I wonder if the computers that do most of the trading have programmed Puetz windows, bull/bear ratios, etc. into their algos. Mostly they seem to trade off newsflow and momentum. They seem to find attractors in moving averages, pivots points, and big point numbers.

My own experience and training as an EE can only compare the current environment to a closed-loop feedback control system gone open-loop; as if elephants constrained in their pen in the zoo have burst out of their cages, running this way and that as they bang into walls.

Phil McDonnell writes:

The trouble with the Puetz window is that an eclipse sounds like a very rare occurrence. After all I have only seen maybe 1 or 2 eclipses in my lifetime. Would you be surprised to know that 4 of them occur every year and sometimes more than 4. There are 2 solar and 2 lunar ecipses every year minimum. The fact is that they only occur in certain relatively small swaths somewhere on the Earth. So the 4 that will occur this year will probably not be visible to most people. Add to that the fact that we are less likely to go outside at night or be asleep explains why we see them so rarely.

Next consider the Puetz window definition. Start with the 4 eclipses then construct a 12 week window from 6 weeks before to 6 afterwards. That covers a period of 12 x 7 x 4 = 336 days if eclipses were randomly spaced. Adjusted for the relationship between solar and lunar eclipses the the Puetz window covers 196 days out of the year. That is more than half of all the days in a year. Adding the full Moon cuts down the number of allowable days to 10 days, 6 before, 3 after and the day of the full Moon. The allowable number of days in the window every year now becomes an average of 68 or 18% of the year.

This has all the classic earmarks of a theory that was hand fitted to a small sample of 8 crashes.



 The Secretary problem, i.e the optimal number of applicants to interview for a secretary job before quitting would seem to have much applicability to the time to come into the markets these days. How many extremes should one wait for in a day before coming in one way or the other, and what is the expectation for such strategies?

Jordan Low writes:

Is it just a coincidence that 1/e is close to 0.38 or the ratio used for Fibonacci time and price projections in technical analysis?

Rocky Humbert writes:

Steve Landsburg recently wrote about a variation on the Secretary Problem. He noted that "an anonymous math department chairman reports on his own strategy for cutting down on the [interview] workload. The math professor believes that one of the most important determinants of a successful career is luck. So each year, the math professor randomly rejects half the applicants without even reading the folders. That way, he eliminates the unlucky ones."

I suspect that there may be a market analogy in this admittedly sarcastic observation.

Phil McDonnell wonders:

Is it a coincidence that Fibonacci believers always seem to use the rhetorical form of: Is it a coincidence that (fill in a single observation) came close to (fill in selected Fibonacci value)?

Russ Herrold replies:

I do not think there is a co-incidence– the human mind tries to order data, and Fib sequences crop up everywhere. It is natural to do a 'trial fit' just as the eye tries to estimate a fit for a curve [and thus the reason for ready transforms as normalization, log, 1/exp and the like in running a regression– scaling often permits identifying the 'noise' and getting a 'good enough' solution]

Doing the math, of a run of repeated application of any two integers (seemingly separated by whatever distance, although I have not done a formal analysis or proof), the series seem to converge to a Fib set reasonably monotonically after say five rounds for low integers.

I ran into Fib numbers, learning the run time pass estimates for the IBM sort-merge algorithms in in the late '60s, and it appears that Knuth found them in sequential pass sorting as well. I seem to recall a childhood cartoon called 'Donald Duck in Mathmagic Land' where that quackish fellow pointed out that golden spiral, and the perfect rectangle 



the broadmoor in Colorado SpringsOne would hasten to recommend the Broadmoor hotel in Colorado Springs where my daughter Artie just graduated Phi B. Kappa from Colorado College as one of the best hotels I've been to along with a few European hotels with similar geological grandeur. The view of Pike's Peak and the lakes and the botanical gardens and 3400 acres on property and the infinity swimming pool, and the fine dining along with its illustrious history with the Penroses and the Palmers with their combination of dashing entrepreneurialism (he sold out to Kennecott Copper at 25 at the high after a 25 bagger, and then used the money to make the hotel the best in world at time with many Maxfield Parrishes and great architectural elements. Where are the Penroses of today one may ask, and how have they lost their incentive to create.

Not too good on the he barbeque there but the Colorado lamb was very good and the three golf courses of Michael Nichols, Trent Jones, and Palmer were about as heavenly as a golfer could wish with a big fairway mountain course. 

Dean Davis comments:

The golf courses are nice too, but beware the thunderstorm (w/ lightening) coming over the top of Cheyenne Mountain (home of CMOC). The siren system can give one quite a start during a back swing. I remember that we were there the night when Princess Diana died.

Nearby, an interesting collection of Golden Trout (not listed because I think they are protected) for viewing at the old school tourist trap Seven Falls.

Pitt T. Maner writes:

It is a wonderful place to learn historical geology and about Florissant Fossil Beds [14 page PDF]

For me, a trip to Cripple Creek for ice cream after a week of UF geological field work was a highlight. Not too far away is Skyline Drive which is on a feature known as a "hogback"–many car ads have been filmed using it as backdrop. One of our class assignments was to measure this section with a Brunton compass (for strikes and dips) and measuring rods (to determine true formation thickness). Once over the top of the hogback you had a view of the penitentiary from the hard white caprock of Dakota sandstone.

Beautiful area …

Phil McDonnell adds:

The Broadmoor is a classic resort. Their Sunday brunch is one of the best to be found.

I would second Mr. Maner's suggestions having seen all but the hog back. Cripple Creek is especially interesting because it was where Penrose and Tutt had their mine. I highly recommend the mine shaft tour and the melodrama at the live theater in town.

The Air Force Academy is just north of there. Pike's Peak is one of the few mountains where one can actually drive to the summit. When I went to the summit, it was snowing in July. Nearby Cheyenne Mountain has NORAD or the Stargate in the basement.

Ralph Vince writes:

I'll second (or triple, or quadripple) the Broadmoor and what Phil says abut the Sunday brunch. It's like the Grand Canyon, or Yosemite. You haven't really experienced America till you've tasted it. 



How to turn lead into gold1. Can anyone on the list state the probability that the Dow Jones would lose (and gain) about 10% in ten minutes, without any external stimuli (news headlines, etc.)? Is this probability comparable to the probability that the Dow Jones will lose (and gain) 90% in ten minutes? And how does this probability compare with the chance that lead unintentionally turns into gold? (more info).

If these odds are similar, is it a defensible investment strategy to buy tons of lead (without leverage), and wait for it to turn to gold? Has anyone pitched this idea to the large state pension funds?

2. Brownian motion allows for the possibility that all of the molecules of oxygen in my office move to the other side of the room, and I suffocate at my desk. Is this a more plausible explanation for what happened at trading desks on Thursday?

3. What were the "computers" (and people) who were selling the large cap ETF's / index funds at $0.01 thinking? There may have been some intra-day margin calls, but why would anyone or any computer sell the Vanguard Large Cap Index Fund at a penny? I will once again go on record as a willing buyer of the ENTIRE US Stock market at a penny. Just give me a call, or in the words of the Sage, "You have my number. And I can respond quickly."

4. Would anyone like to defend a portfolio that runs on the full Kelly Criteria and Optimal F?

5. Buy and hold is suddenly looking (comparatively) good again. That is, compared with people who left intraday market stop-orders.5. Lastly, in three months time, who will look smarter, the guys who sold P&G at 50? Or the guys who bought P&G at 50? That's the toughest question of all.

Phil McDonnell comments:

I will volunteer for the Humbert quiz.

1. Can anyone on the list state the probability that the Dow Jones would lose (and gain) about 10% in ten minutes, without any external stimuli (news headlines, etc.)?

I do not think anyone can accurately calculate such probabilities without also taking into account the serial correlation in volatility in the short run. In other words the normal and log-normal models are only a stationery approximation to what is actually going on. In reality the volatility can change and it is positively autocorrelated. Thus the quick swings in the market can happen simply because the parameters of the underlying distribution are changing with positive feedback in the volatility parameter.

2. Rocky can stop worrying about suffocation. If all the molecules in his 3d Brownian office were to move to one side it would violate conservation of momentum.

3. I cannot defend full Kelly it is too risky IMHO. In my book I explain how to find it but only recommend its use as an upper limit for position sizes. It will lead to sub-optimal Sharpe Ratios among other things.

4 & 5. I have to pass on.



 The Golden Cross has received a great deal of publicity. It is composed of two moving averages, the 50 day and 200 day respectively. When the 50 day crosses above the 200 day that is a buy signal. When the 50 crosses below the 200 day that says sell. Notably the 50 has crossed below the 200 in the turmoil last week.

As with everything this must be tested.

First I looked at the 200 day average alone for the daily Dow since1928. When the Dow closes below its 200 day MA then the return the next day is -.00665%. When above the 200 dma the Dow returns +.03968%. These compare to +.023% for all days. The p values for these two signals were each 7%. So they are not quite significant but you are not crazy if you still want to believe in the 200 day MA.

The question remains, what kind of improvement do we get when we add the 50 day crossover to the mix? On the sell side the 200 dma gave us an expected next day return of -.00665. But the 50 day golden cross sell signal gives a return of +.010%. It loses money!

The same thing happens on the buy side. The 200 dma returns +.03968 versus the golden cross return of .030%. In both cases adding the complexity of the 50 day average reduces return relative to just using the 200 dma alone.

David Aronsen replies:

This is interesting Phil… I just want to be sure I understand what you tested. In the simple case using just the 200 day MA, did you look at the next day return for ALL day's whose close as < MA200 vs. ALL day's whose close was > MA200. Or did you look at only those days were the close moved across the MA200. I suspect the former as the number of crossing days would be very small in number.

With regard to the 50 and 200, I gather you looked at next day's returns for ALL days when the MA50 < MA200 vs. ALL days when MA50 > MA200. Yes?

As to the folks who say the golden cross is as valuable as gold (rather than the other thing) is that the returns from playing the crossings is what is of value, vs. let's say buying and holding or random signals with a similar frequency. Anybody know the data on that one?



 If you are speechless it is probably just because you have some lower body parts stuck in your throat from yesterday's roller coaster plunge. After all it was the worst drop since 1987. The latest theory sees to center on a fat finger Citi trader who entered a B (for billions) instead of an M. The stock in question was probably Proctor & Gamble which went from 62 to 39 and is now back to 60 as this is written. More here.

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



nVidiaI'm wondering if anyone has much experience running trading apps or data crunching on Amazon EC2, etc.? Real heavy-duty analysis where you can bring 16 cores to bear on the issue. It would be helpful if anyone has tips on using Mathematica, R and Bloomberg in such an environment, especially if you've seen trading apps operating real-time.

Phil McDonnell writes:

For the princely sum of around $100 one can get something like 250 cores to do parallel processing. Software is available for R and some other packages and languages. I don't know about Bloomberg. It's all done with the nVidia graphics GPU. It is programmable from the main CPU and massively parallel. The technology allows applications that would otherwise take weeks to happen in minutes or seconds.

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



 A recurring topic on this site is the study of market anomalies surrounding round numbers. Perhaps this idea can be extended to interesting ticker symbols. In the US ticker symbols are formed from letters and thus whether a symbol is 'round' or interesting is largely a subjective matter.

However in Hong Kong the symbols are numbers. So could there be an attraction to round numbered easy to remember symbols? A simple way to look at this is to take all the even hundred symbols and compare them to the Hang Seng index. The following study looked at 0100, 0200, … through 0900 but some symbols were not associated with a stock. Performance for the last twelve months was as follows:

Hang Seng +51.27%

Stocks with Round symbols Avg. +172.61%
Std 108.77
t-stat 3.89
n 6

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

Easan Katir comments:

It seems all too common that a number, whether a price or an account value, approaches or touches a round number, then retreats slightly. Pure chance would suggest it would be over the round number or under equally, but it seems to be slightly under more often. Is this just my wishful thinking, or is there some corollary to Benford's Law. And here is Wikipedia's usual tour de force on Benford's Law.



lilac bushIt's not barbecue, but today I had the pleasure for the first time of tasting lilacs. I was inspired by a kid's book that said that to find out why bees like the taste of sweet things you should squeeze the nectar of some nettle plants. I took Aubrey to the Bronx Botanical Gardens and we smelled the lilacs. By far the best-smelling were the hyacinth lilacs. To me it's the best smell in the world, and it stops time and elicits every romantic spring personage that one could ever imagine.

Inspired by the reverie, I couldn't resist tasting a number of the small flowers. I found that the white ones on the top of the trees were superior in taste and smell to the red ones, especially lilac poincare and lilac common. The taste is like a mixture of raspberries and sweet peas. A slight tartness at first, but then a beautiful saladly green with sweet overtones.

I've seen some recipes for lilacs subsequently, but surprisingly nothing on the actual taste of lilacs, indeed almost a googlewhack. I highly recommend that all speculators take a break from their trading before or after the daily fray and sample a few in their area.

Phil McDonnell writes:

As a home gardener I have been amazed at the number of flowers that can be eaten and are considered delicious gourmet treats. For example, zucchini flowers. Zucchini plants have two types of flowers, male and female. The male flowers stand erect and tall as is only proper. The female flowers are short stemmed and demurely lower. Even though the two flowers look similar, I find it very easy to remember the difference.

The taller male flowers are the first to be found by the bees. They next visit the lower females, thus facilitating fruiting. If bees are lacking, then the higher male flowers can pollinate the lower female flowers simply through wind action. After the male's job is done the gourmet can harvest the male flowers for a real treat. Just sautee in butter, salt, garlic and onions. Each female will give you a zucchini.

Vincent Andres adds:

Reading Vic's post, I was thinking exactly on that: "fleur-de-courgette" and I didn't know it translated as "zucchini flowers". Thanks Phil. I'll be growing some in my potager every year. Beignet-de-fleur-de-courgette is a terribly good (and not so difficult) flower recipe. Here is a video.  I expect to have my own olive oil in the coming years to made it 100% with raw home products. 

Bruno Ombreux writes:

May I recommend a French delicacy: Crystallized violet flowers.

They are very easy to make. These are the flowers you use.



He has made his investors' fortunes…

How has Mr. Buffet actually been doing? On July 1, 1998 BRK-A was 78,000. Today it is about 115,000 per share.

That is a gain of 43% over roughly 12 years — about 2.8% per annum compounded.

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

Kim Zussman writes:

Regressing the last 10 year's monthly returns for BRK-A vs SPY (with dividends, etc), BRK-A's alpha is positive but not significant:

Coefficients  Standard Error     t Stat    P-value
Intercept      0.008     0.005    1.583    0.116
Slope           0.436     0.106    4.113    0.000

However slope (beta) is 0.44, so you could say BRK-A out-gained SPY with less market exposure.

Rocky Humbert comments:

Math is fun. BRK-A has outperformed AAPL!

Total compounded returns (dividends reinvested) since 12/31/87:

BRK-A 18.2%

GE 10.4%

AAPL 15.5%

MSFT 22.7%

SPX 9.66%

And this is all-the-more-remarkable when one considers that AAPL returned 123% over the past 12 months.

As I said, "math is fun."

Rocky Humbert, quantitative analyst, speculator and master chef, blogs as OneHonestMan.



Logo of American and Foreign Power CompanyHow does a company like DuPont have a book of 5 bucks a share when it's been earning 2.00 a share for 100 years? Part of it is that it pays dividends of 85% of earnings. The kind of stock my grandfather would have recommended for me along with American & Foreign Power. Couldn't go wrong with that 10% dividend — until they were nationalized. That corporation was another of his favorites besides Union.

Rocky Humbert comments:

DuPont has been a poster child for the Modigliani-Miller theorem. They've been increasing leverage and buying back stock for years, which — depending on the price paid — can cause a perverse and self-reinforcing decline in book value. And even with a low book value, about 61% of their shareholder equity is goodwill. But their ROE looks very sweet at 25+%.

Ironically, DuPont was originally a dynamite manufacturer. Dynamite funded the Nobel Prize. Modigliani-Miller won the Nobel prize in 1985. So the circle is unbroken. 

Yishen Kuik writes:

A more extreme example is Colgate Palmolive, which at one time had negative book value. The shareholder's equity portion is still a negative number, and the persistent accumulation of retained earnings has since brought book value back to positive. It still probably has some fantastic price to book ratio.

Rocky Humbert adds:

The following stocks all have market caps over $1 Billion and negative book values:


The significance of this phenomenon is left as an exercise for the reader.

Sushil Kedia comments:

Historical Accounting leaves disproportionate under-priced assets due to inflation on the books making book-value appear to be very small in comparison to earnings, for very old and profitable companies that distribute large dividends.

For younger companies in fortune businesses such as exploration, new molecule discovery etc. anticipations of a breakthrough can have large market caps and low hard assets.

Franchise businesses, including those that thrive on brands such as Colgate, customer loyalty concepts etc. will have a very large proportion of assets that are intangible and never appear on the books of accounts making book values very small.

Companies that have dominantly assets with large depreciation rates allowed too will have lower than average b/p price ratios.

Companies that have taken over larger companies would have a lot of ethereal assets termed as "goodwill" making low b/p ratios again.

Phil McDonnell writes:

I note that Colgate has a return on equity of 90% according to Yahoo data. Big Blue reported today. They currently have a respectable 77% ROE. They are paying an increased dividend and buying back stock. To me it is interesting that the large stable companies that are doing this also have fairly large goodwill entries, as Sushil noted. For example Colgate has about $2B in goodwill on the books. Usually this means they paid too much for an acquisition. Too much means they paid more than the book value of the assets acquired. But in the case of stock buyback if the company buys its own stock at market, which is higher than its book value per share then presumably that shortfall is recorded as goodwill. If the stock rises or has risen in the past then that may mean there is hidden asset value on the books in some sense.

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

Steve Ellison observes:

I am looking at Oracle's 10K. Oracle used $3960 million of cash in 2009 to repurchase shares. On the statement of stockholders' equity, Oracle reduced common stock by $550 million and reduced retained earnings by $3410 million. Thus the effect of share repurchases was to reduce stockholders' equity, but this effect was more than offset by the increase in stockholders' equity from net income of $5,593 million. 

Sushil Kedia comments:

If Inflation Accounting seminars held by so many august Accounting Bodies all over the world in the last two decades could not decipher how it could really be done, assume for a moment at some point it will be done correctly.

But then the book-keepers that produce the inflation estimates and keep revising them invariably all over the globe (I guess all gummints are at least alike on this parameter whether they be Capitalists or Communists) are also just book-keepers.

So, this one conundrum will never be solved.

In recent decades there have been some high-brow management consultancy firms that are peddling ideas of Brand Valuation. But then if a company could own a brand worth a Billion Dollars and make only continuous losses their ability and talent at producing so much red is eventually leaving a value on the table of that Brand at just a risk adjusted present value aggregate of these losses as a negative number only. Brand Valuation as an Accountancy tool has no place in the Accounting World, save for nice trips to Bermuda for such conferences.

Replacement Cost Theories have been used and rather mis-used to pamper the valuations of cash-loss generating companies on an idea that it would cost so much to build this same factory today at the extreme end of bull-runs.

Then they say Cash is King. But the King everywhere in this Universe has been only trashing cash ever since it was invented. So, we go back to the beginning of this note. All roads lead to Rome, in the world of Fundamentals.

So what Fundamentals are we talking about at any point and under any framework?

At least the price followers, even if prices are manipulable and get manipulated every now and then are having a far simpler illusion of suffering from knowledge and the best part is this manipulation keeps coming regularly, tick by tick. The follower of price action recognizes if there is an incentive to an economic activity, it is happening already. So, irrespective of whether prices are manipulated or they are not, the stimulus to any system of taking decisions is consistent.

The Fundamental Manipulations are erratic, supposed to be non-existent until an Enron comes by every now and then while they are happening throughout erratically and then with an endless battery of ideal world assumptions the whole Art of Fundamental Analysis has such elegant and consistent formulae for everything. The quantitative screens in each and every idea in the universe of fundamentals is so self-sufficing and yet this form of art never could get known to be any variation of Quantitative Finance.

I am not against Fundamentals at all, but just wish my elegantly consistent brothers and sisters in this art form acknowledge the fool's paradise they are keeping building.



 One is astonished at how far the subject of position sizing has come since Robert Bacon in 1940 when he suggested 2% of your money on each bet, then a buck on the races so you could lose 50 in a row before going under.

How about an approach where position size was a variable that you put in your statistical return and reward space to start with, then examine the distribution of returns with various positions sizes and determine how your utility fits in with the distribution.

For example, today a 20 day high of 230, indeed a 1½ year high. What is the distribution of the six such?  Max 4.8, min -5, moves to relevant endpoint 2, 5, 2, 2, 1, 5, -2, 3. No trade from Bacon. Wait for overlay. Pittsburgh Phil in the background.

Phil McDonnell writes:

The hard truth, to me, is that it is all position sizing. –Ralph Vince

I agree with this only up to a point. In order to have a winning strategy one must have an edge in a statistical sense. You cannot win with a losing system. One needs both a winning system with an edge and a solid money management system. Neither one alone is sufficient.

After one finds a winning system then you must also have a money management system that does not expose you to ruinous losses. If you graph the expected amount of money you make at various position sizes for any winning system you will find that it looks like a mountain. The peak of the mountain occurs at precisely the positions size Ralph calls optimal f. But if you also look at a chart of risk (stdev) you find it is a monotoncally rising function of position size. Thus as you continue past the optimal f point you are giving back return but still increasing risk. It is the worst of both worlds. If you go far enough past it you can actually wind up losing money even with an overall winning system. That is why I prefer to call the optimal f point the point of maximal investment return.

kahneman receiving nobel prizeWith respect to Vic's comment about utility, there is much merit to this approach. None of us truly knows our utility function and if you believe Kahneman and Tversky it is probably irrational anyway. So then the next best thing is to construct a rational function mathematically from some logical first principles. The three most obvious choices are Sharpe ratio, log, and my favorite is log log Sharpe ratio. Except for the simple log function, one invariably finds that using these utility functions one chooses a point on the mountain graph somewhat to the left of the optimal f peak. So in that sense optimal f is really only 'optimal' for the case of maximizing compounded portfolio return but is sub-optimal and dangerously past the optimal point for maximizing any utility which explicitly takes risk into account.

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

Ralph Vince adds:

I agree with most of what you say here. Like the old Frenchman used to say, "Most people don't know what makes them tick; they only know that they tick."

Most people do not really know what they are in the markets for — and I think there are very many different and good reasons for being in the markets aside from mere growth maximization. But most don't know what they are here for.

I think until someone can answer that they're probably better off not being in this arena. But I no longer think one needs a winning strategy, and I beg to differ with the notion that you must have a positive expectation (and, this too further indicates that timing and selection are subordinate to sizing). Ultimately, you are in this for a finite number of holding periods or trades (call this T) , and given that you have control over your quantity, you seek to come out at T (or before, if you have achieved the objective of your criteria) with the objective of your criteria.

Again, and I will use this for illustration of the idea — if I could do a full martingale on my capital, and I had unlimited capital, and my goal was to accumulate, say, X……

I could then do a full martingale on a losing system, and when X was achieved (or at necessarily time T) leave the game.

I know for years I too bought into the idea that you have to have a winning system. But I am seeing guys who have specified their criteria well, and are getting astounding results, and are trading approaches that are, at best, feeble. 

Ralph Vince is the author of The Leverage Space Trading Model, Wiley, 2009

Phil McDonnell replies:

I would love to see an example of a system that had a negative expectation but could somehow be turned into a positive expectation through money management. The martingale example is a system that exchanges a high probability of winning a small amount for the small probability of losing a large amount.

Examples of such 'systems' with skewed distributions would include:

  1. Selling out of the money options.
  2. Setting a profit target of $1 with a stop of a $10 loss.

Until I see one I shall remain skeptical that one can reliably expect to profit from a losing system simply through money management.

Rocky Humbert:

As a philosophical matter, I question whether a system can truly have a negative expectation. Because if you take a system that supposedly has a negative expectation and simply do the exact opposite, you should have a system with a positive expectation. I am skeptical that any market participant believes that his approach has a negative expectation.

If you have ever tried to play checkers to lose (instead of win), you'll see just how difficult this can be.

(Note that I am excluding transaction costs from this discussion. But there should be no a priori (efficient market) reason to believe that always buying out of the money options should have a better result than always selling out of the money options– unless there is a systematic mispricing.)

Steve Ellison comments:

crapsAny casino game is a system with a negative expectation for the player (except a blackjack card counter). In craps, one can bet against the shooter, but the expectation is still negative. The only way to take the other side is to be the house. 

George Parkanyi writes:

In my REAP system (Relational Equity Allocation Program), I made the position size a function of the relative separation ( % move of X minus the %move of Y determined the % of position X to sell to fund the purchase of position Y) between two securities made over time. You can re-allocate based on a specific net separation (e.g. 30%) or re-allocate at specific time periods come what may. This has a positive expectation over long periods, because there is dollar-cost averaging dynamic involved - a more aggressive version because fewer shares are sold of the relatively higher security, and more shares bought of the relatively lower security, and the wider the separation the larger the re-allocation size. The compounding over time depends on the volatility (and therefore degree of divergence and funds transfer) between the matched securities.

Trade sizing can also be used for money management in trend following. The simple principle of scaling into a position as it rises keeps your risk relatively low on initial entry, and there is a cushion of profit to fund the risk of subsequent higher-up scaling purchases. Here again, you can optimize by how high you go before adding, and what tranche sizes you add at each level. The trade-off is that you limit your profit potential by scaling, but your stop-outs are cheaper, and waiting to add provides confirmation of the trend.

I currently am using a 40-30-30 scaling sequence, using a specific setup pattern rather than a fixed % rise (e.g. 0%, 10%, 20%). You could use a relatively wide stop on the first tranche, or really keep your costs down and use a very tight stop that allows several inexpensive stop-outs before you "latch". The latter is a better way to go I think if you are trading breakouts and strength patterns. A good break-out doesn't look back, so your tight stop doesn't factor in. If you have to stop out 3 to 4 times before you catch it, you can still keep your misfire costs low.

Rocky Humbert:

Fair point. I was referring to the financial markets (and not casinos,) but you can indeed buy and hold the shares of publicly traded casino companies and you are taking the other (positive expected) side.

Turning a system upside down highlights an additional phenomenon: path dependency can determine whether one is a trading "genius" or "moron."

Nigel Davies comments:

Fascinating discussion.

If I might offer my two cents I've found that in my field there are an immense number of practical difficulties in bringing a nice piece of theory to the board. From my amateur perspective I see many issues with regards to the subject under discussion:

a) A maximum loss size implies that you have a clearly defined exit point, i.e you are trading with stops of some kind and these can nonetheless leave you a winning system.

b) Assuming you have your exit point, how realistic is it that this will be achieved (slippage etc).

c) Does assigning all trades the same position size represent maximum efficiency? I suggest that some are much better than others and should therefore be weighted more heavily.

I'm sure that readers of this site can think of many more issues such as these. This in turn makes me wonder about the utility of trying to apply very precise mathematics to practical and very messy issues. Surely it should come with a good sized dollop of common sense and flexibility in which good lab experiments are regarded as mission statements rather than straight jacket rules.

Of course doing this is an art in itself which will extends into all sorts of psychological nuances. If anyone is unable to do this they should be looking to work on themselves rather than 'the system'. Discovering the reasons why people can't operate effectively under pressure is very valuable, both in the markets and in life.

Craig Mee responds:

Fair call, Nigel, though the one thing I would have to agree about on the surface but disagree on is "I suggest that some are much better than others and should therefore be weighted more heavily."

It had been my humble experience that the trades I thought were crackers ended up as duds, and those I thought were tradable, but just above the criteria, turned out to be 4-10 baggers. Setting the same cash risk, at the start was imperative across the board.

Nigel Davies writes:

 Well, yes, that can be a tricky one. But if one's assessment of bullitude/bearitude is unreliable vis a vis degree, what makes you so sure that they're not completely the wrong way round!? It could be that 'sure thing' trades lower one's vigilance in which case we're back to the human factor. Anyhow, now I'm more awake I can think of some other flies in the ointment in this position sizing debate. What about:

a) The good part time trader with a day job who wants to build up capital. Perhaps he should he push the boat out more at first so as to get a big enough account to go professional.

b) The improving trader; shouldn't he trade small size whilst learning?

c) The successful professional trader who wants to protect capital. Shouldn't he gradually reduce size rather than have his entire wealth and livelihood on the line.

Don't get me wrong, I think that an understanding of position size risks is essential. But there's a lot more to this than just numbers.



an illustration of momentumTo what extent is there momentum in the surprise of quarterly earnings reports and is it reflected in similar moves in individual stocks or stock markets?

Steve Ellison writes:

I studied the impact of earnings by comparing the movements of the S&P 500 during the second half of the first month of each calendar quarter, when the market receives much new information about earnings, with the subsequent 2½-month period in which there is much less earnings news. For 2003 through 2009, I found a negative correlation with a t stat of -2.18. Interestingly, when I repeated the same test with 1990s data, I got a positive correlation with a t stat of +2.11 — changing cycles, again.

Philip J. McDonnell comments:

I would conjecture the Sarbanes Oxley Act of 2002 may be the line of demarcation between positive and negative correlation.



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.



Starting Monday the Earth was hit by a series of Coronal Mass Emissions which were the strongest in over three years. The CMEs produced a spectacular multi colored aurora show at both the North and South poles and lower latitudes. According to an Atlanta Fed study the CMEs are also associated with temporary weakness in stock prices in affected countries. The usual lag is about 3-4 days. The Fed paper gave no reason for the hysteresis.

The paper by Robotti and Krivelyova is here.

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



It seems like

1) naive people think the market will go higher as the momentum is that way

2) the smart people think the market will go lower because the VIX is at a low level, and they want to look smart being contrarian. They also know that you always sound smarter if you are bearish, being too afraid of being thought to be naive, and only Buffett is allowed to be bullish

3) the super smart think the market is going higher since the IPO market hasn't taken off, M&A hasn't taken off, and there are still people who have missed the rally, i.e., money on the sidelines. They also would rather talk about the rho than the vega.

Category 3 often overthinks the market, in my opinion, and some of the worst stock pickers are found in that category.

Phil McDonnell writes:

Mr. Andersson's point about rho's being important is noteworthy. The normalization of the yield curve will be the biggest macro event over the next 12 months. It is not a question of if, but when. Selling options when that happens could be hazardous to your wealth because increasing rho will cause them to rise.

Jim Sogi comments:

It seems from the depth there is some big money bidding up here. Brokers? There was also big money bidding the '07 highs as well, so not sure if that means much, but the size sure is squashing the market. No one is hitting the market, all limits, at big numbers. 



An article in Business Insider suggests that after a 40% run up in stock prices the market will suffer a correction. Sadly this conclusion is based on close reading of a 90 chart of the Dow. Thus one is suspicious.

