# Cork Removable, from Jim Sogi

June 10, 2007 | 1 Comment

Say you are in a remote valley with a nice bottle of wine to go with the barbeque but darn, forgot the wine bottle opener, don't forget the Hawaiian wine bottle opening method. Take the wine bottle and wrap the bottom of it with a towel. Go the a tree and smack the bottom of the bottle while wrapped in a towel against the tree about 50 times really hard. (not so hard you break the bottle of course). The raps slowly move the cork out enough to grap it. Try it, it works. Enjoy your wine.

# Trading Efficiency, from Tom Ryan

Last night while swimming laps I was thinking about efficiency of movement through the water. Actually this started last Friday happy hour when I took a pile of people from here to the pub and they happened to have the America's cup on TV. Several of the folks here are part-time sailors and while watching the kiwis fend off Italy through tack after tack a seed of a thought started germinating in my mind.

Efficiency is a critical component of all kinds of systems involving movement. In fluids for example we know that flow can be steady or unsteady, laminar or turbulent, and uniform or non-uniform. The more the fluid flow is steady, laminar, and uniform, the less energy per unit mass it takes to move the fluid. Unlike solids, however, elements of a fluid mass may move at different velocities and be subject to different accelerations. Still, we have three fundamental anchors: the conservation of mass (continuity), the principle of kinetic energy (flow equations), and the principle of momentum (from which the forces exerted by fluids can be established). What I am most concerned with however in this gedanken is efficiency, therefore energy relations. The most basic energy equation for flow in a fluid mass with boundary constraints, say in a channel or a pipe is (Energy at point 1) + (energy added) - (energy lost) - (energy extracted) = (energy at point 2).

In swimming, energy is added via the muscles, energy is lost due to drag, and there can be a slight effect of energy being extracted depending on the movement of water in the pool. For example, in racing at elite levels measurements have shown that the racers who are lagging behind the others can get slowed ever so slightly as they approach the wall if the wave front generated by the lead swimmers hits the wall and is already bouncing back into them. But in any event the main concern here is with drag.

We know based on the Froude relations that drag of a body or vessel through water is a function of the ratio of the length of the body to its width and depth. In general experiments show that the higher the ratio of length to width, the less drag that is exerted, which is why racing hulls tend to be long and narrow.

In swimming the practical example of this is the use of the method of front quadrant swimming, which was popularized in the 1980s and has recently come back into vogue as people examine Ian Thorpe's technique. (At least as a term or methodology.) It's beyond the scope of this post to discuss all of the minor details of FQS (you can Google it) and there is always some controversy when it comes to swimming technique but the main gist is to maximize and maintain the ratio of your body's L/w in the water in order to lessen drag. This is accomplished by swimming mainly on the sides of your body, using rapid but fluid transitions from one hip to the other, with a long body position in the water that is created by keeping one hand out in front at all times (not straight out in front of the surface of the water but in the front quad in front of your head).

I can say from experience that working with FQS can drastically reduce the number of strokes required to cross the pool, in my case by about 15-20% (3,4).

This leads me to contemplate trading efficiency. To me trading efficiency is not the same as volatility of p/l that is really what is captured by Sharpe, but rather is using the least number of contracts to capture a given level of profit. We know that in trading, as in swimming there is considerable drag in commissions, account fees, and the bid/ask spread which has to be overcome.

Also, as with swimming, I have noticed as I get older that it is not so much the losses that annoy me (although they can definitely hurt at times) but rather the periods where I am churning and getting nowhere. As daytraders we have terms we use to describe this annoying feeling, like "not in gear," "last to get the joke," "the broker is my best friend this week," etc, all of which capture that feeling of trading inefficiency.

It also begs the question as to whether trading efficiency as a metric has any predictive value, at least for traders following a systematic approach to positions. Or, conversely, is there a metric that might be developed for the market movements as whole, say over the course of the week, to assess the degree of market efficiency or the degree of market efficiency as it moves between certain goal posts (1500-1520, 1520-1540, etc)?

We have discussed before how the market often has a tendency to turbulent behavior during the course of the week only to finish nearly unchanged on the week and Victor has proposed that this is one way the system maintains itself, by enticing people to do the wrong thing at the wrong time and thereby make a contribution to the upkeep.

Here are a few additional considerations: Swimming underwater creates less drag, so there are some rules limiting the time, say one stroke, underwater in swim racing. I have a lot of experience swimming underwater trading and in the ocean when I wipe out surfing, but it seems to be part of the game and is a necessary component that might be factored in to your equations.

I like spending only the optimum time underwater, ideally none, but only a breath or two. A two-wave hold down is serious and approaches drowning. Some time underwater is necessary to pop through waves, but also to build a position, as it's impossible to get a full boat on the bottom tick every time.

The second consideration in water is planning. At a certain speed and with certain hull designs the boat starts to plane up on the surface with a break out from the limitations of the hull length/width speed formula into a new equation. When surfing, the commencement of the plane from paddling through the water is the start of the 'ride'. The length of time in a trade getting to the profit ride part seems very important in efficiency terms.

The longer and faster profit/ride, the less time underwater slogging, the greater efficiency, especially tallied over a large number. Paddling a surfboard through the water, getting onto a plane, and jumping up, while at the same time not missing the wave, takes incredible timing and strength. This is a key to trading as well, to time the opportunity, to have the strength to plow through water, sometimes under water, and get to the plane, and ride the ride, maneuvering through the changing face of the wave. Maneuvering around the sections, under the curl, until the wave ends and before hitting the reef takes skill.

Just like every trade requires such strength and courage to enter with the risk of going underwater, skill to read the changing market turns and getting the maximum distance. These things could be quantified in performance stats, but lost opportunity must also be added in as a variable, and lost opportunity has been the key variable in the recent cycle.

## From Vincent Andres:

Here is a humble suggestion. Let each trade be evaluated automatically by your computer according to some criteria (many have been given here). There may well be around 10 criteria. Evaluation may be a note between [-100, +100].

After enough trades, have a look in the criteria space to see if there is some clustering or if the distribution is random or not. Also, this is nothing else than an alike computerized version of Chair's "keep in a notebook" recent advice.

# Linearity and Randomness, from Jim Sogi

This weekend we visited Waimanu, one of the most beautiful spots on earth, accessible only by ocean, or a daunting exhausting six-hour 11-mile hike up and down cliffs. The valley is deserted with a river running down the middle surrounded by 2,000-foot cliffs and a gorgeous 2,000-foot waterfall cascading into a clear pond.

We swam out with our gear through the surf at Waipio Valley and met my best friend and his boat outside the surf line and climbed aboard. We set out the fishing lines and trolled for ono. Outside the valley he hooked up a 25-pound ono that was to be the barbecue for the night. We swam in all the supplies to the camp site.

Meanwhile, while we were fishing, his boys ages 11 and 14 gathered coconut husks, ironwood needles for tinder, twigs and small sticks to get the fire started. After we let the wood burn down to a mass of red embers, that is the perfect time to start barbeque. Open flames are no good unless you like blackened fish, and you can't wait too long or the embers will die out.

We did not bring a saw to cut the branches so they stuck out of the fire. When we came back at dark they had a nice fire going. We filleted the fish into chunks and put on salt, pepper, some French herbs and some butter. We used plain soy sauce on the cooked fish. The smoky flavor from the fire was delicious with rice and salad. We even had rocky road ice cream for desert thanks to dry ice in one of the coolers.

It was much more deluxe traveling by powerboat than by Hawaiian canoe. That night the blue moon was bright and full. Sleeping in our Lawson Hammock tents kept us comfortable, dry, off the hard ground. During the May season the trade winds die off, so there were no waves and no wind making beaching through the surf less life threatening. During the perfect blue days we explored some of the other deserted oases like Lapahoehoe Nui, a small shelf below huge cliffs with waterfalls falling on it. We dove in the clear water among fish.

A few thoughts of statistics and the markets during the weekend concerned linearity and randomness. Our course, as typical of any endeavor on the ocean, and with my best friend, is never linear. We never go in a straight line from point A to B, always weaving, back and forth, in and out with the tides, up and down in the water to breath, dive, breath, but always making some progress, surviving and having a great time in the process.

In the Jonathan Raban book, Passage to Juneau, A Sea and its Meaning, he talked about how the European settlers could not understand the Indians on the water. They would never go in a straight line, but would wander about, loiter, talk, fish, go this way and that. They did not understand the under currents, the eddies, the unseen forces carrying the boats in and out, the tides, the surges, the forces of underwater rock formations. This is like the market. It never is linear and rarely takes a straight line. When it does, like the recent bull market, you don't expect it. Always up and down, back and forth, fits and starts, backing, surging, stopping for air.

Another thought came watching the wake of the boat and the surface of the ocean and the clouds in the sky. They constantly vary in random patterns, but taken as a whole system they are very organized with the smaller random variations taken as a coherent surface pattern. Above the small surface patterns are larger groundswells that travel through and then even larger tidal shifts. Beyond that there are larger evolutionary shifts slowly eroding the island away, the slow rise of the sea. These are a perfect metaphor for our markets, and if seen in the proper perspective may aid in the quest to see and make sense of the market.

# Broker, from James Sogi

Systems can be designed to trade end of day or once a day, the best of course being buy and hold, which was hard to beat last year.

There are many niches. The issue is whether it is possible to adapt to the appropriate niche given the trader's current state, and the state of the market, both of which vary from cycle to cycle.

The diversity of the markets is beautiful. It can accommodate many needs and does so from the bank to the hedge fund, the governmental retirement fund, the small saver, the retiree, the active trader, and the buy and holder.

# Failed Attempts at a New High, by Victor Niederhoffer

Remarkably, each of the four days this week the S&P Index has traded above its previous all time high close of 1527.9, but then failed to set a new closing record.

 Day High Low Close Mon 1534 1526.6 1527.9 Tues 1533 1525 1525 Wed 1535.7 1524.3 1525.5 Thur 1532.5 1507.8 1511.6

Note the artful way that the market was able to be down on the week by a hair, as of Wednesday, setting up the longs to increase their positions, only to decline 25 fast points the following day. It would take a Rommel or a Stonewall Jackson to duplicate such cunning.

Thursday had the highest single day range since March 21st; it was up seven by 10 a.m., but then down 18 by 3.40 p.m. (NY time). This is about two and a half times the average range of last year, and shows the usual ability of the market to do the unusual.

Finally, there have been four serious down afternoons, and these are presumably related to the fake Drs. feelings about China … let us hope he visits there for a second time soon, as the first time he was only there for a day (with Paulsen, just 1 year ago).

## From John Floyd:

I think other contributing factors to the market's retreat are also tied to the cycling of rate expectations, economic data, and "carry trades." The beginning of yesterday's sell-off started not soon after the stronger U.S. economic data and coincided with a sell-off in interest rates and carry.

In addition to the Dr.'s comments, who does seem to be losing some of his "mojo," the directive of the latest comments were towards China and the market has disregarded the comments and moved to new highs since them. The overnight price action in carry and Japanese inflation data continuing to border on deflation should make today interesting.

Also of note, combined with other indicators, is that gold last Memorial Day was at roughly the same level and subsequently fell sharply.

## From James Sogi:

Why three times? It's like the old knock, knock joke. Who's there? Always three times of course. Three is the minimum number to create a pattern. "Knock, knock. Who's there? Orange you glad I didn't say banana?" The three tops were also the three-mountaintop candlestick pattern. Seems like the market likes threes. "On your mark, get set, go!" Seems like something deeper, but what? But it's something to ponder over a three-day weekend.

Speaking of weekends, here's a favorite barbecue: Yakitori.

It's great for sitting on the deck because you can eat holding the little stick and still have a free hand for the beverage and you can gesticulate with the little stick to make your points more emphatic. Serve rice of course, or better yet Musubi. Here's how to make Musibi.

## From Dylan Distasio:

If you're in the NYC area, check out Yakitori Totto on the West side for awesome organic yakitori and a great sake selection. They actually have an East side location also. My wife and I have eaten at both fairly often, and the food is delicious. They cook most of it over the long slim charcoal grill on skewers, and you can order any piece of a chicken you can imagine (and then some). It's fun to just order an assortment of small skewers and drink some sake. There's a great atmosphere also. I've never been to Japan but it seems pretty authentic. We're often one of the few Caucasians in there; the rest are usually all Japanese-speaking, including the entire staff. I'd highly recommend it.

Actually if you want sake and good food the other place to try is Sakagura on East 43rd street, in the basement of an office building. There are several hundred of types of sake to choose from, anywhere from a few dollars to a hundred dollars for a masu (traditional wooden box cup).

# Niches and Markets, Part 1, from James Sogi

In Models of Adaptive Behavior, Houston and McNamara discuss the state of an organism and how that might affect its behavior. The state is characterized by a set of variables.

An overfed bird is less likely to engage in risk to feed. Its state is overfed and one can predict it will spend less time feeding when hawks are around. Companies like the Sage's are overfed, and by their own admission not feeding. It can't find food because it has no incentive to search when its state is overfed. It doesn't engage in research, as it has plenty of food. It's old, and doesn't seek partners, and won't reproduce. It relies on pecking order and crowing like an old rooster.

A company with no earnings is hungry, lean and will take risks, engage in research, and searches for new niches, new partners. A young company seeks partners and more capital.

## Steve Ellison writes:

Geoffrey Moore wrote the book on this topic for the technology sector. It's called "Crossing the Chasm". There is a "chasm" between the needs of early adopters of a new technology product who love new technology for its own sake and the mainstream market of conservative information systems managers who want others to be the guinea pigs for a product before bringing it into their own organizations.

The companies that successfully make the transition from serving the relatively small number of early adopters to gaining significant market share in the mainstream market generally start by customizing their products for a specific niche market. Ideally, customers in the target niche should be currently served only by general-purpose offerings from large companies. By customizing its product, the upstart company can offer a product that is five to 10 times better for the target niche. Thus the company can dominate the niche, while staying under the radar of the large companies, who perceive only scattered customer defections. The niche gives the company a highly profitable customer base from which it can expand to a larger market.

Here is an example of how I might use Mr. Moore's ideas. Looking at this week's Value Line, I see five stocks with Timeliness ranks of one or two in a technology-related industry. I instantly recognize company A as the leading company in the industry with a larger market capitalization than all the others combined. I research the other four companies. I find that company E operates exclusively in a niche within the industry. In this niche, company E has the leading market share, 30%, well ahead of company A's 18% share in this niche. Thus company E appears to be a potential chasm-crosser, a potential high grower for years to come. Companies B, C, and D each operate in one or more niches, but none is a niche market leader, so I am not as interested in them.

# Educated Opinion, from James Sogi

Few college students pay full freight. Most get a package of grants, scholarships, loans, jobs, etc, designed to allow them to pay according to their ability to pay. It's an ingenious method to milk the most and get the highest price.

However, at under \$20,000, it's still a great deal. Education in America is the dividing line between the classes, and the key to upward mobility for most.

# Boundary Layer, from Jim Sogi

When water boils, it hits 100 C, but doesn't immediately turn to steam and change state to the higher energy level. Instead it requires additional energy at 100 C staying at the same temperature, until finally it breaks out into a boil. The various convective currents within the pot swirl around in interesting patterns during that time.

In the market system, how does heat in the form of capital get transferred? On the tick level of course there are individual transactions. The overall energy level of the system is the price. There are holders of capital at various prices. The inside price is like the convection as it comes down to various levels and stirs up the holders at the lower levels with energy to spur capital transfer.

On 5/17, the boundary layer at the top, above 1420, required more energy than was available to change phase. Perhaps more convective action is needed, and more stirring to transfer capital. The convective current swirled around the top but that did not seem to gather enough energy or tip the balance. Nuclear engineers study such currents when transferring energy to water to create steam for power.

Imagine a set of nodes. Each node may have some value. Those nodes are interconnected via constraints, e.g., node1+node5+node25 < 5, etc.

Let's call alpha the ratio: number of constraint per variable. When alpha varies, there is a phase transition phenomenon quite analogous to the water phase's transitions.

