mr. Fox?" and does the well documented predictive relation between low scores in baseball still continue to predict the market as previously enumerated in Practical Speculation?

4. Sometimes the kind of language used is a signal of vast underlying unearthed issues and problems. Times of crisis provide many nice examples of these and here a few which should be quantified and tested. In talking about his meeting with the former head of the investment bank who seamlessly moved to the chair of Treasury, the head of the now bankrupt investment bank said, "Our brand with the Treasury is very good." A Canadian central banker said about his meetings with senior bank executives, "If you were having a meeting with a central banker such as I and the conversation drifted to opera or the ski slopes at Davos or some such social setting, I think that's an issue." In discussing his tenure as consultant the former Treasury Secretary who seamlessly moved to consultant of the troubled bank, said  "When you have a risk book…, you can't earn more unless you risk more," and he according to others asked to "bulk up" the book. Others involved said that, "as long as you grow revenues you can grow bonuses," and apparently the risk manager and the risk taker in CDOs were once stranded together on a "boat on a lake that ran out of gas" on a fly fishing trip. (That's not exactly language but it recalls the similar incident of the server CEO who was stranded on a boat with his assistant during a survival exercise before the comparable plummet in his stock after they bought an interest in a company he owned for 1000 times revenues or so). In talking about the risk controls, a former president of the troubled bank said "our reputation with the public and the regulators must be an asset." These are paraphrases just to set the ball rolling, and I would be interested in other telltale uses of language that reveal deep truths below the surface.

## Gregory van Kipnis replies:

You can not read too much into the fact that 60 cars are waiting for the "No Parking" period to expire so they could park overnight for free. I live in that neighborhood and such a sight has been seen every night for seven years. Perhaps if you knew if there was an increase in the number of cars that didn't get one of those spots you might have a hardship barometer.

Much more revealing, however, is that two weeks ago everyone who parked on the street got a flyer on his windshield, saying he could park for $211 per month, guaranteed for one year, at an undisclosed garage, just call (212) xxx-xxxx. That's a$150-200 per month saving over the prevailing monthly rate in the neighborhood, and was being offered by one of the leading garage chains. I took the deal and wound up in a better garage than the one I left.

## Charles Pennington writes:

They made a few hundred thousand dollars in Vegas, and that's a story worthy of a $35 million dollar film that grossed$150 million? They made real money snowing the public, not the casino.

## Chris Cooper says:

Prof. Pennington is, of course correct. It is worth mentioning that casino gaming has served as a springboard into trading and speculation for many, who have become much more successful in that arena than they ever could have been in the casinos. Ed Thorp is the legendary example, but there have been many others. My gaming experiences certainly inspired me, many years ago, to return to school so I could learn the math (control systems, signal processing) I thought I would need for trading. Also there was the "Eudaemonic Pie" team. Blair Hull is another instance.

Trying to make a living via casino gaming teaches you many lessons which are directly applicable, even essential, to effective speculation.

## John Floyd observes:

There is a lot to be learned from casino games, much of it applies to trading. In particular, deciding when you have a positive expected return, varying bet size, risk of ruin, etc. Not to mention that one should study the games, as is true in financial markets, and develop an understanding before putting serious capital at risk.

Many of the games offer one the ability to get a statistical edge on the house such as blackjack and some of the progressive poker machines. The problem is that any success is usually found quickly by the house. The house then takes methods to decrease your odds such as reshuffling often in blackjack and then asking you to not play anymore at their fine establishment.

A player therefore needs to take several steps to camouflage what they are doing, such as: spreading bets across several hands, decreasing bet size, not varying bet size too much, making some "dumb" bets to throw them off the scent, moving around casinos and tables when necessary, playing odd hours, wearing hats, etc. The casino runs like a machine and grinds out the vig. The pit boss is evaluated on a per hour basis of what he takes in, a hit of a few thousand dollars draws his and the house's attention very quickly.

While the challenge is fun for some time it can get tedious. Furthermore, the return on an hourly basis even if one is a good player pales in comparison to successful trading in the financial markets.

3faf

# The Extendable Cane, from Anonymous

October 10, 2008 | 10 Comments

Over the years, I've enjoyed and preferred the company of working people. The people I'm referring to are fishermen, lawn guys, lifeguards, surfers, and other blue collar types. These people live without credit, loans, real estate, bank accounts, or any other financial instrument, save for their eventual social security benefits. In the past couple of days, I've had five people come over to my house wanting to buy common stock. Without exception, they weren't able to open accounts at brokers, and want to buy good stocks because they heard that stocks are cheap, and they believe in America. They all came over, cash in hand, asking if I would get down the trades for them. They wanted me to buy the stocks and sign over the certificates to them. I wonder what kind of indicator this is, as I've never seen anything like it.