Putting this to a test one finds that the market gains .024 per day in all days since Oct 1929. But after a 40% gain in the previous 252 days the return nearly doubles to .043 per day. During days without the prior 40% return the average day only gains .023%. Full summary results:

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

Rocky Humbert comments:

That article demonstrates many flaws, including the way the question was posed and the fuzziness of the outcomes.

Here's a different spin: What would happen if you bought the Dow Jones only after a 40% annualized gain, and held the position for the next 90 days? The results:
1933: +18%
1935: +10.9%
1943: +4.9%
1954: +6.7%
1983: +8.1%
1986: +4.0%
1987: -23%
1996: +3.2%
1997: +3.5
1999: +0.4%
[Data do not include dividends]

(There are 14 data points in the article versus 10 above. The difference is due to my having an open position and not double-counting a re-entry.)

Conclusion: Buying after a 40% rally provides returns that are better than long-term drift unless you get caught in a market crash. Hence, if history is predictive, it's actually a fine time to go long and pay 1% premium to buy some out-of-the-money puts to attenuate the tail risk. Applying a T-test is above my pay grade.

I interpreted the article as arguing that an initial move over a 40% ROC had bearish predictive value — and history suggests that it does not. Re-entries were not mentioned…One should also consider the source of the article: Business Insider picked it up from a website aptly called whose author (Michael Panzner) wrote the eponymous book, Financial Armageddon (2008) and more recently, When Giants Fail (2009). I have not read either book, but I'm told that his most recent tome doesn't mention Eli Manning. 

Rocky Humbert, quantitative analyst, speculator and master chef, blogs as OneHonestMan.



partial lunar eclipse in earth's penumbraThe penumbra is a partial shadow around an opaque body like the moon or market where only faint sight is possible. It was applied in a classic article by Taussig to the region around the intersection of supply and demand curves within which stocks fluctuate in a seemingly haphazard fashion. As anything Taussig wrote 100 years ago is infinitely superior to what passes for economic analysis of markets today, it is worth quoting in full on the concept of a penumbra. First described in stocks by Taussig in 1910 ish. For reference:

IS MARKET PRICE DETERMINATE? By Frank William Taussig. The Quarterly Journal of Economics 1921, vol XXXV

[ … ]

This does not mean that there are unlimited or quite unpredictable fluctuations. The underlying conditions of supply and demand are known for all the staples well enough to make possible a rough prognostication of the season's course of prices. It may be quite clear that potatoes will be higher than last year. But there will be a penumbra of uncertainty. Within this there will be ups and downs, many and perhaps wide fluctuations.

[ … ]

Now it is with regard to the fluctuations within the penumbra, the familiar ups and downs of the market, that we need to be cautious in stating any theory of market price. The daily or weekly or monthly "equilibrium" of supply and demand is a very ticklish matter. To return to the egg market, mentioned at the outset by way of illustration: demand and supply and price are not necessarily connected, for short periods, in the way commonly assumed. Suppose a well-known dealer cuts the price and puts eggs on the market at a lower figure; others follow his lead; the price will fall further; the lower price will quite possibly stimulate still others, not to make purchases, as is usually assumed, but on the contrary to make sales — until the edge of the penumbra is approached. Then indeed there will be a reaction, or at least a check. Eggs will not go down indefinitely. But within the penumbra there is no certainty about the effect of lowered price on supply or demand or on the further course of prices. Conceivably the course of events may be just the opposite of that just described. The well-known dealer who cuts his price may be confronted by another dealer equally well-known, who snaps his offers up and bids for more at the same figure. Then still others will follow his lead, country dealers will hold back, not force their supplies on the market, and eggs will go up until the other edge of the penumbra is approached. And so it is, I take it, in the wheat pit or at the cotton post. There is no telling what immediate response there will be to an offer of larger supply or to a decline in the day's or week's quotation. A heavy sale by a big operator and a lower price accepted by him may easily mean, not that more will be bought by others, but that buyers will be scared off and that price will fall still further. This is precisely what the big bear operator expects to bring about. Or the bear's maneuver may not succeed. Price may not fall further; it may rebound and rise.

To put the matter in more technical terms: the demand curve over "short periods" — which may be a matter of weeks or even months — is not necessarily inclined throughout in the same direction. It may be inclined positively.1 And similarly the supply curve, indicating what quantities are offered for sale at different prices, does not necessarily have that constant positive inclination which is usually assumed. In the course of the higgling of the market this in its turn may have a negative inclination.

The combats of bulls and bears, familiar phenomena of the market, are incomprehensible under the orthodox theory of market price. They can be understood only if we admit that within the penumbra there is no determined or determinable market price. A good observer has said that the successful speculator is not necessarily a man of wide statistical information or of much experience in the trade. But he must be a shrewd judge of human nature. As regards the fluctuations within the penumbra, there is much truth in the statement. The market may react in all sorts of ways to changes in offers and bids and going prices. The outcome depends on men's hopes and fears and guesses and momentary states of mind. The nervy man may make money by coolly watching his more sensitive fellows and playing on their frailties.

[ … ]

From a reference that I cited with approval in my 1964 thesis, and that Professor Zeckhauser has been looking for for 30 years, and kindly provided by Alston Mabry. The area beyond the penumbra is one that Taussig felt might have continued moves indicative of shifts in the demand curve and new equilibria.

I thought to test this starting with the pencil and paper at an elementary level. I considered the 10 best Nasdaq and 10 worst performing Nasdaq 100 stocks in the first quarter of a year. Next I looked at the subsequent performance of these two groups of 10 stocks in the subsequent 9 months. I repeated this process for each of the last four years. The results are interesting.

Year Best10 Worst10 Medn10 Comment

2006    11      6        3   sd = 40% non signif (ILMN = 50%)

2007    93     46       22   sd 200% FSLR up 500% 1 rnk both periods

2008   -28    -29      -38

2009    90    130       63   reversal of fortune


Year - Calendar Year

Best10 - Performance of best 10 stocks in next 9 months

Worst 10 - Performance of worst 10 stocks in next 9 months

Medn10 - Median performance of all stocks

The results indicate that in the bad year, the worst stocks did the best in the last three quarter, but in the good years, the best stocks in the first quarter continued to excel. The 10 best performing stocks this year are Baidu, Liberty, Wynn, Sears, Garmin, Illumina, Hologic, Ross Stores, NII Holdings, Mylan. The 10 worst performing stocks this year are nvidia, Linear Tech, Foster Wheeler , Google, Qualcomm, Expedia, Warner Chilcott, First Solar, FLIR , KLA Tencor . One would be interested in other first efforts to explore the penumbra concept of Professor Taussig.

Phil McDonnell performed his own study:

In 1921 Taussig argued that there exists a penumbra around the current price in a market. He based this on the argument that at any given time the supply in a market is relatively inelastic. There is only so much wheat and more cannot be grown until next year. There are only so many shares of stock and it would take a while for the company to issue more.

This suggests a simple strategy. One could keep an average of recent highs and lows and use that as a predicted high or low for the day. One would buy at the predicted low and exit at the close. One would sell at the high and exit at the close. The following study was done using SPY daily data. For this study the average was a 10.72 day with lag removed.


       Sell Hi     Buy Lo

avg   0.022%    0.040%

std    0.994%    1.255%

count 1290        1273 %

up     48.84%     51.61%

t-stat 0.79           1.13

Results are not significant.

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

Alston Mabry shares another Taussig work:

The Silver Situation in the United States F. W. Taussig 3rd ed, 1900

A discussion of the silver situation in the United States divides itself naturally into two parts. On the one hand, we have the purely economic aspects of the problem — the working of the silver legislation, its history, the results that have flowed from it in the past or may be expected in the future. On the other hand, we have the intricate and difficult questions of policy involved — the right and wrong of the legislation, the evils or benefits that have ensued and may be expected, the best course to be followed in view of all the emergencies of the situation; the treatment of the problem not only from the economic, but from the wider social and political point of view.



Terrance OdeanTerry Odean is a Professor of finance at Berkeley's Haas School of Business. He has done several papers on the profitability of small investors and day traders. They are listed on his web page. Here is one:

"Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors" with Brad Barber, /Journal of Finance, /Vol. LV, No. 2, April 2000, 773-806.



Shiller and SiegelThere was an article in yesterday's WSJ updating the bear v. bull debate between grad-school buddies Jeremy Siegel and Robert Shiller .

Shiller, who correctly called the 2000 stock and 2006 home price bubbles, contends the current rally has taken (his version of) stock market P/E above its long-term average, and the on-life-support real estate market will continue to drag on corporate earnings. The concern is that for some time FED/government intervention has artificially buoyed stocks above their "natural P/E"; beginning with the 1998 Russian debt default (thank you Mr. Meriwether), Y2K, 911, tech bubble bursting, and the recent credit crisis. In spite of all this help, we just ended the worst decade for stocks since 1930.

Professor Siegel counters that Shiller's P/E method is flawed, and that a version of analyst earnings estimate suggests that earnings will increase now that the credit-crisis write-downs have been taken.

Another possible explanation for a new, higher P/E regime is the transformation of investor thinking: Stocks changed from the "sucker bets" of our parents and grand-parents to the main-stream, primary investment for retirement. This is a self-fulfilling prophesy: since people associate economic well-being with the market, governments now borrow heavily to buy puts (of course someone has to pay for these, hopefully only those making more than $250,000/yr).

There is no reason embedded in nature that stocks must center about a certain P/E. They could stay higher or lower for decades without reason. One of the weakest arguments in Siegel's "Stocks for the Long Run" relates to the question of who will buy stocks as baby-boomers retire. His answer was foreign investors in developing countries -who currently look to be pretty well stocked up on American securities.

Currently the heroes of liquidity-provision are the mavens of Wall Street, who now hold the P/E levers and remain beholden to a market too big to fail.

Stefan Jovanovich comments:

I share Kim's skepticism about Professor Siegel's end-game for American securities. There is no historical evidence for the proposition that wealthy people in developing countries want to put their savings into the common stocks of the already developed/relatively declining countries. The periphery does not send capital to the center. Europeans bought American securities in the 19th century and again after WW II, when the U.S. offered superior growth prospects; those were precisely the times when Americans kept their capital at home, except, of course, for buying trips for foreign baubles. (Every time I visit the Huntington Library I find myself wondering how much the sale of Gainsboroughs for the pound; perhaps the rich in Singapore will develop a taste for the Hudson River school). The only event that could drag capital from Asia to North America would be the political collapse of China; if that were to occur, the money would be flight capital, and that would hardly be enough to cash out 50 million IRAs and 401(k)s. If the United States is going to return to the path of financial progress, like Sebastian the crab we will have to do it ourselves. It is going to take a while.

On another note, I finally understand Keynesians. You guys literally don't think balance sheets matter; it's all about the flow. But what do you do when the pipes have sprung a permanent leak? Opening the sluice gates won't help because the little water left behind the dam has to be kept so no one will worry about a drought and the Valley farmers have already used up their allotments.I have no understanding of the world of 3rd party incomes and investments - the one where the students don't pay the teachers and the money to invest is always OPM. I have not lived there in 35 years; my last brief visit was 1 year as a salaried tax lawyer before the combination of the 1976 tax reform act and my unfortunate manner got me fired. Since then, all I have known is the world of incorporated wallets. Right now in Munchkin Land investment bargains exist; but they are there precisely because the income flows are diminished. The prices have come down because the people who own the businesses do not themselves have the cash to reinvest. They simply want out. And, many of the bargains are anything but because the businesses are simply failing.

That, combined with the likely further extension of confiscatory regulation, makes any current investment here in California very much of a dodgy proposition. The risk of loss seems much, much greater than the reward. If there is to be new investment, it will have to come because we greedheads think we can make money, not because we have a positive cash flow. Until we can see a prospect for profit at the prices for capital assets, the flows will go into the bank to wait. Those businesses that have access to bank and government credit may, indeed, be recovering; but few, if any, small businesses and non-government employee customers are. Their own income prospects are lousy, and their balance sheets are under water. Hayek would blame all this on the past nationalization of credit and money. (Cf. Good Money, Vol. I and II). That, and the prospect of having the government tax more of the flow is only encouraging people to look for ways to camouflage their wealth. Someone - it may have been Jim Farley but I can't find the precise source - said about Joseph Kennedy, Sr. that "he was the only guy I knew in 1932 who could buy something without having to sell something else." The Kennedy political tradition may be dead, but the bootlegger legacy is alive and growing.

Kim thought Siegel was being naïve in expecting that new capital to be invested in America from abroad to buy out the retiring geezers like me. I agree, but God only knows; perhaps Brazilians will acquire a taste for windfarms in Tornado Alley. What we do know is that growth in real wages is a pure function of increased investment. Workers who get to play with newer, more expensive machines make more money because things and services can be provided better, cheaper and faster. I don't like the term capitalism, but one should give Marx his due. He did understand what was at stake. The money and credit and assets held by competitive enterprises - what he would define as "das capital" - are the only chips in the game. If the capital stock is diminished, the holders of cash who are able to invest at 6 or 8 x present earnings will probably make money; but they will be doing it at a time when the workers will be making less - as they did in the decade after the 1982 bottom. (Marx would say it was BECAUSE the new investors were making more money; and even if he was wrong about the causality, he was right about the coincidence; workers' wages do not increase dramatically while capital stock is being rebuilt. They have to wait their turn.)

What we also know is that a world of lower stock prices is one in which profits have declined and the prospect for future earnings has grown less cheery. Those situations usually do present opportunities for future gain but only if someone has "das capital". Andrew Carnegie said that, if you have a choice between losing the factories and losing the people, you want to lose the factories because, with the people you can build a better factory. Being a 19th century primitive, Carnegie presumed that a prudent businessman always had a stash of money - what used to be known as a reserve - whose value was not subject to confiscation or abolition by the government. Carnegie also presumed that he and other prudent businessman would use the cash to pay the workers their wages while the new, better factory was getting up and running. What was different in the past was that there was a stock of private capital willing to speculate after a factory had burned down or the market had crashed.

The question that Kim raised– and for which there is still no apparent answer - is where will that real cash come from now? The diminished future can only be a Grand Bargain after private savings are restored. Until then, it is likely to be a Grand Fail with both the young and the old getting far less than they expect. "Other than that, Mrs. Lincoln, how did you like the play?" 

Phil McDonnell writes:

One important aspect of this discussion is to look at the required level of stock prices. To this end it is helpful to consider that there is a large store of wealth in the world which must be invested somewhere. Right now Real Estate is in the dog house so people are dis-investing in that area. But bonds and stocks are relatively close substitutes with comparable liquidity.

Thus the required yield on stocks is simply the reciprocal of the P/E ratio. To be competitive stocks must yield something comparable to and competitive with bonds. But bonds yields are remarkably low now largely through Fed intervention. So stock P/E ratios can go quite high and still remain competitive with the historically low yield of bonds.

Alston Mabry comments:

Perhaps Dr Siegel's thesis will be supported by a new paradigm that dispenses with the connection between "American" and "securities", i.e., is Coca-Cola really just an "American" stock? Or Exxon-Mobil? Or Microsoft? Or many smaller US-based companies whose business is actually global in scope? Or think about the large foreign companies that are a big part of daily trading volume here and also part of most/all retirement accounts. Increasingly, it may be that boomers are selling their holdings into a more and more homogeous global market.

from the WSJ article:

"They say they've been chewing over the issue during vacations together at the New Jersey shore."

One shudders to think of the reality-tv-show possibilities….

Rocky Humbert comments:

An alternative way to look at this issue is to consider whether one's ownership of equities is an investment based on an assessment of future earnings and dividends — or a speculation based on a greater-fool theory.

To quote Keynes: "Most of these [professional investors and speculators] are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the public. They are concerned, not with what an investment is really worth to a man who buys it "for keeps," but with what the market will value it at, under the influence of mass psychology, three months or a year hence." Source: Keynes "General Theory," Harcourt,Brace & World 1965 ed. pg 155

This quote is reminiscent to statements made by a certain gentleman from Omaha, whose company has now outperformed the S&P-500 for the past 1, 3, 5, 10, 20 years…

Stefan Jovanovich adds:

The gentleman from Omaha has an easy standard of comparison. If you apply the average tax rate of the S&P companies to Berkshire's past 20 years' earnings, the company's book value drops by roughly 1/3rd. Never mind being a specialist in a bull market; in my next life I want to come back as the owner of an insurance company who is on a first-name basis with the Secretary of the Treasury.

I hate to trash what was once part of Dad's backlist, but Keynes' presumption about what is in the minds of investors and speculators is the truth only because it is theory that has won the academic beauty contest. It has been the most fashionable theory going since neo-Marxism trumped all else (note the reference to "mass psychology"), but it no more likely to be the truth than any other guess about something that is unknown and unknowable.

"The man of system is apt to be very wise to his own conceit. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board." - Adam Smith

Tyler McClellan writes:

I don't understand the relevance of any of the above. There are complicated ways in which falling stock prices affect on economic growth and even more complicated steps through which this transmission affects corporate profits.

But surely other than these effects, we don't care about the price of the capital stock. We care about the return to the capital stock at the given price of transfer. If the profits don't decline, so what if the old transfer the assets to the young at 12x or 15x, excepting of course the old.

Considering the IRR of social security has gone from high 30s for the first generation to slightly negative in mine, I can assure you that we need not worry about the "misfortune of the old". Social security is a flippant example, but the fact is empirically undeniable, the current generation of old people have benefitted from the most massive transfer of wealth to them from the young the world has ever seen. The baby boomers will do materially better than breaking even at current projections (driven almost completely by medicare), and the next generation will do substantially worse.

Its astounding to me that we allow the "old" to impart their wisdom to the "young". Now of course the young will benefit in the non-taxed sectors. If no one in Westchester's children can afford their parents houses, then in aggregate the houses must go down in price. This is a benefit to the children, just as lower stock prices with the same future earnings are a benefit to the young.

I call this the Grand Bargain, either we eliminate the entitlements and the asset prices can stay high, or we pay the entitlements and the asset prices fall. I'm not sure which is preferable.

I am basically a doctrinaire Keynesian, although I'm not sure what analytic work such a concept does or does not perform.

I would simply say that the process you outlined in the below is actually quite different than where you began. You seem to argue on the one hand that the businesses wont reinvest because they don't have any cash flow and then in the second that they wont reinvest the surplus cash flow because they are not confident in future X, Y, or Z.

As you can see those are mutually incompatible facts. Keynes believed that because changing expectations of the future largely effect plans reliant on the far future (such as investment), that in times of panic one should create investment to make use of the excess demanded savings, specifically when the excess of demanded savings was sufficient to make lower interest rates incapable of increasing the demand to invest sufficiently to absorb this excess savings.

Expectations of the future are a source of current period aggregate demand. Changing expectations of the future where everyone wants to invest less than he wants to save (which by the way savings is a flow of income as you correctly identify further down in you argument), can only be accomplished by destroying enough income such that the savings is not actually produced. There cannot be more savings than investment. There is no way to store money, there is no flow of savings that is not spent. That is to say, all savings is spent, just some of it is spent on investment.

I suspect you agree with the above and simply doubt that the way to get people to demand greater investment is to do it for them, and that rather we should provide future tax clarity, lower regulation, jump through hoops… fine, and I don't particularly disagree, but you will see that the fundamental insight remains. With no demand to invest, we cannot fulfill the demand to save. Period, end of story.



buy low, sell high cufflinksBuy Low and Sell High. It is the oldest maxim on Wall Street. The trouble is that it is difficult to do without a copy of tomorrow's newspaper. Even better would be a copy of next year's paper.

An article cited by a reader claimed that buying at the low in the second year of a Presidential cycle and selling at the high produced superior returns. To test whether there really is something remarkable about the second year of the Presidency we can compare the return in that year to the results for all years again assuming the unrealistic advantage of knowing when the annual low is and the next year's high.

The results for all years:

average      41.4%

std             25.7%

count          81 %

Up           100%

t-stat        14.50

Minimum   11.0%

The results for the second year of any presidency:


std           18.5%

count         20 %

Up            100%

t-stat        12.13

Minimum   16.9%

The second year slightly outperforms by 8.8% but that hardly seems significant compared to all years. The t-stat for all years is better primarily because of the larger n. Again we are reminded of the Chair's admonition that of the four possible hypotheses (1st year, 2nd year, etc.) one of them had to be the best.

When we consider the claimed monthly seasonal study the picture is even murkier. We recall that there are twelve months. But that is not 12 hypotheses. That is 12 possible starting months. There are also 12 possible ending months. This gives us a combined total of 144 (12 x 12) hypotheses. The article then assumes that using only 100 data points is sufficient to test 144 hypotheses. It sounds like junk statistics to me.

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

Steve Ellison replies:

I have tested the presidential cycle. Comparing the actual prices of the S&P 500 index to a 4-year centered average, I got the following t scores for 1950-1983:

Election year t plus score

0 2.95
1 0.78
2 -6.97
3 0.30

There was a clear tendency for highs to occur in presidential election years and lows to occur in midterm years. However, when I did the same analysis for 1984-2003, the results were not statistically significant:

Election year t plus score

0 -0.25
1 -0.56
2 -1.52
3 0.05

An investor who noted the presidential cycle in the early 1980s when its wonderful record became clear would not have profited much from it, sitting out not only the terrible decline of 2002, but also double-digit advances in 1986, 1998, and 2006. I have heard of the presidential cycle many times, but never of the caveat that it should be ignored in a second term, which makes me suspicious the caveat is retrospective curve fitting.

Another indicator that was strongly correlated with stock price changes until 1983 was the 12-month change in the US unemployment rate. From 1948 to 1983, there was a strong positive correlation between changes in the unemployment rate and subsequent changes in the S&P 500, i.e., when unemployment went up, stock prices followed. However, from 1984 to 2008, that relationship was also statistically insignificant; in fact the correlation was slightly negative.

Alston Mabry responds:

The "Xth year of the presidency" strategy debate brings to mind the "sell in May and go away" strategy.

To analyze the "buy and hold for 6 months" strategy (for all years, not just 2nd-year-of-presidency), I look at all the Dow months since October 1928 and calculate the return for each of the 12 strategies that correspond to "buy on the open of month Y, and sell on the open of month Y+6". Here are some stats:

For each month, showing the total return (since Oct 1928) for the strategy where that month is month Y, the average return for all the 6-month periods with that month as month Y, and the SD for those 6-month periods:

Jan  673%  +3.51%  14.30%
Feb  829%  +3.42%  11.48%
Mar 1604%  +4.47%  15.09%
Apr  295%  +2.86%  15.48%
May   19%  +1.03%  12.57%
Jun  142%  +2.04%  13.61%
Jul  349%  +2.95%  14.12%
Aug  241%  +2.55%  13.77%
Sep   91%  +1.84%  13.82%
Oct  926%  +3.89%  13.93%
Nov 3134%  +5.28%  13.09%
Dec 1370%  +4.42%  14.15%

In the actual data, November is a clear winner, though March and December are nothing to sneeze at. But how to get a context for the significance of November's outperformance?

Just can't help but run a quick simulation, and the easiest thing to do is to take all the percentage gains for all the possible 6-month periods and randomly reshuffle them, so that a 25% gain that historically fell in the November column might wind up in lowly May, and so on.

Running that 1000 times produced the following results: For all 1000 runs, the smallest maximum total return was 1072%. In other words, each run produced a set of 12 total return percent figures, one for each month. Looking at only the maximum return in each run produces a set of 1000 maximum return observations. The smallest of these was 1072%.

For these 1000 maximum returns, the mean was 5035% and the median was 3943%. So the actual total return for November was below the simulated median and well below the simulated mean.

This was surprising because when you reshuffle data like this, you tend to reduce the overall volatility by mixing volatility regimes. Also, the actual data series of all possible 6-month % changes is highly auto correlated (+.84 at a lag of 1).

So, another way to try to establish a random benchmark is to take the month-to-month percent changes in the actual data and reshuffle those, creating a new series of 6-month % changes each time, with each simulated series being highly autocorrelated like the actual series. Running that simulation 1000 times produced the following stats:

smallest maximum (of 1000 total): 1289%
mean of 1000 maximums: 5045%
median of 1000 maximums: 4153%

Again, the actual data for November are well below the mean and median values in the runs. So, the results of these simulations do not provide any support for the idea that the November-April holding period is outside what one would expect from a random process.



 Hello Everyone:

I noted that the GOP would not meet with BHO at the U shaped table he was going to provide and finally the GOP and DEM agreed on a square table to meet!

To me a round table would make all equal when they meet for discussions? With the Market down today to 150, I look at those elected officials and feel there are more pressing matters at hand for America!

Now watching FOX while I enjoy a cup of Constant Comment tea I see the table is officially square. That makes me feel so much better.

Regards: Alan

Phil McDonnell replies:

Debating atmospherics like shape of the table and seating protocols is usually a sign that one side wishes to delay any agreement. In this case I believe it may be the Reps who wish to have the health care debate linger into the mid-term elections. Polls show most Americans are opposed to the health care bill in its recent form(s) and the Reps hope to make it their issue this fall.



A VeltmanThis phenomenon cannot be denied, if one simply eye-balls the daily charts over the past year. I hypothesize that as the co-relation has become more-widely observed (and embraced as an automated trading signal), it partly became self-fulfilling and re-enforcing. All simple trading ideas follow their learning curve and eventually suffer from over-crowding; this one appears to be at its pinnacle right now. There are two main propositions to consider:

1. Which precise instruments to choose: SP vs. HG, SP vs. AUD/USD, SP vs. AUD/JPY, Nikkei vs same, etc.

2. Pinpoint the causality, i.e. which leads the other; and, possibly in what time-zones and under what special circumstances.

Empirically, I have long noticed that when North-American activity is somewhat curtailed due to holidays or snow-storms, the Australian Dollar moves that precede North-American time-zone will in fact tip the US stock market direction. A very hard to swallow idea: given the enormous size of the US Equities arena. On the other hand, if one's philosophy is that markets move more on perception than they do on reality - then why not?

It's also very important to incorporate varied leverage into your model. In course of 2010, for example: trend runs in outright percentage terms were greater in currencies than SP; and twice as big in Copper than SP! If you further add the effect of widely used 100:1 Forex trading leverage or the high leverage of Copper futures - results are even more outrageous… This is where Theory of Reflexivity may enter near market crests, and those leveraged bets will cause "fundamental reality" to succumb to speculative forces.

Phil McDonnell writes:

To investigate Mr. Veltman's conjecture it might be helpful to do some counting. Looking at SPY relative to the copper ETF JJC and the Australian dollar ETF FXA showed the following coterminal 105 day correlations:

        SPY JJC FXA

SPY 100 60% 71%
JJC  100 71
FXA               100

Clearly the simultaneous relationships are strong and positive. But to trade we need a predictive relationship. Looking at the same vehicles but lagged 1 day for FXA and JJC we get the following correlations to SPY the next day.

SPY JJC 0% FXA -7%

Both correlations are insignificant. Neither yesterday's move in JJC or FXA is any help in predicting the next day's move in SPY.

Nick White comments:

I echo Dr. McD's analysis. There are far too many players joining the dots between AU index — resources stocks — AU FICC without any real (well, "real" as how most Dailyspec readers would define it) reason to.

Anatoly Veltman adds:

This was yet another in the series of testing accidents, this time from esteemed Dr. McDonnell. Where would anyone get the idea to lag Australian action by a calendar day, before impacting North American S&P? And if you switch the lag around: that's not the causality hypothesized.No surprise here: for any test to be meaningful, considerable resources are required to set up proper test. Usual handicap: quants are not precise in coding trader's idea.

I originally described this idea in connection with the previous Feb.10 snow-storm. Price action could not have been more clear: Australian Dollar strength led the eventual "surprise" intra-day upside resolution in (hesitant) North American S&P, many hours in advance. S&P's (technical) up-trend then lasted for days! But how will this ever be coded… 



Sometime ago Victor posited a relationship between the angle of descent in the market and the resulting bullish reaction. His argument was based on the physics analogy with Brewster's angle.

Today, on his blog my friend the market analyst Chris Carolan provided a remarkably interesting study of this phenomenon at three time scales.

Readers of Ed Spec will immediately recognize 'When in doubt drop a perp' as sage geometry advice. As a recovering physicist, I immediately recognized a phenomenon called Brewster's angle. In the physics of light this principle governs reflections from such surfaces as glass and water and others. The principle can be most succinctly described as: the angle of incidence equals the angle of reflection.

In this case the angle of incidence is the initial bear decline. The angle of reflection is the subsequent bullish reaction.



a geomagnetic storm on earth due to solar activityThe NASA site has a prediction of 25% chance of geomagnetic storms at mid-latitudes in the next zero to 48 hours. The chance at higher latitudes is 30%. Recall that geo-magnetic storms have been linked in an Atlanta Fed study to stock market weakness in the nest few days following the event especially if accompanied by Coronal Mass Emissions.

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

Jeff Watson writes:

Years ago, I looked at the correlations between solar activity and markets using the solar flux, A index, J index, and K index, and Sunspot number, and couldn't find anything offering predictive value. The only correlation I could make was the total solar output with grain prices, and my conclusions were suspect, to say the least as many other factors were in play. A great solar storm,on the level of Sept 1-2 of 1859(which blew out the telegraph system world wide) might be bullish on chip makers and other electrical component providers, plus would be very bullish on metals. However, a solar storm of that magnitude could possibly wipe out our digital communications, computer system, and internet, for a long time.

Yishen Kuik comments:

I'd never heard of the 1859 storm before. A little more recently, the Toronto Stock Exchange was halted by a solar storm in 1989.



free hand chalkboard drawing of a perfect circleA recurring topic on this list is the study of market anomalies surrounding round numbers. Perhaps this idea can be extended to interesting ticker symbols. In the US ticker symbols are formed from letters and thus whether a symbol is 'round' or interesting is largely a subjective matter.

However in Hong Kong the symbols are numbers. So could there be an attraction to round numbered easy to remember symbols? A simple way to look at this is to take all the even hundred symbols and compare them to the Hang Seng index. The following study looked at 0100, 0200, … through 0900 but some symbols were not associated with a stock. Performance for the last twelve months was as follows:

Hang Seng +51.27%

Stocks with Round symbols

Avg. +172.61%
Std 108.77
t-stat 3.89
n 6

Kim zussman comments:

Round is Feng Shui, and Feng Shui is lucky.

Easan Katir writes:

It seems all too common that a number, whether a price, or an account value, approaches or touches a round number, then retreats slightly. Pure chance would suggest it would be over the round number or under equally, but it seems to be slightly under more often. Is this just my wishful thinking, or is there some corollary to Benford's Law?



wheatFrom the 1980s up to 2005 there was a phenomenon in the wheat market that locals referred to as the "Noon Balloon." Four days out of five, the market would rally 2- 3 cents on big volume at the noon hour, then settle back after we sold into it and the buying stopped. It was so regular, that we'd start bidding up the market a few minutes before noon, hoping to get the buyers to pay even more.