Alpha small = system with many solutions, may stabilize easily

Alpha too big = no solutions, erratic system

Alpha near the alpha limit = maybe/maybe no solutions, let's be : node1 = bonds, node2 = stocks, node3= real estate, etc., and we are not too far from "markets dynamically related".

# Consciousness, Identity, and Values, from Scott Brooks

May 18, 2007 | 1 Comment

I have witnessed the Darwinian, dog-eat-dog world on numerous occasions. It is truly a world of fang, claw, might, and brawn. There is very little tenderness in the wild; there is mainly an indifferent or fearful view of other animals towards each other.

There might be some tenderness in higher mammals towards their young, but that doesn't last long. Adults will take care of themselves first and foremost and eventually try and dominate the young who will someday return the favor.

As a hunter I can appreciate the unpleasant side of the contract. But I'm not sure that is an apt description. For me it is not unpleasant. I actually enjoy the hunt, the whole hunt. I enjoy the process of getting ready, the exactness of detail to be truly prepared if the moment of truth were to arise, and the beauty and relaxation provided by Mother Nature.

There is one unpleasant side the hunt, though. Every so often, you're going to be involved in an ugly kill. I don't like it when these happen. I don't like it all. I figure that somewhere around 5 to 8% of kills are ugly kills. I define an ugly kill as one in which I don't make a clean killing shot.

But after years of hunting, hunts that have included ugly kills, I can tell you this with great certainty: I am the most humane killer in the woods. All deer/turkey will die. The best death they can have is at the point of my arrow or the point of my gun.

## Jim Sogi writes:

Before we get too bleary-eyed, animals can be vicious in their quest to propagate. It's vicious out there in the wilds and the markets. Rarely is quarter offered in reality.

## Laurence Glazier writes:

The comments about the turkey are not dissimilar to actions of humans to humans in distressed parts of the world, e.g., Sierra Leone. We are fortunate enough to be domesticated animals, but the wild human being is fearsome.

Now, the creatures sharing Scott's wonderful land are fortunate to have such a considerate steward, but though they are usually unaware of the moment of their transition, perhaps they live their lives in a more heightened sense of insecurity than otherwise, observing other members of their group being removed from their tribe, and being sorely missed if they too are taken. How is a balance kept between animal and human interests, both the good and the gory episodes?

The sound of a cow bellowing for days on end after its calves are taken is testament to the anguish of separation animals can feel.

So the question is, how do we act to animals? And that depends on our perception. In what way were aboriginals perceived to enable "wise and intelligent" people to hunt them?

I would also note that the tools and practice of hunting and warfare go hand in hand, and wonder if these histories will always be linked. Without wishing to sound like Kenny Schikler, of Goodnight Burbank, Star Trek dealt with this well in its allegory of the Hirogens.

## Scott Brooks replies:

I'm not sure the cow is bellowing from anguish over the loss of its calf. Calves are frisky, much like small children, and want to run and play and explore. They have a tendency, like small children, to wander off. The mother calls them back with her bellowing. If a calf disappears the mother will keep looking and bellowing to call the calf back in. It may be instinctual or hormonal. She calls the calf because it's bred into her genes. Or maybe as her udder/teets burgeon with milk, she may be compelled to call the calf to come eat.

On my farm, calves are able to wander onto the grass between their fence and roads — "grass is always greener on the other side of the fence" situation. But they won't wander too terribly far from mom, who will eventually call them back. And every year there are a few calves that are rejected by their mothers and have to be hand-fed by the farmer/rancher.

I can't say for sure that cows don't feel anguish, but from what I've seen, I doubt they do.

[Editor's comment: There is a fascinating discussion available online, on research in this field, which is called Cognitive Ethology.]

# Fifteen Minutes a Day, from Steve Leslie

May 16, 2007 | 4 Comments

The average child spends 34 hours watching television a week.

A recent poll indicated that over 90 percent of the population of the United States never reads a newspaper. Fewer read more than one book a year.

There are 1440 minutes in a day. If one spends 15 minutes reading, one can read a 300 page book in a month.

Question: What is the difference between someone who can't read and someone who won't?

I had not heard these terrible statistics before. The United Negro College Fund coined the slogan "a mind is a terrible thing to waste." Children today sit endlessly in front of the boob tube, which serves as a babysitter for many parents. Thirty-four hours per week is staggering.

Recently my daughter took her cable TV back to "basic" and has no Internet for her two young sons. Solomon makes all A's and Forest is a B student. She is conscious of the time they spend on video games and TV, and she makes sure they are involved in school and after-school sports (currently soccer). They also have to do their homework as soon as they are home from school.

Pizza Hut and Tim Hortons in our area have a book program once a month for students, where they read and have their reading certified by a parent. My daughter says Pizza Hut is under fire for this because they are, in a way, encouraging bad eating habits for children. I suppose Tim Hortons will come under the axe next for selling donuts!

I am lucky that my parents encouraged me to read and I enjoy learning new words to this day. I wonder what can be done to change the terrible trend amongst our nation's youth?

## Tom Ryan replies:

I really hate to be the park ranger, but is there really a study that actually has data about kids and 34 hours of TV a week, and what poll was it that indicates less than 10% read one book a year? Can we get back to numbers on the table?

Conversations on how "things are going to heck these days" only bring us all down and serve no purpose, not to mention that I don't believe in the premise in the first place. I, for one, am very encouraged by what I see going on with young kids these days.

## George Zachar offers:

When technology permitted advertisers to study viewership with greater detail than the old Nielsen diaries, they discovered that having a TV on counted as watching, whether there was anyone in front of the box or not. Cooking, chatting, copulating, sleeping all counted as viewing, as long as the tube was clicked on.

The periodic release of alarming statistics about the decline and fall of literacy in America is one of our country's most enduring traditions. It usually coincides with the discovery by publishers that they are losing market share to another medium. Forty-five years ago the new scandalous fact of America's illiteracy (prompted by the rise of color television) was that Americans were now spending more on pet food than on books. When I told my father the book publisher of this alarming fact, his comment was that it confirmed the obvious: dogs and cats eat more than they read. I think that (yet again) the apocalypse may be a bit farther off than the New York Times fears.

## Jim Sogi writes:

As our esteemed resident philosopher states, "happiness is the end that alone meets all the requirements for the ultimate end of human action." The distinction between wants and needs makes it harder to make a concrete rule for action. For example the desire for honor is not something that is needed, but is a worthy aspiration. The more concrete way to frame the dichotomy is to put it terms of "stuff". If the goal is to get a lot of stuff, the wants never end. If the goal is to get rid of stuff, and end up with a wooden bowl and a robe, there is a finite goal. Once the stuff is gone, only the needs are left and true happiness is possible.

Regarding television: it is evil and promotes the acquisition of stuff, thus fostering unhappiness. Those who seek happiness in stuff are never happy, for there is always more. Eliminating television will improve life. The least benefit is the added 14 hours per week available for self-improvement; the greatest is the freedom from incessant exhortations to feed a desire for more stuff. For children, it avoids the frenetic programming of the brain into 3-second sound bites, which can destroy the ability to concentrate and focus.

# Consumer Punks, by Victor Niederhoffer

May 15, 2007 | 4 Comments

One of the never-ending bearish ideas promulgated by the chronic pessimists is that the consumer was really punk in April 2007. The idea, according to a certain weekly financial columnist and his camp, is that whereas the 1990-1999 bull market (which he was consistently bearish during) just went up without raising warning flags, the rise in the markets in 2007 has raised a million warning flags. And that this is now bearish.

Some people have actually read the chronic bear columnist's columns in 1990-1999, and contrary to what is stated, there was nary a week during that period that warning signals of imminent decline were not hauled out by one or another of the curmudgeon's friends. Such bearish reasons are memorialized in Practical Speculation.

It seems petty on my part to constantly point out the fallacies in the chronic pessimists' (the Abelprecbuffgrosoros') arguments. Eventually they will be right, and I have no idea if the current market is more bullish or more bearish than at any other time, and I certainly don't find this a more than usually good time to establish positions — but the point is that there is no reason to think that the reasons for bearishness are greater today than at any other time in the last 100 years. Nor is a decline in previous or prospective consumer spending or real estate prices good or bad for the market — that would depend on the totality of market interrelations and forecasts of discounted earnings for the market for the indefinite future. All the chronic pessimists I know of who actually trade, (in contrast to the weekly financial columnist) and who must take responsibility for their calls, are scratching the backs of solvent members from their perches and living quarters in the vicinity of the Trinity Church graveyard. Such will continue into the indefinite future, because of the creative power of the individual when placed in a system with proper incentives and the protection of property rights, as memorialized in the work of Dimson, Marsh and Staunton.

Chronic pessimists often have surface reasons for being bearish. For example, several years ago they talked about how P/Es were too high. Of course this didn't take account of interest rates or growth or past prospective relations between P/Es and market moves. The bearish P/E relation is specious, based on retrospective, part/whole fallacious, out-of-date relations from the Shiller database. And these, by transference from the academic world, have so much more credibility (if you didn't know he's been saying the same thing since Dow 1000, like the weekly financial columnist).

The question is, whenever the ratio goes the other way, like P/Es, now the lowest in 20 years, or oil, down 5% over the past year, or now the dollar up against the yen over the past year, why do you never hear about the relation that was formerly bearish and is now bullish?

Another purported reason to be bearish is that the dollar is very low and when you look at things in terms of the Great Man sitting on a platform above the world with the lever, he's not really making money on his dollar holdings, and this is bearish. You could substitute any other market, like oil or food prices, that is going down or up when stocks are rising as a reason for bearishness. None of these putative reasons for bearishness is ever tested. Instead, vague qualitative statements are posited about the unwanted dollars piling up in foreign coffers that could create a landslide.

## From Stefan Jovanovich:

There is at least one reason to think that the "record highs" in the stock market averages reflect faulty counting: those averages are being measured in U.S. dollars. Adjusted for the fluctuations in the Federal Reserve Bank's Broad and Major Currency Indices, the S&P 500 Index (excluding reinvestment of dividends) is still well below where it was in June 2000. Scaled to the Broad Index the S&P 500 is still 6.7% below where it was nearly 7 years ago.

The Major Currency Index is probably the more appropriate measure to use since it reflects the change in the value of the U.S. \$ against the other currencies used in the world's capital markets. Scaled to the Major Currency Index the S&P 500 is right now at 72% of its June 2000 price.

# Ostrich Economics, from Gregory van Kipnis

May 14, 2007 | 2 Comments

It is time we get our heads out of the sand and stop subtracting out food and energy and admit we have an inflation problem. Energy prices are up and are going to stay up. It has been going on for two years and we (the Fed) must stop fooling ourselves into thinking there is only transient inflation which will likely reverse itself and that there is no core inflation. The transient is now permanent, though volatile. We really have an inflation problem.

## Michael Cook writes:

I disagree that we necessarily have an inflation problem just because energy prices are up and are going to stay up. The fact that they are up is sending a legitimate economic signal that supply and demand are not in balance, similar for food. Were the Fed to choke off this "inflation" by throwing us into a recession, these price signals would not be able to do their work of drawing out competitive supply in the form of nuclear, solar, biofuels, fuel cells, etc. - whatever the creativity of entrepreneurs comes up with.

## Jim Sogi writes:

The other unidentified variables are the global currency/capital flows that render the "island model" obsolete. There are a number of well-tested empirical theories and studies. But early into the floating currency regime the dynamics are not well understood. There are various theories.

Productivity, things like hours per week are one measure. Other tested theories include comparisons of monetary conditions, fiscal policies, economic growth, central bank policies, portfolio balance, purchasing parity (McDonald's indicator) that seek to predict currency flows. The size of these capital flows are so significant as to render traditional measures of domestic economic conditions no longer reliable or as predictive as they were. Ignoring these variables is a mistake.

This argument has been made repeatedly, but is there any empirical basis for it, or any rigorous theoretical basis?

Can it be stated in a falsifiable way, such as the following:

"If money supply measure X (M1? M2? M3? something else?) increases by Y percent, then price index Z (CPI? PPI? sum market caps of stocks, bonds, real estate?) will also change by Y percent."?

My understanding is that history shows that there are times when the value of "everything" drops or increases, without any change of comparable magnitude in the various measures of money supply.

The market cap of the U.S. stock and bond markets add up to about \$30 trillion. For just residential real estate, I find numbers that are a few \$10s of trillion. Meanwhile the most liberal definition of money supply has it on the order of \$10 trillion.

From say 1995 to 2000 the stock market more than doubled, and real estate went up, too. Just the changes in value of stocks and real estate over that period clearly add up to more than the entire money supply. Prices of other things, in general (as measured for example by the CPI and PPI), certainly did not go down over the period. So it appears to me that there can be massive repricing of things in general, of magnitude that dwarfs not just the change in money supply (about \$2 trillion over that period), but the money supply itself.

This tells me that pricing of things in general has pretty wide latitude to move around. The value of "everything" dwarfs all measures of money supply, and makes moves of magnitudes that dwarf changes in the money supply. One should never think of there being some kind of grand conservation law, though I'm sure there are useful correlations.

# Neuroses, from Jim Sogi

Neuroses are unconscious attempts to use what worked as a child in the changing adult landscape. This principle is at work in the markets as many lost opportunities result from attempting to use what was successful, even yesterday, in the current situation. Fixed systems are but one example.

Difficulties with overcoming personal issues are known to anyone who has overcome these things. The difficulty of adapting to the daily changing market cycles, the major difference between long and short, the difference in up days and down days, ranges and runs, are not like shifting gears in a car or wearing a different hat. The difficulty shifting to different analysis, different tools, different tactics, different markets, and the need to switch all these things on a dime cannot be overstated.

Some like to stick to just one mode, one system, and wait for the mountain to come to Mohammed, to avoid the switches. Just recognizing that the cycle has shifted is hard enough, but then to change course in the old battleship is even tougher.

# The Low Bar Blues, from Jim Sogi

The Low Bar Blues (Original by Jim Sogi)
B - E riff (With feeling) and repeat

Refrain:
Looking for the Low Bar blues
I'm searching for the low bar blues
Lookin' for the those low bar blues
Those spus 'r taking me down.

Just sit and wait
Until you think its time
Press that button,
You spend a dime

Looking for the Low Bar blues
I'm searching for the low bar blues
Lookin' for the those low bar blues
Oh spus,  don't  take me down.

Its gonna drop
You just bot the top
Gonna hurt
You just lost a lot

Looking for the Low Bar blues
I'm searching for the low bar blues
Lookin' for the those low bar blues
Those spus are taking me down.

But wait, It'll turn around
Hang on, just stick around
forget the pain
Let me hear,  one more refrain

Looking, looking, looking for the Low Bar blues

# Bad Days, from James Tar

May 10, 2007 | 1 Comment

On days like today, when I have been proven wrong by the market and I am down a considerable amount of coin — when my nose is completely shot off — I close my book, take my losses, and start looking at the market all over again. I might re-enter, I might pass on the remainder of the day completely.

What I am seeing today: nothing has changed. I have not seen the market this fearful of an additional sell-off since May 1, or April 12, or March 30. Who cares if some imaginary geometry on the SPX has suddenly come into question?

I pay close attention to what the market has become: fantastically efficient. I see the market doing its dirty work in a much more efficient manner than even a few months ago.

The market ebbs and flows like the tides, sometimes every 24 hours. I note today the Dow is down 120 points, however what about all the past days it went higher and higher? A short time ago it fell 400 points, but it all came back and then some. It stands to reason that at certain points traders are going to sell off certain holdings and thus take a profit. Then the market settles down and begins to climb once more to a certain level. Mr. Tar is in the market every day and gets in and out all the time. I stand back and watch oils, precious metals, lumber, etc.

## Jim Sogi extends:

Blaise Pascal wrote in "The Philosophers" in 1623:

Continuous eloquence wearies. Princes and Kings sometimes play. There are not always on their thrones. They weary there. Grandeur must be abandoned to be appreciated. Continuity in everything is unpleasant. Cold is agreeable, that we may get warm.