The Fifth Amendment allows me to decline to answer whether I accommodated their requests.

Canes come in all shapes and sizes and styles. My paternal grandmother, who remained illiterate in her native tongue of Polish as well as in English for her entire life (probably because of undiagnosed dyslexia), took grandfather's stash of double eagles saved from digging ditches and bought a 3-story rooming house in Denver after the 1919-20 crash for 12 cents on the dollar. Even in the Depression it generated enough free cash flow for her to send all 3 children to the University of Colorado. The money from the sale of the property after her death sent 1 grandchild to the same school in the 1980s, which may signify more about the relative value and price of education in the 1930s versus the 1980s than anything else.

## Vinh Tu responds:

Suppose one is operating on the premise that a recovery will occur, but one has no idea how long it will take, or how low the market will go before recovering. What is the optimal trading strategy? I think it should be some kind of optimal Kelly fraction. If one maintains a constant fraction of cash and equity, as stocks approach zero, one's number of shares approaches infinity, which is nice once they recover. If the stocks actually REACH zero, then hopefully one has also stocked some canned food, ammo, etc and learning the art of shoemaking.

So what is the optimal ratio of cash and stocks? What assumptions do we need?

# Invariants of Markets, from Chris Hammond

May 30, 2008 | 1 Comment

In my own research, I have discovered the usefulness of a tool that was developed by mathematicians at least as far back as Sophus Lie, the use of invariants to characterize geometric objects. The idea is pretty simple, given some sort of geometric objects and some notion of equivalence of such objects (e.g., two surfaces are equivalent if you can translate and rotate them so that they coincide with each other), find a finite set of intrinsically defined quantities such that two objects are equivalent exactly when those quantities are equal. This idea has recently found its way into computer vision. If you have a particular person's face in mind, it will appear different depending on the angle from which it is recorded. How does a computer recognize the face? One approach is to compute some invariant quantities and compare those to the ones on file.

My question is, are there any invariants associated to various markets or to various "phases" of markets? I would readily accept that there aren't in any meaningful way, and that I am just infatuated with this idea, but I am interested to know what others might think.

## Vinh Tu says:

I order to count, one often needs first to classify. In some cases the classification is trivial. But it can also be pretty complex. For instance, how do you define a trend, or a break-out, or a reversal? You have to discard some part of the data, which you call noise, and fit the "relevant" parts into categories based on invariants. Interesting that you mention computer vision. I've been thinking about computer vision algorithms as well, and how they could be used to classify the features of market movement. There are myriad ways of presenting facets of market data as surfaces of varying dimensions, and I suspect perhaps there may be useful computer vision algorithms to classify areas by flatness, roughness, stability and slope. And, as always, after one has classified and hypothesized, one needs to count. I remind myself that, before jumping to conclusions based on some measurements, one should always check to see how likely it is those measurements may be due to chance. And, as often demonstrated on this web site, monte carlo and bootstrapping techniques can be very useful, both for solving analytically hairy problems as well as double checking ones math.

# Market Completeness, from Vinh Tu

January 31, 2008 | 2 Comments

"…Left off the balance sheet is the value of the asset that Gary Becker, Nobel Laureate in Economics, calls human capital. Professor Becker says that the skills and experience of our people are worth more than half a million dollars per person. By this calculation, traditional assets comprise less than 25 percent of the national balance sheet, which means that true U.S. assets exceed $180 trillion…" Mike Milken I haven't had my morning coffee yet but here's an attempt at arithmetic along Beckerian lines: A recent FT article put Japanese assets at 75% of its GDP. Pulling a totally random number out of nowhere, if the return on assets is 5%, GDP = 5%*(total assets) GDP = 5%*75%*GDP+5%*humancapital 19.25*GDP = humancapital Looking at World Bank statistics World GDP 2006 = 48.2 trillion World financial assets = 170 trillion Return on assets = 5% (can someone give me a better number?) Return on financial assets = 8.5 trillion Return on human capital = 39.7 trillion Human capital = 794 trillion population = 6.6 billion Average human capital per capita (hheh..) = 120303.3 Anyway, very rough calculations with numbers plucked from the ether, but the order of magnitude at least is in line with Prof. Becker. (Also, I left out something important - GDP is not just a return on capital (even human capital) because human ingenuity produces excess profits and increases the value of the capital. So you'd have to adjust the calculation of human capital to account for growing return. And risk adjustments. Etc. etc.) Any real macro economists care to point me in the direction of more accuracy? ## Phil McDonnell replies: Rather than pulling an imaginary growth rate out of our … armpit, perhaps a better approach can be found. GDP is the goods and services produced by a society. However much of that is consumed as well. The number we are really seeking is the net 'profit' figure that can be carried forward into the next year. It is good to remember that any 'profit' carried over must be held in the form of an asset. Thus a reasonable measure of the rate of return would be the net increase in total assets year over year. ## Yishen Kuik counters: Maybe I'm too classical, but I've always thought that GDP is a flow measure of all the goods and services we produce, of which one portion is consumed to give us present utility and the remaining portion is invested to enhance our ability to increase GDP in the next period. Presumably all goods have some aspect of both utility and investment ("school is fun and you learn something" or "bridges are beautiful and enable transportation"), but we can think of the investment portion of GDP as flowing into a stock of accumulated capital. The stock of capital deteriorates over time, so some of that flow is just running to keep still. Part of the stock is human, part of it is physical plant, and part of it is institutional arrangement of society (courts, laws etc). The dollar figure we attach to capital stock is just a very rough attempt at measurement, and doesn't take into account the importance of having the right arrangement of the 3 kinds of capital stock. The right arrangement catalyzes a$100mm investment to return 15%, while the wrong arrangement will have no such catalyzing effect. That is why \$100mm produces such different results when invested in America versus Africa.