Many a fortune was made on this anomaly and it was our personal ATM machine. The Noon Balloon curiously disappeared with the demise of REFCO, and was just one of those quirks that a sagacious person on the floor could exploit. Since so many people jumped on the Noon Balloon, the effects were exaggerated. Whenever I see an uptick in wheat at 1PM (12cst) I fondly think of the Noon Balloon.

Jeff Watson, surfer, speculator, poker player and art connoisseur, blogs as MasterOfTheUniverse.

Victor Niederhoffer observes:

A published report relating to an irregularity supposedly found regarding afternoon movements has been disseminated by a very profitable brokerage. The subsequent comments relate to the layers of meaning and deception behind such reports. 

Jeff Watson comments:

Not all players have the same motives in the markets, Case in point, hedgers will sell no matter what the conditions might be. Certain commercials will play with spreads, defending them for no discernible reason. Many games are played in the delivery months, and with deliveries being re-delivered, and on and on. Commercials try to stack the pit committee, and play with the settlement price (which is not necessarily the last trading price), for their own gain. Despite the fact that trading has mostly gone electronic to improve market efficiency, a whole new series of land mines has been laid down, part of the law of unintended consequences.

Tom Marks writes:

The question of a published report with an intra day trading regularity arises from Victor and he suggests that something seemingly useful like that must have an ulterior motive. I demur. But what if they figure that the jaded such as ourselves have figured that out that nobody provides gratis which otherwise provides profits, so they in turn fade the faders. Especially when they have the wherewithal to cross-check against the order flows of whom was provided with that report in the first place. Artful deceptors rarely ply their craft one-layer thick. They like suggest texture and added dimensions. A trompe l'oeil effect that fools the eye. 

Nigel Davies adds:

The fact that the effect has been noticed and publicized seems likely to make it behave differently from the past. At least some traders will want to jump in ever earlier to exploit it, and then there will be those who fade them etc. But the last thing I'd expect to happen is an exact repetition of the past…

There's a good chess analogy to this in that the champions tend to set new opening trends but move on as soon as the crowd has noticed.

GM Davies is the author of The Rules Of Winning Chess, Everyman, 2009

Phil McDonnell writes:

To echo the Chair's observation I once reviewed a quantitative study of some market anomaly. It showed that some 700,000 (!) trades backtested would have been 80% profitable over a 10 year period. The authors were a well known TA writer and his researcher. Although the report had none of the usual tests of statistical significance that we might use here, still the sheer magnitude of the number of observations was compelling.

Nevertheless publication alerted the antenna and caused me to ask why. I redid the study on a smaller sample for the most recent year. In fact it lost money in the recent period. Hence the reason for publication — it no longer worked. But it enabled the authors to keep their names in the press.

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

Tom Marks responds:

Perhaps the real intent was to get the market so confused over this "anomaly", that no substantive moves would happen around 12:30, and those at GS could get a bite of lunch. Like the strategy we played with my 7th grade social studies teacher, simply mention Vietnam and you could ignore him and safely work on your math homework for the next hour.

Russ Sears writes:

When it comes to deception, there are different strains, some ultimately less problematic than others. Toward that end, the 7th grade social studies subterfuge may be as benign as it is precocious as it is brilliant as it is utilitarian. Everybody wins. The teacher gets to indulge his fixation, maybe even sharpen some pedagogical skills, while the kids learn how to best juggle academic time constraints by effectively calling some sort of curriculum timeout.

Sure, in terms of flawless honor, it's a little chipped, but so is the Venus de Milo. Doesn't make either any less a work of art.



 Trading hours upset the circadian rhythms of millions of people and we need to learn the side affects of sleep deprivation and how to deal with them.

Jim Sogi agrees:

When you don't sleep enough you get grumpy, uncoordinated, depressed, groggy. It's bad news.

Nigel Davies comments:

If trading does that to someone and he can't find a way around it — smaller position size, some kind of healthy stress relief — he should quit. It just isn't worth it.

Phil McDonnell explains:

A considerable amount of research has been performed into our nightly dream cycles. The typical cycle lasts about 90 minutes. So in six hours of sleep we get four completed cycles. In 7.5 hours we get fvie cycles, in nine hours we get get six. Note that eight hours does not give us an even number of cycles.

The importance of a full cycle was established a long time ago. When sleep researchers monitored test subjects and woke them at their deepest part of the dream cycle they were shown to be mentally impaired on simple cognitive tests. Awakened subjects could remember their dreams.

Subjects awakened after a full cycle performed much better on the same tests. The full cycle subjects could not remember their dreams.

Ideally sleep should be an even multiple of 90 minutes and one should awaken with no memory of the last dream. A corollary to this is that if one is awakened after, say, six hours and cannot remember a dream then it my be wise to get up. This is especially true if one feels refreshed and cannot stay in bed for another full hour and a half.

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



Below is a graph of the distribution of 52 week price changes for stocks tracked by Google. To me the interesting part is the distinctly bi-modal shape. Some companies are doing well in the last 52 weeks and the mode of the right hand side is about 66%. But others are clearly struggling and the mode on the left hand side is -21% in an otherwise up year.

The valley in the middle is centered around unchanged.


Charles Pennington responds:

I'd think the left-hand peak is just an artifact of the fact that Google used the wrong horizontal axis — they should have used ln(Pf/Pi) (where Pf=final price; Pi=initial price), rather than percent return — which they would have known if they had read "Optimal Portfolio Modeling" by Dr. Philip J. McDonnell.



Sun Storm with a CMEThe work by Krivelyova and Robotti on geomagnetic activity and market returns is fascinating.

They find outperformance vs buy and hold, but concede that factoring in transaction costs equates it back to buy and hold performance.

I'd be curious to hear critique of this paper or similar research (e.g. Dowling, Lucey; Kelly, Meschke).

The paper by Krivelyova and Robotti is another Atlanta Fed paper that has been discussed here in the past. When I did a followup using their data sources the only correlations that appeared significant were the Coronal Mass Emissions (CME). There did not seem to be much there for the basic sunspot and geomagnetic data. The CMEs only seem to have a Terrestrial effect when actual Solar matter is ejected and it hits us. CMEs visibly show up as auroras and radio and electrical interference. My test was only using a linear model not the somewhat more sophisticated cosine transform used by the authors. In any event neither study showed a strong effect.

Remember that a statistically significant effect is not necessarily strong enough to make money, especially after vig. Note that Golden Slacks has its own entitlement program that extracts $100 million a day in trading profits in order to do G_d's work. The rest of us contribute to that.

Chris Tucker writes:

Current space weather (read solar events) is always available at NOAA for those interested.

Jeff Watson adds:

I like for solar activity much better than NOAA.

It seems that the sun has been quiet the past couple of years and solar activity should be picking up soon because we're supposed to be in a new cycle. Some believe this reduced activity might be part of a supercycle that the sun exhibits every 222 years or so. Needless to say, all indexes from the J index, K index to the A index all point in this direction.



Counted 58 jets over Christmas/New Year Week. Empty spaces. More small jets. This is thinner than prior years. It's still impressive to see a billion of hard assets parked there all shiny. The corporate guys probably can't use the company jets to fly their kids anymore. Some great custom paint jobs on the private jets.

Great waves over the week. The seasonals on waves are remarkably consistent with large global forces at play. No reason why markets should be any different.

There is really no such thing as randomness, only ignorance of real causes. The ancients attributed it to dieties.

William Weaver comments:

Kamstra, Kramer and Levi find in their 2003 paper "Winter Blues: A SAD Stock Market Cycle" that stock returns are significantly related to season. Their study examined equity performance during the six months between fall equinox (SEP 21) and spring equinox (MAR 21) for the northern hemisphere and the opposite for the southern hemisphere. Overall, stock markets underperformed in the seasonal summer and outperformed in the winter. As an example, the authors cite the returns of a portfolio invested 50% Sydney, Australia and 50% Stockholm, Sweden. From 1982 to 2001 the portfolio earned 13.1% annually. If the portfolio was rotated following darkness (SEP-MAR = Stockholm; MAR-SEP = Sydney) the portfolio returned 21.1% annually. Following the light (opposite above) the portfolio returned 5.2% annually. — Paraphrased from Inside the Investors Brain, Peterson

I ran the numbers through present and found significance using a sample of two means. The recent returns are less impressive; L/S is possible to create long term AR.

Also, are we able to understand all confounding variables given our position within the system? I'm going to open a bucket shop on the moon. No inter-sphere communication, just observation. The shop will be open to moon people with no connection to Earth.

Phil McDonnell replies:

Unless I totally misunderstand the point of the paper it shows that the strongest return in the US comes in Jan following a sharp rise from Oct through Dec. The weakest monthly return is Sep, which neither corresponds to maximum sun nor minimum sun. Apparently the claimed effect is that minimum sun causes us to buy stocks. This is not what I would expect if SAD is the true cause.

Also the claimed effect of a ten parameter regression explains only 1.1% of the variance in both US and Sweden. That does not give one much of an edge for ten parameters.

Henry Gifford writes:

Persons who have attributed aspects of human behavior to DNA/evolutionary related causes have noted that after 9 months in a relationship women ask for a longer term commitment, and then either receive it or move on.

William Weaver writes:

In the past four years I've ended four relationships in October or early November and started a new one in December or early January with the exception of one year where I started a relationship in June. Might this be influenced by weather/seasons or other variables that could influence behavior and thus financial market volatility?



Here is his most recent article:

An above average 2010, from Sam Eisenstadt

Perhaps now that he has left Value Line we'll learn a bit about what really went on with that ranking system?

Kim Zussman replies:

Similar results [to what Sam Eisenstadt reported regarding "rally from recession lows"] when isolating on major declines in DJIA (1929-09, weekly closes), defined as:

This weeks close = low for prior and future 20 weeks (major low) + This weeks close = low for prior 255 weeks (5 year low)

Using this definition, here is the size of the decline (from max prior 5 years to the major low), return next 40 weeks, and return for 20 weeks following the first 40:

Date         decline    nxt 40W    nnxt 20W
03/02/09    -0.53      0.59      ?
09/30/02    -0.36      0.22      0.12
12/02/74    -0.45      0.41      0.21
05/18/70    -0.33      0.38     -0.07
04/20/42    -0.50      0.35      0.14
07/05/32    -0.89      0.99      0.15
11/11/29    -0.40      0.05     -0.30

Four out of 6 subsequent 20W returns were positive, with the notable exception of 1929 (whose repetition has been ruled out through close study by the current Fed Chair).

Phil McDonnell writes:

What went wrong with the rankings? Gaming may be part of the answer. Sam Eisenstadt clearly did not know the answer when I asked him a few years ago. In my opinion, the SEC has the best theory but they let the 'monsters' off easily with only a fine and no admission of wrongdoing. According to the SEC they were funneling money off to an in-house brokerage, in effect skimming the investors.

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

Sam Eisenstadt replies:

I hope Phil is not implying that I was somehow involved in the SEC case against Value Line. Nowhere in the SEC charges am I mentioned, nor was I aware of the goings-on in the brokerage area. As far as Jim is concerned, I recognize that he has never been a fan of the Value Line Ranking System, even when it was performing well from the late 1960s into the late 1990s. I would recommend he read Fischer Black's "Yes Virginia, There is Hope — Tests of the Value Line Ranking System. " In recent years, the system had problems as "earnings growth," (the major component in the system) was deemphasized in favor of "value" factors. The Niederhoffer Theory of Changing Cycles. Perhaps we're approaching another change, in which event we may not hear from Jim for a while.

Victor Niederhoffer explains:

What everyone associated with, or knowing of, Sam Eisenstadt, certainly all contributors here and those associated with me, has thought about this issue is that Sam is just the finest gentleman anyone has ever had the pleasure of meeting. A beacon of light in our industry. The Osborne of fundamentals. The Balder of our field. What a joy to have him swinging and gliding again unfettered from the River Styx.



the st. louis fedThe latest release of the bi-weekly velocity of money multiplier series at the St. Louis Fed shows that the velocity has fallen to an all time historic low. The current reading is .811 and means that a dollar of money supply only produces 81 cents worth of GDP in a year. Another way to look at it is that the Fed needs to print $1.23 of new money to produce $1 of GDP in the next 12 months.

Part of economic impetus driving this situation is extremely low interest rates. At short term rates under 1% there is little urgency to invest. Putting your money under the mattress results in little in the way of lost interest. But it does save one from the savings account counter party risk and hypothetical failure of the FDIC program. The mattress strategy might even yield a net real return if deflation is the future.

The following link is to the St. Louis Fed site with a chart of the velocity of money and the most recent numbers.

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

Stefan Jovanovich replies:

Dr. Phil's statistical expertise dwarfs my poor abilities to add and subtract, but we Hayekian arithmeticians remain stubbornly skeptical about the relationship between official monies and wealth. If all the Fed really needs to do is print $xx.xx of new money to produce $yy.yy of GDP aka the sum of private and public incomes, then those in charge are clearly derelict in not immediately printing 2, 3 or 4 times $xx.xx.

Could it be that the evil capitalists are huddling at zero maturities, no matter what the price being paid for their lending the government back its official money, because the risks of (a) 2,3, and 4 times $xx.xx being printed or (b) the collapse of the carry trade in world commodities priced in U.S. dollars are BOTH best hedged by having the shortest possible terms on their official IOUs?

Those of us who dream of a return to the stupidities of Austrian and 19th century American gold standard economics fantasize that there will be that magic day when some impeccably credentialed Dr. of Economics stands up at the Emperor's testimonial dinner and asks why the accounting tautology of MV=GDP is any more meaningful than the one that says Equity=Assets-Liabilities.

MULT: The M1 multiplier is the ratio of M1 to the St. Louis Adjusted Monetary Base.

M1: The sum of currency held outside the vaults of depository institutions, Federal Reserve Banks, and the U.S. Treasury; travelers checks; and demand and other checkable deposits issued by financial institutions (except demand deposits due to the Treasury and depository institutions), minus cash items in process of collection and Federal Reserve float.

Adjusted Monetary Base: The sum of currency in circulation outside Federal Reserve Banks and the U.S. Treasury, deposits of depository financial institutions at Federal Reserve Banks, and an adjustment for the effects of changes in statutory reserve requirements on the quantity of base money held by depositories.

Rudolf Hauser writes:

 We do not live in a barter economy but rely on money instead. Anything that is convenient to use, that is very widely accepted in transactions and that retains it worth can be used as money. As with all goods and services, humanity is served by efficiency. Gold has the advantage that it is a limited commodity in nature, which keeps it relatively scarce and hence helps it to retain value, but one major disadvantage in that it is very costly to produce, making it an inefficient use of human resources. Paper money is cheap to produce but retaining value depends on the will of the producing authorities to provide an amount sufficient to meet demand for liquidity without exceeding it such as to neither increase or decrease its value (and the lesser problem of avoiding counterfeiting).

A decline in velocity indicates an increase in the demand for money relative to available supply. To measure velocity against economic activity (GDP) one most consider the lags typically involved. I prefer to use a two quarter lag. On that basis velocity was still declining for M1, M2 and MZM in the third quarter. But given the performance of financial markets I believe that the present monetary growth, while not that rapid of M2 and MZM, but more rapid for what I call liquid M2 (M2 less CD's, without institutional money market funds included in MZM), is adequate because of the increasing confidence which should be reducing the demand for money. Hence, the decline in income velocity is a reflection of the lags. Monetary growth was clearly inadequate earlier in 2008 given the rising demand for liquidity until the Fed finally panicked in the autumn.

Money creation does not increase real economic activity from a stable state level, although an erratic or inflationary monetary policy will probably decrease real growth potential. If money is inadequate to supply the effort to restore liquidity will drive down other financial asset prices and reduce economic activity. In such cases the supply of more money will meet that liquidity demand and result in an increase in financial asset prices and real economic activity. This is just a restoration from a prior inadequate supply of money. An increase in money from a starting state in which the demand for liquidity in a non-inflationary environment might increase real economic activity temporarily if there is money illusion, that is nominal demand increases are mistaken for real demand increases. Otherwise it will just cause inflation, with the lag depending on the state of the general view on monetary policy. In an inflationary environment the lag to an inflationary impact would be minimal to non-existent, but in a world with much confidence in the monetary authorities it is likely to be longer.

Stefan Jovanovich adds:

The arguments against the gold standard always come down to the "inefficiency" of having to carry around a heavy bag full of sovereigns or Double Eagles. This has, of course, absolutely nothing to do with the history of coinage or official money; but, given how few good arguments there are in favor of fiat money, it should not be surprising that it is the standard explanation for why our paper currency is no longer exchangeable for specie. One should never underestimate the determined historicisms of the monopoly academic mind. What is ironic is that the "inefficiency" explanation is made by people who depend on the credit records of the 19th century to establish their certainties about the relations between "money" (sic) and GDP (sic).

The gold standard, as adopted by the United States of America at its founding, and by the United Kingdom, France, Germany, Belgium, Netherlands, Italy, Spain - the list is too long to continue - in the last third of the 19th century did not require people to carry bags of coins. What is remarkable is that it did not even require people to a particular money. All the gold standard said is that the sovereign government would mint coin in gold of a standard purity and that, on demand, the government would redeem its debts in such coin. You can find that pledge in the American constitution and, for that matter, in the constitution of the Confederacy. The gold standard did not require people to demand bags of coin as payment for the Treasury bonds, and even at times of financial distress, very few people did actually demand specie from the government. But the gold standard gave them that choice. "Ordinary" (sic) people could demand that the government meet its promises according to a standard that the government itself could not manipulate. Now, as Rudolph points out, the measure and weight of money is dependent on "the will of the producing authorities".

As Hayek kept reminding us, with elegance and without intemperateness, the notion that the government "supplies" money is the fallacy. Governments have minted coins from the beginning of recorded history, but they have not supplied that wealth; they have only collected it. Governments insisted on an official money because they could not live with private money. The idea that, before governments, people lived only by barter is truly fantastic; there is evidence of private money in every literate culture in history. As soon as people figured out how to write, they started issuing IOUs to each other. But, the promise of Fred the grain merchant of Tigris to pay Harry the wheat farmer two goats and a dowry for Gharry's daughter was not going to be very useful in paying the hill tribesmen pay/bribes/rewards for serving in the king's own regiment. The hill tribesmen did not know Fred or speak his dialect; they wanted something of tangible value. Official money developed out of the need/desire/vanity for armies and the necessity of paying them. That is still official money's ultimate rationale; the state needs to be able to pay its minions with a money that they will accept.

But why, as Hayek asked, does official money have to be a monopoly? Why are our most "progressive" thinkers in favor of a world currency, for example? The inefficiency argument hardly applies in this case; having 3, 5 or even 50 different sovereign currencies is no more difficult to manage in the age of computers than a single currency. The answer is obvious: with competing monies there is still a means for people to accumulate and hold their own wealth. That liberty may only be available to the very rich but it is still a freedom that exists and that could possibly be expanded to include "ordinary" (sic) people; and that movable private wealth represents a very real threat to official power.

The one valid argument that defenders of the Confederacy have is that Lincoln did want to impose a Federal monopoly on money and that, once the Civil War started, he did just that. What the defenders of States rights do not acknowledge is that state governments had been as eager monopolists as Lincoln. They had also, like Lincoln, been willing to default on specie redemption for their borrowings.

The reason that you have a period of rare political unanimity on the question of the gold standard for the 4 decades between the Resumption Act and the closing of the New York Stock Exchange at the beginning of World War I is that Northerners and Southerners, Democrats and Republicans, of any sense all understood the monetary lesson of the Civil War: if government is allowed to exempt itself from a Constitutional standard for money, then ruin follows. When governments can literally manipulate the weights and standards of money itself, the currency becomes a mechanism for theft by those who sit closest to the King.

But, there is no point in quarreling with the true believers in the money supply. It is part of the same theology that has as an article of faith the certainty that, without compulsory government schooling, none of us would ever learn how to read. One can only laugh at the irony that it is the true believers who have the most at risk. The contingent payments to the civil servants themselves - those glorious pensions - are the promises most likely to fail. The coins cannot be clipped, and competing monies do represent a restraint on hyper-devaluation. All that is left is default. Given a choice between defaulting on Social Security/Medicare and public employee and school teacher pensions, there seems little doubt what the electorate will vote for ten or twenty years from now - assuming, of course, that the issue is even put to a vote.

Alex Forshaw replies:

But, there is no point in quarreling with the true believers in the money supply. It is part of the same theology that has as an article of faith the certainty that, without compulsory government schooling, none of us would ever learn how to read.

I'd go even further than this.

In my (thus far brief) speculative experience, for every one brilliantly complex idea which spectacularly vindicates the prophet lost in the wilderness, there are 99 "brilliantly complex" ideas whose complexity proves nothing more than a refuge for the proponent's ego, for him to delay admitting he's been wrong all along. Such is the case with the academic mumbo-jumbo that belabors arguments on monetary policy, among others.

Arguments about money supply, liquidity provision, bubbles and the gold standard revolve around some very basic presuppositions.

Can bureaucrats be trusted to Do The Right Thing when specialized constituencies' interests, and bureaucratic institutional self-interest, unite on the other side of the argument?

Or do they–under the cover of complex esoterica completely foreign beyond their own constituencies–generally convince themselves that The Right Thing happens to align perfectly with their own institutional self interest?

I do not understand how anybody can look at the history of money, and the history of human nature in general, different from "hell no."

In my opinion, if you take the other side of that question, as Rudolf has, you will find yourself justifying the most brazen monetary manipulations any of us has ever seen. The rest is just pedantry. How does anyone have the arrogance to set the cost of capital for an entire planet? How does anyone else sucker themselves into believing any one individual ever has that kind of "edge," on any kind of ongoing, predictable basis?

Theses that can't be explained simply, should not be trusted. There is a lot more egotism than truth in complexity. No amount of academic mumbo jumbo will help contemporary, "how D A R E you suggest our tripling M1 in 1 year was anything other than saving the economy from Armageddon?" Keynesianism pass the bullshit test; and that's where the line in the sand should be drawn.

If you accept the terminology and the givens of the monetary clergy, you tacitly concede intellectual honesty on their part. For someone not invested in the status quo (or invested beyond that), all debate beyond that point is a waste of time. You aren't going to change anything, so why not just find something better to do?.

Rudolf Hauser counters:

I am not going to persuade Stefan to abandon his love of gold, so I would not even waste my time trying. He like our sometime contributor Larry Parks are staunch advocates. But other members of the list might be open to alternative viewpoints. First of all, I do not advocate a government mandated monopoly on money. I believe individuals should be able to hold whatever assets they wish, gold included, and contract to deal in whatever medium of exchange they prefer. I like Stefan object to efforts to restrict such as was done when the gold standard was abolished under the FDR administration. The inefficiency I am thinking off is not people carrying bags of gold around but the human costs of mining the stuff. How many work under absolutely miserable conditions digging through mounds of dirt for a few grams to buy them a meager subsistence in Central Africa? How many work under extremely hot, unpleasant and I suspect not without danger depths of South African mines? How many wasted their lives digging for gold without most finding much in the gold field booms of California, Alaska, etc.? Digging for the stuff costs lives and ruins lives. People would still do so for the non-monetary uses of gold, but the price would be lower and the resulting activity less. The use of IOUs etc. in early human activity not expressed in a common medium of exchange is still a form of barter. Only when you have a substance widely accepted by a large group of people in which the value of all other goods and services are expressed do you have something that can be called money. A near money, like the non-M1 components of M2 are not transactional money, but may be considered as money for analysis if they can readily be converted to a transactional money without any or most minimal cost. Transactions in international trade involving two or more currencies represent additional risks and costs. Not only is your competitive position determined by what happens to the demand and supply of your products but also by the overall balance between the countries in question which will impact the exchange value of the currencies. Hedging will reduce the risk somewhat but not without cost. I am not advocating a single currency as that also creates even greater problems with regions growing at different rates, etc.-just pointing out there is both advantages as well as disadvantages to having to deal only in a single currency. A gold standard will not prevent a government from defaulting. It only changes the form that the default might take. A fiat standard makes it easier to do so without being so overt about it, but in extreme situations it will not prevent that from happening. For an economy to function most efficiently, it needs to have an adequate but not excessive medium of exchange. Gold is limited by the amount in the ground. Any currency, etc. backed by gold at a constant amount would still be limited by the available quantity of gold. Major gold discoveries have lead to inflation, albeit very modest compared to what happens with inflated fiat money. A shortage of gold leads to deflation. As the experience of the latter half of the 18th century in the U.S. showed you can still have good real growth with modest deflation. But there is a problem here. Most people rely in others to make investments in real ventures (that is, capital spending, etc. as opposed to financial investments). But since the nominal return on money practically go below zero (storage costs, etc. might reduce it slightly below zero), the amount of deflation will set the risk free interest rate floor. As that rate rises higher and higher, fewer and fewer investments will offer enough of a return to attract saver's dollars. As such, investment and real economic growth, with resulting improvement in living standards, would lag behind potential. Efforts to accommodate this by reducing gold backing, changing conversion rates get you right back to the issue of government discretion that Stefan was talking about in the first place. You could end up with a monetary shortage as people hoarded available money. Alternative private forms of money might develop, but as they would represent more inflation prone forms of exchange than would private money such as gold under current conditions, they do not strike me a first glance as an attractive alternative to a sound fiat standard.

Alex, M1 did treble-relative to Feb. 1985. It has increased 22.9% in the past two years. M2 was up 13.2% over those two years. On a continuing basis that would surely be inflationary. But given the financial uncertainty, it resulted in that time, it has probably been desirable. I am very concerned that it might not be reversed when the demand for money decreases again and then we might have an inflationary result.

Efficient societies depend on trust. Remove trust and the ability to make progress is greatly limited. But the biggest problem in modern society is indeed the need to restrict and control the power of government. We have different view on how that should be done and what government should be allowed to do.

Also, Alex, M1 did treble-relative to Feb. 1985. It has increased 22.9% in the past two years. M2 was up 13.2% over those two years. On a continuing basis that would surely be inflationary. But given the financial uncertainty, it resulted in that time, it has probably been desirable. I am very concerned that it might not be reversed when the demand for money decreases again and then we might have an inflationary result.

Efficient societies depend on trust. Remove trust and the ability to make progress is greatly limited. But the biggest problem in modern society is indeed the need to restrict and control the power of government. We have different view on how that should be done and what government should be allowed to do.

Jack Tierney comments:

 The arguments against mining (not just of gold but most other "raw materials") has become extremely popular. Much of the case made against the practice include elements similar to those put forth by Rudy (the larger and more revealing reason is that the government in general and the leeches in particular, want a bigger piece of the action, i.e., higher royalties).

Unfortunately, most are convinced that the maintenance and continued health of our "way of life" is dependent on computerized technology. It is not - not now and not ever. Our way of life began when individuals, so sympathetically described by Rudy, began digging holes. Our development as a country and our continued successes are wholly dependent on the mining, refining, fabricating, and moulding of raw materials. Autos exist because poor people dug holes in the ground in Michigan. The iron ore produced was useless without a refining process that called for other poor souls to harvest the coal beneath the soil of Appalachia. And what use is the auto without a group of speculators and rough necks drilling the world for oil?

The specialty steels used by defense contractors is insufficient without the necessary rare earths which greatly enhance its strength. Solar panels and longer enduring batteries are inconceivable without silicon & lithium (among others) which also must be mined and refined.

And all the miners, fabricators, designers, innovators, developers, and speculators still depend on someone digging a hole in the ground, dropping in a seed, adding a little (mined & refined) fertilizer, watering it (pumped from an underground aquifer), and, eventually, producing a crop which after further milling, purifying, packaging, and shipping is available as food.

Make any case you wish for or against gold, but we cannot do without hole diggers and those processes which follow the raw material in the production process. Yet we have abandoned all those incremental steps and continue to believe we can somehow maintain our standard of living. We are left to purchase many required finished products which, at one time, we produced in such abundance that we exported the raw materials (e.g., copper & iron ore) necessary for their manufacture (and, whether measured in dollars or ounces of gold, paying an increasingly higher price). We face a situation in which these manufacturing countries are still creating the end products but now, due to their internal growth, are consuming much of what they produce. Understandably, our need does not trump theirs.

I can accept that a great deal of the industrial transformations we have experienced can be related to global labor arbitrage. However, it behooves any country which pictures itself as an "international power" to continually monitor the world production of those raw materials (from origination to end product) which are essential to its continued health. We already have strategic petroleum reserves - but that reserve is exactly that: petroleum. It is not gasoline, diesel, or kerosene -products which can be used immediately. It must be refined; yet, in spite of no new refineries in 40 years, Valero just closed down another operation within the past week.

We not only need to consider strategic reserves of a wide variety of raw materials, but also the means to produce those essential end items. But we must keep digging holes.

Rudolf Hauser responds:

I agree with almost everything you write with regard to mining. My point was that I rather have people engaged in other productive activities, mining of those other minerals included, instead of doing unpleasant work digging for something that serves a function that could be served with much less human effort or cost. Much of mining has always been somewhat dangerous and hazardous to health, just as building railroads and canals was in the 19th century. People took those jobs because the need for the income and the available income was judged better than the alternatives. Keeping their families alive here and now was worth more to them than longevity. As overall living standards improved, so did mine safety. It is still difficult work but vastly improved over what it once was. Because living standards are lower, safety standards still lag ours in places like China. And yes, we are still dependent on the rare materials produced and the processing of such. The cost of externalities such as resulting water pollution still have to be allocated to the producers in some cases .

But while my main point was that it is more efficient to use paper money than gold or silver when possible to do so responsibly, I also made note of the human misery associated with gold. Just as people will gamble when they think that the odds of winning big are great but at the same time be reluctant to undertake a risky investment that is likely to yield a superior return with much less risk of loss than those activities and investments designed to make giant killings for the very few (like lotteries), so to it was with gold discoveries. Some made millions, but many more made little. Those with the best prospects were the merchants and others who serviced the miners. Digging for coal, oil or copper will not do the same. That takes larger operations. Even wildcatting is expensive. It's not like taking a few simple tools and looking for gold. Gold you measure in ounces, the other minerals in tons. Today there are dictators and war lords in central Africa who exploit people desperate to make a living by having them dig in unsatisfactory conditions for diamonds and gold. And the South African gold mines are some of the deepest mines in existence, and it gets hotter the further down you go. There have got to be better ways to earn a living.

Stefan Jovanovich replies:

I can't argue with Rudolph about the nastiness of mining. Grandfather Jovanovich was a miner; he dug for coal in Pennsylvania and Southern Illinois and Colorado and for copper in New Mexico, and his stories of those days were never, ever about the ease or safety of the work even though he loved it. But, using the particular barbarousness of finding and smelting the monetary metal seems to me a very weak argument to make against the lessons of several millennia. Lead mining and smelting are far more nasty, brutish and toxic; and that "near-gold" element is - so far - the unavoidable technological foundation for our brave, new Green world full of batteries. It is equally improbable that the gold miners in South Africa would be willing to trade places with the coal miners in China. The sociological argument against gold is, at base, pretty weak.