Nature acts by progress, itus et reditus, It goes and returns, then advances further, then twice as much backwards, then more forward than ever. The tide of the sea behaves in the same manner, and so apparently does the sun in its course.

And so does the market. Pascal's quote brings to mind yesterday's pyrotechnics on an otherwise unremarkable FOMC plain talk release. The broker's quotes disappeared for a number of minutes, but at least they were busy filling orders in a timely manner. Globex seemed overwhelmed. Why the market goes through these circumlocutions is not clear, but a few things stand out. First, there is some sort of clearing function. Second, the action seems to stretch the capacity of both the Globex system and the trading platforms, which are not good signs. The PPI announcement led to a similar reaction in bonds, which dropped a point in three minutes, then rallied. This has the smell of a mechanical issue rather than an economic reality. It is the thorny path the S&P futures must take to their inevitable new highs. The appearance of a madhouse, of panic, so different than the market's normal stately mien, reminds me of the little chickens in the yard scattering, the mother squawking, all running this way and that from their cover in a panic as the hawks pick them off. Then ending right back where they started.

## Victor Niederhoffer remarks:

You can't expect any market, even one with a six percent-a-year upward drift, to go up every day, especially after a series of maxima. The problem is that if you wait for just the truly high-Sharpe days, you'll miss the 10,000-fold-per-century rise.

# Two Book Reviews: Krakatoa and Heart of the Sea, from James Sogi

Krakatoa, by Simon Winchester is a fascinating account of the social and scientific world in 1883 and the impact of the explosion of the volcano of Krakatoa. He is a geologist and explains the history of the idea of tectonic plate movements, which is standard knowledge now, but dismissed then as nonsense, like many new scientific theories.

One theory is that Krakatoa ushered in the global age that is now driving financial assets. The explosion sent shock waves through the air that traveled around the earth 7 times and registered on the many barometers in London! The tidal wave registered on tide meters 7,000 miles away. The particles created spectacular sunsets around the world for months and lowered temperatures. It was not Krakatoa that caused the many crop failures but another explosion that turned summer into winter.

The then recent telegraph and the new cables allowed the news to travel within days around the world leading to the realization of the importance of world events. A man named Reuter used pigeons to dispatch news from Europe to London to be the first to convey news of interest and financial importance. With that edge he was able to expand subscription to his services.

In the Heart of the Sea, The Tragedy of the Whale Ship Essex, by Nathaniel Philbrick, is a heartbreaking account of the attack by a sperm whale against the Essex, its sinking, and the devastating 87 days at sea in small whale boats and the suffering and struggle of the diminishing crew. As with many tragedies, though perhaps precipitated by some random event, a series of miscalculations, errors of judgment, both before and after led to creating a much worse situation.

In the case of the Essex, it was an older ship and the owners may have skimped on some repairs leaving it weakened structurally allowing the whale to stove its sides. The new young captain through bad sailing allowed a knockdown near the beginning of the voyage leaving them short of whaleboats. They were unprepared for a sinking.

After the sinking, rather than head for the Society Islands a few hundred miles away as the Captain first decided, he succumbed to the opinion of the mate and crew to go up wind, thousands of miles to South America. This example of poor leadership resulted in suffering and death. The horrific plight of the starving sailors on the small boats and who survived and who died and why in the social order gives much food for thought. It is notable that Captain Pollard eventually sunk a second ship by crashing it on a reef. Was it random? Bad luck? Or something else at work. The story reminds me of the feelings of a trader stuck in a bad trade or drawdown, starving for days and weeks and months on end but eventually making it back. Some even go on to live out their lives, but for some reason, the characters in this book seem to attract the plague of the fates. In this case, were correlation and causation related? That is an important question.

The Essex was the basis for Melville's, Moby Dick, which leaves off as the Essex horror continues. Interestingly, Melville was a commercial failure as a writer and had to work the docks during his life. As an aside, I have a fried here who taught us the hundreds of knots and lashing to lash a traditional sailing canoe who looks just like Quequaig with the tattoos and the top knot and is a seaman of the highest order and speaks of his death. He has tattoos on his back and head which mark where his life force will exit at his death.

# The Fat Finger of Fate, from Jim Sogi

It's hard to test the overnight fat finger of fate bar on the jobs, but like the clearing fire, like the probing action, they seem to have a clearing function. Last year there were a few of the night spikes ups and the subsequent follow through. A lot of brush has grown between here and 1527 cash SPX in the last five years, but the function of the futures seems to be to probe, peek a light in the darkness ahead, clear away the brush for the main army which follows behind. I can't see how the army will not push through the short distance.

With only 500 stocks in the S&P to absorb a global glut of productivity, industriousness, striving, youth, inventiveness, and of the world, These are 500 of the best, systematically weeding out the losers, and it seems that there is much upward pressure and bias on those precious assets. Look around and see how crowded it is everywhere you go, and how prosperous and well fed everyone seems. Consider the linear rise in prices inexorably higher even to the point of exponential rise. Remember the 80's, the late 90's. Bears are trapped, break outs up, every dip bid back in a rush.

Consider the new highs in the Dow and the proximity of the S&P highs, current daily multiyear highs, the breakdown of many old systems and cycles. It's easy to say and see after it happens, but in practice its a very difficult environment when moving to and into new ground, and the old rules no longer seem to work so well.

# Mathematics, from Jim Sogi

May 4, 2007 | 2 Comments

Mathematics does not correspond precisely with the real world. It gives an unnatural sense of precision that does not exist. The equals sign is a good example of a basic fault with math. Take 1=1 which seems simple, but in the real world nothing is equal to another thing, and nothing is the same as something else. Everything differs from everything else in some manner, in small details, in space, in time. Nowhere in nature or the real world will you find a line, a circle or a point. Zero is convenient for computations but zero does not and cannot by definition exist. This problematic from a philosophical standpoint.

Math may be useful as a model to help predict or understand but has basic flaws that are often overlooked at the users peril. The remarkable advances due to math cannot be denied, but from the realist's view, the discrepancies loom large. From this discrepancy creeps in random results present in the real world.The Mathmatician argues that calculus and limits, and statistical procedures account for this real world fuzziness, but the idea of limits and central limits can be ways of shortcutting by creating a simple model to represent a much more complex process and cramming it into a little figure which remains black, non transparaent and unexplained.

The mathmatician argues, "Who are you, untrained philosopher who never studied math, to say this." Point granted, but the analysis stands.

The bright side of statistics is that it attempts to measure the discrepancy between the line, the curve and the real world and in the process captures some information about the real world and its deformities exhibited as randomness.

# Survival, from a Friend of Daily Spec

May 1, 2007 | 1 Comment

If there's one overriding principle of successful market navigation, it is that survival is the most important thing of all. The market will always be there, and if you have an edge, there will be a chance to rise to your rightful place in the firmament — if you survive.

Because survival is so important, I am always on the lookout for survival lessons from other fields. One of the reasons I always read Bo Keeley's writings is that he has had at least 81 near-death experiences, and by dint of proper planning and response, survived them all.

One of the best things about the Patrick O'Brian series is that in each of his critical battles, the hero, Jack Aubrey, goes through innumerable steps to survive and minimize the deaths of his crew, often changing tactics midstream, so that what would have led to certain death instead led to a long, beloved life.

I have 100 books on survival, at least one of which is on my desk at all times. I have books on survival at sea, survival in the mountains, survival on the battlefield. The problem is that others know infinitely more about the principles of survival in such fields than I do. However, I recently had some direct experiences related to survival that gave me confidence that I might have something to add in the continuing search for lessons.

For almost three months, I have been visited off and on by a racking cough and runny nose. The symptoms were the same as the flu. I have always been very resilient to colds and flu, and I expected each day that the symptoms would disappear and that I would go on my merry way. But on Sunday, April 22nd, after a game of tennis and family activities, I suddenly found that I could not walk without agonizing chest pain. I was about to have dinner at a restaurant with a trusted companion and before the first course arrived I asked her to pay the check so we could leave. She said she would call paramedics and I told her not to. I begged her to listen to me and do nothing. I stepped outside for some air, and within 30 seconds, two fire trucks and an ambulance had screeched to a stop on Park Avenue. Despite my efforts to elude them, they wrestled me in and administered tests. I rejected their advice to come with them to the nearest emergency room, and signed a release form stating that I knew I might lose my life in the next minute.

I went home and slept. In the morning, I could not muster the energy to walk 10 yards to my trading screens to see where things were opening. Those concerned called an assortment of relatives to persuade me of the error of my ways, and there was much talk about possible heart problems — which I refuted with elegant logical and philosophical proofs and reminders that I had played sport every day for the last 50 years. Furthermore, I refused to be transported by ambulance to the indignities and travails of an E.R.

But one thing led to another, and a triumvirate of magnificently determined women tricked and manipulated me into an E.R., where a battery of tests quickly revealed that I had pneumonia and that one of my lungs had stopped working. My brother who was working behind and in the trenches the whole time, subsequently sent an article indicating that my particular condition was associated with at least a 25% mortality risk within the next 30 days, and I submitted, albeit not without further complaints, to the ministrations of doctors.

Here is what I learned about survival from my experience:

1) The worst person to make a decision when survival is at issue is the person whose life is in danger. He may be concerned about discommoding others — or the Grim Reaper may have dulled his senses. If I had not been hurried into treatment against my wishes … I won't finish that sentence.

All market traders should have a designated person to take over decision-making in their positions when survival is in question.

2) For three months, I had been subjected to extremely non-random changes in my health. This had to be a 1-in-1,000 shot. When my symptoms didn't respond to the usual remedies, I should have seen a doctor.

When a market starts reacting in a completely non-random fashion, especially when it's against you, you should throw away the databases and get down to fundamental principles. Any persistent rise such as what we've been witnessing in the stock market for the past month, or the non-random episodes that happen so frequently in the commodities and foreign exchange markets — anything that refuses to give you even one chance of a dignified exit — should be treated with the most serious consideration, as survival may be involved.

3) I was admitted as a cardiac patient. If I had gone to a cardiologist's office or a dignified heart center, I am certain that I could have talked my way out. Instead, I was put into a hellacious, poorly ventilated, noisy, crowded emergency room where I received 20 tests in an hour or two and quickly learned that the problem was my lung, not my heart.

The lesson for market people is that during a survival episode, simple routine tests or systems of the kind that brought you into the trade are no longer sufficient. What is required is a wide-ranging approach that may have nothing to do with the original system.

4) A friend of mine told me 20 years ago that the only way to get good medical attention these days is to be on the board of directors of a hospital. I don't believe that the statistics on survival for poor and rich bear this humorous platitude out, but I do think that the only way to convalesce in quiet, or to die with dignity, is to be a friend of a key board member.

Because I have some important friends, I was whisked from the E.R. into a fancy section of the hospital where it was possible to breathe and to accommodate all my well-wishers and caregivers (although I was pegged mistakenly as a diabetic and the TV monitor was programmed to show me Diabetic Channel only). Somehow the name "Soros" kept being wafted about. The powers that be may have believed that my potential contributions to mankind would be of a Palindrome-like magnitude. It was rather amusing since Soros, I believe, would have been very pleased to have me shuffle off the mortal coil at any time during the last 10 years. But such is the power of reputation.

5) One of the items listed in the Patient's Bill of Rights posted in every hospital is that you won't be discharged from the hospital until an advocate for you has pleaded your case. Apparently, the tangled web of the third-party payment system so frequently impairs the profitability of some patients that these appeals have been made a basic right.

It would be great if they had a similar system in place in the market. Cases like Amaranth Advisers and Long-Term Capital Management make clear that it is not entirely likely that you will be accorded the dignity of such checks and balances before you are discharged from your positions. At least you should understand this in advance and try to set down the terms of timing, execution and procedures by which such discharge would be made.

Another key aspect of the Patient's Bill of Rights is the protection of privacy. Apparently somewhere along the way somebody in charge realized that patients are human beings and they like to be accorded the respect in their persons that they try to maintain in their homes.

Any market trades that are not kept private are an invitation to the ruination of your financial health. The levels of your stops are too tempting to those on the other side; the wolf point at which you must pull the cord, once disclosed, may almost certainly be expected to become a target.

6) Most deaths occur between 2 a.m. and 5 a.m. My nurses tell me that this time is known as "the wolf hours." While many people think night nursing is a breeze, somehow everything seems to happen in those three hours. I dreamed every night that the Grim Reaper was standing by my bedside trying to entice me down into Hades, and I woke with a start each time and asked my night nurse to minister to me.

The key times to worry about your demise in a market position are approximately those same hours - the closing hours in Asia and the opening hours in Europe, the time when the final tumultuous gyrations of the e-minis seek to send you and your positions to Davy Jones' locker.

## A Friend continues:

How to steer between the Scylla of wreckage and the Charybdis of certain death:

For many years, I have harbored the goal of making a citizen's arrest. People do things wrong so often, especially violating rights to life liberty and property. I felt, as Jay Gaynor said, it was every citizen's duty to take the law into his own hand and act as a policeman would in arresting the malefactors. He won the mayorship of New York on this platform.

I made that citizen's arrest, ending up paying one-eighth the cost of the policeman's heart attack, lost every decision, paid the other side's legal fees, and was out a big ace before that one was over.

I've also wanted to experience the heroic feeling of liberty in Beethoven's Fidelio prisoner chorus upon seeing the first light of day after being in prison darkness for years. I wanted to combine this with the escape that Churchill made from the Boers by walking out of the Transvaal prison in top hat and coat in complete nonchalance and then descending into the rails.

I was more successful in this pursuit today as I dressed in my normal clothing, got out my tennis racket, and strolled out of the confined prison I was in, with windows that didn't open for seven days straight, and a feeling of fetidness waiting in the wings to engulf me at every stage. All the while the doctors tried to track down someone who would take responsibility for discharging me, even though I refused their last three X-rays and blood tests. I was much more successful in this second pursuit and I made my escape to the Central Park air at 1 pm yesterday.

At taking that first breath of fresh air, I felt utter happiness, the feeling of life's rekindling itself. It was exactly the counterpart of Beethoven's prisoner's song.

I feel the same exhilaration after exiting a losing position that I feel after coming into the fresh air. I believe they are both life-enhancing acts, and should be taken much more often and earlier. However, this must be contrasted with the terrible wrongness of the morphine drip, the one thing they were sure was working,

After making my escape, I voluntarily came back to the prison, feeling like Willie Sutton, who found it so difficult on the outside because of the kinds of people he met inside and knowing that a posse of concerned parties who had done much good would be discommoded by his absence. I didn't want the extra X-rays and blood tests for a simple reason. The change in my health that might have come from any intervention resulting from the tests had an expected value of zero, whereas the costs of the pain and discomfort of the tests was quite tangible. It was impossible for me to explain the concept of the value of information to the doctors who so earnestly wanted more and more facts to base their further treatments on. Ultimately, there was an impasse and I was discharged properly and walked out a free man.

## Dean Parisian writes:

Sometimes women just know best. Don't fight the tape and don't' fight the E.R. help. Fighting can seriously affect one's livelihood. Ah, hope and wishful thinking can be a wonderful thing. They can make things happen!

Yes, survival is the first point. The rest will always be there.

Resting is very important for a durable recovery. Time to fully recuperate is not lost time. I hope you'll find the time for that. Hear the wise women!

A prescription suggestion: Two weeks of cool trout or salmon fly-fishing in Ireland. Remember The Quiet Man. The place where they made the movie is really lovely.

## Jim Sogi extends:

It is good to consider one's death every day. Nothing else is more certain statistically. Would you be happy with your life if you died today? It is not morbidity; it is a celebration of what is important in life. Were you 10 times happier when your bank account grew to 10 times what it was? Were you happier to be hugged by a child? Hearing recently of a close friend's near death from appendicitis, skiing the life and death gnarly in Alaska, feeling my own mortality face to face, seeing my aging parents, makes the important choices in life loom large. Health has to be the first priority, then family. That is where the greatest wealth is, not in the bank.