I think it is this accumulated capital stock (human/physical/institutional) which is the right place to discuss big picture returns on investment. Unfortunately much of it is unquantified and unquantifiable.

## Adi Schnytzer brings up the stock market aspect:

Surely the real issue here is that, however, we define GDP, it's notoriously unpredictable? After all, why has the market been shooting up and down so furiously lately? In part it's because every one has been wondering whether or not the US economy is moving into a recession. Well, if we could agree on a way to to measure and predict GDP, we'd have solved that issue for the market pretty quickly, wouldn't we?

## Derek Gard dissents:

This assumes the market moves based on GDP at all.

From 1950 to 1960 GDP went from 1696.765 to 2517.365 (48%) and the DJIA went from 198.89 to 679.06 (241%)

From 1960 to 1970 GDP went from 2517.365 to 3759.997 (49%) and the DJIA went from 679.06 to 809.2 (19%)

From 1970 to 1980 GDP went from 3759.997 to 5221.253 (39%) and the DJIA went from 809.2 to 824.57 (2%)

From 1980 to 1990 GDP went from 5221.253 to 7112.100 (36%) and the DJIA went from 824.57 to 2810.15 (240%)

From 1990 to 2000 GDP went from 7112.100 to 9695.631 (36%) and the DJIA went from 2810.15 to 11357.01 (304%)

GDP during the 60s was higher than the 50s and yet the market barely budged. And GDP during the 60s and 70s surpassed the growth rates of the 80s and 90s, yet what decades saw the greatest gains in stocks? Stock market moves do not correlate well with actual GDP data over decades or even years, let alone the daily thoughts and musings of financial pundits.

To say stocks move on GDP data, or confusion thereof, is not supported by raw data. This is the same logic that says, "Stocks rose on a drop in oil prices" one day and then the very next day says, "Stocks fall despite a decline in oil prices." It is a fallacy promulgated by the same people who earned 3.5% per year in stocks during the 80s and 90s when the market was earning more than triple that.

My argument was not that the market moves in line with GDP, rather that lately the market has been reacting to news suggesting either an imminent recession or not. To measure the relevance of this assertion you need to check whether or not the market falls some months before a recession (thus anticipating it) and not whether over a long period the market tracks GDP.

## Nigel Davies opines:

As a simple chess player I must admit to being confused by the apparent
implication (seen everywhere right now) that positive GDP is good and
negative GDP is bad. In my own admitedly primitive pursuit one rarely
gets the opportunity to play expansive moves on a continuous basis,
there are periods when one must regroup in order to increase the
potential energy of a position.

So if I were an economist I would not be looking for answers in simple
linear relationships. Instead I'd try to study the interplay between
'potential energy' (one might try to define this in many ways, for
example by defining debt in 'real' terms) and GDP. And I'd hypothesise
that one of the most bullish economic times would be during a recession
in which personal debt was being reduced.

## Vinh Tu tries to sum up and conclude:

Whether more GDP is "good" or "bad" is a normative judgment. To an
economist, however, since GDP by definition refers to the production of
"goods", it has to be good. (It is generally assumed that utility is
monotonically increasing with goods.) Whether the increase in goods
produced corresponds to an increase in share prices is an entirely
different matter. A share represents a claim on assets which, in turn,
yield a stream of goods (or money which can be exchanged for goods.)
Whether an increase in GDP is beneficial for share prices has
everything to do with where that increase comes from. An increase in
efficiency, whereby the return on existing assets increases, would
probably increase share prices, all else being equal. On the other
hand, the creation of new capital assets would not increase the value
of pre-existing assets if it resulted in the assets being less
efficient.

2080