Gold's virtues are simple: it has been accepted throughout history as genuinely precious and scarce, it is not easily counterfeited (unlike, for example, diamonds and silver), and its costs of production seem to have a remarkably consistent relationship to the real costs of doing things when measured over centuries and even millennia.

The only argument that has even half-succeeded against the gold standard is the one that Rudolph makes. It is the one that was made in favor of the adoption of the Federal Reserve Act - namely, that a massive new discovery of gold - like the one then happening in South Africa - would unbalance the price structure of that newly discovered thing called "the economy" by increasing the quantity of money. But that argument only wins if one accepts the strict monetarist premise that prices change only because of the fluctuations in bank reserves. One had to believe that innovation, enterprise and science AND the varying animal spirits of the people getting and giving credit had no significant effects on prices.

What has worked to defeat the gold standard is the theological argument that Money and Credit are really one and the same. Given how bitterly we Christians have argued over the mysteries of the Trinity, it should hardly be shocking that the young science of economics has fallen into the snares that captured Church Councils, but one wishes that somehow, as a science, economics could avoid the mystical notion measure of Credit and Credit itself are both separate and one. To the rationalist Deists who voted for our Federal Constitution the endless analyses about M's 1 through pick a number would have seemed like the very doctrinal arguments they wanted their new country to set aside. The delegates who suffered through the true global warming of the summer of 1787 in Philadelphia formally adopted Article I. Section 8. for the same reason they insisted that there be no establishment of religion even in this nation formed under God. The delegates adopted a gold standard for the United States of America to prevent the Congress from extending its monopoly power over Money (which was granted by the Constitution) to a monopoly power over credit.

The original Constitutionalists would not have found Ron Paul's arguments any more persuasive than Rudolph's. In their demand for a gold-backed currency the Paulistas are not arguing for a restoration of the Constitutional gold standard; they are insisting that gold to be the sword that will slay the dragon of fractional reserve banking itself. To the delegates in Philadelphia in 1787, that would have seemed as lunatic as our present fiat Money system. Abolishing the ability of banks to deal in their own credit would have been as crazy as requiring all businesses to deal only in cash.

Having lived through a war, and its destructions, the original Constitutionalists were not in a mood to accept either Rudolph's monetary extremism or Ron Paul's. The country had lost its primary banker - the United Kingdom - and had destroyed its own currency - "not worth a Continental". What the Constitutionalists understood - and what we moderns still do not understand - is that thinking about money as a "medium of exchange" puts the cart before the horse. People will exchange things whether or not they have an official "medium"; what they cannot do, without money, is have savings whose future value is under their and not the government's control. That is, of course, the root of the problem we face now. If money itself is nothing but an IOU, then the government can resort to the form of cheating that had been a universal constant throughout history: the government can demand payment of its taxes in something real - grain, for example - and pay its obligations in something mostly false - adulterated coinage or paper like John Law's.

For better or worse, the original Constitutionalists gave the Federal government an extraordinary monopoly power; Congress alone, of all the governments in the United States, had the power to create Money in all its forms. See Article I. Section 10. "No State shall …coin Money, emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts". Only Congress had the power "coin Money". To assure that the Federal government would not abuse its monopoly power over Money, the Constitution required that Congress "regulate the Value thereof". (Article I. Section 8.) Morris' words need a careful reading. If one uses our current understanding of the word "regulate", one fails completely to understand the sense of what was written. In 1787 the word "regulate" was a technical term of science; it meant "to make regular" - i.e. to make uniform and consistent, in this case, in the assay. No other interpretation makes sense of why the founders then gave Congress the authority and obligation to "regulate the Value" of U.S. Money and also foreign Coin. Both were part of Congress' more general authority and obligation to "fix the Standard of Weights and Measures". Congress would have sole authority over Money, but that authority could only be exercised by fixing Money's Weight and Measure - i.e. purity.

The Constitutionalists took it for granted that the price of Money - what it would buy now and what it would be worth in future credit - would fluctuate. That was in the nature of credit itself. What should not fluctuate was the Value - i.e. the assay - of Money. If Congress wanted to add a further Measure - to define a particular weight and purity as a "dollar", that was certainly within their authority. What was not within their authority and certainly not within the President's Executive authority was to abolish their Constitutional obligation to regulate the Value of Money.

I don't really expect to convince Rudolph or anyone else who has been schooled in the modern Temples of Erewhon that Morris, Washington and Franklin had a greater understanding of money and credit than Paul Samuelson. But, the evidence seems overwhelming. The difficulties of arbitrage that Rudolph makes such a fuss over are precisely the difficulties that the original Constitutionalists expected the citizens to endure. No government on earth could make Money "safe" in the sense of guaranteeing its future purchasing power and assuring that its price in Credit would not suffer. Holding Money by itself was not enterprise; the citizens would have to take the daily risk inherent in either spending or keeping their Money. What they could be promised is that the Money itself would be true and "regular".

Alston Mabry writes:

Just by the way, I was thinking the Treasury and Fed kept separate gold accounts, but it appears they each list the same 261M oz, with the Treasury using market price and the Fed using $42/oz. The "gold stock" line on this Fed report dated today, shows the Federal Reserve Banks having ~$11B in gold, which, @ $42, equals 261M oz.




 Many will recall Ross Miller's study of Fidelity Magellan fund under Robert Stansky, in which he shows the fund to have been essentially indexing — without adding manager value (however you define that).

This paper appeared circa Feb 2007; shortly after which Mr. Stansky was dismissed.

Here is a check on whether Fidelity Magellan's new manager is real or just a shadow. FMAGX daily returns (cls-cls) were regressed against big-cap SP500 index ETF, SPY. First for an equal 704 day period prior to Ross' study:

Regression Analysis: FMAGX- versus SPY-

The regression equation is
FMAGX- = - 0.000106 + 1.06 SPY-

Predictor        Coef       SE Coef            T      P
Constant   -0.00011  0.00011  -1.01  0.313
SPY-           1.064     0.01640  64.88  0.000

S = 0.00278542   R-Sq = 85.7%   R-Sq(adj) = 85.7%

FMAGX slightly underperformed SPY (NS), with high correlation.

Here is the same regression for the 704 days since the study:

Regression Analysis: FMAGX+ versus SPY+

The regression equation is
FMAGX+ = 0.000011 + 1.07 SPY+

Predictor       Coef         SE Coef      T      P
Constant   0.0000111  0.00023   0.05  0.961
SPY+        1.075         0.01152  93.22  0.000

S = 0.00594187   R-Sq = 92.5%   R-Sq(adj) = 92.5%

Basically identical to SPY, with same beta as before, now with even more correlation.

Eclipsing the shadow.

Alston Mabry continues:

However if one invests in 200+ large cap stocks stocks among 60 subgroups, they are going to likely going to correlate closely with the S&P 500. For example, over the past two years, an equal investment in each the nine stocks he listed would have had a 95% daily correlation with SPY.

Following a similar path, one calculates correlations for the daily log% changes of a few stocks vs SPY, over a 120-day period:
MCD by SPY: +0.36
MSFT by SPY: +0.52
PG by SPY: +0.54

Then, simply add the daily log% changes of one or more stocks together, day by day, and run the correlation against the SPY:

MCD+MSFT by SPY: +0.58
MCD+PG by SPY: +0.55
MCD+MSFT+PG by SPY: +0.67

It doesn't seem surprising that for any combination of components of SPY, one gets a higher R than any of the individual components in the combination.This is just a "back of the envelope" test, and I don't know how it would look for all possible combinations, or taking cap-weighting into account.

Phil McDonnell adds:

If one were to re-do Big Al's study it would be better to use simple percentage changes not logs. Logs are for compounding and are needed for one time period following another if reinvestment is allowed. But since step two in this process is to average the stocks into small 2 & 3 stock portfolios a simple average would be better.

In general building portfolios of positively correlated stocks will tend to move the portfolio toward the average return. However if one searches for negatively correlated investments with positive expectation returns can be achieved with less risk.

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

Kim Zussman writes:

MSFT is 2.4% of SP500/SPY; MCD is 0.7%



 What is the significance for markets of the fact that only 5% of major league baseball games are completed by the starting pitcher these days versus 50%, 50 years back? And that relievers like Rivera average 1 inning a game these days?

George Parkanyi writes:


Lack of accountability

Symptom of the money spent on distracting the general population with sports, entertainment etc.

Counting — playing the percentages (right vs left-hand, hitter's success against specific pitchers etc); running baseball more like a business

Sensitivity to starting pitchers' self-esteem

Phil McDonnell adds:

In the 1970s a Professor of Statistics studied the game of baseball and noted several things:

1. Starting pitchers tended to be less effective somewhere between the 5th and 9th inning. For most pitchers a pitch count of over 100 is where the trouble might begin. Maximum pitch count is somewhat specific to each pitcher and can vary from day to day. The prevalence of radar guns has made it easier to measure any decline in pitch speed as the innings go on. Clubs also use a variation on a Shewhart chart to track the ratio of strikes to balls to quickly identify any loss of control.

2. He also noted that a pitcher who had thrown more than 2 innings was not as effective the next day. Thus the strategy of short relief and closer was born. Pitchers who only pitched 1 inning maintained a high level of effectiveness the next day. Even with only one inning of work on two consecutive days they still need a day off on the third day.

3. It was also discovered that by using relief pitchers for 2 or 3 innings starting around the 5th or 6th inning that the odds of winning improved. These short relief pitchers could also play again in that role after a day or two of rest. In contrast starters who pitched more than 100 pitches (usually about 5 innings or more) required about 4 days of rest.

Baseball, like trading, has evolved because of Counting and is getting more competitive every year as people learn to play the game more intelligently.

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

Stefan Jovanovich replies:

No wonder Dr. Phil and I keep doing Rodney King and the LA cops over baseball. On this subject I don't think we will ever "just get along". Baseball in 1970 was going through the transition from being the childhood national sport to being 3rd choice behind football and basketball. The result was that most of the culture of the game was being lost. In the 1950s and even the early 1960s pitchers were still expected to know how to through at least 5 pitches for strikes. Even Bob Feller knew how to throw a knuckle ball. As a result pitching was something that had no specialization, and pure journeymen like Don Larsen could throw complete and perfect games even in the World Series. (Check the news reports of the time — 1956 — and you will find that no one thought the complete game remarkable at all; it was only its perfection that was significant.) By 1970 the culture of the game that Larsen and hundreds of thousands of other professional players had grown up with was gone. Pitchers no longer had the experience of learning the game from uncles, cousins, fathers who had played in the military or in the minor leagues. They were the products of Little League. They were lucky if they had 3 pitches they could throw for strikes, and they had no experience with varying speeds and/or arm angles for the same pitch. Most were straight 2-pitch pitchers. It was hardly surprising that the "modern" pitchers had no surprises left by the end of the 6th inning. Some had none left by the end of the 1st. Since the essence of the game is keeping the hitters off-balance, the only possible solution was to bring in another 2-pitch pitcher the batters had not seen before. Hence, "relief pitching".

What is fascinating now is that the money has gotten so good that pitchers are realizing they can extend their careers by adding pitches to the repertoire. Lincecum - the back to back Cy Young winner for the National League — is the most remarkable example. He learned/was taught the change-up after he was in the major leagues. (If he learns a 4th pitch, he will be Christy Mathewson reincarnated.) As Hayek would have reminded us, the thing being counted — the "game of baseball" — is not a thing that can be quantified in the same way that the mining and smelting of copper can be. An pound of copper in 1970 is the same as thing as one produced this morning. Human activity not only varies; it also changes. Statistics applied to what people do without a knowledge of history easily becomes an exercise in counting what is no longer there.



 There is a very timely article in the Wall Street Journal that discusses Simpson's Paradox (a form of aggregation fallacy) and other statistical myths. A brief snippet:

Is the current economic slump worse than the recession of the early 1980s?

Measured by unemployment, the answer appears to be no, or at least not yet. The jobless rate was 10.2% in October, compared with a peak of 10.8% in November and December of 1982.

But viewed another way, the current recession looks worse, not better. The unemployment rate among college graduates is higher than during the 1980s recession. Ditto for workers with some college, high-school graduates and high-school dropouts.

So how can the overall unemployment rate be lower today but higher among each group? The anomaly is an example of Simpson's Paradox — a common but misleading statistical phenomenon rooted in the differing sizes of subgroups. Put simply, Simpson's Paradox reveals that aggregated data can appear to reverse important trends in the numbers being combined.

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

Stefan Jovanovich writes:

There may be a simpler answer: the BLS is now using a base 12 numbering system. From the report: "About 2.3 million persons were marginally attached to the labor force in November, an increase of 376,000 from a year earlier. (The data are not seasonally adjusted.) These individuals were not in the labor force, wanted and were available for work, and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey."

For those who do not know labor-speak, "searched for work" is a term of art. It means that the person did not report a job search to their state Labor department. And why did the unemployed person fail to show up and tell the clerk behind the desk that they had looked for work? In most cases, it is because the person was no longer entitled to receive unemployment benefits and he or she had ceased to find any humor in reading the same stale job listings posted on the bulletin board. In California right now those receiving benefits do not have to report their job searches because the EDD (Employment Development Department - how is that for an Orwellian name?) computer system has crashed. The BLS has not yet excluded California's unemployed who are receiving benefits from the total who are officially counted as unemployed, but that may be coming soon. "Statistics! I'll show you statistics!" said the academic Federales in answer to the question about badges.



Most say this rally started on Mar. 9th at the ominous level of 666 on the S&P. It seems to have stalled at about 1110. What number does one get when 1110 is divided by 666?

Kim Zussman writes:

It's 666 raised by 66.6%.  Evidencing the Antimistress.



 "Deeper meaning resides in the fairy tales told to me in my childhood than in any truth that is taugh in life." — Friedrich Schiller.

What fairy tales have deeper meaning for markets than truths taught by others in texts, shows, and talking of books?

Phil McDonnell writes:

The Tortoise and the Hare is most profound story for traders of any in Aesop's Fables. The drift is there for all to ride. But if, like the Hare, we are knocked out of the game then we cannot enjoy the full benefit of the drift.

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

Mr. Albert adds:

Not exactly a fairy tale, but the mythological phoenix encompasses the necessary creative destruction, the natural end to what's working, and the ability to come fresh from the ashes.

Also, Pinocchio has volumes to say about deception and gullibility. It's worth re-reading. I was surprised at how often Pinocchio is conned before he finally learns his lesson.



 Just got in from a basketball game at Ohio University vs. Lamar. Noticed the basketball coaches wear suit and tie. The baseball managers wear the team uniform. The majority of football coaches dress casually (except Tom Landry). I wondered why the difference in dress among these three sports?

Victor Niederhoffer adds:

And what is significance of the terrible millhonian fact that 99% of the people in any mid-level restaurant these days are wearing black? Is it the consequence of a lagging response to a recession — a harbinger of a deep pessimism, of a boat about to capsize, a conventicle of worship for the higher blackness in our midst, a signal that stocks are still not invested with much of a risk premium, or whatever cultural straws in the wind are you seeing of this subdued nature? And what does it mean?

Dan Grossman replies:

1. On the coaches, it's much colder outside on the football field and easier to dress warmly in casual clothes. A suit and overcoat would look ridiculous.

2. In the restaurants, dressing all in black signals the maitre'd and staff you are someone not to be trifled with. You are more likely to get a table without a reservation, or a faster/better table with one. Black says you are from town, perhaps even an artist, writer or in the fashion industry, not from the sticks or the burbs.

Dean Davis writes:

Supposedly black is a slimming color. Perhaps those that frequent comfort food restaurants like those found at the mid-price level have something to hide. I have heard that the quality of diets slide in poor economic times.

David Wren-Hardin writes:

Baseball has a longer, and more recent, history of player-managers. Pete Rose was, I think, the last one. Football seems to reflect the average dress of the time. Back in the fifties, all men wore suits. It may look formal to us now, but the suits were probably pretty standard, not the same as Pat Riley's Armani suits, for example.

As our culture has become more casual, so has the football coaches' dress, especially since they are outside. I think they may even be prohibitied from wearing suits. I recall a coach last year (Jack Del Rio?) who wanted to wear a suit to honor his father, and either had to get a waiver, or paid fines.

You can see similar dress cultures in trading. Traders associated with banks tend to dress more formally than traders in hedge funds. In my current firm, wearing jeans and t-shirts is an expression of pride. If I wear khakis, everyone wonders where I'm going after work. At my last firm, a European owned group, we never wore jeans, and if the bosses from Amsterdam were in town, we wore suits.

Essentially, it seems to have settled out where if you deal with customers, you wear a suit, and if you are a trader, you dress down. The more powerful/profitable you are (or think you are) the more you dress down.

To make it more personal, does how we dress affect how we trade? If I'm more formal, am I less prone to risk-taking? If I'm dressing down, am I more relaxed and making better decisions?

Steve Ellison shares:

That has been the case at MIT for years. From Fred Hapgood's 1993 book Up the Infinite Corridor: MIT and the Technical Imagination:

In his time Ernesto Blanco has designed robot arms, a lens for cataract operations, steerable catheters (that can navigate inside arterial branches), a microstapler for eye surgery, a stair-climbing wheelchair, a forklift truck, film-processing equipment, high-voltage transmission line connectors, a helium pump, and a raft of devices for the textile industry — from pile stitchers to faulty needle sensors. So he has earned the right, which he exercises, to dress his barrel chest and ramrod carriage in rich blue blazers and snowy shirt linens, silk ties, Italian leathers, and flawlessly crease flannels. In this he faces against the winds of fashion at MIT, where an Armani suit suggests not success or achievement but a serious problem with self-esteem, a lack of confidence that the product, the work, will be adequate to win the desired rewards. The psychology expresses itself as a fashion paradox: at MIT you dress up, you dress for success, by dressing down. So in this sense Blanco is like a banker who wears jeans to work; he is good enough to wear what he likes, and what he likes is Fifth Avenue.

Phil McDonnell comments:

The black-is-slimming meme has been around for several years. The older Seattle Grunge look may have spawned an idea that casual is good and, perhaps more importantly, colors that blend in are good. Some time ago I ate at one of the nice Google restaurants and did a quick Galtonesque count of the number wearing black. It was nearly 100%. I was the exception. Many of these young people are from India, China, Russia and elsewhere so it is not just California. In some circles they say that gray is the 'new black'.

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



 My second-oldest daughter Katie's post on Igon Values is very relevant to our field. Who are the useful idiots in our field and how can their self-serving posings be used for profit? Let us start in the Midwest. Or the islands.

Alston Mabry adds:

I thought the "igon values" thing was a joke, but upon reading Pinker's review of Gladwell, I find it isn't. For one who writes about research, as Gladwell does, to not be able to sit down and work linear algebra problems is fine (me neither), but to not know that there is a word, "eigenvalue", which may arise in conversation with scientists — that's embarrassing.

The issue of "igon values" bears on the more general issue of knowledge production and dissemination. I like watching science shows, but even when I'm watching a high-quality show like NOVA, I'm wondering, "Where are the folks, with the same level of expertise, who think at least some of this is crap? What is their critique?" It often seems that a well-communicated disagreement can help the audience understand more of what's important. And actually, a good example is Pinker's review of Gladwell.

In most or all fields of research, one could assemble a group of experts who have similar training and knowledge, but who disagree on important points in the field, especially at the boundaries of discovery. Then you have popular writers trying to understand and condense some field into book form — but if the experts don't agree, how can the popularizers possibly be "right"?

Stefan Jovanovich writes:

Mr. Mabry is far too kind. Scientists talk their books all the time. A scientific reputation is made by presenting a theory that is striking, original and difficult to evaluate.  That theory becomes the scientist's brand. His/her future in academia is tied to the success of that brand.  Few, if any scientists, are crazy/honest/selfless enough to challenge the truth of their brand.  Hence, Heisenberg's comment that "the progress of science can be measured by professors' funerals."

In science, practitioners would rarely be lying about what they are doing. But in markets, who tells the "truth," unless that truth is consistent with the talker's book? Then there is the sheer volume of new "knowledge" produced on a daily basis. How does one cope?

Bruno Ombreux writes:

H G G JrHere is a suggestion. I believe it is linked to the Igon.

I am halfway through a book that is dealing with all these issues: Scientific Method in Practice by Hugh G. Gauch. It sheds light and fosters reflections on such things as scientific questions and methods, disproving or proving hypotheses…

It is a book about science. Since good trading is a science, this is a book about good trading too. Good trading is necessarily scientific, because good trading requires good predictions. Only science can yield good predictions. If trading is not scientific, it can't be good.

This is also a philosophical book. After a few chapters, I have enough philosophical ammunition to completely destroy the Black Swan school, on epistemological grounds. The Black Swan ideas that we cannot have models that work, that variance is either infinite or undetermined, are just as naive, and far less nuanced, version of David Hume's radical skepticism. In one sentence: we can't know anything. Scientific Method in Practice advises not to waste time arguing with radical skeptics. They are not targeting science, but common sense. Common sense is literally what humans can sense in common. In this case, we all can measure variances. Common sense is a key presupposition of science. Without common sense, there can be no science. Without science, there cannot be any debate between scientists and radical skeptics, since the later are saying in effect that the former don't exist.

Incidentally, the fat tails debate wonderfully illustrates one problem mentioned in the book, that is the underdetermination of theory by data. Observing fat tails, I can find offhand a bunch of explanations:

  1. power law
  2. slowly converging normal
  3. Student
  4. truncated Levy flight
  5. mixture
  6. Markov switching model
  7. Agent-based dynamics

The same evidence produces a handful of theories. We are confronted to the issue of theory choice. In this case, I would start by getting rid of those that don't make predictions. Power laws would be the first casualty.

EigenvaluesNow, on to another book recommendation: a first-year course in linear algebra and as such is related to the original topic. "Igon values for dummies," if you want. And it is free. This is a useful book for traders, because it is impossible to understand any recent article on economics or statistics without at least a passing knowledge of linear algebra.

I don't think mastery of Igon values is required to trade well, but other concepts can be very useful. For instance, the notion of projections, covered in chapter 3.VI, really helped me understand multicollinearity in regressions. Multicollinearity is the rule in financial time series. Often, its presence is not a problem, but you'd better know about it and when it can be a problem.

Combining this book's chapter 3.VI.2 about Gram-Schmidt Orthogonalization, with chapter 3.2.3 of this other free book, one gets a clear understanding of multicollinearity.

Jack Tierney writes:

 Being unfamiliar with eigenvalues (whether spelled correctly or not) led me to follow the threads in Katie's article. Those threads, in turn, led to still others. I finally landed on this.

The author laments the increasing propensity of Rhodes Scholars to go into the world of finance as opposed to some of the nobler scientific fields that once claimed so many of those blessed by old Cecil's beneficence.

"This break in an almost century-old pattern coincided with great increases in occupational earnings differentials, which have continued to grow, seemingly exponentially…the differentials in earnings…were often rationalized by Rhodes scholars as reasonable additional compensation to balance the lower standing of business jobs among their peers. "When differentials could become a hundredfold or far more — and as investment banking and similar firms started to recruit young Rhodes scholars who had degrees in math, physics or even history, English and theology — the yawning prospective wealth chasm understandably became impossible for many to ignore…"

So there we have it. Offer enough money and even the brightest will sell out. Let a dilettante like Gladwell emulate them, though, and the wrath of the informed will be merciless (just follow some of the threads and you'll discover that Kate's handling of Gladwell was relatively humane).

However, numerous responses seemed refer to the incalculable worth of the scientific method and were it adhered to, we would all be much better off and far less likely to be exposed to the ditherings of Gladwell et al.

Back in '93 a remarkable book written by a woman embittered by her brother's courtroom experiences hit the best seller list. It was "Whores of the Court" and detailed the lengths to which those supposedly trained in the scientific method quite easily (and lucratively) sold their conclusions. Each side could present "experts" with similarly impressive credentials; each side had access to the same evidentiary material; yet their conclusions could not
have been more different.

It might be legitimately argued that psychiatrists/psychologists aren't scientists in the pure sense of the word. Currently, however, we have scientists whose credentials most definitely measure up. Yet on issues ranging from the efficacy of ethanol to global warming to the amount of oil left within the earth's crust, their conclusions couldn't be more disparate. To put it bluntly, our scientists' opinions are for sale and this is occurring as government policy is
more and more determined by their conclusions.

Whose opinions are the most sought after and well rewarded (at least through speaking engagements, articles in the mainstream journals, and in research grants)? Generally, those whose views are the most dire or the least apocalyptic. This, in itself, is a sad development. But increasingly scientists whose expertise lay elsewhere are chiming in on one side or the other. As a result we are faced with promotions that announce that "X Number of PhDs Support Global Warming Theory", or "Y Number of PhDs Claim Peak Oil is a Sham."

I am increasingly exposed to individuals who claim (and firmly believe) that their opinion is as good as anyone else's, that it's unnecessary to study both sides of an issue, that it is quite OK to shout down a speaker whose views diverge from yours, and that it's quite alright to do whatever it takes to get whatever it is one wants.

In such a world, is Gladwell to be condemned or lauded? Are the newly minted Rhodes Scholars so misguided in pursuing wealth? Are scientists who missed the gravy train to be faulted for making a last mad dash for the gold ring on the caboose? Was Linus Pauling correct in observing that peers are nothing more than people who pee together?

Alston Mabry adds:

This post reminded me of the book "Psychology of Intelligence Analysis" which contains these guidelines:

"Start out by making certain you are asking–or being asked–the right questions."

"Relying only on information that is automatically delivered to you will probably not solve all your analytical problems."

"Do not be misled by the fact that so much evidence supports your preconceived idea of which is the most likely hypothesis. That same evidence may be consistent with several different hypotheses."

"Proceed by trying to reject hypotheses rather than confirm them. The most likely hypothesis is usually the one with the least evidence against it, not the one with the most evidence for it."

Chris Tucker replies:

Wow.  Some great reading in that book.  Thanks, Al. This is from Chap. 2 "Why Can't We See What Is There To Be Seen?":

People tend to think of perception as a passive process. We see, hear, smell, taste or feel stimuli that impinge upon our senses. We think that if we are at all objective, we record what is actually there. Yet perception is demonstrably an active rather than a passive process; it constructs rather than records "reality." Perception implies understanding as well as awareness. It is a process of inference in which people construct their own version of reality on the basis of information provided through the five senses.

This is so important in my line of air traffic control.  I am constantly telling trainees that listening is not something that happens to them, it is something one must actively engage in.  Upon hearing a pilot read back a clearance, whether it be an altitude, heading, speed or route, one must pay close attention to what is said and to check it against what is expected to be heard.  It is common for trainees to simply assume that they heard the correct readback and disconcerting to them when it is pointed out that this was not the case.  We spend a great deal of time teaching them how to listen attentively.

Another facet that I have mentioned before is teaching them to get the data from the scope — to look at groundspeeds and recognize overtakes, to look at altitudes and calculate rates of climb or descent, to look at aircraft types and make hypotheses about expected performance, to look at routes and destinations and see who has to get below whom, and to create plans based on all of these.  And then to observe and check hypotheses, again and again to make sure that what one expected to happen is really happening.  And if not, how to take steps to create the reality one intends.

The key to improvement in these areas is a combination of repeated exposure and active thinking about the available data. Exposure alone can make some tasks become automatic, but active thinking and attentiveness can accelerate learning and skill acquisition.

Phil McDonell comments:

Gladwell self styles as a translator from the arcane indecipherable world of science to the everyday world of business and laymen. A good translator must understand the vocabulary of the original source language and must have a command of the vocabulary of the target language. However a command of the two relevant vocabularies is not sufficient. If it were computers would be the best translators.

What Gladwell lacks is semantic comprehension. It is often not sufficient to merely translate the words without a deeper understanding of the content. His Igon Value mistake is a glaring example.

Clearly his substitution of Igon Value for eigenvalue comes from only hearing the word as opposed to actually reading it in a book. Perhaps someone explained it in a phone or lunch conversation and Gladwell seized on it as an interesting buzz word.

Eigenvalues are actually a very beautiful construct in linear algebra. A simple intuitive way to look at them is the amount by which a quantity is stretched in a certain dimension. Suppose a stock or mutual fund has a beta of 2 and an alpha of zero. The equation is:

stock return = 2 * market return + zero

The eigenvalue for the above system is simply 2 because it stretches the market return by a factor of two.

The idea generalizes to 2 or more dimensions. Each dimension of a linear system has its own eigenvalue. If you have ever looked at yourself in a fun house mirror then you can understand this idea. The mirror that makes you look tall and thin has a stretching eigenvalue in the vertical direction and a shrinking eigenvalue (<1) in the horizontal direction.

Like the fun house mirror a matrix can be thought of as a transformation or mapping of one image to another. If one takes the eigenvalues of a matrix and multiplies them together the product acts much like a volume just as length times width of a rectangle gives the area. In Linear Algebra this volume is called the determinant. If any of the eigenvalues is zero then one of the dimensions has collapsed. It also means the determinant will be zero, the system of equations cannot be solved and any regression will be meaningless.

I have never seen any financial model take into account a determinant. Yet there seems to be a grudging acceptance of the idea that when a financial panic hits all the correlations approach 1 as people seek liquidity by whatever means necessary. Rather than simply look at risk from a simple beta model or VAR approach perhaps the proper way to model disaster is the determinant where all the risk are multiplied together.

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



Cachaça"Trading is fun", I hear once in a while. It's a "cachacinha" ("Cachaça" is a Brazilian alcohol beverage made from sugar cane). They mean, trading is addictive. From "fun" to "addiction" it takes only a small step.

I was once addicted to trading. My account suffered. It took a LOOOOOONNNNNGGGG time to free myself from the addictive power of the markets. Now I'm making money, for me and for my clients. Guess what? The fun is gone. The fun is completely gone, for I'm using a method to improve profitability and reduce overtrading (overtrading leads to poorer performance), and, as a side effect - and what effect! - the emotions of trading are gone.

Whoever you talk about trading, they will tell you amazing epic stories about great bravery, suffering and battle. They include all emotions: fear, greed, joy, pain, etc.

Few, very few people will tell you that trading is boring, just like factory work. Guess what? The emotional traders are not making money. The boredom traders are taking money from them!

What is boring about trading? To be honest, to quantify is boring. It takes time. It takes effort. It takes more time. And it takes more effort. So it is to parameterize. To test is boring. To avoid spurious correlations is boring. To avoid anedoctal evidence is boring. To do the same trades over and over and over is boring. To not deviate from the plan is boring - specially when your gut feeling makes an extraordinary call about the markets. All that is boring. Boring. Boring. Boring. Boring.


It makes you money. Trading is such an interesting field that one cannot get FUN and MONEY at the same time.


Nigel Davies comments:

The acid test may be if someone stops trading, will he miss it? Chess stopped being fun for me a very long time ago, but when I don't play something is missing. Some colleagues who've given up say this goes away after a while, others keep playing their whole lives. The progression seems analogous to being in love, being married and breaking up.