## David Humbert remarks:

You have learned the awful truth that hospitals are dangerous places, and to be avoided unless absolutely necessary. As a general rule, your constitutional well-being is a reasonable proxy for how you are recovering from a medical event. In other words, if you are feeling well, you are probably improving internally. Expect weariness, remember that your body's immediate response to injury of any type (surgery, infection, etc.) is to cannibalize skeletal muscle in order to obtain the protein building blocks necessary to repair tissue. This leads to an obligatory weakness that can only be overcome when the body shifts from its catabolic (breakdown) stage to its anabolic (building) stage. That occurs at a variable time but probably sometime 10-14 days after the original insult.

“All market traders should have a designated person to take over decision-making in their positions when survival is in question.”

There is a designated person who often takes over when survival is in question, the Margin Clerk. Heed the warning!

In New York State, you cannot be discharged over your own objection, without the hospital jumping through onerous legal hoops.

After my father had his gall bladder removed, NYU tried to discharge him 48 hours later. He was in his late 70s, weak, and obviously needed longer to recoup. Nonetheless, the staff hectored him to sign the release, and it wasn't until I said "you will literally have to carry him out over my body, and I'm not bluffing" that they relented.

Once they saw he was going into a different insurance category as a result of my statement, the staff demeanor flipped from bean counting to healing, and all went well.

# Recovery, from James Sogi

The idea of recovery is linked to the subject of clearing. After a clearing, how long does recovery take? The measure of your fitness is the recovery rate to normal heart rate after reaching your maximum heart rate. You should be able to return to your normal rate quickly. The longer it takes, the worse shape you are.

It might be asked of your emotional health: after an argument how long does it take to regain your composure and to forgive? After illness, how long does it take to regain your normal strength? What is the best path to recovery? Rest of course, but the struggle back up the hill is always twice as hard.

This might be asked of the market, what shape is it in? How long does recovery to old highs take? It might be asked of a trader: after a drawdown, how long does recovery to new highs take? After a fire, our colleague showed recovery is especially rapid. We will see what kind of shape our market is in here soon. So far it seems pretty healty with a start at recovery.

# Briefly Speaking, from Victor Niederhoffer

May 1, 2007 | 2 Comments

You never hear much about the real facts when people are trying to waft a detrimental meme past you. Now that inflation is all the rage again and people are fearful that there is going to be a terrible thing happening — not sub-prime, not China, not earnings slowdown, but inflation — don't expect anyone to point out that bonds closed the month at 111.24, a 35 calendar high, and up a bit on the year.

Perhaps the adjusted deflator index for March or April of this or that seasonally adjusted economic series would be more meaningful, as well as a parsing of the forces that will beset Bernanke. It is such a pleasure to have at the Fed a real economic man, who seems truly interested in providing the backdrop for a proper growth and inflation, rather than his predecessor who was always posing and always had a hidden agenda. The fake doctor reminded me of one of the old men who sat at the club windows on fifth avenue and commented on the mini skirts and diversity walking by these days.

Note the freqeunt high fives the fed boys gave each other under Dr. Greenspan when he used to tell them that by fooling the market one way or another he was able to avert upward movement.

There are many circuits in electricity and biology where the energy and health of a system is not complete until a clearing event has occurred, (I would very much like some good examples from the specs). It is interesting to speculate if such a clearing event can be described and used predictively for market movements. I would think it worth much study.

Hint … One such clearing event occured today.

## Jim Sogi writes:

On the inflation meme, I was astounded at how cheap a car went for. It seems less than they cost years ago. Cars now are bigger, better, more engine, last longer for less money. Go figure.

On clearing, forest fires are a great example. There has been a debate for years in the US Forest Service on fighting fires. The policy before was to fight all the fires. The policy cost lives and in fact made the fires later worse because the underbrush grew creating tinder. The natural fires clear out the underbrush and give way to new growth and healthier forests. The policy now is to allow more natural fires to run their course to have a healthier forest. This is true with markets. A few little fires here and there help to clear out the dead wood, leaving the healthier more vibrant life. Some forests need fires to regenerate.

On that subject of running their courses, these long bars are always of interest. My favorite biochemist studies how to attach new molecules to the molecules that they want to track and follow in the body. The ones they want to track try to hide and avoid detection. The only was to find them is to cut and that is no good. The scientists attach a "handle" or a long bar molecule sticking out of the diseased molecule. To that handle they attach something like a glowing chemical or tracking device so they can see the disease in the body without cutting. This is my layperson's simplification of a complex process, but in my mind at least describes the process. Molecules operate on a very physical level, like a key in a lock. The long bars are a kind of handles that help track the market and are good handles to tag to follow the market.

To add to (and hope not diminish from) Mr. Sogi's comments, I quote from a Botany textbook I received from Arizona State University.

Many viable seeds do not germinate right after they are shed from the parent plant, nor do they germinate during the following growing season. Seeds can lie dormant for many years before conditions are suitable for their germination. Everywhere that seed plants grow, the soil contains viable, ungerminated seeds in natural storage-that is, a seed bank.

Seeds in a seed bank may be dormant because of their own inhibitors, as in many desert plants. Ecologists can sometimes determine what kinds of seeds are in the seed bank of a particular habitat by removing the shrubs from a small area. When a new growing season begins, the seeds of many annual plants germinate. Such experiments simulate what happens, in part, when fire sweeps through an area. In addition to eliminating the source of potential germination inhibitors, fire also releases the nutrients contained in plants. Thus, annual plants grow abundantly in burned areas during the first growing season after a fire. As perennial plants become reestablished, the newly replenished seed bank of annual plants once again goes into natural storage until the next fire."

Seed banks that require favorable environmental conditions to germinate can be compared to the famous caneology. Some of the lesser plants that do not have strong enough roots to withstand the "heat" can be cleared out in order for those other plants, the plants that have been leaning on their canes for quite some time, to show up on the stage.

## Vincent Andres writes:

There are many circuits in electricity and biology where the energy and health of the system is not complete until a clearing event has occurred.

Some rough thoughts. I would distinguish at least 2 kinds of clearing events, based on the event's duration.

1. Long clearing events:

Biology: at the end of the day we sometimes get tired, e.g., quite unable to solve a problem. A good night sleep and the problem gets solved. I think most of the night "clearing" we use our energy for our brain/body reparation/maintenance/etc.

Mechanics: I ask a bit too much to my motorized cultivator or my chain saw. So it becomes dangerously hot and I have to give it "clearing" time in order to cool a bit.

In both above cases, the clearing event is quite long. At least it has some proportionality with the working time.

Maybe markets also need to rest or to cool.

2. Short/instantaneous clearing events:

Electrical: e.g., the soft reset or hard reset on some computers. Necessary to bring a computer out of a endless loop etc. The clearing event is very short, but this effect may be very beneficial. The computer system is rebooted to an initial state.

Biology: Sometimes our mind gets confused. A problem seems very difficult. We try many issues and none work. And suddenly in the middle of the confusion a little detail, a little connection occurs, and we understand. I believe that in fact, the understanding was already here, already present, but hidden in the confusion/drafts of the work. The clearing event is maybe the moment where we decide to wipe out the useless stuff. A clearing event may also be the recognition/awareness, of denial. It's a short instant, but it may have great consequences. But, I think it would be erroneous to believe that all occurs just during the short instant. All is already prepared. The question is "when will we look at it?"

The straw that breaks the camel's back catches our attention, but the responsibility is not the straw's. And detecting the straw is probably much more difficult than noticing that the camel is overloaded.

Maybe markets have also some trigger or revelation.

I think markets are concerned by both kind of clearing events but I'm respectfully curious about precisely which kind of clearing event you were thinking of?

"For fifteen days I struggled to prove that no functions analogous to those I have since called Fuchsian functions could exist; I was then very ignorant. Every day I sat down at my work table where I spent an hour or two; I tried a great number of combinations and arrived at no result. One evening, contrary to my custom, I took black coffee; I could not go to sleep; ideas swarmed up in clouds; I sensed them clashing until, to put it so, a pair would hook together to form a stable combination. By morning I had established the existence of a class of Fuchsian functions, those derived from the hypergeometric series. I had only to write up the results which took me a few hours."

Henri Poincare

It is interesting to speculate if such a clearing event can be described and used predictively for market movements. I would think it worth much study. Hint: One such clearing event occurred today.

## David Wren-Hardin writes:

There are many circuits in electricity and biology where the energy and health of the system is not complete until a clearing event has occurred.

The first that comes to my mind is both electrical and biological. When our nerves send a signal, it's sent by an action potential. A neuron maintains a potential difference across its membrane through the use of a Na/K pump; it pumps Na out of the cell, and K into the cell. The action potential is kicked off by a signaling event, and the gates in the cell membrane open, and Na floods into the neuron, causing a rise in voltage. The Na gates are sensitive to depolarizing events, and a positive feedback circuit ensues, where more and more Na channels open, causing a spike in voltage — the action potential.

The Na channels don't just stay open, however. After depolarization and opening, they are inactivated in a voltage-dependent manner; the very process of opening and depolarizing the cell leads to their own inactivation. Another action-potential is only possible after the Na/K gradient is re-established, and the refractory period ends. In other words, more activity is only possible after a clearing out of the activity of the previous event.

One could also see the action-potential itself as the clearing event. A large potential is built up over time, and with a seemingly small synaptic event, a cascade begins that triggers a large event.

# Up Months, from Jim Sogi

SPY        Up Months in Year
2007       3

2006      10
2005       5
2004       9
2003       8
2002       4
2001       6
2000       3
1999       7
1998       9
1997       9
Average    7

High SPY 3/00  155.75
High SPY 4/07  149.80

SPY high is not too far off. What path to get there?

# Cars.com, from Jim Sogi

I just bought a new car. Cars.com gives good referrals to the Internet sales departments of two or more competing local dealers and gives the dealer invoice price and cost of options. The referrals result in what seem to be the best deals. Having the info about manufacturers' rebates that might be in effect is also very helpful. The sales process was no-nonsense. After choosing the car, the salesman knew I had checked with other dealers and had a prior quote, which he beat. I walked out with a price below what I had expected to pay. In all, it was the least painful way to buy a car. I recommend this to new car buyers.

# A Radical Notion, from Jim Sogi

April 27, 2007 | 1 Comment

What is it about square roots that they are so prevalent in natural phenomena? Gravity diminishes as the square root of distance. Tsunamis travel at the square root of the depth of the water. Energy is mass time speed of light squared. Why is this? Is it just a mathematical convention for ease of computation, and if so, why do natural phenomena follow this relationship?

Sound, gravity and waves are propagating like surface of an expanding sphere. The surface of a sphere is 4*pi*r^2 (squared distance from the center). Thus the square is a result of the two-dimensional property of a surface.

# Bay Area Dinner, from Jim Sogi

Many thanks to Chris Cooper for hosting a wonderful Korean barbecue dinner in Oakland, CA. Attending were Easan Katir, Tom Larsen, Henry Carstens, Chris Cooper, and the Sogi family. After the initial toast to Victor and Laurel for bringing us all together, we heard tales of adventure in the options pits, debated systems and discretionary systems, heard insights from decades in the institutional brokerage business, discussed lookback periods and changing cycles, practical hedgefund back-office tips, programming, mathematical algorithms, trade execution, and pros and cons of having a separate office outside the home for trading.

To add excitement to the evening we even heard trading signals and alarms at work in the background from Chris's trading room. To my delight, my daughter, a PhD candidate at Berkeley, held forth at length from her perspective as a scientist studying molecular biochemistry and application of the scientific method. Each of us had a completely different approach to quantitative analysis, making for interesting debate. It was a pleasure to meet many in person whom I hold in high regard. It was a fun and educational dinner.

# Confidence Query, from Victor Niederhoffer

April 15, 2007 | 1 Comment

I have been considering the many confidence games that players in the market are exposed to with particular reference to the many false signals of imminent decline, programs of fixed quasi arithmetic bent, and expert con men who claim to have an easy way of making money. I used to use myself as an example of playing an unwitting role, i.e., being a key middle brow naive person who blindly goes his happy way allowing experts to take his money.

Indeed, I've written on the subject. And when I asked the collab the best way to research this subject she said, "go to our past writings on it." But I'm a little rusty on it and I think there have been so many new cons in the market lately that are so extensive that any previous typology has to be augmented. Any help or ideas that you all could give on this subject, particularly those related to some of our discussions on funds, that might be not as good as they seem, would be appreciated. I found the following article very helpful as a jumping off point for eliciting some market cons.

## From Jim Sogi:

It is something about the mark that allows the conman to 'turn' the victim. As with the baseball maven, the appeal to the esoteric investor who has the depth of capital to withstand drawdowns must appeal to some 'streak' in investors. In confidence games it is the greed, or dishonesty of the mark that is the key to the game. Each person, no matter how optimistic and bright, has a dark side.

Often the most apparently cheery have the darkest side. It is the job of the conman to find that side that can be used to turn the mark to his advantage. Or he finds his specialty niche. This is how elderly are preyed on with winning drawings, or the Nigerian scam. It is the combination of need with greed and a dose of dishonesty in the mark. The typical description of a con focuses on the perp, but the study of the victim yields more lessons. Most do are not aware of these seeds of darkness within, and there lies the danger.

This is the same technique used in sales, cross-examination, and religious proselytizing. Leading the victim down the primrose path feeding the victim's inner need and darker impulse. It is what happens in the market so often. Look to the victim. Look to yourself for the secrets of the con.

## Eason Katir writes:

If ya gotta lotta nerve
And ya gotta lotta plenty
Five'll get ya ten
And ten'll get ya twenty

— Singsong of the 3 card monte grifters, as they throw the
cards.

It has been written that, "In religious confidence games, this means that the religious leaders must convince the prospects that they (leaders and present members) have a special relationship to a personal God."

Market equivalent: the supplicant must prove he is worthy (accredited) and have a pious bankroll (high minimums) to have a special personal relationship with the elite hedge fund.

"The doctrine of a personal God supports: (a) perfect (infallible) leaders, (b) perfect (inerrant) sacred books, (c) perfect (marvelous) miracles, and (d) perfect (eternal happiness) posthumous rewards."

Market equivalent: the hedge fund prospectus supports (a) managers who have had a good run at some period, supported by much media hype, (b) infallible trading edge supported by scholarly white papers, (c) backtesting, hearsay, testimonials (d) eternal retirement happiness: the TV commercial or glossy magazine ad depicting the WASPy looking character in his argyle sweater sailing his wooden boat through retirement with his loving wife by his side.

"Incorrect details can expose a con game. Accordingly, details such as the location of Heaven and means of transportation thereto are not mentioned. The posthumous rewards are claimed to be wonderful, but no details are given which can be checked in the present. "

Market: black box systems. Opaqueness of current hedge fund positions.

"The advantage of the confidence games with posthumous promises, of course, is that no deceased person is going to return and ask why he did not receive his reward."

The market hasn't worked this one out as well as the article's example yet. Best it can do is provide tables and charts showing hypothetical increase in value over some long period of time, and a posteriori rationalizations about why a system stopped working.

"The religious leaders have another advantage. They carry little inventory and have small expenses."

Financial salesmen have this same advantage. They don't have to finance an inventory of expensive cars or other widgets. The mark puts up his money, and sees only flickering pixels in his browser representing his bet. Another confidence game: Feng Shui is popular. The delusion that one can fix one's problems by rearranging the furniture.

Market analogy: Beat the market by rebalancing sectors.

## Michael Cook writes:

On of the most interesting insights in "The Big Con", for me, was that it represented a new insight into human nature, namely, the depths of delusion and self-deception a mark can be led into. The very fact that the "big con" is possible was an important discovery.

And if you look at the world through the eyes of a con, it seems that everybody is conning everybody all the time, and everyone is conning himself most of all. The con, in his sociopathic cynicism, thinks that everyone is being conned except himself, but there's some saying to the effect that it's always easiest to con a con man. Why should this be true? I think it is because the most effective way to con someone is to believe the con yourself. As George Costanza said: "It's not a lie if you believe it." And once you get in the habit of believing your own lies you lose the distinction between what you know and what you don't know, the "taste" of knowledge. So the most dangerous cons suck you in by virtue of people who believe in them, and who you trust.

Hypnosis has always fascinated me as a phenomenon, and as a description of the state of mind we inhabit so often, a sort of "waking sleep", in which we are driven by suggestions, associations, and habitual patterns and reactions. Con men harness this power of the mind, as do advertisers. Are not advertisers con people? And salespeople? And don't we all sell ourselves and promote ourselves, and in so doing, engage in cons? Creating a resume is a good example - the goal is to gain the confidence, or at least the interest, of the person (or machine, these days) that is reading it. And it is shaped, edited, selectively biased - from one point of view, a "pack of lies".

The con man uses a person's propensity to con himself against him, like the way a judo master uses the momentum of his opponent against him.

If I try to convince you of anything, i.e., persuade you that it is true, am I "conning" you?

It is a compelling metaphor for all human interaction, which is a little depressing. I don't really like looking at the world through a con man's eyes, and yet I have been conned, and didn't like it, and am therefore skeptical of people's hidden motives at times.

But someone said "you must be as wise as serpents and as innocent as doves" - alert to the confidence games all around you, and even in yourself, but somehow not going through life assuming the worst about people.

One of the most visible "behavioural biases" is overconfidence, and it always amazes me when people make claims to know something that they can't possibly know. Which happens every single day. And that's their job - there is a demand for that. Portfolio managers want analysts to "pound the table" on their ideas, to have confidence, and some don't care to hear what that confidence is based on.

So overconfident salespeople marketing products they believe in - Caveat Emptor!

I have been attending dog-training classes on Saturdays, which is really a class on "trainer training." One thing the instructor said that struck me was that most of your dog's behavior problems can be corrected, if you can get the dog to believe you have a omniscience about everything important to them.

To paraphrase, the dog won't go nuts over that leaf that flies by the window. He will say 'my master must know it, it must be ok.' And eventually you can take him for a walk and that squirrel running by your path, will not cause him to bolt if you say 'no.' He will say, 'its ok, my master saw him and knows what he is doing.'

Dogs want you to correct them before they do it, while they are thinking about it. Still, there certainly is some element of physical force to establishing dominance. This is downplayed as many owners overestimate the need to be "omnipotent." It's more about consistency. Always show them you know what they are thinking.

It seems many of the con's tricks are similar. People have a need to believe that someone knows everything, and therefore the assumption is they are in control. One does not imply the other, however, as the media and dooms-dayists would have you to believe.

For the pacifist owner, dominance need not be harsh, but rather omniscient and omnipresent. Always have a plan. Rattle the keys annoyingly, throw rocks over their heads when they bolt etc. The preparedness causes the dog to think they knew that would happen so he knew what I was thinking. Rather con thinking is, you knew it "could" happen and were ready to imply that it "would" happen.

Perhaps this is the "set-up." Where the journalist digs out the "dirt," the reader never suspects that the story was planned, even written long ago. The subprime is a good example…

# Hidden Sword, from Jim Sogi

Hidden Sword is a chick flick masquerading as a samurai movie. There was one good scene where the samurai went to his teacher Toda before the big showdown to the death with his friend who was ordered to kill him.

The teacher told him, "Whenever a man draws his sword, he becomes emotional and tempers go up." The teacher taught the samurai to duck and dodge, and draw the attacker. "Withdraw in body, but the spirit still advances." In that way the opponent is drawn in to attack. As the fighter withdraws, the opponent attacks and his temper goes up as there is no engagement. However the samurai waits for the opponent to have a moment of emotion or temper and rushes in reaching. At that moment, the samurai turns quickly and attacks under the opponent's sword and kills him.

In our market operations, despite quantitative signals, strategy is useful. When the opponent in the market is engaged, tempers go up. When looking for an entry, it is sometimes good to withdraw orders, but not the spirit. The opponent's temper is aroused and when there is a rushing in, that is a good time for an attack. By the same token it is good to recognize this as the market retreats from the order. Care must be used when tempers are aroused and there is danger from rushing in. There are many variations of this move in judo and aikido.

Today's market was notable for the linearity of the move after the early reversal. There have been hints in posts about automated systems. Globex is a backdrop to any system and the linearity of its function seems unnatural and nonrandom and a buffer or framework to the participants.

# Weather, from Jim Sogi

The weather is important for surfing, sailing, skiing and markets. The weather in Alaska comes in large systems that move across the Pacific, lasting two weeks or more as they spin across the Gulf of Alaska.

These large weather systems have many random eddies. From day to day or hour to hour the sun or rain and snow may vary, but in a weather system more then 80% of the days are rainy, windy or snowy. In good weather, there was a stretch of nine days of sunny calm days up in Valdez. The big satellite pictures give a good sense of the scale of the systems and storms, more than just looking out the window from day to day. Seeing the spin of these large systems allows better prediction over days. A harbinger of a storm is sometimes very calm conditions with little variance in the wind speeds. After a very turbulent storm, there is a period of calm as the pressure and temperature gradients stabilize.

The markets have large systems that spin across the globe, visible as price history structures. Market systems are similar to large weather systems or structures that span the oceans or continents and last a similar period of one or two weeks before spinning out. This last big market storm in March lasted a few weeks, then we had nice sunny weather for a few weeks after. It takes a few days or more for the systems to change, and then they pick up speed, with good or bad days predominating for a week or two.

A period of flat calm may signify the winds of change are coming. About 15 years ago we went camping on Superbowl weekend. That night, the ocean was smoother than a bathtub with nary a ripple, and dead calm. We commented. "How odd!" Then at 3 am the wind started to pick up, and by dawn it was blowing over 60 mph. Eleven boats were blown on to the rocks that night. It was called the Superbowl Storm.

We have had two days of below six point ranges in the S&P500. A period of unusual calm. I wonder if it might portend turbulence.

# Between a Rock and a Hard Place, from Jim Sogi

The book Denali chronicles the history of climbing Denali, tallest mountain in North America. Severe storms can set in with little warning and can trap climbers for days with winds of up to two hundred miles per hour or blow them right off the mountain. The deaths occur when unprepared climbers are caught near the peaks in a storm in temperatures down to 100 below zero with wind chill, and high altitude dehydration, and the accompanying errors in judgment that start to pile up. Small slips can lead to a fall and death.

A classic error is waiting too long when the opportunity presents itself. When near the top or the bottom when good weather presents itself, it is imperative to make progress immediately. Waiting, wasting good weather can result in getting caught later in a bad storm. By waiting, the odds of getting caught in storm increase. When caught, the climbers get stuck in a position where they can neither go up nor down. Bad situation.

In markets it is easy to let opportunity on high peaks slip by for one reason or another, be it bad judgment, bodysnatcheritis, fear, busy with something, lack of attention, a million reasons or faulty reasoning. Once the good weather slips by one is running behind. The odds of getting stuck in a bad place increase. Getting stuck, too late to enter, too late to reverse, can't go forward, can't go backwards. Stuck. Not a good situation, and all arising from the initial failure to take advantage of the good conditions.

## From John Floyd:

On a related note I remember a quote that Ed Viesturs once told me. "Getting to the top is optional, getting down is not." Ed has the ability not only to summit numerous peaks but to do so while treading the fine line of pushing limits while always remembering survival is the paramount goal.

Likewise, I have found in trading it is important to know when to push the limits of risk. In fact, without pushing the limits it will be impossible to earn high rates of return over time. On the other hand, those limits need to be put to the test in conjunction with a full focus on survival. If we lose our bankroll getting back into the game will be that much more difficult.

## Alan Milhone writes:

Aside from scaling the heights of mountains there are those who scale financial heights and lose their head when at the pinnacle.

I think about the tirade that ensued between Donald Trump and Rosie O'Donnell. Mr. Trump is at the top of his mountain (though he constantly looks for higher peaks to conquer in the financial world). However I feel he should not lower himself to trade barbs with Ms. O'Donnell and a man of his caliber should keep himself well above the fray. Did he verbally attack her for ratings? I am sure the 'haircut' bet with Vince McMahon was 100% over ratings and money.

As a billionaire I am sure Mr. Trump has a gigantic ego to feed. I like what the Chair says about being humble in what we say and do. I admire Mr. Trump for his successes and am sure he does a lot of behind the scenes donations for various charities. So when climbing the financial mountains one should maintain humility and civility in what is said and done; many are watching every move.

# Persistence of Errors, from Ken Smith

April 7, 2007 | 3 Comments

Errors are rewarded in strange fashions, ways which are abnormal and thus unperceived by individuals with normal perceptions; meaning a right-minded person does not expect strange types of reinforcements to be in the mix of rewards.

One instance of strange reward I know of is referred to in some circles as a drive for self-destruction. Normal individuals perceiving an individual persisting in error that is harmful will not catch on that the error is accomplishing a reward, that reward being harm, and harm not generally acknowledged as a reward.

The hawkers of doom who get paid for their opinion to be persistently gloomy are being rewarded by an audience who appreciate the darkness. These readers return again and again to renew subscriptions with enthusiasm and this rewards the hawkers. In brief, doom hawkers speak to an audience of believers.

## Stefan Jovanovich writes:

A correspondent from Canada writes to me that the move today in oil up and down in the five minutes after the Ahmadinejad awarding of the medal, lead him to query ways of generally profiting from such false and ephemeral signals.

I immediately thought of the many times that it looked like a vivid event that had been associated with the tremendous market decline might be occurring again, and the many opportunities that provided. Indeed, I have a confession. During the summer there was a time that I was short a line of stocks. And a former Yankee pitcher played too near an apartment building. The rest of the story is too sad to tell. However, all parents should play "a boy stood near a railroad track" for their kids.

But this method must be generalized. It only happens about five times a year, and the 50 or so points you'll make from it each year must be counterbalanced against the expert sage Mohammed's view that big risks are not properly priced so that the one time you lose, let's say in 10 years, it will be more than 500 points.

Here's one attempt. I wonder if there is a very big list out there in cyberspace of people who like to read about scandals and failings among liberals, and negativity. Much of the economic news on such a list I would presume is planted. I would assume that the source might not be an overly reliable in informant or forecaster for various reasons. These include the lack of evidence of forecasting ability of the planters, their temptation to feather their own nest (except for their high moral turpitude and altruism and the checks and balances that the receivers and transmitters of such info must have), the anonymity of the source, and their insulation from the consequences of good or bad calls.

I would speculate that such economic news would tend to lead to ephemeral moves that are copperful to the caned when directed south. Such would happen, I would speculate, much more often than 10 times a year.

However, one seeks to generalize on this subject. We all know such people. Why can some people be wrong so often and yet maintain a following? We all know such people, the financial weekly news columnist for example is one icon in this regard. The economist who is always bearish in public but even more bearish in his private briefings is another. The technician who always sells the lows and buys the highs is another. The person who writes a book that's very persuasive and then starts a fund and loses hundreds for his clients but then rises up again and again like the Phoenix in another context. A consultant is another (doubtless many of my enemies will use this opportunity to say this about me). The self-indulgent authoritarian chief executive with a terrible management philosophy who hangs on and on is another.

Still another is the old eminence Arcadian who hasn't changed his views about anything and wants to do things the same way as the past and who eschews modernity like Chair Volcker (who, when I saw him in 2004, told me he sees no need for modern things like tape recorders).

I have written on Delphic forecasts. A condition for these people to hang on is often the couching of their statements in fuzzy irrefutable terms. That would apply to most of the ones I know.

But also, the ability to retaliate with force when their views are found to be falsified. This would apply to the Jonestown type error person as well as to the adviser who will sue you if you say anything about their record.

I would add that in the cases where the errorful have good motives their inabilities seem to be inordinately associated with a lack of education. They tend to be unaware of current scholarly work in their field, but hide behind a veneer of pseudo scientific talk as described by Marin Gardner and exemplified by Velikofsky, et al.

I'd be interested in augmentations, even example of why errors persist so that we can try to reduce the hard and persistence of same.

It is gratifying to disparage our opponents, however, even as we dismiss the turtles or news oriented lists, breakouts/breakdowns which have not worked for years seem to be occurring more and more as ranges widen again. The market seems "newsie" moving on Fed news, oil news, war news, and economic announcements. Contempt can breed complacency.

## From J.T. Holley:

Two things stick out for me: the lack of recognition of change, and laziness. The pack, herd, society, for the most part, don't like change. They would rather hang themselves and repeatedly take the easy way out than utilize anything remotely scientific that requires blood, sweat, and toil.

Miller's Willy Loman is a wonderful example of this. He would rather stick to his old sales ways than change like the young guns. Get rich quick schemes involving his son show this as well by Miller. Even in the end, Willy tries to leave more for his family by suicide but fails. This was laziness and lack of effort involving changing his ways.

I don't know. My PaPa told me on his deathbed to embrace change. It was like they were the most important words to me than anything else he had taught me up to that point. From that moment on I have always seen that as a sign of success in others, their willingness to be flexible and bend.

The persistence of errors-types would rather die in all forms than change! They'll take their hardheaded ways to the grave. This is laziness. Why else would someone be willing to succumb to such? How could you face the truth dead in the eye and not change? Denial must have its talons deep within people of this nature.

Once a charismatic type possesses both persistence of error disease and gathers a congregation it becomes lethal and the flock thrives.

Guys like us who are individuals, hardworking, non-altruistic, and embrace change, don't have big congregations! We just have empathy to fire us up occasionally.

## Abe Dunkelheit writes:

The errors persist because, psychologically, there is no alternative. One could go on and on, but everything would come back to the same basic thing: the impossibility of living without repression.

"[M]an is the more normal, healthy and happy the more he can … successfully … repress, displace, deny, rationalize, dramatize himself and deceive others." [Otto Rank]

The whole dilemma is perfectly elucidated in the Pulitzer Price winning book The Denial of Death, by Ernest Becker. But I am not sure if one should want to know too much about it.

When we say neurosis represents the truth of life we mean that life is an overwhelming problem for an animal free of instincts. The individual has to protect himself against the world, and he can do this only as any other animal would: by narrowing down the world, shutting off experience, developing an obliviousness [to facts] to the terrors of the world and to his own anxieties. Otherwise he would be crippled for action. (p. 178)

# Coffee, from Jim Sogi

April 4, 2007 | 2 Comments

The best coffee is Arabica. You guys drink the worst coffee. I'll bring some good Kona stuff out when I come next.

I got a sampler of eight different international coffees with the new iRoast 2, in green bean from Mexico, Peru, Timor, Sumatra, Congo, Panama, Nicaragua, Guatemala, and a few others. I'm not sure if it's what they're trying to sell or just trying to get rid of, but none held a candle to fresh roasted homegrown hand-picked sun dried Kona Coffee. Most were bland. Peruvian was about the best of the bunch, but still rather bland. Some were close to undrinkable. Sumatra tasted like dirt, Panama very bland, Nicaragua very bitter, and Peru mellow, good to mix 10% with 90% Kona.

Why does anyone voluntarily drink "flavored" coffee? I'm having a cup just now, because "hazelnut flavored" beans were all we had on hand in the office today. But I feel like the high-school stoner who's so desperate he'll smoke roaches. The stuff tastes like something the EPA would send HazMat-suited guys out to Jersey to detoxify.

A coffee importer once told me that the flavoured coffee industry grew out of a desire to use cheaper robusta beans and yet avoid the inferior aftertaste that caused manufacturers to prefer arabica. But then flavoured coffee took off.

## J T Holley writes:

Having earned and financed my college education working at various coffee shops such as Mill Mountain Coffee and Tea in the Roanoke Valley, and Food For Thought in Missoula, MT, I can tell you very few [buy flavored coffee]! Most coffeehouses have pots of coffee lined up on the counter of some sort for self pouring. The ratio to the best of my knowledge on refilling those was around 5 to 1 compared to regular coffees of many varieties.