Nick White responds:

I don't know — I think trading can be enormously fun. I think what Newton is really driving at here is the difference between process and outcome and the balance of emphasis between the two in different groups of traders.

I would argue that process-driven traders spend much more time doing "dull" activities like researching, programming, quantifying, testing etc. Furthermore, I would say that traders involved in these process-driven activities do so because they genuinely enjoy being in the market, love the challenge / intellectual stimulus of trading and are committed to learning as much as they can.

Focusing on process grounds the trader - if the trader gets it wrong, she has a foundation to revisit her thesis, look at the data and learn from her mistakes. If a trader is doing well and trading at his high watermark, a process-driven focus helps him fight hubris. The NYT article about Shane Battier had it exactly right - process driven performers don't measure themselves explicitly by whether they won or lost on a particular trade - they measure themselves on whether they did the right thing at the right time given the information they had. So, net-net, process-driven traders are likely to enjoy the activity of trading irrespective of the final result: they like the research, they fight for their edge and they play it. If they win, so much the better. If they lose, it still sucks, but they can put that loss in perspective…the kicker being that enjoyment of process-driven activities gives a much higher likelihood of getting positive outcomes in the first place.

On the other hand, outcome-driven traders seem to want the high of good pl without the necessary work to ensure non-random results. They seem to trade to prove something either to themselves or others. I'm sure Dr. Steenbarger and Dr. Dorn would be able to contribute much on this point but, from my amateur armchair, I would say that traders driven by outcome aren't really into trading because they like it, but are into trading as a proxy for some other need they are trying to fulfill. In that sense, trading probably is addictive for much of the same reasons that any activity or substance can become addictive - it likely helps to reinforce desired feelings and self-image while shunning unwanted ones.

In short then: if you trade because you love it and like doing the research work for its own sake, then you are more than likely going to enjoy trading irrespective of the final result - but you also have a greatly increased chance of success. Trade to "be" something / somebody and you are likely to come unstuck quite quickly. (All this is said with the caveat that these two camps aren't neatly delineated, but seem to be something of a spectrum, with all of us lying somewhere on the line at different stages of our careers.)

Process can be dull; no doubt about that. But, as an old coach once told me, "what you can't do in training, you won't do in racing". If you haven't spent the time to quantify, test, understand and introspect about how you would approach your chosen market in a given situation, you won't know how to respond when it happens for real. It is one's emphasis on process / outcome that determines whether results are a statement about one's self, or are simply indications of progress on the path to improvement.

Philip J. McDonnell remarks:

One of the trading mottoes I live by is:

If trading ever gets exciting I am probably doing something very wrong.

The underlying logic is that losing is what makes trading exciting. Think about a savings account. It always wins and is very boring. It is boring because it wins. The losses appeal to us emotionally. They create the nor-adrenaline rush. It is too easy to get addicted to the rush. The adrenalin driven figt or flight mode satisfies us emotionally but numbs the mind. Slow and steady is better and frees the mind to think logically.

Newton P. Linchen replies:

Phil just nailed it!



I am a reasonably knowledgeable baseball fan (read a lot of Bill James) but have always wondered about the following very basic question:

Batter hits a line drive, but he is out because he hit right at a defensive player. Is that predominantly luck, a few feet left or right and it would have been a hit? Or has the defense correctly positioned its player and the pitcher correctly pitched to the batter to make it likely he would hit where the player is? I realize it's not 100% either way. But is it, say, 75% luck? Or 75% that the defense has correctly positioned itself and the pitcher correctly pitched to make it come out that way?

Phil McDonnell replies:

P McDThe game is played both ways. The batters try to aim for holes in the defense. The usual infield holes are between 1st and second, up the middle and between the 3rd baseman and shortstop. The outfield holes are the left center gap and right center gap. It is rather easy to hit a ball exactly where you want in a soft toss to yourself. The real problem is when the batter is facing a 90 mile an hour pitcher with maybe a little break on the ball. The key is to time the swing so that the bat hits at exactly the right angle. Sometimes batters just miss.

It is sometimes said that football is a game of feet and inches. If that is true then baseball is a game of millimeters. For example a ball hit squarely on the widest part of the bat will generally result in a line drive. But if the ball hits a little high then it may result in a fly ball or even a simple pop out. A little low and the batter will ground out.

Pitchers know that batters rely on timing the swing in order to hit the ball where they would like it. The key pitching counter strategy is to vary the speed of pitches. There is no pitcher in the major leagues who does not have a fast ball and at least one other off speed pitch. Changing speeds is the key to good pitching.

Pitch placement is also essential to good pitching. Generally most pitchers will throw fast inside and soft away. This forces the batter to read the speed earlier than otherwise if he is trying to place the ball by timing his bat angle.

Sometimes the fielders get into the act as well. The second baseman and shortstop will often read the catcher's signals and signal each other as to who will cover second base and who backs up if there is a runner on 1st. In this situation the batter will try to hit 'behind the runner' aiming for the hole between 1st and second. The double play 2nd to short to 1st is slightly more difficult than the short to 2nd to 1st. The reason is that shorts and 2nd basemen are always right handed. The guy at second has to turn his body in order to make the throw back to second with the shortstop covering.

The defense knows the batter will try to hit behind the runner and counters. The pitcher will tend to pitch fastballs inside to make it hard for the batter. The shortstop will probably play closer to 2nd to take the throw. This frees up the 2nd baseman to field a wider range.

There are statistical services that teams buy which analyze where a player is most likely to hit the ball. Usually it is shown as a scatter chart on a baseball diamond. Ted Williams was famous as a player who would predominantly hit to the right side of the field. Consequently several teams came up with the Williams shift, where they left only one outfielder and one infielder on the left side of the diamond. Initially the shift worked and Ted struggled a bit. But he finally demonstrated the fatal flaw in that defense by successfully bunting toward 3rd base which had a gaping hole.

In any one at-bat using these strategies only gives one a small edge, maybe 10%. The average player bats maybe 500 times in a season and there are nine players, so about 4500 chances in a season. On defense there are about the same number of chances for a total of maybe 9,000. But as in trading and gambling, over time a small edge adds up to a winning strategy.

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

Dean Davis adds:

On the two youth teams I coach we move our players into spaces where they have a greater chance to make a play depending on the pitch I call. For example I'll signal the right fielder to move in and to his left when I am pitching a right hander at the belt, but off the plate (away). That results in many outs from weakly hit fly balls to right field that would otherwise be singles that drop in. Sometimes we luck into a grounder hit through the hole that the tight right fielder can throw out at 1st. I build a defensive game plan around the tempting pitch that is hard to hit well.

Ken Drees writes:

In early youth leagues we were coached to check out the third baseman's position. If a right handed batter simply turned himself somewhat towards third base and opened his stance towards left, he could aim a hit down the line or in the hole depending on the 3rd baseman's position. This also gave the batter a better chance of making it to first since it was the 3rd baseman or left fielder against runner. The 3rd baseman had to field and make the long throw over to first and beat the runner. This was versus hitting the ball up the middle, where pitcher, second baseman or short stop seemed to be covering and the throws to first were more manageable.

This technique is erased as you go up the ladder, but it does help early players get some action if they seem to always be hitting straight into the defense. It also helps to eliminate hitting into easily turned double plays.

Rodger Bastien responds:

It's my view that it's mostly fortunate for the pitcher that the batter hit it directly to the fielder, with an assist to the defensive alignment, in some cases. In most instances, a batter is trying to simply make solid contact when facing a pitcher with outstanding stuff. When facing a pitcher who is struggling or faced with an at-bat that dictates situational hitting (i.e. man on 2nd no outs, need to hit to the right side to advance the runner) the batter is more likely to attempt to hit the ball somewhere specific. The defensive alignment plays a role due to the positioning of the fielders that is based on the advance scouting that each teams does which determines each hitter's tendencies throughout the season. Like so many things, this part of the game is more of an art than a science.

Laslo Minks remarks:

My belief is that it’s pure luck. You want to hit line drives, usually up the middle. And a good hitter goes with the pitch, you pull an inside pitch (if you are right handed) to left-field and an outside pitch to right. You want to hit it just over the infielders heads, but it is ridiculous to think that you are, for instance, trying to hit around the shortstop. The point of trying to hit line drives is that the horizontal velocity is the fastest and therefore most difficult to field. You hit line drives regularly and you will have a good batting average. You play the odds. If you hit it right to the shortstop or second or third baseman, that is just bad luck. Anyone who says differently is overthinking it.



M o NA popular bureaucrat some odd weeks ago passed away at the age of 77. That reminded me of an observation I once read about long ago and never forgot. People tend to pass away from this earth on or near multiples of seven years. True statistic or not, I always compute "the seven" when I hear about someone's death age. It's a habit of mine.

So it goes that if one can make it past 49/50, you then have a strong chance of making it to the age of 56, and so forth. I pulled The Mystery of Numbers by Annemarie Schimmel from my bookshelf.

It's an interesting book that gives a comprehensive view of how numbers and number systems developed over the course of world history. It shows how religion (Jewish, Christian and Moslem) and culture contributed to similar understandings concerning numbers. It relates how luck (good and bad) can be cast upon certain numbers based on religious practices. The book brings together diverse historical references to each important number in a most readable way. It also integrates biology, nature and other systems to illustrate why certain numbers have meaning and significance. It's a nice enjoyable read, providing an eclectic mix of scholarship.

For example, regarding the number eleven, I paraphrase and summarize:

Number 11 is the Mute Number. Standing between 10 and 12, both round numbers that have significance, 11 was always interpreted in medieval exegesis ad malam partem, in a purely negative sense. 11 had no good part to it. The 16th century numerologist Petrus Bungus claimed "11 has no connection with divine things". The Muslim Brethren of Purity consider 11 as the first "mute" prime number beyond 10. 11 is found in Babylonian myth and in Greek mythology in similar negative fashion. Soccer has eleven players and the Germans call the penalty kick, Elfmeter (11 meters?). Psychologist Friedjung sees the 11 players in soccer and other games as an allusion to human imperfection. But, 11 could also mean bounty-even more that 10. And the German Rhineland carnival season begins on 11, 11 at precisely 11:11 am-to amuse our minds.

The number Seven is a large chapter in the book. One part relates to changes in a person every 7 years. "The Jewish philosopher Philo of Alexandria points out at seven years you get teeth. The next 7 puberty, at 21 youth sprouts a beard, the fourth heptad is the high point, the fifth is time for marriage. The sixth heptad is intellectual maturity, the seventh is for the soul to mature, the eighth perfects reason and intelligence, and at ninth passions are tamed." Backed by Psalm 90, Philo asserts that age 70 is best for death-as 3 score and ten is said to be man's lifespan.

MayanWhile the Mayan culture was quite advanced in counting, astronomy and date forecasting, some cultures did not develop significant counting systems. The un-advanced culture counter becomes confused after 9 or 10 items-not having words denoting 14 or 15, but this same person could look at a large herd and know precisely how many there are or if any were missing. How does this occur? Can I see large systems and remember their traits with a glance? I glance at my quote screen and quickly can tell if something is amiss.

Tom DeMark
's counting work influenced me early on. I made trades based on extended counts of stocks that were close to exhaustion trend count limits, as defined by Tom. Today with supra-hedge fund leverage, market moves are much faster, the counts seem compressed.

When is termination of trend? Stocks seem to have life force. Stocks seem to have a birth, youth, maturation, old age and death phases. Stocks have counts, like heartbeats or steps along a path. Base 10, base 6, base 3-I like to count things as they appear to me as rhythms.

But for now as we wait, and in terms of breathing here on earth, lets all keep pushing to and through our next "7". Push on and through to a new count and into a new heptad of perfecting oneself.

Laurence Glazier extends:

In the days of Gottlob Frege some of the vitality of mathematics was removed by the use of equivalence classes of convergent sequences of "random" numbers to define quantities which still have poetic names, like "transcendental", yet a flaw in that old argument, is that "random", by definition, can never be defined, and if one discounts those old constructions and uses instead a form of computability, then it is possible to create ever newer numbers. (There is obviously a political and ideological aspect to the notion that numbers — as with people — might be random.)

If we are talking of sevens, this is a number important to any musician, and it can go beyond music. George Gurdjieff's cosmology was based partly around this number, and as one who uses harmony to affect emotions, I take it seriously. It is a difficult cosmology as it is not Copernican, a paradigm virtually without possible dissent except among creationist communes.

In music, the fourth level has a natural tendency to fall back to the third, if there is insufficient energy to take it further in the octave. At eight it starts again. In chess a pawn is often stalled at the same point in its progress to a new life at the eighth rank, though of course it cannot fall back. And I was amused to notice recently, that were a space voyager intrepid enough to go beyond the fourth, red, planet of our System, the barrier of asteroids before the fifth, giant orb, might incline a retreat to Earth, the Third.

If trading, along with the natural psychological lessons which accompany it, were to imbue a more sensitive appreciation of numbers, that would more than suffice for me.

Phil McDonnell reminisces:

Tom DeMark’s counting work influenced me early on. I made trades based on extended counts of stocks that were close to exhaustion trend count limits, as defined by Tom. Today with supra-hedge fund leverage, market moves are much faster, the counts seem compressed.

DailySpec contributor Larry Williams collaborated with Tom DeMark on the early work on sequential counts. My sense of such things is that to the extent they work they have more to do with human psychology and less to do with any intrinsic mystical properties of numbers.

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



SunspotsIt is likely that the Sun is entering a cooling period of 20 to 30 years according to some scientists. The current sunspot minimum is the longest and most severe in roughly the last 100 years. The NASA site has more on this.

We hear dire predictions that the Earth's temperature may drop 1 degree C over a certain number of years. The question arises as to whether this is a normal fluctuation in the Earth's temperature or not. Scientists often speak of the Solar Constant. It is the mean energy output of the Sun. In fact it only varies about 1% up or down. This doesn't seem like a large deviation. Based on an average room temperature of something like 20 degrees C this sounds like it would mean an average temperature variation on Earth of about .2 degrees. Clearly the global warming prediction are much larger that this by about a factor of five. Most global warming proponents simply ignore the variation in the Solar Constant as too small to be relevant.

All such thinking as the above is based on a simple numerical fallacy. If the Earth was a rock in the middle of space and not near any star such as our Sun it would have a temperature of about absolute zero which about -273 degrees C. Almost all the heating to about 20 degrees C is due to the Sun's energy hitting us. Thus the Sun generates about 500 (~273 + 20) degrees C of heating on the Earth not just 20 degrees. But when we remember that the Solar Constant can vary by 1% during normal fluctuations we realize that these variations can cause 3 degrees C worth of climate change, having nothing to do with man made causes. Suddenly the dire predictions of 1 degree cooling seem relatively modest compared to the natural cycles of 3 degrees. This calculation is consistent with the fact that the highest temperature on record over all the Earth was 1998 and it has been cooling for the last 11 years.

Then the question for speculators is how to trade these fluctuations. If one believes we are in a cooling cycle then buy land and stocks in Southern areas perhaps even South of the US. Certainly one would consider selling the same in Northern latitudes. If one believes that the warming proponents are right then buy Northern land and Canadian stocks.

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

Canadian trader George Parkanyi responds:

I've been monitoring the sun-is-cooling chatter as well. Here in Canada, anecdotally it certainly "feels" like cooling. We've barely had to use our air conditioner the past few summers - and Ottawa used to have very hot, muggy summer days in August and July. None this year.

If we have a 3 degree dip in the average temperature of the earth, it's going to get very uncomfortable. That may be mitigated somewhat by warming effects from greenhouse gases. However, the C02 is causing other problems, like raising the acidity of the oceans, killing reefs and plankton etc. Carbon emissions are not just a climate-change issue. They're also a pollution issue.

As to whether this is tradeable? Long-term perhaps, because the changes are slow, but which scenario wins out? And how will you be able to tell which climate effect is temporary, and which part of a long-term trend?

Cooling will pressure agriculture, as might excessive warming (droughts). Agricultural commodities could become an either-way bet. Either scenario would also force significant infrastructure changes/adaptations. Basic materials?

With cooling, energy would be huge - carbon or otherwise. Natural gas will be interesting to watch if we have a colder winter than last year. Alternative energy would be a winner as well, less so biofuels because of weather vulnerability. Nuclear could become quite important again out of necessity.

Certainly a lot of food for thought here.

Tristram Waye replies to George: 

Thanks to global warming you and I get a chance to live and travel this land. Canada was covered by ice some 10-18 thousand years ago. The great mountain valleys and bountiful fresh water are lush nutrient rich plains are a result. I am thankful for global warming myself. Especially when I take that boat cruise across Waterton Lake to Goat's Haunt, Montana. 

I think the problem with the debate on global warming is that it is one-sided, myopic and short-sighted. We live 90 years and therefore we lack the perspective of thousands or millions of years. Where I am sitting was covered with many feet of ice at one time; but its melting seems unrelated to certain large vehicles, cow exhaust and people in general.

The idea that warming is bad is unproven. The idea that more CO2 is dangerous lacks credibility. The belief that men can change the temperature of the earth presumes that we can even get the weather forcast right three days in a row, and five days out. One has to laugh at the concept of climate change, otherwise known as the four seasons. Even Vivaldi knew about that.

The notion of man made global warming sets man apart from the planet he lives on. It presumes that we are not of the earth, but gods of it. Tsunamis destroy villages and lives. Hurricanes can not be predicted, eradicated or steered beyond harm's way. And yet there are those that believe we can change the climate of the whole world when we cannot even predict it five days out? Who should decide the optimal climate for the world? Imagine that debate at the UN. If we are cooling, will we receive subsidies for driving F-250s? I can't wait to hear that answer.

The investment thesis here should be focused on the premise that too many people and governments are on one side of this idea, and have sold their souls to it. There is no turning back for many of these ideologues.

A cooling trend will badly damage many careers, organizations and individual reputations. Perhaps all of the money currently being wasted on a natural process will find better uses elsewhere. Perhaps they will turn water into wine, or get blood from a stone for their next great cause to save humanity.

Craig Humbert remarks:

Sunspots have picked up the last two weeks, so maybe this is the upswing predicted for the last three years. This is a really interesting year with the Arctic cooler than normal due to the volcanic activity in Alaska and Russia. The tropics are warmer than normal because of El Nino and increased sunspots would presumably add to that. Iben Browning talked about this years ago saying the clash of these extremes whips the jet stream up and down like crazy. El Nino years normally are good for our grain belt but this year should provide plenty of excitement.



What is the explanation (either your own or the "conventional wisdom") for why bonds have been rallying concurrent with a strong stock market and all the talk about recovery?

Bloomberg news reports:

The $12 billion of [long term govt bonds] offered yesterday drew the strongest demand in more than two years. The U.S. Treasury auctioned [a total of] $70 billion of notes and bonds in three sales this week to help finance a record budget deficit. “It was a stellar auction at much lower rates,” said Thomas Tucci, head of U.S. government bond trading at RBC.

Paolo Pezzutti adds:

It seems that all assets are going in the same direction (commodities, bonds, stocks). Is there anything negatively correlated that one could consider to diversify?

Alston Mabry has a one word answer:


Phil McDonnell also replied:

Same day correlations for various assets with respect to stocks (SPY) for the last 105 days:

FXY yen -44%
TLT 20yr -32%

So there are still some things that are negatively correlated with stocks. Same day correlations are not useful for Granger-style prediction [of one time series from another], but they are useful for reducing the risk of a portfolio constructed using the various assets.

It should also be noted that just because price levels have gone up over a certain period of time [i.e. an upward drift in both series] does not mean that the price changes are positively correlated. The preceding correlations were calculated based on daily net changes in order to avoid the spurious correlation problem caused by using price levels.

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

Vincent Andres answers:

Why have bonds been rallying? In the past, government(s) were putting their hands in the machine only under exceptional/rare occasions. Now they are doing that on a regular basis. Markets (as we used to know them) have never been so oligopolistic and manipulated. The fact that old rules like stocks up/bonds down (and many others) now no longer works is simply one of the signature of all those oligopolistic interventions.

A possible scenario : The stock rally being a completely constructed one, concerning in fact only a restricted number of actors. Those actors aside, the stock markets were not rallying, that is what bond buyers believe and why they buy bonds.

For our stock "markets" (and some others), just a facade subsists.



Dr PhilFor much of today's action the Nasdaq lagged behind the S&P index in percentage terms. The Nasdaq has a higher beta than the S&P so one would normally expect it to move farther and faster both up and down. Like a race horse making it final surge to the finish the Nasdaq managed to surge ahead of the S&P in the final minutes of trading to restore the normal order of things.

Naturally this raised two questions. First, what happens if the Nasdaq under performs the S&P on an up day? Second, what happens the next day after the Nasdaq is stronger than the S&P? To resolve these questions the following study looked at a little over 4100 days of trading for the Nasdaq index and used the SPY ETF as the trading vehicle for the next day. The following table shows the next day results after SPY is up and it is stronger than or weaker than the Nasdaq in percentage terms.

.         +SPY>Naz       +SPY<Naz

Avg     -0.00012        0.00008

SD       0.012612993    0.010327566

n         968            1271

% Up     0.508          0.509

t-stat  -0.290          0.275

The average returns are close to zero and the percentage of times up is about 51% for each case. However the t-stat is non-significant for both cases despite sample sizes of ~1000.

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

David Higgs remarks:

As of late there have been some days where the move of the markets was attributed to just one or two stocks due to short covering. But then this is a different fly in the ointment…



CycleI may well be wrong, but my belief is that we are at the end of a big cycle. The end of the "easy debt" cycle?

1/ 2008-2009 shows clearly that nothing will be done by borrowers to stop their dependence. Nothing will be even tried. On the contrary. Because of our debt levels, this triggers the question of solvency. At least, this makes the question of solvency exceed a significant psychological level for the lenders. Confidence lenders/borrowers is definitely affected (gone). (Even if little is publicly said about that).

2/ This situation of confidence loss is new. The exhibition of our attitude at such a level is new. The awareness/knowledge/understanding of this situation is new. Presently, neither the lenders, nor the borrowers, have exact plans to deal with this novelty.

3/ … but, under the calm and apparent status quo, they are of course actively searching. At least the lenders. With the intent to do something. (Something will be done, even due to randomness. At least some small domino pieces will fall.)

4/ so my belief is we arrive at a delicate/complex crossroads/nexus/crux/bifurcation point (à la Prigogine). We're now inside a huge, real-life, game theory exercise. Many many things can happen. (But I believe many probable scenarios will share common steps). (I believe even dramatic events are now made possible.) But the status quo seems me rather improbable (even if it would be the case, this would just postpone things).

The above sequence lacks numbers (and may look abstract), incomplete, too coarse and biased with a sort of "pessimism", (but it's not how I feel about it). I'll thank you for any help to remove the flaws/omissions/clumsiness of this reasoning.

Phil McDonnell replies:

Debt is an important part of the big picture.  But I believe that a better perspective on current economics is that private consumer debt will no longer be easy.  In fact current figures show that consumers are 'saving' in greater amounts.  To be sure this savings does not show up in savings accounts or other tangible assets.  Rather it shows up as consumers pay down credit cards and mortgages.

The key thing to understand is that the powers that be do not want a reduction in total debt.  The size of the world economy is directly related to the size of the world money supply and all of its assets.  Given the destruction of wealth in mortgages, real estate, stocks and commodities the only source of money creation to reflate the world balloon is government borrowing.  So in effect the consumer debt is being replaced by increased government debt and conscious efforts to print money out of thin air.

J. Rollert predicts:

The present environment will make people treat debt like our grandparents did… and not trust financial types in particular. This is a social change beyond the cycle.

Paolo Pezzutti recalls:

People will not change behavior and attitude unless they are forced to do it.  When I arrived in the US from Europe two years ago I went to a dealer to buy a car.  There were signs on the cars on sale indicating $400, $350 and so forth that I could not understand at first.  When I started to talk with the guy it became clear to me that the signs were the monthly payments you had to make.  When I buy a car I want to know first how much it costs, not how much I have to pay each month.  But in the US people are apparently either encouraged to buy on debt, or they like to buy on debt, or they must buy on debt because that is the only way they can afford a car.  Only if the behavior of the lenders changes, we will see a different attitude of consumers.  And this is what could happen. Even with 0% interest rates.  Unless lenders find "new" ways to lend "easy" money.

Russ Humbert writes:

It is not just Govt. debt in the traditional sense, that the Govt. is increasing, it is putting more risk on the Govt. balance sheet on the asset side as well.

The Bernanke plan is to keep it coming, from what I can tell, to those that are willing to beg from the government.  Securitization is not dead, for the government quasi guaranteed it… This includes education and housing loans for most people, up to the point of being "rich".  It would seem that those that have no real prospects of paying off the principal, those that won't better themselves will be frozen out. At the other extreme those that better themselves to the point that it's clear Government is impeding personal progress, will not get this "risk free" money.  There won't be another AIG to scoop up all the risks, without any real capital backing it, for a long time.

This may seem momentarily like we are headed back to the sixties, before even credit cards, because of the sharpness of the down turn.  But this still leaves the US with much more debt capability than existed 10 years ago, before things got out of hand.  And money will flow down to consumption, it just won't be direct and if direct not as cheap.

Legacy Daily is skeptical about big changes:

I perceive debt to be the current fuel in the engine of growth. Unless an "alternative energy" is discovered, I believe debt is here to stay. The donut maker got it wrong, "America runs on debt." One reason for the efforts to improve the geopolitical landscapes in emerging economies is to also help raise their asset bases against which further debt can be created to satisfy the unending need for growth that our markets, our 401(k), and our lifestyles require. Since there's nothing new under the sun, just as soon as this cycle of diet and slightly better behavior has run its course, the patient will be right back to the liquor store for more of the same and a new cycle will be born. When and in what shape? That's the really difficult question.

We received a contribution from thin air (or is it Thin Air?):

Let me introduce myself: my name is Thin Air. Yes, THE Thin Air. I've been around for eons upon eons and have enjoyed a fairly tranquil existence. Who or what am I? A Princeton web site defines me thusly: "thin air (nowhere to be found in a giant void) "it vanished into thin air." That's OK with me, I can even live with the example which characterizes me as the passive element in an inexplicable event. Over the centuries millions of people, things, explanations, excuses, villains, heroes, and life savings have "vanished" or "disappeared" into me.

No problem. If you humans lack the will or imagination to discover just whatever it was that was lost, misplaced, filched, or embezzled, that's fine with me. But trust me on this, I don't have any of those people or things….never even was aware they were gone until I looked me up on Google - imagine, almost 3 million references. Rosie O'Donnell's number is just slightly higher, Bill Clinton's is 7 times greater, Barack Obama's 25 times greater, and Michael Jackson's 70 times greater- a telling measure of your society's priorities.

Those individuals weren't chosen capriciously; as a member of the "thin" contingent I chose two thin representatives and, by contrast, two fat ones - although it appears I'm being dissed in relation to other "thins", I love it and want to keep it that way. But Philip McDonnell served as the straw that broke the camel's back when he penned: "So in effect the loss of consumer debt is being replaced by increased government debt and conscious efforts to print money out of thin air."

I'm getting so, so tired of hearing that. You can't get through an hour of CNBC or Bloomberg without hearing that phrase or a riff on it. But those people are pretty lame and I expected Dailyspec contributors to provide a creative twist to a tired theme. Additionally, when phrased as shown above, it appears that I had an active part in the event; that I somehow swooped down and dumped billions and billions of dollars upon a group of bankers. First off, I'm broke; I neither have nor need money (gasp). Secondly, if I did have money, do you really suppose I'd drop it on that group of dummies? Not a chance.

Being a disembodied element and not a human, I can still make value judgments, tell the truth, discriminate, and speak out without fear of being condemned, jailed, boycotted, or shunned. Among those things that are unquestionably bad is excessive debt. It would seem this is self-evident, and Mr. Andres ought to be commended for bringing it to the fore. Similarly, Mr. Conrad (on another thread) reveals that the WEEKLY treasury begging bowl calls for low-interest-loving optimists to pony up almost one quarter of a trillion dollars. If this occurred every week, Treasury's annual issuance would approach the nation's annual GDP.

One can hardly blame debt buyers, though, as it's a given that the system will get better (or as the Sage, a student of Pangloss, stated this a.m. "better than ever") and that American Exceptionalism will prevail where, in similar circumstances, similar efforts failed. On the contrary, we witnessed major adjustments following the Tulip Bulb mania, the South Sea Bubble, Teapot Dome, the Great Depression, the Salad Oil scandal, the S&L fiasco, Russia's Default, LTCM, Y2K and Tech Mania, Enron, and the Real Estate Bubble.

History has demonstrated that none of these came out of Thin Air, nor did their eventual solutions. You can check it.

Thanks for your consideration and

Please leave me alone,

Thin Air



It is rather interesting that the ubiquitous 200 day moving average (actually 40 week ma) still works at all, because everyone seems to know about it.

Larry Williams replies:

Technical indicators, I think, can be widely known about and still 'work' because of the frailty of humans; as a group we have problems with following/sticking to rules. We can all know we should not drink and drive, speed, do drugs, smoke, etc… but most violate basic rules.



P MBonds and stocks compete for their piece of the investment pie.  Yields on long term bonds have spiked from 3% to 4.5% in the last several months, an event that cries out for some counting.

I looked at the last 30 years or so of market history.  Using a definition of yield change as:

chg = r(t) / r(t-1) - 1

the study looked at monthly data for US 30 year Treasury yields and the subsequent monthly net change in the S&P.  For the 39 times when the monthly change in bonds exceeded 5% the market in the following month performed as follows:

P M Study

The first column of numbers shows the stock performance one month later, the second is for two months ahead. The one-month results might seem anomalous, in the sense that the market is usually up, some 64% of the time, but down on average. The 64% figure is actually not that high given that the market was up some 61% of the time for all months in the sample. Looking at the individual events there were three occasions when the market dropped more than 5% the next month.  This is also consistent with the relatively large standard deviation.

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



J RobinsonWhat can we learn from baseball that is applicable to markets?

In looking at how to hit for Aubrey, I focus on posing and gaining potential energy by moving the back foot back or lifting the right foot up before hitting the ball. Also holding the head directly at pitcher, and the trigger point. Also following through the ball with the bat following it on a line before snapping up. I don't know anything about baseball but all this seems applicable.

Please augment. We have quite a few experts on baseball who read this site and the All-American also.

James Lackey replies:

They don't teach you to lift your foot up anymore when you bat. You use a wide stance, and you pivot your back foot towards the pitcher and snap your hips. Some teach you to pivot your back foot on the ball of the foot, with you front foot on its heel while swinging, and you end the swing with your feet pointing to the pitcher. My son's 11-12 year old hitting coach had a hard time retraining my kid. He cut a 1" piece of PVC pipe the length of his shoulders made him stand over it and do a zillion swings to get his front foot down before he could snap his hips. We were all taught to keep your elbow up, use a narrow stance and step into the pitcher.

J.P Highland comments:

Being able to choose the pitchers we want to face gives us a great advantage over baseball hitters. The Nymex's pitching rotation is my favorite. They like to intimidate batters with lightning fastballs but their stuff suits my swing, as opposed to the tough off-speed pitches ES has mastered that have victimized me so often.

James Lackey adds:

My kid was born with a cannon. I knew it at age four when he threw me a hardball. By 10 he could throw from the fence to the catcher. He was a good pitcher at 12, but his coach would always yell at him over the top when he lost control.

Now what I do not quite get is that his football coach yells at him at practice to quit throwing a baseball. It's how quick you release to give the defenders a chance to attack. My son explained to me how it works, but I still do not get the mechanics.

The only good thing to report is I have never been his football or baseball coach only dirt bikes. So naturally he loves team sports.

Tim Melvin writes:

I'm not a much of a pitcher as I have a noodle for an arm and always have, but in the excellent baseball book featuring John Smoltz and Mike Mussina we learn that speed, location and deception are the keys to successful pitching over time. I am not just talking about power speed either. The Nolan Ryans are the one off Soros and Buffets of the baseball world. The ability to vary speed and move the ball around are the key to long term success.

I shall leave you all to draw you own market conclusions as there are many that leap to my mind.

Scott Brooks comments:

Good pitching isn't about overpowering batters and striking them out, it's about throwing the ball so that the batters make bad contact, and then letting your fielders do their job.

Stefan Jovanovich writes:

 Albert Pujols does both old and new school. He has his right foot turned 45 degrees towards the pitcher, the right knee bent slightly, the hands held back and high (at the top of the strike zone), the right shoulder held above the left, with the bat vertical. When he unloads, the left foot and hips do a quarter turn, the right shoulder drops slightly as he throws the bat at the ball, and the bat stays level to the ground for the full travel across the plate. In 4 days against the Giants he made one bad swing: when Matt Cain threw him a 1-2 slider down and away. He absolutely ate Barry Zito alive even though Zito now has game back and had no trouble at all with the rest of the Cardinal lineup. Theoretically, you could throw him changeups and curves down and away; but, when Lincecum tried it, by the 2nd at-bat, Pujols was hitting doubles down the line in right. It was like watching the Yankees try to pitch Williams inside (with his long arms and height, he should have been vulnerable) and watching him take the ball early and park it in Ruth's pavilion. Yo-Yo Ma with a pine bow.

Pitt T. Maner suggests:

This article which I quote from was interesting in light of an optical illusion I had seen a few days earlier on the internet. Many years ago I had read stories of knuckleballers who had pitches where even they themselves were not sure of the ball's pathway to the catcher's (often oversized) mitt.  This story has a bit of that mysterious, "unhittable" pitch reminiscent of Plimpton's April Fool's hoax:

"DiFelice grips the ball across the seams, like a four-seam fastball, and tilts it so his middle finger rests along the red stitching. He squeezes the ball with his middle finger, raises his index finger and throws it as he would a fastball. The result is confounding: The ball spins like a fastball and moves like a slider, and the optical illusion it plays on hitters allows him to get away with throwing an 82-mph pitch the batter knows is coming."

And here is the optical illusion (best illusion of the year in fact).

How would you learn to hit such things? Would you need to learn to selectively ignore information coming from your eyes?

Phil McDonnell writes:

Lifting the front foot high does not inherently add energy to the swing. If you think about it lifting a foot straight up adds potential energy only in an up and down direction. The point of a baseball swing is to drive the ball in the horizontal direction. Any energy from the foot lift is orthogonal to the intended swing and does not add any power.

The real reason for the foot lift is that it enforces a good weight shift. When the foot is lifted all of your weight is on the back foot by necessity. This allows the weight to start on the back foot and shift to the front foot. The weight shift adds power to the swing by starting the twisting motion of the body and the hips. Fundamentally the power is generated by the centrifugal motion of the bat. The center of that motion is the twisting of the hips and body.

There is another subtle but important aspect to batting. That is the need to have a good follow through. The key is the hands. If you do an imaginary swing with your hands you will see that when you fully extend your left hand in a follow through that your right hand cannot stretch out nearly as far as the left (for righties).

This compels two types of follow through motions. The first kind is simply to break the hands. The follow through continues with only the left hand still holding the bat as the right hand is released. Reverse for lefties.

The other type of follow through involves a roll of the wrist. Basically the right wrist rolls over the left as the bat passes to the left of the body. The object of either finish is to keep the bat moving even after it is in contact with the ball.

The one follow through technique that is bad is to keep both hands on the bat without a roll. If you try it you will see that you get a hitch in your swing just about when the bat handle passes your body.

One little known, but good exercise is to simply swing a light bat 50-100 times with your left hand only. The left hand is an important hand for guiding the bat. The left tricep is the important muscle for this motion. This exercise is best started pre-season because it often leaves the tricep sore after the first few times.

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

Jeff Watson adds:

 With much ado regarding the merits of different pitching styles, and the physics of different type of curves, knuckelballs, fastballs, and sliders, I'm surprised that nobody has brought up the pitches of Gaylord Perry and Joe Niekro. Perry allegedly did wonders with a spitball, and when the heat came to tough for him to bear, he replaced spit with Vaseline. Perry was constantly hounded by umpires his whole career, and had to develop different methods for hiding his illegal substances after the 1968 ruling regarding wiping the mouth before a pitch. The spitball was one of those pitchers that made the ball seemingly disobey the laws of physics, and was hard to hit. Perry and pitchers of his ilk had deceptive moves down to a science, and whether they threw a spitball or not, the batter was never sure. The market has shown similar characteristics in the past and present, where following the rules is winked at. Certain reports are released early by officials to their friends, and nobody really says anything. Naked short selling was allowed until it was apparent that there would be a possibility of the whole financial sector going to zero. The market players just had too much of an advantage over the public and the rules had to change, much like they did in 1968, and much like little things like the height of the hill being modified from time to time. Even after the rules are changed, in baseball and the markets, people still try to cheat. Niekro was caught red-handed by the umpire after he was searched for an emery board, and it flew out of his hand onto the field. That was one of the classic moments of baseball.

Stefan Jovanovich responds:

 Niekro used a piece of emery board to scuff the ball so he could get a better break on his curve. That was what he was throwing away when he was caught. Perry used perspiration from the back of his neck to load the ball so his sinker would have more drop. (He would take off his cap and run his pitching hand over the back of his head and down to adjust the top of his jersey). Baseball, being like the SEC, had and still has elaborate rules that are utterly useless in terms of actual cheating on the mound. For example, the pitcher cannot go to his mouth while standing on the mound (automatic ball to the batter; balk if there are men on base); but he can still walk off the mound and lick his fingers all he wants. However, since saliva doesn't work nearly as well as sweat (which is much heavier because of the salts and dries more slowly), the anti-spit rule itself is pointless. The spit ball was outlawed was the one where the spit the pitchers used was loaded with chewing tobacco.

The idea that pitchers used vaseline is a media urban legend. There is no question that the stuff could be useful; but you would need a towel boy with soap and a basin of water that you could go to between pitches so you could clean off your hands. However, since the batters - who are always looking for an explanation for their inevitable failures - never figured this out (not being particularly concerned about hygiene), Perry and Early Winn and others always made a great pretense of using it. Perry still does; but you can hardly fail to notice the twinkle in his eye whenever he gives his seemingly evasive answer to the latest interviewer.

In my next life I want to hit against the pitchers on Dr. Phil's team. Everything he wrote is wrong. The knuckleball wobbles because it has no gyroscopic balance. It has no gyroscopic balance because it has no spin. The pitch is thrown with the ball held by the nails so that when it leaves the hand there is no friction with the skin. The trick is in holding the ball with the nail of the thumb; that is the part of the grip that defeats most people. (This is why nuckleball pitchers are fussier than manicurists about their nails; they want them trimmed so that they perfectly fit the curve of the ball.) The pitch is called a knuckle ball because when you have the proper grip the knuckles all stick out on the pitcher's hand. That also makes it instantly noticeable so there is no deception whatsoever about what the pitcher is throwing. If the ball has any rotation at all — even the magic reversible one from the "sail effect of the seams" that Dr. Phil has discovered, then the pitcher is in for a world of hurt because the pitch becomes a batting practice fastball (think Tim Wakefield pitching relief against the Yankees in the playoffs). All the other pitches Dr. Phil mentioned — the palm ball, fork ball, split finger — do have spin; they have to because the pitcher has to control their location. The knuckleball and the true 95+ mph fastball are the only two pitches where the pitcher can say "here, hit it" and not worry about where he or she throws it. (Some day some bright woman is going to learn how to throw a knuckler!) What the palm ball, fork ball, split finger all do is change the velocity. By holding the ball against the palm or jamming it down between your fingers, you lose some of the whip from your release. The circle change has the same effect; by holding the ball with all 4 fingers, you lose speed while keeping the same arm action. The cut fastball that Pitt posted about earlier is different; it is like the screwball. You are throwing the pitch with the same speed as a fastball but with a different rotation.

Phil McDonnell remarks:

 Curve balls really do curve. There are many proofs of this but the simplest is the center field TV camera where the resolution is too poor to show the spin, but the curvature is obvious. If the viewer cannot see the spin then it is difficult to explain how it can be an optical illusion.

Basically the curvature comes from the spin of the ball. The easy way to remember is that the direction that the front of the ball is spinning is the direction of curvature. A pitch that is thrown with a right to left spin will curve to the left. A pitch that is thrown with a down and to the left spin will break low and away.

The spin exerts a small orthogonal force on the ball as it speeds toward the plate. This force is governed by Newton's equation:

Force = Mass * Acceleration

Note that the last term is the acceleration not the speed of the sideways movement. The ball actually curves at a faster and faster rate. Thus the most deceptive part of the curve occurs right at the point where the batter swings.

The knuckle ball is a bit different. The idea of a knuckle ball is no spin. What happens is that the seams act as little sails that catch the passing air causing curvature in one direction or another. Naturally the seams also cause a very slight rotation of the ball until the another seam comes around. The effect is that the ball begins to curve one direction and then as the seam changes it actually begins to curve in a new direction. From the batter's perspective the ball can appear to wobble. Other times it can fly off in one direction or another in a strongly curving manner. Even the pitcher does know what it will do. The knuckle ball is not the only grip that results in no spin. Others can be the fork ball AKA split finger fast ball and the palm ball.

Another deceptive use of these no spin pitches is that they can be thrown just like the pitcher's fast ball. If the batter has previously timed the pitcher's fast ball then he will likely start his swing based on that timing only to be fooled by a ball arriving slower than expected. So even if he is not deceived by the wobbles of the ball he may be swinging too early or need to hold up his swing and lose critical power.

In many ways these change up style pitches are reminiscent of the deceptive action of the seemingly dead market last Friday which suddenly exploded to life in the last seven minutes of the trading session.

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

George Parkanyi comments:

In pick-up ball where it's pretty easy to hit, I choose the direction I want to go by adjusting my back foot. If I want to hit to the opposite field because I'm being played to pull the ball, then I'll drop my back foot further away from the plate, which turns my torso to slightly lag my swing and "point" the direction of my "power" through to the opposite field. If I want to hit to center I line up parallel to the plate, and if I want to pull the ball, I move my back foot closer in toward the plate. If you connect well with the ball, it will go in the direction of your set-up. Against a professional pitch, I think I'd be happy just to touch the ball — perhaps even just to see it.

Dean Davis writes:

The most critical thing you can teach Aubrey is to avoid moving your head forward (toward pitcher) in the process of moving from a loaded position to the striking the ball. This is often the result of a hip shift which moves weight to the pitcher side of center (this destroys a hitter's power). The timing of hitting a baseball is difficult enough without ceding an advantage to the pitcher by destroying his stereo-vision by moving your head forward.

If you can get him to solidly place his stride foot slightly closed (closer to the near edge of the plate than the back foot), before he starts his swing (done by merely rotating the back heel low to the ground until pointing away from the pitcher), you will avoid him having to relearn the swing when he gets to a select/traveling/high school team later in life.

The Texas Rangers pitchers are taught to throw the circle change where they are attempting to "throw the O" (the circled index finger & thumb) at the target (pushing the index finger down to close the O at release). This means that their middle three fingers are are pointing at one of the dugouts as the shoulders are square to the target. That exaggerates the screwball spin and drop. Index finger should lay across the seam.

I teach my pitchers (age 11 & up with longer fingers) to have the same grip (floating the the middle finger off the ball if possible, substituting the ring finger for stability), throw it like a fast ball (the hand is more behind the ball when coming over the top) and emphasize the index finger pressure through release. They get the same screw ball action and drop as the major leaguers (to a lesser degree). When thrown by a righty to a righty (or lefty to lefty), it is a devastating "out" pitch (thrown on a X-2 count). My pitchers love to see the hitter "corkscrew" into the ground trying to make any contact.

Here is an interesting interview with Mike Basich (gave up record breaking HR to B Bonds) about how pitchers cheat (he names names!)

Steve Leslie contributes:

A great lesson that one learns from baseball pertaining to the markets is in the area of hitting. There are many different types of hitters those who are contact hitters for example and those who are home run sluggers.

Many consider Ty Cobb the greatest hitter in the game. He had a lifetime batting average of .367 over 24 seasons. This is the highest career batting average in the major leagues. He also had 724 doubles 295 triples and 117 homer runs. Through that whole period of time he had but 357 strikeouts. He also stole 892 bases. With the exception of his first season in the majors he never batted below .300 and his peak performance was in 1911 with 248 hits and a .420 average. He also held the batting title 12 times with 9 in a row. Ty Cobb forcused on what he did best which was hit the ball, put it in play and as a result of this dedication maintained a productive career that lasted a quarter of a century.

After his retirement, Cobb was a very wealthy man having been advised by executives and others in the Detroit area how to properly invest his money. He went on to invest in stocks and was a major stock holder in the Coca Cola company.

The lessons for the investor is that success in the markets is a lifetime pursuit. It is showing up for work every day and dedicating onself to the task at hand and utilizing the particular skills and they have been blessed with. Ty Cobb had a very productive and successful career because he concentrated on what he did best and he did it very well. Year in and year out .

Phil McDonnell admits:

Yes, I did pitch for Cal in the PAC-10. We actually won the conference when I played although only slightly due to my minor contribution. Since that time I coached about 50 kids in Little League. Of those, five players were drafted into the Major Leagues for a total signing bonus of about $5 million. Somehow that does not seem random to me.

The wonderful thing about the markets and baseball is that everyone thinks they know all about it. There are many ways to skin the cat. Perhaps I can arrange some batting practice against one of my ex-players next time they visit the A's or the Giants.

With respect to the back foot weight shift, we can do a simple thought experiment. Lift your back foot into the air and try to swing. Did that swing feel powerful? The fact is the weight shift from back to front occurs whether you are conscious of it or not.

The fingernail ball is something I have never taught. However I have never had to pull my starter for a broken cuticle, nor have I ever needed to smuggle an emery board out to the mound for emergency fingernail repair. I have coached the circle change. It is an excellent and easy to learn off speed pitch. My technique is to circle the two fingers in an OK sign, the the three remaining fingers are used to throw a weak pitch. The spin is the spin characteristic of a screwball (curves to the right). But the pitch does not curve because the spin is too weak and the speed is too slow. It is simply an off speed pitch.

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

Stephan Jovanovich replies:

Heck, Dr. Phil, with my eyesight I couldn't tell you from one of your former prodigies, let alone see the ball. I stopped playing ball at 18, after I went to the Phillies organization pow-wow and met the three catchers they already had in the system and compared the sizes of their hands to mine. The only talented pitcher I ever caught blew out his arm in AA in Odessa; he was from Guatemala, and he had the same stuff Mike Cuellar had. He would have been a marvel. I know enough about the bonus baby mania baseball went through to be unimpressed by the "about $5 million"; it is one of those factoids that is like Clinton's 100,000 new cops - wonderfully round and purposely vague. Hell, even with my puny hands and Molina family footspeed, I was offered $10,000. If you want to post your stats and the stats of your magic kids, I will be more than happy to eat crow and buy you and your camp followers each a bottle of bourbon. Until then, let's call it a draw. You still don't know anything about hitting, but there are few people who do. As for pitching, I would still recommend to the List that they send their kids to Dean's camp, even if his players have never been offered a stick of chewing gum by a scout. He knows far more about this than you or I do, and he lacks your cocoa puffed ego and my bad temper. Neither is a good temperament for teaching people. But - last shot - the most important reason to trust DD (listen up, Lack!) is that he clearly has no interest in any of the kiss-ass rituals that have turned so much of "organized" baseball at the junior level into a game of "my daddy knows your daddy" (out here in the Bay Area it has become even worse than it is in soccer).

Phil McDonnell suggests:

Lifting the front foot high does not inherently add energy to the swing. If you think about it lifting a foot straight up adds potential energy only in an up and down direction. The point of a baseball swing is to drive the ball in the horizontal direction. Any energy from the foot lift is orthogonal to the intended swing and does not add any power.

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

Charles Pennington demurs:

Potential energy does not have a "direction". Why do batters start with the bat held up high? That's potential energy that ends up contributing to the kinetic energy of the swing, when the bat is low.

Let me add that the pitcher lifts his front foot in an effort to throw the ball fast in the horizontal direction.

Stefan Jovanovich notes:

Randy Johnson did it — at age 45. He became only the sixth left-hander in baseball history to win 300 games in a career. And, like Teddy baseball's final game and last home run (at his last at-bat), it happened while the world was looking elsewhere — before a tiny crowd on a rain-sodden field. Pure Brueghel.



 Was the Vasa was the greatest warship of her time? By the time Samuel Pepys (great gossip, even greater Gilbert & Sullivan head of the Queen's Navy) became Secretary, the Stuart Navy was successfully challenging the Dutch and the French and offering its protection the Swedish merchant marine ships in their trade in the West Indies.

In his Miscellany Pepys lists the following classes of ship:

Rate          Name        Length     Beam     Draft    Tons  Men  Guns
First          Sovereign      127         46         19     1141  600  100
Second      Fairfax          116         34         17     745    260  52
Third         Worcester      112         32         16     661   180  46
Fourth       Ruby             105         31         15     556   150  40
Fifth          Nightingale      88         25         12     300   90   24
Sixth         Greyhound       60         20        10     120    80  18

A comparison of the Sovereign with the Vasa is dispiriting. The Vasa was roughly the same size - 1200 tons; but it was nearly twice as long - 230 ft. - and its beam was 8 ft narrower (38 ft.). That is a length to beam ratio of 6 to 1.

That was asking for trouble. The rough rule of thumb since people first started sailing and capsizing boats is that a monohull should be three times as long as she is broad. This should not have been news to the Vasa's architects. The Mary Rose (built 90 years before the Vasa) had a ratio of 3 to 1.

There is a reason for the Vasa's builders to have wanted it to be so long. There is even an explanation of why they thought they could build to such an extreme ratio. The longer a boat is, the less beam she needs proportionately. A boat's resistance to being overturned varies as the fourth power of her waterline length, the heeling moment of the wind pressure on the sails or the waves and swells against the hull in an engine powered ship varies as a cube of her length. Length is desirable in itself because the maximum speed of a vessel is - roughly - 1.2 times the square root of its length at the water level.

The Vasa's builders were trying to achieve the same results that American naval architects produced with the Iowa class battleships — the last ones ever built by the U.S. and the last battleships to operate on the high seas. The Iowas had to fit through the Panama canal and be able to keep up with the carriers (which were much lighter and, therefore, faster for the same propulsive power). As a result, they had an extreme beam to length ratio (8 to 1).

Then, why did Iowas survive typhoons while the Vasa sank literally in port? The answer is that the added stability of length can be horribly offset by increases in height. The Vasa had a height of 172 ft. - 75% of its length. For the Iowas to have had the same proportion, their hulls would have had to be 500 ft. high! Adding another 3+ ft. and a great deal more ballast kept the Vasa's sister ship from sinking in the Baltic, but it could never have survived the North Sea. Even using the 3.5 to 1 length-to-beam ratio that the smaller rated ships in Pepys' fleet (the Worcester, for example) would have required the Vasa and its sister to have beams of at least 65 ft; and, in the age of sail, there was no way for them to reduce its height to the dimensions of the Iowas.

The analogy with financial engineering is certainly appropriate. Somewhere in Stockholm in 1630 there must have been some bright young men who looked at the extraordinary success of the ancient Viking long ship designs thought "leverage can only lead to greater glory." But, the little matter of the Viking long boat's limited sail height seems to have be ignored. There are no surviving rigs for the long ships, but the best estimate for a 30 meter boat is that it had a mast height of 12 meters or roughly 40% of its length.

Phil McDonnell writes:

 I visited the Vasa Museum. It is a fascinating story of the greatest warship of her time that heeled over and sank within minutes of first setting sail in moderate conditions. In many ways it is the story of man's attempts to master engineering, be it naval or financial. The ship was only raised in the last century with modern engineering and is over 90% preserved due to salinity conditions in the Baltic. The interesting sequel to the Vasa disaster is that her sister ship which was completed two years later was only one meter wider but had significantly improved ballast engineering. The redesigned ship actively served Sweden in the war against the King's cousin, the King of Poland. Highly recommended tour.

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

Paolo Pezzutti comments:

 Maybe the ship was top-heavy.  If the ballast, for example, is not enough, the metacentric height (distance between the center of gravity and the metacenter) is too low, the ship would be unstable.  
From the thesaurus:

"metacenter - (shipbuilding) the point of intersection between two vertical lines, one line through the center of buoyancy of the hull of a ship in equilibrium and the other line through the center of buoyancy of the hull when the ship is inclined to one side; the distance of this intersection above the center of gravity is an indication of the stability of the ship".
(The center of buoyancy is the line of action of the resultant of all buoyant forces of the immersed portion of the ship).
(The center of gravity is a function of the distribution of the weights on board the ship and the ships itself).

There could have been different problems. An initial instability because of low metacentric height. Shifting of weights on board the ship may have altered the center of gravity. Or both.

Is how to calculate the metacentric height of a market a silly question?



P McDTo understand the serial correlation in a time series it is helpful to look at a simple random walk model such as:

p(t) = p(t-1) + u

where p(t) is the price level at time t and u is a random variable, the net change for the time period.

Suppose the price started at 100 years ago. Then the current price level will be the sum of all the previous daily changes plus the original 100. Over time the dispersion of the sum of these random changes will increase with the square root of elapsed time. This growing dispersion can be interpreted as a trend by one reading a chart even for a truly random price series.

As far as real markets go, we know that the daily serial correlations between changes is small and generally has tended to be negative in recent years. But it is also true that the variance of the market movement is serially correlated. In other words volatility persists. So we wind up with a slightly more complicated model where the u's in the above formula have a wandering variability.

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

Jim Sogi comments:

Phil has written often that price levels are serially correlated. This is a characteristic of a time series. Why is this? For some mechanical or structural reason levels are limited in the amount of their change over a given time. In markets in general, the market forces and competition of bid and ask tend to compress prices. In Globex, the 1/4 point tick and the depth prevents large jumps or moves in between trades. I posit that this is one of the basic market forces, and can be used to the trader's advantage. Globex itself as a market making mechanism has incentive to dampen wild price swings. Market makers, and stat arb traders have incentives to prevent wild price swings and big trends.

The second main force in markets is the force that overcomes the gravity, so to speak, of the serial correlation, and overcomes the structural dampening mechanisms inherent in a time series. This is described in part as volatility, or also as trending. This is the force that moves the market away from any given price. What is this force? It might be market imbalance of supply and demand much larger than the inside depth or of one day or week's trade volume as we saw this year and last. It could be underlying financial movements, changes in investor perceptions that outweigh the tendency of correlation. It might be government risk. This appears to be the balance of force between mean reversion and trending.

Another aspect of trending is the appearance of trends in a random time sequence as an artifact of the correlation and the increase or variation in volatility. This calls into question the fundamental nature of the force or explanation of the market forces as an explanation for trends.

These two forces might be quantified, and a metric used to define a trend. The serial correlation appears to be the basis for mean reversion trading for which trending is an anathema. Some trading methods utilize trending but it is problematic defining a trend. One of the problems is the existence of trends as an artifact of random time series and how to distinguish such artifacts from a fundamental move, in advance. The answer will also change with cycles.

The worst thing for a range trader is for a break out. The worst thing for a trend follower is a range. A single big move can wipe the reverter, and multiple range entries can ruin the trend follower before he catches the train. The correlation continues during a trend and results in the channel phenomenon, so this can be used to the traders advantage both contra and following.



 The bid/ask spread is another one of those hurdles that speculators must jump over in the quest for profitable trades. The spread is the instantaneous inside market, reflecting current market conditions, but it also is a product of unbridled free market forces. The bid/ask spread is a profit engine, for those in the right place at the right time, make no doubt about that. Many of the great fortunes on Wall Street were the result of always being able to buy at the bid, and sell at the offer.

In earlier times, people would pay for the privilege of an exchange membership in order to capture this spread. It must have been a worthwhile investment, as exchange membership prices have gone up on average for the last century. Now, in these more democratic, electronic times, it is harder to collect the spread on an all day, everyday basis. Much more confusion at the bid/ask point of the market reigns in this digital age. The mistress of deception likes to have her way with this spread. In today's supposedly open electronic age, where tyros see transparency in the markets, the same ages-old bluffing, misdirection, feints, probes, and stabs rule the inside market, as always. The same deceptive games played in the open outcry market have seamlessly morphed into the electronic markets, but with much more ruthless efficiency. Big players can see the open book, get the little ducks all lined up in a row, then slaughter them mercilessly. The inside market, the bid/ask spread, is tough to trade from anywhere on the outside, especially if you're a small player. Limit orders attempt to avoid the bid/ask spread, but one is really not avoiding the spread with a limit order when you think about it. Market orders give the other side of the trade an instantaneous profit, or return on their investment. No matter what you do, you're going to bump up against the spread, as it's unavoidable.

The bid/ask spread can represent the minimum amount of risk a player is going to assume, or it can cause a maximum amount of pain, it's your choice. Liquidity seems to rule the day in the bid/ask spread, with the more liquid instruments having narrow spreads, and some illiquid instruments (like pink sheet stocks) having up to a 10% spread. The spread can still change in liquid instruments, depending on the free market forces, fear, greed, deception, or any other emotion in nature's handbasket.

Emotions come into play when you are trying to get a trade down and don't get filled because the bid/ask spread won't allow it. Emotions can cause you to chase a market while the bid/ask spread seductively dangles a carrot in front of you. Emotions can cause you to avoid a good trade because of a perceived increase in risk when the spread is wider and you don't want to pay the cost, or assume any extra risk. I like to keep an eye on the spread, as I find that it gives many, many valuable market indicators, especially in thin markets and after-hours. However, like commission, vig, slippage, and mistakes, I accept the bid/ask spread as part of the cost of doing business.

Legacy Daily comments:

Some of the volatility seems to be created to soak up more money from the participants in the form of the spread but even with this money printing-press the houses got slammed in the past year. With their collective voice, maybe they would say that is their cost of doing business but I am yet to fully comprehend the societal impact of a bid/ask spread between a 1% deposit and a 5% loan. 

Phil McDonnell writes:

The bid/ask spread, volatility and liquidity are very much related concepts. When the spread is wide there is usually greater volatility. When volatility is greater the spreads widen. It is difficult to say which causes the other, rather it is safer to reason that they are manifestations of the same underlying phenomenon. In both cases that phenomenon may be liquidity or lack thereof.

The bid/ask spread and volatility are directly observable. But underlying liquidity is a hidden variable which cannot be directly observed. The St. Louis Fed has done some limited research looking for the underlying cause of volatility. In that work they found that consumer liquidity was highly correlated with market volatility. That offers a strong hint that liquidity, spreads and volatility may all be manifestations of the same thing.

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

George Parkanyi responds:

The spread is a market price in its own right –- the price of liquidity, and also of laying off risk. If you want to establish a full position immediately, or liquidate one, you pay the price for that convenience. If your small orders can piggyback the action of the big lines in a liquid market, then you don’t have to pay very much at all. If you’re the only guy walking up to the table, it can be pretty-much take it or leave it when things are thin. Market makers maintain a position in the security indefinitely. They can wait you out. Your interest is typically transitory, and you often want to get in quickly to act on an idea, or get out and move on to something else. You don’t have as intimate a relationship with that market. So the bid-ask is in effect a service, for which you pay a price.

I’ve stopped trading certain ETFs because they are too thin. The spread on the thinner ones was sometimes 10%, and even when I was getting a signal I couldn't always execute. This was disruptive, so now I’ve spent some additional effort weeding out thin markets where the spread is too costly, or makes me miss signals that would otherwise be profitable if I were trading a similar, more liquid security.

I’ve thought about and played with spreads a lot, and believe that with adequate capital, you can effectively simulate being a market-maker yourself by maintaining a “virtual” bid-offer. You simply put in limit orders to buy and sell at certain increments. The profitability of your “market-making” depends on how wide you make your “spread”, and how volatile the security. Too wide the spread and you might not get enough action to warrant the risk, too narrow and you may pick up a whole lot of inventory going the wrong way that you don’t want. Looking at the profitability of the specialist system, I believe you can make good money with a strategy like this in a market in which you have a reasonable grasp of the dynamics, although you won’t have the visibility of other limit orders — you’ll have to do it statistically.



 Do High beta stocks tend to be leaders in various time frames of movements and do low beta stocks tend to be laggards?

Such a question carries the in-built flaw that the beta itself is not stable across time frames and hence may require a modification in studying the original question of studying it within say +/- 2 standard deviation ranges of any particular beta level.

Why such a query arose in my mind today is that the ratios of Price levels on various emerging market index futures (Korea, China, India etc.) vs the SP1 tend to reverse ahead of the SP1 at bottoms and tops on visual inspection across last 7 years or so that I inspected. Given the amplitudes or swings of movements across spans of movement ranging from days to weeks to many years is far higher in these markets (including the drift) compared to the SP1 for the last decade one has tended to make a comparison of such with SP1 as being higher beta with the beta of SP1 being 1.

An exercise in quantification of such a frame of thought across either these indices or constituents of any particular index itself vis-à-vis the index may have some utility.

One wonders aloud here, that if the situation is similar as the race between a tortoise and a hare where the hares run ahead, get pompous and lie down for rest while the tortoise does take the hares over (during beta changes) and another variant of the story not told where the hares run so quickly ahead that they genuinely are able to move only very slowly as they get closer to the finishing line while the tortoises continue to turn up at their own pace and the race to the other end of the course begins again similarly.

If one wanted to also think in terms of a third set of players, the snails running the race and never reaching any end of the race track wherein after the tortoise have reached the finishing line the hare and the tortoise start returning and the snail changes course finding them somewhere still in a new race. I would say the likes of C , AXP , BAC , JPM have been the hares, the likes of JNJ , PG , XOM have been the tortoises and the likes of MSFT have been the snails in the last big race.