Not that what you drank was good but there are two ways to flavor coffee. I have utilized both ways. One is with a horrible flavored oil and the other is via bottled syrup. The oiled way is to roast a rather cheap Columbian bean and then mix the oil and coat the beans (like applying chemicals to kill weeds). The other is much better and that is having an individual cup of coffee and adding a shot of flavored syrup. This seemed less toxic to me even though both are probably the same.

I witnessed very few people other than women that would order flavored coffee. Espresso drinks would be the exception to that. I would classify flavored coffee along the lines of 100 cigarettes. We used to joke that those extra long 100's were for people that like to ash not smoke. They don't smoke the cigarette they simply puff to be able to "ask" so they look sleek and sexy or something. Same with flavored coffee drinkers I've witnessed. They don't drink coffee like you and me, they sip and end up throwing half of it away in those plastic lined trash cans that weren't made to hold liquids!

My experience in the Navy taught me something about coffee as well. Cream and sugar were rarely added to a cup on my ship. Your sexual orientation back in the early 90s when I served was questioned if you had a stir stick in the cup. It was taunting or hazing thing on my ship. Words were slung at you in humiliating ways and made a man either quit drinking coffee altogether or go with the straight black cup of coffee to avoid the hassle.

It's amazing how psychological warfare works. I drank my coffee straight anyways so it wasn't a bother to me, but literally saw fights break out. Can't even imagine what would've come about if someone would have brought their own International Flavored Coffee onboard.

On a lighter note, I spent 6 to 8 years of my life roasting and serving coffee in all of its varieties. I have to confess that it is amazing how much caffeine is abused and that literal addicts consume the beverage. The mark-up on a cup of coffee from raw bean, to roasting, to brewing and serving is utterly amazing to me as well. The shops that I worked in did absolutely zero advertising as well, another fascinating fact of the coffee business.

I hate to think of the abuse one might get for using the following, but based on a crude experiment it does seem that cold brewing makes for a smoother (some say lack of) taste.

With respect to Nicaragua there seems to be a fair amount of variability in the taste of the coffee. The best coffee growing region is up around Matagalpa and Jinotega in northern Nicaragua.

The Nicas seem to like to drink it black with a fair amount of sugar.

Problem with all coffee though seems to be how long it has been sitting on the shelf. You don't always get a "born on date" on the package. Of course you can pay \$9 a pound for some of the brands that are sealed with nitrogen gas.

I know of someone who actually was marketing small discs that you put in your coffee maker to flavor the coffee of your choice. Better living through chemistry indeed.

## Pamela Van Giessen writes:

The Irish coffee flavored stuff is the worst. My mother served it to me once when I was visiting. Being sleepy I didn't focus on the malodorous nature but the second it hit my taste buds I literally spit it out. Thankfully we were outside. I think that stuff was made for older ladies.

## Scott Brooks writes:

Chicory is a plant that I use in my food plots to feed and attract deer and turkey. It is highly desirable, palatable, and nutritious to deer and turkey as well as many species of birds, and other assorted animals.

I am a big chicory fan. The only kind to get is Cafe Du Monde. Every other kind I have tried is terrible. That being said, I don't know that it mellows the flavor, unless the underlying coffee is much more harsh than regular. I drink it with sugar and cream.

# Every Day Tells a Story, from Jim Sogi

April 4, 2007 | 1 Comment

Each day seems to have its theme. The stories connect from day to day, as chapters in a longer booklet continuing a theme for a few days, or maybe a week or more, referencing back elements from the prior days. The same characters are involved from day to day. Sometimes, as when watching a movie, it is apparent what the theme will be and you can figure the outcome. Other day, it is hard to figure out and often the ending is a surprise with unexpected plot twists. Looking back, the plot and the surprise always seem obvious, just as looking back at Friday's doji reversal bar, in retrospect, seems so obvious. It is easy to lose track in the middle of the week. It is good to remember when watching how the theme started, how it is likely to resolve. Where you are in the story? What are the clues to the plot? Who are characters? The timing is designed to deceive. There are periods of suspense and denouement. As in fiction and drama, there are several broad themes around which many sub-plots are woven. The main stock market theme is one we discuss often, the upward march to new highs and redemption and the battle between the Force and the Dark Side.

# The Costanza Doctrine, from Nigel Davies

April 3, 2007 | 1 Comment

This has been used of late in a political context, but the Costanza Doctrine (taken from a Seinfeld episode in which George Constanza temporarily improved his fortunes by doing the opposite of what his instincts told him) would seem to offer hope to thousands of losing traders. The trick would seem to be to buy when you feel that knot of fear in the pit of your stomach, or sell when you feel the joy and excitement of a trade going your way.

George:

"Why did it all turn out like this for me? I had so much promise. I was personable. I was bright. Oh, maybe not academically speaking, but I was perceptive. I always know when someone's uncomfortable at a party. It all became very clear to me sitting out there today, that every decision I've ever made in my entire life has been wrong. My life is the complete opposite of everything I want it to be. Every instinct I have in every aspect of life, be it something to wear, something to eat… It's always wrong."

Jerry:

"If every instinct you have is wrong, then the opposite would have to be right."

There is a twist to this. In the markets, and in life, there is an asymmetry of some sort that throws this equation off. How it works in life will take some thought. But in markets, long is not the exact opposite of short.

## From Kevin Depew:

A funny application of the Costanza Doctrine (pre-Seinfeld) appeared in the movie "Let It Ride," which may be the closest the movies have come to real-life racetrack bettors in action. The main character, played by Richard Dreyfuss, is a degenerate gambler/loser who one afternoon mysteriously begins winning. (That the notion of winning at the track would be considered a) mysterious, and/or b) noteworthy enough for a film or book, is itself a pretty hilarious inside joke.) Anyway, in the middle of his winning streak he decides he's not even going to handicap the next race and instead walks around the track asking various degenerate gambler acquaintances of his who they like. Whichever horse they name, he scratches off the program and eliminates from contention.

When he gets to the one horse that hasn't been named, he lets his winnings ride on the unwanted horse with predictable winning results. As an aside, Robbie Coltrane has a nice turn as a dour teller. Also worth noting, the hatred emanating from his fellow degenerate gambler "friends" as his winning streak grows; everyone hates a winner; everyone loves a loser.

Interestingly, last night on the Black Donnellys (clearly, I'm watching way too much television these days), two of the Donnelly brothers are at the OTB to place a bet and hopefully recapture some money they owe to a crime boss. The "expert," Kevin, (a fictional character who nevertheless I am convinced is a direct blood relative of mine) can't decide between two horses. After much prodding from his brother, Tommy, he chooses one rather indecisively. Naturally, Tommy bets the one Kevin didn't choose, with predictable winning results.

By the way, the Black Donnellys is not a good show. The main character, Tommy, seems to have modeled his mannerisms on Tony Soprano, and the Irish stereotypes run for a full 47 minutes, laddie; may misfortune follow you the rest of your life, and never catch up. This may sounds strange, but I think I watch the show because Eisenberg's Sandwich Shop is one of the locations for filming.

One of the first things taught in a first-semester computer class is that the opposite of > is not < , but rather < or = . This applies to markets as well. The opposite of "long" is not "short," but rather "short" or "flat."

# A Simple Knot, from Jim Sogi

On a sailboat there are dozens of lines, but not a single rope. You've got your mainsheet, anchor rode, jib halyard, downhauls, uphauls, outhauls, and reef lines. They are all attached by simple knots. In fact the simplest knots are the best. They hold best and they are undone quickly and easily, which is very important to be able to release a line at the appropriate moment. Some knots are so simple, it is a matter of merely crossing two lines over each other and applying the appropriate pressure to be able to hold upwards of a five ton vessel with one hand.

I had a few landlubbers on my boat the other day. They tied a line to a fitting and it looked like a rat's nest, a tangle jumble of lines, impossible to undo, with questionable holding power. Their model, more is better, is flawed. A simple square knot or bowline cannot be beat for simplicity, ease of release, and reliable holding. Trading has the same needs: simple models and a simple position that can easily be unwound in a jam but that will hold well in a storm.

The problem of pattern recognition is quite fascinating and similar to the problems of knot classification and application. A jumble of indicators all crisscrossing this way and that is often not the best. In creating predictive models, statistically speaking, simplicity is best to avoid the problem of curve fitting the past, and reducing predictive power.

Humans are quite good at recognizing patterns, even ones that don't exist. Humans can recognize faces, even in disguise, remember a loved one's perfume, the smell of a certain flower, read hand written scribbles, spot fake antiques, recognize dangerous driving conditions, and spot good opportunities in financial markets. Now, machines can do almost none. Why? There is obviously a learning process, and a judging process. B.D. Ripley, in Pattern Recognition and Neural Networks, discusses these problems. He is careful to distinguish that the term neural networks is not an attempt to recreate a human brain in the box. Rather it is the process of creating statistical models to recognize and rate pattern recognition algorithms in terms of the their predictive power outside the learning set.

On a sailboat there are dozens of lines, but not a single rope. You've got your mainsheet, anchor rode, jib halyard, downhauls, uphauls, outhauls, and reef lines. They are all attached by simple knots. In fact the simplest knots are the best. They hold best and they are undone quickly and easily, which is very important to be able to release a line at the appropriate moment. Some knots are so simple, it is a matter of merely crossing two lines over each other and applying the appropriate pressure to be able to hold upwards of a five ton vessel with one hand.

I had a few landlubbers on my boat the other day. They tied a line to a fitting and it looked like a rat's nest, a tangle jumble of lines, impossible to undo, with questionable holding power. Their model, more is better, is flawed. A simple square knot or bowline cannot be beat for simplicity, ease of release, and reliable holding. Trading has the same needs: simple models and a simple position that can easily be unwound in a jam but that will hold well in a storm.

The problem of pattern recognition is quite fascinating and similar to the problems of knot classification and application. A jumble of indicators all crisscrossing this way and that is often not the best. In creating predictive models, statistically speaking, simplicity is best to avoid the problem of curve fitting the past, and reducing predictive power.

Humans are quite good at recognizing patterns, even ones that don't exist. Humans can recognize faces, even in disguise, remember a loved one's perfume, the smell of a certain flower, read hand written scribbles, spot fake antiques, recognize dangerous driving conditions, and spot good opportunities in financial markets. Now, machines can do almost none. Why? There is obviously a learning process, and a judging process. B.D. Ripley, in Pattern Recognition and Neural Networks, discusses these problems. He is careful to distinguish that the term neural networks is not an attempt to recreate a human brain in the box. Rather it is the process of creating statistical models to recognize and rate pattern recognition algorithms in terms of the their predictive power outside the learning set.

The Bayesian models figure prominently in many pattern recognition texts such as Ripley's, but also in Bishop's, Pattern Recognition and Machine Learning.

One of the issues is the use of parametric and non-parametric models. Often it seems that the data do not fit a normal model easily, and a non-parametric model may give better prediction. Ripley states the following,

"The normal distribution is a convenient abstraction, but all careful studies show that real distributions do not quite follow a normal distribution but have slightly heavier tails. In addition we should consider the possibility of outliers, that is examples which do not belong to the class under consideration….If the distributions are non-normal, then we need to take into consideration that the tails will be longer, and assuming a t distribution will be more appropriate."

A continuing issue is how to combine normal densities with outliers, like 2/27, to arrive at robust estimators. The traditional statistical approach to model selection includes the iterative process of backward selection by eliminating features until the best remains, or forward selection by starting with none and adding one at a time.

One method of arriving at a non-parametric model is through the use of Monte Carlo with replacement to ascertain the parameters of the learning set. Ripley finds that it may give superior predictions over a parametric model. Before computers, the difficulty of computing non-parametric models must have been insurmountable. But with fast computers why is greater use not made of non-parametric models?

We recently had some discussion on creating some rule of thumb benchmarks for easy computation based on non-parametric models created through Monte Carlo methods. This is an example of how recent market activity might be modeled simply.

A way to incorporate cycles might be with a rolling testing learning period to give estimators and in a Bayesian framework use those estimators going forward. That way the distribution parameters will morph to reflect the current regimes rather than be stuck with a fixed system. The Bayesian Information Criteria, which penalize size severely, might be used to determine a good leaning set/lookback size.

## From Pitt T. Maner III:

With respect to pattern recognition, this reminds me of the thief knot used by sailors in days past.

Isn't it amazing, too, how easy it is for random lines to get tangled or knotted up and not break and yet how compounded simple knots done with willful intent can come unraveled in the blink of an eye and fail their purpose. It's one topological mystery.

# Stops at 24, from Jim Sogi

The bears who project great declines and market breakdown on fears of Iran, the nervous longs with the same fears of subprime mortgages and recession, buyers at market at today's gap up open today, those that recalled with trepidation last month's breakdowns, all had their stops at June ES 1424, the prior day low. As GM says, it was too obvious.

# Childhood Games, from James Sogi

When no friends were around to play, I would spin nickels like little tops. Dimes were harder since they were smaller, and there were fewer of them. Pennies were plentiful. I would try to see how many I could get spinning like a top at one time.

Watching the market paths recently, in line with Chair's study on dimes and nickels, June ES seems roughly like a coin spinning around the dimes and bouncing off the nickels.

## From Steve Ellison:

I have been thinking in terms of quarters since the frightening intraday drop of March 14 that left a low-water mark at 1375.9 and the rally later the same day that breached 1400. The post-Fed exuberance was turned back just above 1450, and today the market rallied from just under 1425.

# Sudoku, from James Sogi

March 26, 2007 | 2 Comments

This weekend my daughter taught me how to do the Sudoku puzzles that I have seen others doing. They say it is good to keep the brain in good working order and to prevent brain atrophy, and it's fun. It involves a process of elimination, narrowing down the possibilities across different variables in order to have a better chance of recognizing the patterns. It is similar to the SAT aptitude test technique of narrowing choices to one or two, to increase your chances of arriving at the correct answer.

Perhaps such a process of elimination might be fruitful in market analysis, where one does not need to be exactly right all the time, but in order to achieve some level of success one needs to avoid being totally wrong all the time. Eliminate the possibilities that have a poor chance of occurring and it reduces being totally wrong.

The tendency for the news and the public seems to be to assume that whatever trajectory the market is on it will continue on in that direction. After a big bounce and big up, is it likely for the market to continue up forever? After a big drop, like earlier in March, will the market, as the news seems to assume, continue down forever? What scenarios might we want to eliminate from consideration?

Let's say the market is caught in a tight range for days on end after a move. The process of elimination might make pattern selection a bit less error prone. And though it might not make you right all the time, at least you might not be wrong all the time, which is a start. If you are at least not going in the completely wrong direction, that is about 68 percent of the battle.

# Rhythms in Markets, by Laurel Kenner

March 23, 2007 | 1 Comment

The market's repertoire of rhythms extends past human grasp. Sometimes it seems to make no sense at all, at least to me.

Sometimes, things seem to become clear. Just as in Afro-Cuban music, a strong voice - the "mother drum" in bata - dominates the counter rhythms of the smaller drums, sometimes the Fed's announcements dominate the backdrop of lesser voices — Chinese monetary authorities, fixed-systems followers, and what have you.

Earnings season has a peculiar rhythm. But it's ever-changing, based on which companies are strongest at the time.

One quality the market shares with music, good music, anyway, is "always the surprise." Bach, Mozart, Beethoven were all masters of deception and expert at weaving rhythms across bars. Beethoven's sforzandi, unexpected sharp accents, and sudden pianissimos, will be appreciated by all traders.

Back in the '90s, when I was the editor for the stock coverage, a humorous bond reporter at Bloomberg had a saying when stocks had yet another amazing jump: "Stocks ONLY GO UP," he would say, rolling his eyes knowingly, meaning just the opposite. No good musician plays loud all the time.

## Victor writes:

I am thinking of ways to quantify the rhythms of markets. Instead of looking at what others do, critiquing it, and then augmenting, I thought I'd just take a crack at thinking of it my own way.