I am certain that I can learn much, observing good ways of application of quantitative tools on such a theme if some of the proficient quantitative minds on the list do consider this an interesting thought to dissect it in such manner.

Phil McDonnell writes:

PhilAs usual Sushil has raised a deep and interesting question. For clarity one should start by defining two different terms. One is a leading indicator, by which is meant a stock that turns before the entire market turns. The second is the idea of a market leader. A market leader is one that out paces the market during its current move.

We recall that beta is derived from the following regression model:

(stock change) = b * (market change) + a

where b is beta and a is alpha.

From the foregoing definition of beta we can see that a high beta stock will necessarily be a market leader in the sense of moving farther and faster than the market during a given move. The alpha is really a measure of the performance independent of market risk. So in that sense alpha is really what the shrewd investor should seek.

To answer the question as to whether certain stocks turn before the bottom or turn before the top is somewhat different. For that we can look at lead lag relationships. For me the simplest way is to look at correlations at various lags. The chair recently mentioned the weakness in the Nasdaq index relative to the S&P and Dow. If we look at the movements of the QQQQ ETF 4 days ago we find that it is 23% correlated to the SPY ETF changes today. Thus the Q's act as a leading indicator. To be significant the correlation should be about 25% so its a little too weak to be considered academic proof.

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



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



Since this web site is read by many very successful investors, I was wondering if any of you had any insights on selling stocks. It seems there are a million different books and strategies on buying stocks, but not many people talk about when to sell. Right now I basically go off of what I am satisfied in gaining and start selling at that point. If it drops I usually keep buying as long as my analysis of the company still holds. This has worked out okay but I've missed out on a lot of gains and feel there is more to learn here. For instance, I bought ZINC at $2.50. It went up and bounced around from $3 to $4 for a while and I determined that at $3.50 I was satisfied with a 40% gain. Of course after I do this it shoots up to over $7 over the next couple months. On the other hand, in an attempt to exercise more patience, I held on to TRID when it was up over 40% and I am now in the negatives with it. I currently am up 110% on TUES and am confused about what to do with it. My instinct has been telling me to sell and lock in the gains but it just keeps going up. My dad once told me to "Sell and be sorry, but sell." This seems like pretty good advice but I can tell you when a stock keeps rising I sure am sorry I sold. Could anyone help me out? Not sure if it matters, but my investing style is that of value. Thanks in advance!… Brave Rifles!

Philip J. McDonnell replies:

Phil MMr. Bates posed the interesting question of when to sell. Much of his discussion focuses on minimizing his subsequent regret. Many of us buy stocks because we fear the train will leave the station without us on board. We fear taking a loss because we cannot accept the cognitive dissonance of admitting a mistake. We also fear that the stock will recover from the loss adding regret to the cognitive dissonance. We fear selling a profitable trade because it may go higher and cause us regret. For most counters the question of when to sell is often answered before they buy. Suppose one did a study such as Vic and Laurel did in PracSpec looking at REIT returns in one quarter and what the market did in the next quarter. Then the criteria of when to sell is one quarter later just as used in the study. In fact very often the criteria used in a quant study is based on time and not on price. One can suggest a few general guidelines. One should sell if:

  1. The criteria used in your analysis have been met. This could be time or it could be something like the first profitable open such as Larry Williams has suggested.
  2. You no longer have an advantage.
  3. You have a profit so large that the position size is too large relative to your portfolio. Note that this criterion only requires a partial sale. My book talks about position sizing.
  4. You have other better opportunities and need to raise cash.

For a fundamentally oriented value investor the time element may not be so clear. Corporate reporting is on a quarterly basis so presumably the time frame for a value investor is quarterly or longer. So one should look to value as the criterion for exit as well as entry. If a stock has gone up quite a bit then much of its advantage in the value sense has disappeared. The position size may now be larger than the optimum and other under valued stocks may present better opportunities.

Correct position sizing is the only reliable money management tool. Stop losses are not guaranteed to work because of gap openings. They also do not work the way most people expect. Buying puts is usually too expensive. Thus we are left with position sizing. For a value investor with longer holding periods one might arbitrarily decide to cut positions in half to allow room to double before position size adjustment is required.

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



The market is like a beautiful woman of the fatale variety who always amazes with her virtuosity and newness. Never the same. Both must be quantified and used to advantage.

Phil McDonnell adds:

Phil McDA couple of years ago vic initiated a discussion of Information Theory and how it might apply to markets. One particular aspect of information theory deals with how codes can be represented. For example the letter A could be 65, B is 66 and so on. To interpret the market's signal one can classify market moves into categories. An up move would be a 1 and a down move a zero. This would be a simple two letter alphabet. For a four letter alphabet of market moves we could take large moves of more than +.5%, small moves up, small moves down and large down moves of more than -.5%. For larger market alphabets we could break the moves down into more bins with finer granularity.

In doing the study I looked at various alphabets from 4 to 16 characters (bins). In each case the results showed a significant predictive ability when one computed the information content of the resulting bins. On thing I noticed at the time was that the larger magnitude bins (both up and down) carried greater information value.

Another observation was that characters which were 'missing' or in relatively low frequency tended to be more likely to appear. This latter phenomenon is very much consistent with the Chair's femme fatale metaphor. The market tends to surprise us with what we have not seen in a while. Come to think of it, it has been a long time since we saw positive drift in the market.

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



 Redundancy is one of the keys to digital cell phone transmissions, and packet transmissions for the internet, human speech, credit card numbers, music composition. The list goes on and on, but should include the market. In speech, typically people say the same thing over and over, to guaranty the message gets through. Digital cell phone technology uses some sort of redundant error correction to insure the correct message. Musical composition often has three verses, and repeats the theme to get the message through.

The market does the same. The mechanism is the result of trial and error, to some degree, but also of communication, error correction. A minimum of three is needed to provide some sort of error correction, and to insure transmission of the message. This is why we often see things in threes. It is good to know or expect repetition or redundancy as it gives an edge. For some reason the news and commentators seems to think rather of endless continuation as the normal mode.

Paolo Pezzutti adds:

Redundancy increases reliability of systems, usually in the case of a backup. You can find in many critical-performance systems and applications that some components or modules can be at least doubled. When you have a federated system, for example, you can choose to have a central "intelligent' core and a number of "non-intelligent" sub-systems, or you can have "intelligent" subsystems providing a higher degree of resilience to failures. This is typical of some combat systems on board ships for example. The point is that not only redundancy adds reliability, but it increases also the performance, because intelligence is distributed throughout the system of systems and decentralization is a more efficient and effective solution (there are less bottlenecks and so on).

Redundancy and reliability, however, have a cost. When designing a system you have to weigh costs and benefits to find a balance that meets the user requirements. Markets find dynamically a balance between costs and benefits through the price discovery process. Also in this case, network-enabled players that apply a decentralized approach have an advantage in situational awareness, speed of evaluating the situation and making decisions, and speed of execution have an advantage over bureaucratic, centralized and slow players.

Phil McDonnell comments:

Redundancy can be very good but there are some occasions when it accomplishes less than one might think. For example, most data centers have more than one server. But if they are running on the same electrical power system they are still vulnerable to the loss of that common critical resource.

Another example might be when the sources of failure are not independent. One example using two servers might be if both are plugged into the same wall plug. They are susceptible to common power surges and lightning strikes transmitted over the power lines. Even several computers connected via long network cables can be simultaneously damaged by the EM pulse from a nearby lightning bolt.



 The Chair has issued a challenge for anyone who can prove of disprove the existence of linear trend lines as suggested by Jim Sogi.

The first issue in doing a market study is to develop an adequate definition of what a trend is. Given that the idea is widely and perhaps first used in Technical Analysis it is good to start there. Tom DeMark, a widely known and respected TA guru, defines a trend line as the line connecting two bottoms in a price series. This, of course assumes one has a good definition of a bottom. He defines a bottom as a daily low which has the property that the low of the previous day and the low of the next day are higher than the bottom low. Thus it takes three days to define a bottom day. The most recent bottom cannot be known until one day after it has happened.

The idea of a trend line is to find the most recent bottom and then go back to the next most recent bottom. The whole pattern takes at least 6 days to work out and can be much longer because there can be an arbitrary number of days between the two most recent bottoms. Our own John Bollinger has confirmed that this is essentially what his understanding is of how trend lines are used by practitioners.

The theory of a trend line based on lows is that it acts as support. In other words the market will tend to stay above the line more often than would be expected by chance. It should be noted that nothing in the above definition presupposes an uptrend or a down trend. In an uptrend the second low point is higher than the first low point. And the difference per day defines the slope of the line. In a down trend the second low is lower than the first.

There is another type of trend line which is based on the highs of the day. A high point is defined as the high day between two adjacent days, whose highs are both lower. Again two high point days are required to draw a well defined trend line.

Mathematically it is always possible to draw a line between two points, so one should not be surprised to find trend line patterns in random data as well as real market data. The real challenge is to test whether they occur more frequently or less frequently. More importantly do trend lines have any predictive value either as measured by higher probability of a successful trade or a higher average return?

The study looked at 1800 trading days of SPY, the S&P ETF. This period started 100 days ago and went back 1800 days. It should be noted that the SPY was down 1.5 points during this period resulting in an average daily return of 0.00% to 5 decimal places. The study was further classified into four categories based on whether it was a high point or low point trend and whether it was an up or down trend:

Low  Up
Low  Down
High Up
High Down

The measure of profitability was the simple next day close to close return for the trade.

For trends based on Low points we have:

Trend   n     # Up   % Up      Avg Profit     Total Profit
 Up     204    109    53.4        -0.212        -43.23
Down    202    115    56.9        +0.031          6.33

For trends based on High points we have:

Trend    n     # Up   % Up      Avg Profit     Total Profit
 Up     182     86    47.3        -0.143        -25.98
Down    225    106    47.1        -0.050        -11.22

Most of the results showed about 200 pairs of trend points. This means that the typical trend point pair took about 9 days to form and thus had about 3 days in between points. TA practitioners would expect more days to be up after a trend point pair is put in place. There appears to be weak support for this idea because for both cases based on Low points the % Up seems slightly favorable. However this is belied by the fact that the avg profit for Up trends is actually strongly negative. Thus the preferred strategy is probably to fade the appearance of and up trend pattern.

For High Points the expectation is that the market has reached an extreme. Thus we expect it to fall back. In fact all the above does qualitatively agree with that premise because both the % Up and the Avg Profit are negative.

The key to all of this is to test the results for significance. Often one has noted that when a trend line is broken there is sometimes a dramatic drop. The import of this is not whether it is true or not. Rather if true then it implies a negatively skewed distribution. Thus the standard normal / log-normal assumptions may be too far off. For something like this then that argues that it would be better to choose a bootstrap test for significance so that we do not have to worry about the normality of our data.

That is the subject of Part 2.

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

Jim Sogi writes:

 Thanks Phil. The problem with defining a 'trend line' is that a rather random number of bars may or may not form the trend 'line'. More than two points would be needed to define a trendline as any two points forms a line, so it become totally random as to which points when only two define it. Then when not all lines touch the support line, then it turns random again. By the way, I was wrong. Random walks DO regularly form 'trend lines' to the naked eye.

One idea is to follow the a variant to the solution to the math problem Buffon's Needle  which determines the probability of a needle of a given length touching two parallel lines when its thrown down. The problem must be restated to determine the probability of a needle of fixed or variable length touching three or more points on a grid of timeseries points. Then the time series could be randomly simulated from actual data, and probability determined or randomly generated and compared to actual data. Here is a nice trailhead with the R code to visualize the problem.

If this code could be altered to solve the above variation, this might help solve this problem.

The solution may require limiting the time period to some defined time period such as a day, week or month so that the 'straw' has a defined length and require that the touches, touch within 1 point of an interval low to give a little slack as you do when eyeballing. However, there appear to be solutions to Buffon's Needle allowing for various or random length needle's. Perhaps Buffon's 'points' could also be lengthened to be short parallel lines that make up the time series, and use the formula to determine the probability that the needle (trendline) crosses three or more time series points to create the trendline.



 I don't understand why prices seem to chart out along a line along their tops or bottoms of the bars in a line. A random walk would not and does not do that. What is the function that makes it happen?

Victor Niederhoffer replies:

What we need to do is write a little essay on the linear thing of Jim's. He asks "why lines drawn between highs or lows tend to be straight in markets." Its a very good question. It reminds me of the work that The Professor and his student Chris Hammond did to test whether there were turning points or bear and bull markets in the Dow. An anonymous donor will give $500 for the best answer for this. Committee of me and Doc Castaldo and Jim Sogi to decide. I would point out that the above duo concluded there was no such thing as bull and bear markets, that the turning points were completely consistent with chance. My working hypothesis is that the same thing is true here.

Phil McDonnell responds:

One possible idea is the cobweb theory. In this, the declines come back to the demand curve which is a 45 degree line supporting successive bottoms. The upper bounds (the tops) are delineated by a parabola. The whole thing can be described by a difference equation. The following site describe the math and have some graphics. The graphs with the rising 45 degree line and the overlaid parabola above it are the most interesting.

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



I was glancing at the performance of the Vanguard family of funds today. Their REIT index fund is down about 26% YTD through March 23, 2009. According to Practical Speculation by our own Niederhoffer and Kenner there is a 50% correlation between REITs in one quarter and stocks in the next quarter. A quick eyeball check of the regression scatter plot in the book shows that this performance predicts something like a 12% move in stocks next quarter. Whether the move is up or down is left as an exercise for the reader. But pages 253-259 would be a good place to start.

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



 Given the current mortgage rates and the fall of the housing market, I want to purchase my first home. Since I am stationed at Fort Hood in Texas, I have been doing heavy research in the Killeen / Harker Heights area. I thought I would ask for some advice. I spoke with Tim Melvin about this earlier, and he mentioned that I should never pay more than 10 times the annual rental rate of comparable houses. Does anyone else have any other good valuation metrics like this or have any knowledge / advice that would help me out as a first time homebuyer?

Legacy Daily replies:

I have found 10x to be used in two cases:

1. High house prices relative to rent — get one to cool off and think more clearly about an investment and do additional homework 2. Low house prices relative to rent - get one to jump in without thinking clearly on a "bargain" investment without doing any additional homework 

Some initial questions worth clarifying:

1. Is this a home or a leveraged investment? a. home — ignore rules like this and find the best place to live, raise a family, pursue happiness… b. leveraged investment — do enough homework to be confident enough about the decision to ignore all general rules.

Assuming investment:

2. What is the holding horizon? What future plans could interfere with that holding horizon? 3. What is the appreciation potential for the country, state, county, city, town, neighborhood, subdivision, this property…? I have not yet been able to come up with sufficient justification to buy for income alone when it comes to residential real estate. 4. What segment of rental market would the property (subdivision, neighborhood, town, etc.) attract? Is that the segment one wants to serve? Real estate agent needed to rent? 5. How predictable is the income stream? How would economic booms/busts affect it?
6. What are the worst case scenarios? What could go wrong?
7. Financial analysis — P&L, tax impact, financing options, downpayment flexibility (very illiquid), initial estimated repairs, etc. 8. Legal analysis — zoning issues, easements, property title issues, locality department issues, neighbor issues, etc. etc.

Couple additional points:

1. Decent real estate attorney representing one's interests can save from numerous headaches (especially true in foreclosure/short sale cases). 2. Avoiding a buyer's broker saves one money, gives additional negotiating room, makes the seller's broker more willing to work extra hard for the deal. 3. Inspections are money well spent, even if one does not end up buying the property. 4. The market is generally very efficient (yes even during this recession). Why has the property one's considering not sold yet? etc.

I hope you find this useful.

Jim Rogers writes:

The rule of thumb I've heard used is 1% of sales price should be equal to or less than comparable monthly rent (that's a little more aggressive than Tim Melvin's measure, especially when you factor in the mortgage tax shield). I'd say, use either and stick to your guns.

Sam Marx replies:

Don't trust what the real estate broker says about a house's value or price. Do your own research.

Try to find prices of recent sales of similar houses in same neighborhood.

Check with the local banks to see what houses they now own and what are their asking prices.

If you can go to foreclosure sales, do it, not to buy a house but to get an idea of what the market in houses is and remember those prices when negotiating with a broker.

I don't recommend buying at a foreclosure unless you're experienced at it.

Don't be shy about making offers 25-30% below asking price when dealing with a broker.

Watch for estate sales, the heirs are motivated sellers.

I don't know your area, maybe it's reached a bottom, but in FL, housing prices are still too high. The stock of St. Joe Land (JOE), FL's largest landowner, was 69 a few years ago — now it's 15.

Phil McDonnell advises:

 Buying a first home can be a frightening prospect. It should start with a realistic look at your needs. How many bedrooms and baths do you need now and in the future? If your life involves one or more women strongly consider the extra bath. If you have the skills a fixer upper my be of interest.

I frequently advise my Realtor wife on the statistical aspects of our local real estate market. Pricing in this market is especially tricky. It is a declining market but that also means buyers have much more negotiating leverage. To measure your local market ask a local Realtor for the latest stats on number of homes on the market and number of sales in the last few months in your area of interest. For a normal market this is about a four month supply of homes at the current monthly sales rate. In this market it is running about 10 months of inventory per home sold. Hence the declining prices as sellers compete. One should consider staying out of the market until the inventory show signs of declining. However do not be fooled by a one month decline in local inventory. Buyers in the Seattle area are negotiating prices an average of 4% below asking. Get the similar number in your area.

As a buyer in this market it is best to view the prices as a price distribution. Suppose we have ten houses in your area. But only 1 will sell in the area in the next month. Clearly it is most likely to be the one that offers the best value on a relative basis. The other nine are over priced for these market conditions. By staying on the market for another month they will probably lose something like 1% in value per month.

There is an old saying in real estate. One should buy the least expensive house in the neighborhood. Generally this is true. After numerous regressions on homes it can be said that among comparables the most important single factor is square foot of the house. For the best resale find out which area has the best schools. Even if you do not have kids the people who ultimately buy your home may have them and it will help resale in the long run.

Check out all the government mortgage deals and tax subsidies. They are offering a tax credit of up to $8,000 for first time buyers. 30 year fixed rates are below 5%. The military may offer even better deals. Remember the $8,000 credit is only paid the following year via a refund so you do not have it to use as a down payment. It is more beneficial the smaller the house you buy. I saw a recent home sold for something like $80,000 in Killeen. The $8k represents 10% on that home, but only 5% on a $160k home.

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

Henry Gifford adds:

Home prices, in general, are still falling in the US, therefore waiting will probably bring lower prices.

As property prices fluctuate, one sign of high prices is easy loans. Times when prices are better tend to be times when loans are hard to get, with of course reasons for this relationship. But, as an affiliate of the military, there are sometimes special deals available to you that are not available to other people, which means you can be one of the few buyers out there at a good time to buy. Some of these loan deals only exist on paper now, as the price limits and interest rates make them impractical, therefore nobody talks about them, but because they are government programs which get updated slowly, and usually out of sync with the market, they can be really good deals at times. Therefore there may come a time when you can get both a good price and a good loan.

Buying near a military base involves risk of base closure (I owned a whole bunch of houses near a base that closed) or downsizing, and since you're in Texas where there is lots of land, upsizing the base won't put much pressure on prices - people will simply build more houses. Perhaps you can ask around inside the gates to get a feel for this.

Buying and selling property involves large costs for brokers, taxes, title insurance, etc., which penalize short term ownership, meanwhile you can get transferred to another base at a moment's notice, which puts you in the position of being in a hurry to sell. If, instead, you buy a commercial property, you can own it as long as you live, with far less management headache, which makes owning it while living elsewhere more realistic than renting a house to someone.

Phil McDonnell responds:

I think the truth in this statement is based on a defect in the way people perceive value. Suppose the average home in a neighborhood sells for $500k but yours is worth $400k. Then if the average goes up to $600k the innumerate masses will think that all homes have gone up $100k not the 20% they really should have. When they do this the $400k home appreciates by 25% not 20%. In other words people add when they should multiply by a percent increase factor.

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

David Hillman writes:

Another part of that defect is focusing on the value of the improvements v. the value of the land.

Some years back, a close friend bought a lousy house on a great piece of property in the best neighborhood. Even though it was a prestigious address in a 'branded' area, he got a deal on the property because the house was so undesirable. The plan all along was to demo the house and built a new one to suit, which is exactly what he did. He had realized the land was worth perhaps 90% of the true total value of the property before the new construction.

Many county auditors, etc. have searchable tax records online with the assessed values of land/ improvements parsed out. One might use that to figure a reasonable estimate of market value of land v. improvements. Don't forget the old saws apply….'land, they're not making any more of it'….and….'location, location, location.'

Bill Egan writes:

In the last 10 years, I have bought three homes and sold two. Did not plan to, but that's the way it worked out due to job changes. Sold both houses in < 1 week for a profit despite forced timing. We were not in subprimeville, either, and the last sale was 2001 before the real estate madness.

My wife and I kept resale value in mind because you never know what can happen to you. We made sure we bought homes that were average to excellent on the following criteria:

  1. School quality
  2. Exterior appearance and interior layout — good and normal
  3. Quiet, safe neighborhood that looks good
  4. Reasonable size (3/2 or larger)
  5. Likely demand due to commuting routes/distance to jobs

For example, I was working at a biotech in NJ from 1999-2001. We bought a 3/2.5 in a newer development, nice neighborhood in Burlington County, right next to an average-quality elementary school. However, the area was less horridly expensive than the homes closer to Princeton, where I commuted to. There was strong demand from people priced out of the homes closer to NYC/Princeton.

Rich Bubb replies:

1.  look at the neighbors. C-L-O-S-E-L-Y… look at the state of their domiciles (even getting "invited-in" for a look see if at all possible), and the state of the upkeeping… especially the immediate next door folk. You might end up living next door to your own personal nightmare. Believe me, it is Not Enjoyable. Even after almost 20 years. Thankfully everyone else on the entire block is somewhat more sane and respectful of their neighbors than my nextdoor nightmare. Or to put it another way: you might get the best deal that no one else could stand…

2. if you really know somebody in the real estate biz (my sister is an agent), have them look around for you. she got her daughter's family a fabulous deal in a great neighborhood. Or to put it another way: sometimes real professionals Do Know what they're doing.

3. look long at the deal, bid low for the deal (Game Theory might help a little here, here is a cool intro), then be prepared to walk away… even if not doing the deal means you'll have to go back and start the whole search-etc process all over again, and don't put pressure on yourself or let anyone pressure you into buying. My wife was not prepared to walk away from her last car purchase. She still got a good vehicle, but she could've strengthened her bargaining position by uttering the words, "Let me think about it." And then purposefully heading for the door. We went outside and argued between ourselves about leaving. She *wanted the vehicle*. It cost her almost $5k more than I wanted her to pay.

4. Consider the cost of long term ownership. I mean, Really figure it out… what's the cost of x, and y, and z, and can you afford it if those costs all hit at once.

5. Tangentially to #1 above, if there'll be kids living next door… would you:

(a) invite them in?, or

(b) chase them away?, or

(c) start scouting for really out-of-the-way burial sites?, or

(d) let them borrow your most deadly power tools?

Just mentioning this as my siblings and I were the 'b-c-d' and almost always the Never-more-than-once 'a'. And the neighborhood's less-than-model parents would often let their barbarians-in-training train at our place… Or to put it another way: your neighbors' kids might have fiends, er friends, worse than they already are…

Hmmm, karma might really exist…

Russ Herrold adds:

A anonymous blogger, 'Benjamin.Publicus' on Thomas Paine's blog  had this this observation:

… The author lives in a community that is (or was) at the epicenter of the mortgage crisis. The developer aggressively marketed the homes to young, first time home buyers, many of whom renters. No money down, own instead of rent, mortgage payments the same as the rent, etc, etc. The development was started in 2001, so the first wave of 5 year ARM's hit in 2006.

…and it goes on from there.

I have spoken to that author (and a couple others) about contributing to DailySpec, but he has been busy.

Dr. Herrold is Principal of Owl River Company, a high-end Unix consultancy

Rich Bubb adds:

As mentioned previously, my sister is a real estate agent. following are her comments on home shopping & buying.

Get a Real Estate Agent to represent YOU as a BUYER. Sign a contract as such. Tell them what YOU want.

There are surely things important to you that you would like to have in one of the biggest investment decisions you will make.

TAKE NOTES of likes/dis-likes of each home you view. re: Basement, Garage, Four Bedroom, Square Footage, LOCATION. I stress location because it can make or break the satifaction of your purchase.

Drive through the neighborhoods you are considering at different times of the day to see what the atmosphere is.Pay attention to the neighbors up keeping of their property. Schools?, established neighborhood?, new additions? child / adult ratio?
Comparison shop, don't just jump at the first home you look at just because you can afford it. Ask your agent to provide you with a CMA (a market analisis of a surrounding area - 5 mile radius ).

Get pre-approval from your lender, look at homes a bit higher than your range and offer LESS - the worst that can happen is, they will say NO or counter-offer and you may wind up with a nicer quality home.

BE Strong in making the decisions of your offers. Be prepared to give and take.

Then BE PATIENT thru the purchase process which seems like it takes forever because we are a see it, buy it, want it now, kind of people. It is a process that is in place to protect you. re: CLEAR TITLE

Again, don't just settle for a home, get as close to what you want as possible.



 Here's an investment theory. Rather than buy when the expectation is greatest, buy when the risk is the least. The question is whether or not they are the same times. I define risk as the lowest probability of account drawdown from entry, rather than common definitions of volatility. A corollary of this is that buying at what appears to the public as the greatest risk is actually the time of least risk. A recent discussion here looked at expectation of range vs expectation of change. The theory of the least risk would be to buy at the expected maximum extension of range, at the time of greatest expectation. The other issue is the holding period and expectation of gain. Some argue that the maximum expectation period over time will reap the highest returns. The problem is that the deviation goes up as fast if not faster, increasing risk. The second problem is the issue of changing cycles and prior history may not match future performance. Dr. Phil has pointed out that profit stops reduce deviation but not necessarily rate of return. Yet account deviation is the bottom line. He has proposed formulas to optimize risk/loss vs return. But realtime trading demands some sort of realtime system. This is hard to implement. The underlying idea is that management of risk is more important than maximizing return. This has been the basic systemic flaw in the recent boom and bust. The idea is distinct from the idea of leverage as risk. The answer will differ from individuals to institutions and funds with differing goals.

Martin Lindkvist comments:

Try creeping commitment, that is, start with a small line and increase if market goes in one's favour. But this has a built in assumption of some kind of trending behavior of prices, which might or might not be true depending on other circumstances.

A twist to the creeping commitment of a single position is to start out a period (year, or other of your choice) and increase risk taking after profits have been made, and decrease if losses are incurred to the capital at beginning of time period; that is play harder with "market money". I believe that both this method and the first one might have some psychological benefits if nothing else.

Risk in the usual deviation sense has sometimes been disguised, through e.g asymmetrical strategies ("picking up nickels in front of a bulldozer") where the risk might seem far away only come back hard when least expected. Moral - one should always be suspect when one thinks one have found a good way of managing risk - "what am I missing". Liquidity issues comes to mind too.

Using leverage as the risk manager, still seems to me the most clean way to manage risk. Cutting off risk with stops or options also is a way but run of the mill costs for these should be higher over time. That doesn't matter though if you meet black swan on day one….

Phil McDonnell writes:

A knotty part of this question is to define risk. To academics it is probably something like standard deviation of returns. To traders it may be only the losing trades, in other words only the downside deviations need to be considered. Another metric might be draw down or maximum loss.

The risk measure one chooses makes a big difference. For example suppose we look at the standard deviation of the market after it has been rising for a while. Assume our criteria of rising is that the market is above its 200 day moving average. We would find that the risk measured by the standard deviation is less for all such periods than it would be for those periods which are below the 200d moving average.

When markets approach major bottoms they are often quite volatile. Currently we often have daily moves of 3 to 5%. If one were to study the subsequent behavior the probability of large down moves the next day are quite high as are the chances of large up moves at such times. This is true even though one can often argue that after such large declines the market is close to good value levels and has not much more to fall.

Note that one can get two different answers to the question depending on time frame. At a low area such as now, the long term risk outlook might be that it cannot go much lower. But because of volatility the short term outlook is for continued riskiness.

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

Legacy Daily replies:

As for this statement, "Rather than buy when the expectation is greatest, buy when the risk is the least," the risk of not being in the market is the least (assuming cash is constant). Perhaps you mean "buy the highest expected return for the lowest risk." Theoretically, "maximize return but minimize risk" may be suitable for a linear programming model where one would need to define the various constraints and let the machine solve for the best alternative to maximize return given the constraints. The challenge: the right definition of the constraints. Also, the optimal solution may change tick by tick.

And as for this statement, "a corollary of this is that buying at what appears to the public as the greatest risk is actually the time of least risk," I think many market participants buy and hold. Therefore, the main reason a market appears a great risk to them is because their money disappears. The more money disappears, the greater the fear (hence perception of risk). It also seems that these "emotions" are only visible during intermediate-term/long-term market turning points which may not be suitable for a day trader.Furthermore, "time in the market" and "percent invested" are also ways to increase/decrease risk when account balance rather than security price volatility is the key criteria. Account balance is an extremely useful risk manager. AUM does not have the same effect.I cannot remember where but I came across the concept of a very successful trader at one point or another getting completely wiped out and some being so good that they could build a fortune multiple times and get wiped out more than once in a lifetime. If true, is that possibly a manifestation of "buy when the expectation is greatest" with not enough focus on "when the risk is the least?"



 Actually this is a tricky question: Even after defining a bear market, could a given decline have occurred by chance — given a random arrangement of returns? One aspect of a bear market could be down weeks clustering more than would be expected by chance, giving rise either to more frequent or deeper declines.

4194 DJIA weekly closes were partitioned into non-overlapping 40 week periods. At the end of every such period, calculated the maximum decline as:

min(this 40) / max (last 40)

Done this way the maximal decline could have been as long as 80 weeks or as short as 2 weeks; the idea was to capture large drops over various periods of interest to investors.

A simulation was used for comparison: The same 4194 DJIA weekly returns were resampled 100,000 times, and multiplied ("compounded", without dividends) out to produce a 100,000 week series. Like the actual market history, the series was partitioned into non-overlapping 40 week periods, and every 40 weeks min/max was calculated for the current and prior period.

One definition of a bear market is "a decline more than 20%". In the actual series, such declines occurred in (a surprisingly high) 26% of 40 week intervals (27 out of 104 40 week pairs). If this were more often than random, it would have occurred more often than in the simulated series. However in the simulation declines more than 20% actually occurred 32% of the time.

So if anything, declines of 20% or more occurred less often historically than by chance along.

But what if 20% is too arbitrary to capture a bear? In the actual series, here are the 40 week pair declines above the 95th percentile (ie, declines worse than 94.2% of the rest):

Date    40 min/max
06/20/32    -0.751
04/03/33    -0.642
09/14/31    -0.564
12/08/30    -0.542
03/02/09    -0.499
08/15/38    -0.469

The mean of these 6 40 week pairs is -58% (all but 5 from the depression). In the 100,000 week simulation, the 95th percentile is -34%. The actual 95th percentile and above mean of -58% is lower than even the worst simlated 40 week pair decline of -56%, which was the bottom of 2496 pairs (99.96 percentile, like the Obama cabinet SATs).

The worst 5% of actual 40 week pair declines dropped much more than would be expected by chance arrangement of down weeks. This is consistent with "fat tails" (at least on the downside), but you have to go out further than -20% to see it.

Alston Mabry comments:

Great study, Dr. Z. One thing I would want to explore would be whether in the simulation process, one intermixed different volatility regimes. That is, in the actual 4194 weeks, you may have periods of high volatility and periods of low. High volatility periods would have larger moves in absolute terms than would low volatility periods, and if the simulation mixed them together, the simulation might tend to produce lower volatility overall - this might account both for more 20% moves but fewer +50% moves. If this were a problem, one solution might be to normalize all the weeks against some preceding period, say 52 weeks.

Kim Zussman replies:

 Knowing that volatility clusters, if one is resampling a long data series this gets shuffled up. So you'll get 4% days near a bunch of 0.2% days (though the stdev of the whole series should be the same -shuffled or not). But if the question is whether the market has structure which is not random, does it make sense to stipulate whether you are in a volatile regime or not? Relatedly, maybe sticky volatile regimes translate to down markets, which is kind of the point.

Alston Mabry responds:

Exactly. To be precise, what I'm saying is that the fact that the simulated distribution produces more +20% moves but fewer +50% moves is simply an artifact of the shuffling process, especially when you shuffle individual weeks and then use 40-week stretches for calculating results. I'm thinking that the shuffling takes the actual distribution of % moves and increases the kurtosis and pulls in the tails.

This is not arguing against the hypothesis, just questioning that meaningfulness of the % comparisons.

Charles Pennington adds:

Prof POne uncontroversial hypothesis that might unify and explain many of these studies is that "markets get more volatile after they've gone down".

If you compute the skewness of the weekly or monthly returns of the Dow since 1929, it's quite negative. However if you take those same returns and divide them by some measure of the volatility over the following week(s)(*), then you'll find that both the skew and the kurtosis are close to zero, i.e. it's similar to a normal distribution of returns. That means that someone trading backwards in time, i.e. he has next week's newspaper but not last week's, would experience safe, non-Black Swannish returns if he just adjusted his position size for the volatility that he had experienced in his recent future.

* for example, one might use the following week's high/low range, 100*(h/l-1), or the average of that quantity over the following N weeks, where N is "a few".

To illustrate, here is a model.

First, create a series of random normal numbers with standard deviation 1, with one number for each trading day.

Now, use the following rule: "If the average of the last three days' numbers is negative, then today's return is 2 times today's number. Otherwise today's return is 1 times today's number."

I ran 2500 simulated trading days using that rule, and it gave 715 5-day maxes and 622 5-day mins. That's similar to what the Chair reported for the market.

More generally, I suggest that whenever you see one of these apparent anomalies of "market falls faster than it rises", try to see if it can be distinguished from the uncontroversial hypothesis that "volatility rises following down moves".

By the way, over the past 10 years, the standard deviations of daily returns of SPY under two scenarios:

all days 1.39% after up three-day move only: 1.17% after down three-day move only: 1.61%

Kim Zussman replies:

The simulation made the skew and kurtosis go away.  Here for the 40 day min/max both from actual series and simulation:
Descriptive Statistics: min/max, sim

Variable   Mean     StDev      Min    Median   Max       Skew
Kurtosis         N
min/max  -0.1435  0.1463  -0.7506  -0.1134  0.0313    -1.70      3.66
sim         -0.1604  0.1008  -0.5576  -0.1504  0.0654     -0.53
-0.04         2496

Even accepting there could be non-randomly down markets, this is a different question than whether they can be predicted.  So a small decline results in higher volatility, and trading smaller long positions can be on average profitable.  But some of the small declines go on to become big ones, and its hard to tell one from another.  Using stops (physical or otherwise) is tuchass saving, but it's hard to know whether "cutting your losses and let profits run" is worse in theory or execution. Which doesn't preclude that others can discriminate good from bad dips, or that they found work-arounds using opportunities independent of short term decline-reversal.

Phil McDonnell writes:

It may be helpful to look at the underlying hypothesis a little more closely. When we randomize by individual time periods we are deliberately randomizing any period to period dependencies. I presume that this was Dr. Zussman's point. Thus we are implicitly testing a null and alternate hypothesis something like:

Null: The original distribution or returns is similar to the distribution of a randomly ordered sequence of returns.

Alternate: The original distribution is not similar to a randomly reordered sequence of returns.

One good test of the difference between distributions is the non-parametric Kolmogorov-Smirnov test. Also one can use the more powerful D'Agostino test.

Another way to preserve the known autocorrelation in variance is to perform block resampling. From memory I believe the autocorrelation fades after about 35 days or so. Block resampling of 40 days should keep something like 97% of the variance autocorrelation and even other unknown dependencies even non-linear effects in that range. Comparing the distribution of the original returns to the 40 day resequence might tell us if there is something non-random even beyond the 40 day block level.

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



 These days all one hears is hundreds of billions here, trillions of dollars there. It almost seems like the B and T keys must be getting worn out. At the very least any politician who doesn't think in terms of billions is clearly not a visionary. Since we do counting here perhaps a little back of the envelope counting is in order. Suppose the government were to guarantee every sub prime mortgage out there. What would happen and how much would it cost? Clearly every sub prime mortgage would dramatically rise in value perhaps even higher than the value when they were issued. Their value on the bank balance sheets would rise dramatically. In many cases 3 fold to as much as 10 fold. Suddenly the banks would be wonderfully solid and flush with money. This massive infusion of capital into all the banks would come without a dime of Federal capital injection.

Just because the government guarantees a loan does not mean that the homeowners would or could keep making all his payments. Some will certainly default. Suppose also that the Government took over all such homes and kept them off the market for the duration of the current unpleasantness. Real estate would turn around much faster without the burden of more new homes being sold in foreclosure. Foreclosures would actually decline because a rising real estate market would give homeowners more skin in the game. But what would the cost be? There are 109 million full time homes in the US with $8T in mortgage outstanding. Supposing that the average mortgage is about 6% then the average payment is about 0.5% per month. This amounts to $40B per month. But in the 4th quarter Bloomberg reports that 0.83% of all mortgages defaulted. So the government would only have to $332M in new monthly payments every quarter. It is somewhat embarrassing to write a number as small as millions these days. Millions are so Twentieth Century! But the reality is we could save real estate, the mortgage market and banks by just making relatively small payments over the next few months.

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

Stefan Jovanovich comments:

Our Dr. Phil's definition of "the banks" is interesting. It includes (1) the borrowers and implicitly (2) the counter-parties to Citi and the other Tennessee Williams banks' outstanding swaps, asset-backed paper and other promises and (3) the bond-holders for these wonders of financial construction. The one group that has been left out of the discussion so far have been those terrible villains of the present economy - the people who insist on saving instead of borrowing and spending money - aka (4) the depositors.

The FDIC has made a belated move to acknowledge that their reserve fund and the contributions of the healthy country banks will not be enough to save the money center bank depositors. As recently as November they were still pretending that everything was OK; now they are realizing they better get in line at the Treasury window if they expect to be able to avoid a bank run. The current increased guarantees for the people who put money into the banks expire at year end. The Treasury barely has enough credit left to make good on its indirect promise to the depositors. If, as Dr. Phil suggests, the "banks" and their mortgagees are going to be allowed to have priority, everyone who can will swap their checking account balances for T-bills and cash. (No doubt Paul Krugman will then decide that it is declining velocity that is the problem.) Having already seen the rerun of 1930, we will see 1933 all over again.

The "crisis" is one that businesses face every day but that most academics literally have trouble understanding (it must be that they can endlessly recycle those same old lecture notes) - namely, the market had changed and a lot of inventory has gone bad. You can changing the price tags on the shelf all you want; no one is going to buy them for cash.

George Parkanyi writes:

I agree with Dr. McDonnell. Western governments should guarantee MOST of the paper (not the worst of the pure sub-prime stuff that's basically uncollectable - something needs to be written down) - at maturity, and not buy it outright now. In fact I would make the interest tax-free in the US, and get the Europeans to do the same in Europe. Make them government muni-bond equivalents.

I would even re-securitize them (make them collateral) for essentially new standardized government Treasury mortgage and asset-backed securities - that would then be traded openly on exchanges - with associated derivates like futures and options created (think the T-Bond or T-Note markets) so the owners can risk-manage them. Banks and financials could then move them off their books over to investors, who would have collateralized government securities - ironically now more safe than unsecured Treasuries.

For all the billions being thrown at the problem, surely a billion or two out of that could buy a lot of accounting and book-keeping horse-power to document, track, and value the "collateral" - the income streams from the mortgage and loan payments, and the value of any re-possessed assets. Create a single clearing house for all these securities that come into the program, managed with a war-time urgency as a matter of national security. The current income, and recoveries from property sales, would fund the first waves of re-payments as they come due. This would serve to defer the un-secured at-risk portion of the total package well out into the future, buying time to resolve all this leverage in a more orderly fashion.

Then move toward solving the structural problems. Still allow financial engineering, securitized products and derivatives, but never again unregulated, off-exchange, or off-balance sheet.

Legacy Daily replies:

I just cannot figure out how the numbers work.

According to this, mortgage debt outstanding is about 15T.

Based on this article around 11% are delinquent.

If government guarantees 1.65T, at 6% average that's 8B per month? Ignoring moral hazard (since already ignored anyway), we still have the issue of 11% increasing as a result of unemployment.

Giving a government ability to hold real estate at a large scale is only a leap or two away from certain factions pushing to "increase" the living standards of the proletariat (similar to what created the sub-prime fiasco in the first place) at the expense of others. With all its issues, the current system of private real estate ownership is a key factor in protecting freedoms. I am sorry but I see many negative "unintended consequences" in the proposals mentioned.



 A LoBagola, as described in The Education of A Speculator by Dr. Niederhoffer, is a phenomenon whereby a market makes an historically large run in one direction, usually up, and then at some unpredictable point begins an equally extreme run back to where it started.

Some recent cases in point would include virtually every asset class there is. Most certainly oil and other commodities have retraced much of their spectacular run ups. Stocks have now retraced the last 12 years of gains with no bottom in sight. Real estate is another prominent example.

To understand LoBagolas we need to understand how they start. They start with some early optimism. Things start improving for a certain stock or asset class. Some early profits are made as more investment dollars chase the emerging bull market. These profits add to account equity and can be used to compound returns through increase margin borrowing. In futures there is not really borrowing but the effect is the same - investors can take larger positions as prices rise. In effect there is a feedback mechanism. Higher prices result in even higher prices as more leverage is added.

But when the price finally cracks the effect is reversed. The first selling causes some short term holders to exit resulting in a further decline. At some point the decline reaches the level where the latest thin margin players are forced out. This results in another round of feedback selling. As prices come down it almost seems like they break in waves. Each successive wave forces another round of margin calls and forced selling. Finally the entire bull run is retraced. All the new holders who were enticed in by the lure of quick profits have been forced out as the whole bubble unravels. That is a LoBagola.

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

Victor Niederhoffer writes:

The question about LoBagola, especially since he was a charlatan, is whether the migrations that he described with an exact retracing of the path but variable in time exist to a non-random extent. How can this be tested, and what predictive value does it have? The picture of me in the WSJ with Lobogola overlaid did give James Lorie the biggest belly laugh of his life and for that it is undeniably valuable.



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.




 The current Administration is very concerned about the poor and the middle class. But little concern is expressed for the upper middle class or as the Administration likes to call them 'the rich'. One wonders if there is a downside to this asymmetric outlook.

About a month ago the National Association of Realtors again called for an easing of terms on the large jumbo mortgages. Their argument is that the upper end of the market has seized up. In fact the data bear this out. In the upper end very few homes are being sold because of the difficulty in getting financing. Only cash buyers are nibbling and there are very few of them.

For example in the Seattle market in some areas there are 30 homes for sale but only one will sell in a given month at the high end. At the high end prices are not necessarily coming down at the rate the Case Schiller index claims. The sellers are not making concessions on a comparable same house basis. Rather, what is happening is that they are financially able to hold on hoping for some light at the end of the tunnel.

So why is there a disconnect between what the Case-Schiller and other median type indices say and the ground truth? Let's take a simple example of a neighborhood with 5 homes sold at the following prices (in thousands of dollars) :

Median = 700

Let's say that was a year ago. Now pretend that the exact same houses are sold for the exact same prices with one exception. There are no transactions above 750 because of mortgage financing issues. So now we have only homes below 750 that are sold at the same prices at which they were purchased:

Median = 600

So comparing medians one might superficially conclude that in the last year that home values have dropped from 700 to 600. But we know that the prices in fact are unchanged from the year before. The point here is that the drying up of mortgage financing at the high end has created an appearance of a greater decline in real estate prices than has actually occurred. The fix is simple and obvious. We must relax rules on high end mortgages and allow that market to function again. The interesting thing is that it will reverse the statistical anomaly and create the perception of a real estate price increase. Most importantly it will not cost the government a single dime in bailout money.

Jason Thompson writes:

J TAs a prospective home buyer that has thus far legged the trade the right way, I've been doing a lot of counting in the arena of luxury homes — following the higher end of the market in my current locales, Chicago and Reno/Lake Tahoe, and a future destination, southwest Ohio. Though I'm leaving Chicago as I've tired of the nanny state and sky-high taxes (10.75% sales tax anyone, or how about a $125 dollar parking meter fine?) I admit I'm going to a place not much better, Ohio, though at least there I will be next door to my kin. While what Dr. McDonnell says about the state of the jumbo mortgage market and the lack of compromise on pricing back to reality is largely true, his observation that easing credit will fix this is not.

Rather, there has been a collapse in the pool of buyers, combined with a glut of custom built homes by small builders that have populated the exclusive suburbs of this country for many a moon. Further delinquency checks call in to serious question the belief that these "homeowners" (they don't own anything, rather are renting from creditors) have the staying power to remain in their homes.

One market I am now knowledgeable about is Indian Hill, the most exclusive suburb of Cincinnati. Median income is $188K per household (its $47K per for Ohio overall) and median home value was $1.1 million in 2007. There are around 6K residents, enough of whom wish to sell their house such that there are 338 listed homes or prepared lots (80% are completed houses). Based on 2008 sales levels, Indian Hill has 11 years of home inventory, yet based on transacted prices, "values" are only down 18% from 2007 levels which were in-turn flat to 2006. To me this is beyond nonsense, especially when some smart sleuthing can determine 90+ day delinquency rates for loans in the 45243 zip code is rising faster than the DJIA is falling. Market clearing prices are likely 30-40% lower, just to adjust to the wealth effect, not to speak of executive level job losses and the imminent sale/forced merger of FITB.

Albeit it is a sample of one market, but it is in the Heartland of America and as Ohio goes so goes the nation, no? What rose-colored glasses should I be using if above not correct?

Kim Zussman comments:

It's relatively easy to look up foreclosures/REO in your area of interest. Realty-Trac sells lists of these (notice they don't call it "Reality"), and the ghost of Countrywide has about 20,000 nationally:

Prices won't bottom until there is no one left with money or interest to buy, and judging by the size of the recent bubble that could take some time. The wealth effect should work both stocks –> housing and vice versa.

Upscale homesellers of coming years have the same problem as stock-invested boomers: sell to whom?

One can quibble with Shiller's methodology or his optimism, but he is certainly on the short list of market timers of the millennium.



Not only was the S&P drawn to the magic 700 round but others were as well in odd ways. The Dow index was down almost exactly 300 points on the nose. The NASDAQ was down almost exactly an even 4% (really 3.99%). Somehow it does not seem random. Even though one was price level, one in points and one in percent change, still all were quite round.



SageI recently did a very crude estimate of the value of Warren Buffett's puts betting that the price of the S&P would be above, relative to their price at trade entry. Conservatively, they're roughly up 3.5-fold, using Bloomberg analytics.

Phil McDonnell writes:

A similar back of the envelope estimate shows that his short puts are up by at least 1.5 fold using current volatility estimates.  Given the rise in volatility the puts are more likely up something like 4 fold.  Thus the write-off should be something like $5.5B * 1.5 = $8.5B (at a minimum).

In a Yahoo article yesterday it was reported that Buffet received $8B for the puts he sold.  So on the higher end the exposure might be $8B * 4 = $32B.  In any event the current write off clearly seems to be understated.

The Oracle espouses such virtues as clean accounting and a preference for mark to market accounting.  And yet, the companies he owns are not marked to market for the most part because they are not publicly traded.  Thus they continue to be carried on the books at a valuation determined by the Oracle.  If we use the S&P as a reference, the market value of the typical company has fallen by something like 50%.  BRK carries something like $250B in operating assets (excluding cash).  Thus it is reasonable to estimate that if his portfolio of companies was marked to market that it has declined by about $125B in current market value.  If this loss was taken today it would more than wipe out the $120B of equity that the company claims.

There are other hidden gems on the balance sheet.  For example one wonders what $4B in deferred long term asset charges are.  The $34B in Goodwill basically represents what the Oracle over paid to buy his companies.  In the current environment one wonders if any of that is left.  The $17B in deferred liabilities remains another mystery.

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

Michael Cohn comments:

The sale of puts was hardly free — just look at Berkshire's stock performance. However, what makes this strategy tenable for Berkshire was that he does not have to post margin, unlike 99.97 percent of counterparties on this trade.  This is the major advantage that allows him to play long term nominal drift and benefit from survivorship bias.  Had anyone else sold those puts they already would have been downgraded by rating agencies.



 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



 Much of the creation of money over the last 15 years was induced by low Japanese interest rates on the order of 1% per annum. However since March of 2008 the Japanese money stock (M1) has fallen year over year in every single month.

In the US, part of the problem is the inherent contraction in money supply caused by people repaying their loans. When a loan is repaid money disappears from circulation.

There is another more insidious problem in the economy these days. It is really a form of fear. Everyone is afraid to make a decision, to invest, to spend or otherwise do something with their money. Thus the money that does exist has largely frozen up. This is best measured by the velocity of money also called the money multiplier. We recall that the multiplier is not an observable number but is simply given by the formula:

G = V * M or V = G / M

where G is the Gross Domestic Product, V the velocity and M is the Money Supply, in this case M1. The latest data shows that velocity has fallen from about 1.6 a year ago to .88 in the most recent numbers. A number below 1 means that the average dollar of M1 is turning over less than 1 time per year. A chart can be viewed at the St. Louis Fed site.

To compensate the Fed is aggressively easing M1, the monetary measure they can influence directly. In just a few months they increased M1 from 1.4 trillion to 1.6 trillion, an increase of $200 billion.

Part of the question of how we got here can be seen in the history of M1. On April 3, 2006 M1 peaked at $1402.5B. For the most part this peak was not exceeded and as late as Sept. 1, 2008 M1 was still at $1391.9B. That means there was essentially no growth in M1 for 17 months!

2006-04-03 1402.5
2008-09-01 1391.9 No growth for 17 months

Somebody at the Fed must have awakened from his snooze and noticed that TARP, TAF and alphabet soup was not quite working. So he started aggressively adding more than a trillion in garbage (the polite term) to the Fed balance sheet. This had the happy result of pushing more than a trillion in cash into the economy. So M1 money supply grew from 1391.9 in September to 1638.1 on Jan. 5th, 2009. The $1T bought us an increase of $200B or about 20 cents on the dollar. Don't ask where the other $800B went. After all they are still trying to figure out where the TARP money went.

2009-01-05 1638.1
2009-01-26 1548.2 -5.5% decline in January

More ominously during January M1 began to tank again. It was down 5.5% in January.

Looking at the broader measure of MZM, money supply with zero maturity we see that it has grown from about $8 T to about $9.3 T during the last year.

Thus M1 represents about 16% of the broader MZM metric. The current unpleasantness began with the decline in real estate and will not end until the real estate market stabilizes. There is more to be done.

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

Bud Conrad replies:

Bud CThe topic is one of great importance as to whether we return to inflation from the deflation we are experiencing, and when if it happens.

One of the problems in our fiat money system is that we have lost the definition of money. It used to be what we could turn into gold. M1 was distorted by the money market funds that replaced much of demand deposits at banks so under reported what was available for transactions. M2 included small savings. M3 had large savings. The Fed stopped reporting M3 which also included some strange measure of Eurodollar accounts and repos that they said they didn't want to spend the money to collect.

MZM seems the most sensible for the measure of money as it is accounts where money can be immediately used to buy things (Money of Zero Maturity).

When the M1 Money supply (Currency plus demand deposits including Reserves at the Fed) changes dramatically higher as it did from September because banks now have gargantuan ($700B) of excess reserves, which is higher than ever before even as a measure of GDP), it is logical to expect Velocity to decrease just from the increase in money supply. GDP is much less fast to respond, but was declining adding to the slowing of velocity. All we have done is let the banks hold a big bunch of money on deposit at the Fed, where they got the deposit invented out of thin air. The low velocity is not a reflection of consumer and business behavior, as much as it is a measure of money expansion. GDP movement was relatively, in % term small. The velocity concept is not wrong, it just shouldn't be a reflection of consumers, but a reaction of Central bank money creation that is stuck at the banks not yet flowing loans to the economy.

The measure to watch should be the Excess Reserves, which is declining some. As to whether this Fed buying assets is inflationary is crucial, and it is the lack of bank lending that eviscerates the Fed, as it is just pushing on a string. My own expectation is that foreigners may come back with their dollars accumulated form our trade deficits to buy real assets instead of financial assets to cause inflation. Such action would also increase Money supply measure sand be inflationary. But foreigners are reluctant to tell us that is what they are doing so we will only know after the fact. We would also see that action in the velocity measure.

Dr. Conrad is chief economist for Casey Research and teaches graduate courses at Golden Gate University.

Stefan Jovanovich comments:

These speculations assume that money is still somehow a "supply". Not now. It has become only a residual - the amount of stuff available to buy things and pay debts, including what can be instantly converted to legal tender. It is what is actually left over after businesses make or lose money, people borrow or save, governments borrow more than they spend. In an age of Bill Rafter and George Zachar and all the other smart people and smartly-programmed computers, central banks no longer enjoy the privileges of seignorage, nor can they conjure up "new" loans by using a magic wand to create reserves. Neither can the Congress and the Treasury "create" jobs using the magic wand of the multiplier. That is why Timmy looks so utterly helpless and Ben so tired. If you are looking for a physical metaphor for the monetary present, try water out here in the West. No one has yet to figured out how to make it rain; and when the ground supplies are depleted or the reservoirs not built and filled, you have a drought. Evaporation is not the source of your scarcity; it is simply the constant. Desalination, like "stimulation" (truly the appropriate metaphor for academic economics in the age of porn), offers the illusion of an answer but only if you ignore the fact that creating fresh from salt water is 2-3 times the cost of simply buying it from the people who have some to spare.

Bud Conrad responds:

Bud CI agree that there is no good definition of money, but the Fed can contribute to expanding the measures that are almost always included in the narrow measures of money, and then also therefore in the bigger measures. It seen best in conjunction with the real source of new credit (money), the deficit of the Federal government. The Treasury prints up new Treasuries. The Fed (usually through middle parties but leave them out for simplicity) creates a new demand deposit at the Federal Reserve Bank in the name of the Treasury out of thin air, in payment for the Treasuries. The Fed's books are balanced with more Treasuries as an asset, and a deposit as a liability that the Treasury can write checks on to buy bombers or pay Social Security. When the Social Security recipient deposits their check in their bank, the deposits of the whole banking system are increased. The usual narrow money measure is M1 that is basically currency plus demand deposits (checking accounts).

To be clear, If a foreigner with dollars from a trade surplus (our buying their products like computers) bought the Treasury, that would not add to the traditional money measures. That would then be considered that the Treasury borrowed the money for the deficit, rather than have it Monetized by the Fed. The distinction is probably over emphasized in money and banking texts, but the reason I bring it up is to be clear that the Fed can create what is generally called money.

You then need to know that the most of the money (demand deposits) is not created by the Fed. It is created by the banks making loans. The banks must set aside a little as a reserve against any new deposit but can loan out the rest. The borrower buys something like a house or car, the seller then deposits the proceeds, and that new deposit minus the reserve requirement can be loaned out again. In that fashion, banks make something like 6 times more money than the Fed does in total. The problem now of the Fed "printing" (= creating demand deposits out of thin air), doesn't work (have much effect), when banks don't lend. The Fed addition is not very big if the loans aren't made. That is called "pushing on a string", as we have now. And that is why we have deflation in the face of the most extreme Fed expansion and the Treasury $2 trillion deficit this year.

Dr. Conrad is chief economist for Casey Research and teaches graduate courses at Golden Gate University.

Legacy Daily comments:

It seems to me that a rosy outlook is in order. When the government and key "experts" say the worst is yet to come, I (and everyone else with me) fear to take on additional loans not knowing if 1) we can pay back 2) we'll make money from the loan. While the Fed/Treasury can create reserves (and pressure the bankers to state how much they're lending), unless there's increasing demand for loans, money will not be created to the degree it was created when every American thought they could buy a house and sell in a year with at least 20% profit.

Unfortunately, this type of shift in outlook will probably roughly coincide with the proverbial "capitulation" when I (and everyone else with me) can no longer imagine the situation getting worse. Until greed comes into the picture, money will not be multiplied to the degree it was multiplied in the past bubbles. The problem is that when greed becomes the key driver, we'll have incredible amounts of reserves - causing "sales" of money and the officials will be late to throttle back the system to prevent inflationary bubbles.

The "assets" are "toxic" because the outlook of getting the promised cash flows is negative. When that outlook changes (the poor guy who borrowed more than he should have sees the possibility of his house appreciating), the "toxic" will actually become like gold that never tarnishes.

What is the flaw in my logic?



 Dissent is good. There is no question about it. The free wheeling discussions are one of the finest aspects of this web site. But as we all know discussions can go down ratholes and become repetitive, heated or even personal. My observation is that this is more likely when the market is going down than when it is going up.

About a year after I had been participating in this web site I developed a personal rule to help me identify when a subject had been over-discussed. For me the rule was:

When I find myself repeating points made earlier it is time to disengage from the discussion.

By this standard the discussion on Commitment of Traders was still productive and worthwhile. For those who wish to learn more about Larry Williams's Commitment of Traders work a good start would be his latest book which is entirely devoted to the subject.

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



If one can predict the market then there are better techniques than Dollar Cost averaging. But DCA is a decent strategy if two conditions hold:

  1. One cannot predict the market.
  2. One has an external income source available to be invested regularly.

Leveraged ETFs can grind investors up in unexpected ways because of the daily rebalancing. I suspect he will see that these ETFs are the exact opposite of a DCA strategy. In DCA your investment buys more shares after a dip and acquires fewer shares after a market rise. Overall your average share price is below the average of the market prices.

Leveraged ETFs employ the exact opposite strategy. When the market rises they are forced to buy more shares. When it falls they are forced to sell shares to maintain their constant leverage ratio. The net result is they buy shares at an average price above the average of market prices over the period. Thus the levered ETFs use an anti-DCA and that is what causes the grind.

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

Larry Williams comments:

I would add a third condition: Markets make new highs.



The touchdown interception in the last second of the first half, changing the score from a likely 10-14 to 17-7, immediately brought to mind whether sports imitates the market. And of course the mistress had already thought of this going from -1/2% at 350 to +1/2 % at the 415 close on two occasions in the last 10 years, and the reverse on four occasions. In each case, the mistress gave the final outcome the next day, to the side that had the 3 50 advantage. perhaps to make it more realistic I should have reported 1150 to 1200 reversals.

Jim Sogi comments:

Don't forget the bad calls being reversed and changing the outcome. And the multiple fakes out of the hike. It just needs to fake one defender out to work. The full field reversals, like the 100 yard interception, feel like recent markets. Even at the last minutes of the game or quarter.

James Lackey adds:

As the regulators throw too many flags.

Gordon Haave responds:

I was thinking about the game in terms of stupid behavior that people engage in, over and over again. In football it is the "prevent defense. Teams play great D all game, then in the last five minutes shift to "prevent" defense, where they take out linebackers in favor of more backfield players. All it ever does in prevent the team from winning. This is why the endings of games are so high-scoring.

In the markets, people do all sorts of things to prevent them from losing lots of money, which only insure that they lose the game. Such examples include most of the technical rules, and the dollar-cost-averaging.

Scott Brooks replies:

What Prof. Haave is saying about dollar cost averaging is true if someone has a lump sum to invest. In that case, unless he thinks he can time the market, he should go all in. American Funds had a nice piece on this a few years ago showing two people who invested a lump sum each year. One did at the market high, the other did it the market low every year for a long time. Of course the person who invested at the market low each year got the best return, but the one invested at the market high still got an exceptional return.

However, DCA is not a marketing ploy for the masses, it is a salvation for them. It encourages them to invest on a monthly basis and be in the market each month no matter what the market is doing. It allows them to invest without worrying about the highs and lows of the market. It gives them peace of mind to invest when times are bad. It, quite literally, gets them excited about investing when the market is not so good.

DCAing is very important to Johnny and Sally Lunchbucket… even if they don't know it!

Also, Kurt Warner has been to three Superbowls. He's lost two and barely won one (see "The Tackle")

In both cases where he lost, it was the defense that let him down. I can't say for sure, but I believe it was the "Prevent Defense" that was at fault. In the case of "The Tackle", a porous defense came within 1 foot of losing the game as the clock ran out.

In each of his three Super Bowls, he played against one of the most highly rated defenses in NFL of that year. He and the offense did their job and scored enough points to win.

Kurt Warner should have three Super Bowl Rings in his collection instead of just one. Unfortunately, his defenses let him down.

Phil McDonnell adds:

The reason Dollar Cost averaging works is because it benefits from volatility. Individual stocks are more volatile than the averages so we would expect it to work better on the 30 individual Dow stocks than just on the Dow average itself. The fatal flaw in any strategy is that one needs to invest in stocks that do not go down. For DCA sideways is OK, it will actually make a little money. But if you put all your eggs in the Enron basket you are still broke, DCA will not save you.

About half of the returns of all the stock markets over the last 100 years are due to DCA. Reinvestment of dividends is a form of DCA. The average return in prices has been about 6%/annum. The dividend yield has been about 3% overall. So one would think that the returns if dividends are reinvested will be about 50% higher. In fact dividend reinvestment outperforms by 100% because of the subtle contribution of DCA.

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

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