Music rhythms would seem to be a good starting point. The rhythms that kids are taught are those they can step or clap or slap to. They can be fast or slow to start with. And I would look to see if the number of moves in a minute is fast or slow and how this changes. The slapping would involve moves from separate markets occurring in the same time period. When we step, the first step is the accented one and that's a good way to look at moves within a period. Is it the first step that's always the biggest, and what happens when the second or third step in a period is the biggest?

I would look next at the rhythms of big moves. They obviously are reversing now, with some big Tuesdays: February 27, -58; March 8, +22; March 13, -28; and March 20, +8. Naturally this kind of stuff isn't predictive in general or else it would come out in the standard time series programs. But on occasion, it comes back and forth to an inordinate degree and the question becomes how to find it.

Animals often migrate at the same time of year to the same places even when transported geographically. One wonders if the migrations of markets after big moves have a fixed place in the price firmament that they go back to. Or is it just in time, like the conventional seasonal stuff that one can expect from the migration? Last year, prices went way down in May and migrated back the last part of the year. This year the migration started in February. The month ended with the three old bags ("a woman her age would never show her posterior to a camera") acting in concert with the rhythmic release of the perennially bearish message from the Sage.

The rhythms of political announcements always seem to follow a circular path. They start with a loose cannon doing something that hits into something else. Then others join the act. One typical sequence involves worry about inflation, based of course on a preview of an upcoming release, then the release of the number, then the big bond fund guy saying he's bearish, then the perma-bears finding other inflationary things, then the opportunistic movement in certain nations that benefit from this or that energy price, and finally the rhythm ending with the release of the next number, or the quieting influence of an open market meeting.

Hoaglin
has some great diagrams of rhythms in the body. And the body has different rhythms that it responds to as molecules bounce into each other and create disturbances throughout other more complex molecules, thus upsetting the usual homeostatic methods. One market makes a big move, perhaps silver, and it spills over into others in a rhythmic sequence, perhaps an up in energy, and then a decline in stocks. It's not over until the initiating market has its move back down as was the actual case with the recent bloodbath and recovery, which seemed to have the elements of rhythm of all the ones I mentioned.

Of course, the rhythms have to be combined with the melodies. The speed of the moves has to be counted with the steps between those moves, sometimes big and sometimes small. And I like the way they quantify melodies in the Joy of Music and in the statistical studies of music intervals that have so much resonance with markets.

A more humdrum approach to rhythms, which I take, is to look at the rhythms of patterns. How often do the 3-day moves with their eight possible directions: —, –+, -+-, -++, +++, ++-, +-+, + — repeat? Is it a first order Markov process vis-a-vis these eight patterns, and what is the correlation between the closeness of each of the last three moves to these three patterns, and future moves? I recently ran some rhythm stuff with open, open to close, and open, and found some ministerial randomness with t's all below one, but enough evidence of non-randomness to get me thinking about rhythms on the whole.

I know enough about rhythms to know that they feel like the basic rhythms come from within the body, like the beating of the heart, and they can model it with rhythms based on the mathematics of African rhythms. Whatever quantifications they are making in bringing African rhymes and Latin rhythms into the heart beat problem would seem to be a natural for extension into the market.

I am fortunate to know someone with perfect rhythm and she is the coeditor of this column and I am going to ask her how she would try to trade in the market if she knew nothing else but markets. Perhaps other musicians with perfect rhythm might have similar expert opinions as to where market moves would be going based on their knowledge and oneness with rhythms in markets. Certainly these experts would be more prone to give good calls than the eminent people who have passed the tests of the mystical societies of America that are licensed to forecast the market.

The market's open now, and I haven't read any of the dozens of books I have on rhythms lately, but after I do and study it on the Net, perhaps I'll have some other ideas. For sure, my colleagues will be able to augment my preliminary fast ideas on this and guide others and me in proper directions.

Perhaps other musicians with perfect rhythm might have similar expert opinions as to where market moves would be going based on their knowledge and oneness with rhythms in markets. Certainly these experts would be more prone to give good calls…

An interesting way to test this would be to submit representations of various tradeables in various time increments to musical prodigies who are naive about markets. I am thinking particularly of junior and senior high school students, who could have sufficient musical training and experience, without having been exposed to what passes for financial and economic wisdom in the popular press.

## Ken Smith writes:

In harmony with Victor's piece on music, rhythm, I attempted to write a melody with three notes. I am having difficulty conveying this little ditty because the note symbols for music are not available in email text messages.

I've tried before to get symbols to end up as they were written when they appear after I've sent them. Somewhere in the Internet circle symbols sent in email get warped, become hijra. Meanings are thus distorted.

So maybe someone can help here. The musical symbols for this simple melody would be symbols for the Dollar, Mark, and Yen, just three notes.

Create a melody using these notes - they are real notes, after all. Then choreograph a dance for the melody. Add lyrics. Create permutations and program computers to trade dollar, mark, yen - according to the melody.

"A salient feature of markets is temptation." (Syncreticus)

## Todd Tracy writes:

Everyday I am inspired by the list and become more humble. In the business of music I had done well being rather sure of myself. That confidence came about from having practiced hours daily for 20 years. And even then I had much to learn. Afro-Cuban percussion was one of those things I knew nothing about until the day that my roommate brought home four percussionists. I didn't know at the time that they would be living and practicing in my living room for two years. And yes, they had many percussionist friends. The neighbors didn't seem to mind. They played all day, ten drummers strong, and then went on to their gigs at night.

One guy, Jacques, studied African rhythms. His guru was Babinga. Another guy, Blake, studied Cuban fusion. His guru was Giovanni Hidalgo. Davey was into Indian drums, Egyptian bells, and all sorts of experimental world music. Josh was a well-rounded guy who did it all. Their friends were mostly jazz funk kit players.

At any rate, I was doing 80 hours a week at the record company but on occasion they would let me sit in with them during rehearsals. When it came to the Congolese and Senegalese rhythms I had to learn to play the pattern given to me and not concentrate on the patterns the other guys were playing. The African stuff doesn't resolve like western music. Each part is simple; the complexity comes from the layering. Euro rhythms resolve every measure. Four beats to a measure at tempos ranging from 60-130 beats per minute. The African stuff would resolve many measures out, like ten equivalent western measures. It felt as though it was random until, with incredible anticipation, the resolution was at hand.

The Latin stuff was different in that the Cubans, Haitians, and Puerto Ricans had fused the African rhythms with western melodies. The most important part to the rhythm was the clave (wooden sticks that ring out when struck). The clave would be a simplified version of the rhythm. Then came the congas. They would play a rhythm called a Tumbao. Again, you had to concentrate on your part but synchronicity was achieved and resolved after just a couple of measures.

I was completely humbled by all that I did not know. But soon, through repetition, I found I had a whole new arsenal. These guys would play until their hands bled every day as they developed the incredible muscle memory needed to counter western rhythmic intuition.

Now the straight up rap beats are simple in that they are looped (kind of like rock music). But it is the anticipation of that resolution that concerns us with the market rhythms. In hip-hop the kick is on the one and the three; the snare is on the Two and the Four. The snares are played late to increase the anticipation. This lateness is the most important part, in fact, so important that rap artists actually consider the two and the four as the one and the three.

All of the rhythms resolve. There are problems in programming the beats in that there is a finite number of places to put each beat within a measure (460 ticks per beat) and the velocity of each beat is set at a value 1-127. We can, however, increase the resolution by doubling the BPM and by fine-tuning these anticipations and resolutions. I am studying the Quantlet Booklets so that I could one day break down the market rhythms as is being shown to me by the list members through the graciousness of Victor and Laurel's benevolence.

As far as what I think the S&P index will do from a musician's perspective is resolving to 1450 after channeling a bit more.

## Laurence Glazier writes:

It is very tempting to apply my knowledge of music in selecting trades, though I like to follow grounded mathematical principles at this stage. I would note that much of what we consider the theory of music was derived by the posthumous analysis of the works of the one and only JS Bach (the Moses of music?), which like much technical analysis is seductive but not necessarily predictive. I work on the principle that part of this analysis represents laws of musical reality empirically testable, but not in the normal way. As Leschetitsky said, "Where words end, music begins."

Of the technical analysts of music, Schenker is particularly interesting, while those who have enjoyed "The Glen Miller Story" may have observed the appearance of another significant analyst, Schillinger.

Having said that, I believe the analogies with market rhythms, while not necessarily predictive, would be very valuable as part of a real-time virtual reality program reflecting the current state of play in the markets, and pose the question whether users of such a system would do better if they were more musical.

There is something rhythmic in the moves of bonds and stocks together, over and above the comparative rates of return that the Duo and Dodger have quantified. And it's like the monkey rope that Melville describes, where when one goes down and the other has to follow. But there is much thrashing around as the turbulence from the whales temporarily overrides the inextricable bond.

And in that context the bonds, after setting a 19-day low at 11,202, are still up 2/3 of a point or about 1/2% on the year. And the stocks, after setting a 19-day high at 1445, are up about 1/2% on the year. Regardless of that it's what I used to call an ugly day and the rhythm is very bad for both when a big decline in one occurs in conjunction with a big rise in the other. Something has to give, and as Berlioz would say in reviewing Beethoven, you know it's going to return.

## George Criparocos writes:

The two days preceding the big note (02.27, the resonant, memorable one) had the bonds making a rhythmic intro analogous to what is expected when the largest instrument of all, the bass, announces a change in melody.

Since then, the contrabass, cellos, and violas (10s, 5s, 2s) are keeping the resonance, while the bass returns. The clarinet (Yen) is hanging around its 200MA set like a rope, refusing to let go of the anticipation and the piano (stocks) are all over the pentagram, in 1/16th intervals: four days low, four days high, four days flat, four days high.

The rhythm seems to be analogous to a symphony, lets say in F major. The allegro is in progress and I anticipate that the andante should follow in a molto mosso way.

Todd's analysis of African rhythms resolving over eight or 12 bars or multiples rather than the simplistic four beat 16 bar square "rock" structure is right on the beat.

One of the most basic rhythms popular in the blues is called the shuffle. It is a short-long, short-long, short-long, similar to the heartbeat or train on the track, da-dum, da-dum, da-dum. This basic rhythm underlies many more complex patterns.

Applied to the market after a small beat, there the long bar, the "shuffle." The count often does not capture the rhythm, just as European musical notation does not carry information relative to rhythm. That is an odd omission. A shuffle might be notated as straight quarter notes, but played as doted quarter and eighth note sequence and designated as a shuffle, all the musicians know right away what it means.

The rhythm can get behind the pocket, giving a laid back feeling, like the end of last week. Or the rhythm can get ahead of the beat, like disco, like last month's drop.

The middle of the pocket of the beat is the march's oom-pah, oom-pah, even beats. The rhythms will swing from behind the "pocket" and give the music different feels. This is very difficult to quantify because the interaction of the multiple players is complex and the "feel" is a subtle thing to capture. Musicians know this.

To capture this in the market is a difficult matter. The main difficulty is the time structure. A structure stretched out over weeks is difficult to feel for human rhythmic sense as our rhythm is based on the heart and walking, and resides in the feet and heart and head motions. So it's hard to feel the market rhythm without condensing the time and looking at the numbers or speeding it up on a replay as an interesting exercise.

## Russ Sears writes:

To Be With Me
by Russ Sears

Chic chic ca dee!
The Bluebird on our clothes line sings to me.
Come home, come home,
To be, to be,
to be with me.

Kar Reeee! Kar Reeee!
The Bluejay mocks the hawk in perfect key
Go! Clear! Go! Clear!
Not free, not free,
No meal is free!

Tit tit ra lee!
The glorious Lark boost for all to see
Stay back, Stay back,
Match me, match me
You cant match me.

## From Vincent Andres:

I am thinking of ways to "quantify" the rhythms of markets.

I didn't test it yet (will probably do so sooner or later) but the already known track of Hurst/Hölder/ exponents seem to me to be a possibly good piece of measurement.

Another possible tool could be wavelets.

Also, I recently came across a paper melting wavelets + Hölder curves : L'analyse par ondelettes, in Science, Vol.119 Sept. 1987. Yves Meyer, S. Jaffard, Olivier Rioul. The paper is in French. Very certainly progress have been made since this paper was published.

# Chickens Don’t Count, from James Sogi

It is spring in Hawaii and the hens are laying eggs and chicks are hatching. We hunt for eggs and when we find a nest we take the eggs. The hens can't count. If at least one or two eggs get left, they hen keeps laying. If you get greedy and take them all, the hen will give up and move. The hens don't know exactly how many eggs they have. When eight are gone, they only have a vague feeling that something is not quite right, but they can't quite pinpoint it. So they keep laying eggs, and we keep having omelets. They can't get very precise about what is the most efficient way to propagate. Of course some chickens are not too smart, like the ones that try to lay their eggs in a tree on branch.

There are vague feelings of unease when a trillion market dollars disappears. But, the eggs must keep getting laid. Sometimes it's good to be able to count the eggs so that so many don't disappear and to keep the right place in the ecology.

# Chair’s Vacation, from Jim Sogi

Ever notice whenever The Chair takes a vacation, the market makes a big time crash? One of the silly jokes around our house is that I need to watch the markets to keep it from crashing, and that if I look away it will crash. I was wrong. It's The Chair who needs to do it.

Thanks, Dr. Niederhoffer for your hard work. Keep watching for me next week while I'm on vacation.

# Time Traps, from Janice Dorn

What are your thoughts or solutions for any or all of these Time Traps?

## From Jim Sogi:

It's not necessarily time, it's really a question of categorizing priorities. Take all the things that have to be done and put them into 3 categories:

1. Must do to survive. Do those.
2. Next are important but not absolutely necessary. Get as many of these done as possible.
3. The rest, get to it if it does not interfere with first two. If not, forget it and give it up.

How does one categorize? In this order: Each lower item must give way to the higher in priority.

1. Health
2. Family
3. Other

Seems to work well but its not going to be what the "Man" tells you or wants you to do. Another good trick is to turn off the TV and radio for good. Disconnect them and throw them in the rubbish. They are evil.

# Asia, from James Sogi

Interesting to note Asia seemed to lead or presage the decline last week, and led the bounce last night. Also interesting dollar/yen negative correlation and lead during same period.

Nikkei
3/6/2007   16925
3/5/2007   16510
3/2/2007   16865
3/1/2007   17300
2/28/2007  17495
2/27/2007  17460
2/26/2007  18235

Nikkei  225                               16,844.50     202.25    1.22%
Hang Seng                               19,058.56     393.68     2.11%
Singapore Straits Times             3,036.52        54.23    1.82%
S&P/ASX 200                             5,808.90        37.10    0.64%

# An Historical Note on 3/1/07, from James Sogi

Many lessons of the list are coming in handy these past few days such as lessons on canes, leverage, liquidity, and survival. More heed might have been taken though to the bear's argument during the past few months, as they were not entirely wrong or foolish. Never underestimate the opposition. It is easy to delude one's self as we and the market were.

Since this panic was the biggest drop since 9/11, it is odd, since there is nothing really wrong like there was on 9/11. It was just one of those seasonal panics that come with the regularity of the seasons or the years as the case has been. The news is good, the economy is good, the market is good, and even the price is good. Anyway, a good time to get long, as it has been difficult to do so for months now.

# A New Kind of TA, from Jim Sogi

March 7, 2007 | 1 Comment

A few years back I read Wolfram's A New Kind of Science. I have been thinking about snow and looking forward to some heli-skiing in Alaska next week while spending long hours watching the market day and night. Wolfram's thesis is that simple binary rules for cellular automata in computer-generated binary or trinary functions develop into patterns as they branch out in an iterative fashion, often random in appearance, but with astonishing regularity. Quite amazing regular patterns, symmetrical patterns, emerge.

One of his theories is that natural cellular development is often binary and such a basic mechanism leads to gross formations with bilateral symmetry such as a hand with five fingers, a leaf, shells on the beach, starfish and a host of others. Applying the ideas to crystal formation, such as snow crystals, a simple branching mechanism tends to create symmetry in its patterns, though varied to infinity within its randomness, but more than random nonetheless, due to the basic binary rule at the heart of the creation of the crystals.

The market bid-ask is a simple binary function which, when iterated, develops the many price patterns in the historical record. The interesting application is the appearance of more than random occurrences of regular and symmetrical patterns. TA practitioners have proclaimed this for years. But might there be a quantitative manner of deconstructing and predicting the formation of a pattern before it completes, in a rigorous predictive manner?

Though he could develop the patterns from a basic beginning formula, Wolfram's greatest question and unsolved problem was that he was unable to deconstruct the basic formula from the developed pattern. But his main query for further study was, if these patterns could be developed from simple basic iterations of a simple rule, then why can't they be backwardly deconstructed?

In the market we know the rules; we see the patterns. Why can't they be deconstructed, categorized, and thus be predicted in a more rigorous manner than the TA practitioners use? There is no question in my mind that some TA rules have grounding and can be used rigorously for prediction. The Popperian problem is to state it in a falsifiable form, in a manner that can be quantified for testing.

# Coals to Newcastle, from Jim Sogi

I heard today that a very large barge of sand from China, so big it fills the harbor, arrived at our local port here in Hawaii. It is for use in construction. It must be cheaper than grinding solid volcanic rock. All the dump trucks are busy ferrying it to a big project here.

Normal meme is raw materials going to China.

# Orphan Tsunamis, from Ken Smith

February 28, 2007 | 2 Comments

Tsunamis occur for which the orgin is unknown in that no source has been discovered. They are called orphans. This week a shock, like a tsunami, hit China and the shock wave extended around the globe. It could be called an orphan. Not accompanied an origin.

Orphans appear out of nowhere, are not predictable, and leave damage that takes time to repair. Lives are lost.

In Japan, officials recorded an orphan tsunami — unconnected with any felt earthquake — with waves up to ten feet high along six hundred miles of the Honshu coast at midnight, January 27, 1700.

So far I've not heard of lives lost this week, no accounts of stockholders jumping from high windows above streets teeming with anguished investors and traders.

Only accounts that were weak suffered losses. However, shock waves reverberate and second waves are common. Today is all we have for knowledge; what happens at the open tomorrow is unknown.

Interesting how the wave traveled and continues to travel around the world, and how Japan follows US action later in the evening. The flu pandemic, which there will be at some point, will follow a similar path, and change many things, such as travel and free trade, more so than terrorism did.

Many lessons from DailySpec are coming in handy these past few days, on such topics as canes, leverage, liquidity, and survival. More heed might have been taken though to the bears' arguments the past few months, as they were not entirely wrong or foolish. Never underestimate the opposition. It is easy to be self-deluded as we, the market, were.

The biggest drop since 9/11, oddly, since there is nothing really wrong, as there was on 9/11. Just one of those panics that come with the regularity of the seasons, or the years, as the case has been. The news is good, the economy is good, the market is good, and even the price is good. Anyway, seems like a good time to get long, as it has been difficult to do so for months now.

# Execution, from James Sogi

February 27, 2007 | 1 Comment

It's spring in Hawaii. The free-range chickens in the yard are having little chicks. They are really cute. The clutches vary from three to 10 chicks. They all follow their mother hens around and peck at little worms. They struggle to keep up with mom, across the grass, up the rocks. Sometimes when the mother is spooked, she reverses direction really fast. Some of the chicks are not paying attention, or are not as fast, and are left behind. The Hawaiian Hawk, or Io, is cruising right above in the trees and swoops down and grabs a chick. Out of ten chicks, maybe two or three survive to maturity. Execution is swift.

That reminds me that when he market changes direction, not everyone is paying attention, or can't move as fast, and some few are left straggling in the wrong direction. A good spec is on the alert and can swoop down for a meal. That brings up the subject of execution. It can account for several percentage points of return, no matter what the system. There is always the tradeoff in fills, between size and accuracy. One can't have both. That brings up alpha. How much alpha is execution? A part of any system is its executability and accounts for a chunk of alpha. Many systems look great, but will they execute? A poor system can turn out great with great execution.

# Sales and Sports, from J. P. Highland

February 26, 2007 | 2 Comments

I'm only 34 but I have been involved in sales for 16 years, when I started selling ads in a magazine. At some point I managed a sales force of fifty and I found the most successful salespeople to be hard working single mothers who needed to work hard to raise their kids. The best salespeople I know come from the lower classes, driven by the desire to have a better life. I can't recall a single good salesman coming from the upper levels of society.

People who play in competitive team sports are sought-after for sales positions because of their ability to "take the hit," face, and deal with a reality in their face that produces an unambiguous score.

## James Sogi extends:

The benefit of sports to a child, which leads to success in life, is the ability to face, accept, and overcome loss. A sporting loss is not life-threatening or career-ending, and the sportsman learns to overcome adversity in a controlled setting. Furthermore, he learns the rewards of effort, ultimate effort, training, discipline and competition. He learns, perhaps the hard way, that he cannot succeed without extra effort, hard work. These are over and above the benefits of health and fun and camaraderie from sports. These are lifelong lessons.

## David Lamb writes:

Many Wall Street firms hire ex-athletes, who are sought-after due to their competitive nature, their ability to take a "hit", and their desire to excel.

## Steve Ellison replies:

It is not a Wall Street firm, but tech giant EMC that has built an outstanding sales force by seeking out athletes. I know a manager there who was a college hockey player. He says that he would give preference in hiring to anybody who was a student-athlete because it takes excellent time management and organization to be able to compete at the collegiate level while completing a college education.

Quote of the day from the sports page describing the Duke lacrosse team's motto for this season: "Succisa Virescit," Latin for "Cut it down, and it will grow back stronger."

To compete, in sports, in sales, in business, even in life and perhaps eternity, it is not enough to learn to "take a hit." Even the losers who barely survive will learn to take a hit.

To thrive you must learn to embrace the pain, to accept that success has a price. This will take you beyond the masses. The runt playing football or basketball for the love of the game will learn this.

To be a champion, you must find your niche; find that pain that makes you stronger. You must learn what exists inside you that, when it is cut down, makes you grow back stronger. You must learn to reinvent yourself until your dreams run parallel to your ability. You must learn to evolve.

Many great successes do make great salesmen. They don't make great salesmen, however, by just selling anything. They must sell something they believe in, on their own terms, not somebody else's.

# Liquidity, from Bill Rafter

February 22, 2007 | 1 Comment

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

Under this view,

1) Where is all the excess liquidity coming from?

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

## Dan Grossman writes:

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

www.mathinvestdecisions.com/us_japan_monetary_bases.gif

## Jim Sogi writes:

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

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

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

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

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

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

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

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

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

## From Bill Rafter:

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

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

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

www.boj.or.jp/en/type/stat/dlong/fin_stat/boj/cdab0150.csv

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

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

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

# Ranges, from James Sogi

The market has days when it consolidates, then breaks out of the range to a new level, like the discussion of bird nests. Counting the last three months by hand shows a count of the number of days to build a bird's nest. 7+5+5+5+3+6+6=37 /7 ~ 5.

The average is around 5 days, after which time the chicks fly off. Today is the fourth bird nest building day. The boughs seem to have bent but not broken. Three times have been breakdowns, 4 times have been up. It's the same idea as the room cleaners in the big hotel. Clean rooms, move to the next floor.

# For Whom the Bell Tolls, by Marlowe Cassetti

Investors are often perplexed by the lack of warning of market tops and bottoms, until after the fact. There is no alarm bell tolling. However, there are warning signs at the tops usually based upon enthusiasm, and at the bottom signs based on despair. Didn't Mutual Fund Magazine close its shutters at the end of the last bear market, ringing the bell near the bottom? So now we have a new FOX Business Channel to start broadcasting this year.

Is this a warning bell that the market is flirting with the top?

## Victor Niederhoffer writes:

This is all very well and good except that there are approximately 1 billion qualitative events like starting a new business channel that come within a month of all market tops, bottoms, and continuations. It is impossible to differentiate the cause, effect, or any other factor related to the seemingly and for the large part random movements from drift.

## From Jason Goepfert:

My local Barnes & Noble is relatively small and its business magazine section is sparse, Forbes, Fortune, BusinessWeek and not much else.

Last year, they started carrying Active Trader, which I found at the back of the top rack. If I weren't 6'6", I never would have seen it.

This weekend, on the second shelf, I was taken aback when I saw the following magazines all prominently displayed: Active Trader; Equities Magazine; Technical Analysis of Stocks & Commodities; Traders Press; Trader Monthly; and Bloomberg Magazine

## Jim Sogi writes:

My daughter called last week and said, "Dad, I want to buy some stocks, now." I said, " Wait till they go down a bit." She said, "You always say that." I told her that, as with the rest of the public, with recent all time highs, the urge to buy stocks at high levels is typical but often wrong. It is better to buy stocks when they are down so you aren't down a couple percent as soon as you buy. She looks at her stocks about once a quarter.

## From Stefan Jovanovich:

The actual use of canaries in coalmines fails to provide the historical lesson that the metaphor promises. Mining for "sea" coal (named because the earliest pits were at the coastal towns like Newcastle in what is now the United Kingdom) began in the 1400s. Canaries were first used in British coal mines in 1911. As part of the political alliance between the Liberals and the new Labor Party, parliament adopted regulations requiring that two canaries be placed in every mine. That, of course, required that someone be assigned the job of canary keeper.

The requirement for canaries was finally abolished in 1986. There is no evidence that the canaries served any useful purpose; the scientific justification was so weak that they were first described as being uniquely qualified to detect carbon monoxide. When that proved not to be the case, they were rationalized as being peculiarly sensitive to methane. The canary in the coalmine is probably better compared to the caboose on the rail train, a "safety" requirement that provided a comparatively soft berth for the man assigned to the useless activity.

# Bird Nests and Markets, by Victor Niederhoffer

February 18, 2007 | 1 Comment

He hovered nightly like a dove around its pillaged nest.

Bird nests provide an environment of shelter and protection for eggs to develop. The exquisite variety of the construction techniques, building materials, and camouflage used in these nests, and also their importance to the ecology of birds is described here. Numerous articles cite the importance of nest building in birds as an essential aspect of their evolution, and such articles include Dawkins The Extended Phenotype For Behaviors. With something as important as this, one would expect that markets would have borrowed from nature and that there would be numerous areas where the mistress and the invisible hand would have developed comparable features in market behavior for the development of the young. Yet a search shows that the main references to bird nests in markets are to the habits of very successful Asian traders in eating gourmet delicacies such as birds' nests rather than using them for profit in their strategies. As a start, this must be remedied by me and the colleagues here.

Undoubtedly, the main application of nests to markets is the protective function that companies in one index play with respect to their graduation to the next stage of life. The mid market S&P 500 is always the best bet for young companies to develop into the big 500. The Nasdaq is a nest for the NYSE, and the S&P small cap is a nest for the midcap. The IPO's are a stage in the life for future NAS 100. What strategies do such companies play? Do the parents of the index themselves play to separate the survivors from those who decay? Are there comparable forms of altruism that some companies play as they do in birds' nests where the young devote their life to feeding their kin knowing that it will lead to a much greater overall transmission of the essence of their being?

Another area where nests are found is at levels of price that bring one into a new class. One level would be the movement from below five where stocks are usually not eligible for margin to above five where companies are eligible for inclusion in most portfolios. The same would happen for a company that starts paying dividends for the first time since certain funds and institutions are restricted to dividend payers only. At a more general level, big orders often rest to provide nourishment for a company. It could be from a buy back program or perhaps an insider who is accumulating Insiders often accumulate stock in their companies. This is sometimes a signal that a change in state, like an acquisition, is in the offing or perhaps a buyout in a going private transaction.

Option strike levels provide barriers and nesting sites for traders to nourish themselves until the price is ready to come out of the nest into an area where real buying, selling, exercises and conversion of the stock are possible. Considering the strategies of nest building, in particular the effort that is put into its construction with reference to the probability of survival for the egg to maturity, one should consider the many fledgling companies that are incubated in research laboratories, entrepreneurial efforts within companies, and previous acquisitions that are being nourished for a proper time in the market.

May I suggest that we expand the subject to the many fruitful areas that could be considered and fomented by a general study of bird behavior. Such questions as the following would only be a beginning. How do the feathers of birds enable them to fly? What are the special functions of display behavior in birds that are so successful in the sexual selection of their partners, in particular, the back and forth strutting that stocks often do to attract the interest of the public and the dealers? What are the migration patterns and timing of stocks that follow in the footsteps of our feathered friends? Most important of all, what are the functions of birds, the stocks and companies that fly about in the general structure, growth, and stability of markets? What songs do markets sing to attract, warn, and establish territory?

## From Alan Milhone:

"Birds of a feather flock together." Is this the same with investors and brokers in that they all want to stay with the winners (performers)? I liked the way you described the construction of a bird's nest, guess that is where the term 'nest egg' developed? Or 'putting all your eggs into one basket' meaning one should stay diversified? The strong and secure nest is analogous to a strong and protected portfolio.

I enjoyed the Chair's article and it gave me a different perspective on nesting & ways of attracting investing. Not sure about songs used for attraction. My guess is how online or televised marketers vie to attract a potential investor's attention in hopes of getting them to buy into their program, much like a male bird hoping to attract a female's attention. The male bird's 'chirping' is music to the females' ears (hopefully) and the online/televised promoter of various stocks and investment programs is hoping to lure our attention in similar ways.

## Jim Sogi writes:

Another bird nesting behavior in the market is the bunching of the price range within a certain area. For example over the last few days we see the bunching nesting behavior in the 1256 area, and before a nest was built in the lower branches at lower levels. When the little birds are strong enough, they venture out and start to fly from the nest, taking forays flying to higher levels.

There is busy back and forth activity as the nest is build. The nest normally must have a structure and normal time to build before the birds either venture out or, for some reason, the whole nest falls out of the tree an on to the floor, as in rare occasions it does, killing all the little chicks. Bigger birds like eagles that build bigger nests at higher altitudes soar higher. Perhaps that is why Dow big birds are hitting all time highs and SPs are still moving up to their all time highs, in sight a couple bird nest levels away.

## J. T. Holley writes:

On a similar note [to previous post] you can look down the option chains intra-day and see birds perched either on nests or on wires and see them "spooked" as higher and higher numbers are reached historically. It's almost like opening up a dark room and seeing the cockroaches scatter when the light of day hits them.

# Review of Larry William’s “Trade Stocks & Commodities with the Insiders,” by James Sogi

February 15, 2007 | 1 Comment

I am glad to consider Larry Williams as a friend, so it is was with great enjoyment that I read his recent book. One of the great pleasures and benefits of knowing the Specs is being able to meet and discuss market ideas with the best.

The commitments of traders report provides good additional information to speculators in the futures markets. Larry presents many good ideas for quantitative specs to test, and even hints at some of the many tricks he has up his sleeve, without giving away the family jewels. The book's use of charts is aimed at the less quantitatively inclined beginner, and while some of the chart-based reasoning suffers from chartism's typical retrospective bias, Larry does have a chapter on quantitative tests, although limited to win/loss ratios and amount of wins, and briefly discusses down days in S&P. However, any astute spec can test the many good ideas rigorously and develop his own more precise methods.

Ideas for new trades can come from any source, as the Specs have shown us, and new ideas are necessary to keep an edge in a competitive market. Rather than try to find entries base on comparing chartpoints and indicators which is non predictive, better to use the ideas and data to refine the entries. It is in this spirit that the book is helpful to a speculator. It's a fun an quick read, in Larry's breezy and folksy style.

In many ways the most basic and important call in the market is if it is going up or down. Seems so deceptively simple, but the paths it takes throw one off the track. Good information, just a bit more than the next guy, is what it takes to head in the right direction, and the COT report may give an edge.

# Costs of Advertising, by Jim Sogi

Sometimes it costs some money to make money. You have your advertising. You have your expenses and normal overhead. Sometimes you have to fix up the merchandise to make it look good. You have to pay off your shills. You have to paint up them horses so they look nice to the buyers. Sometimes you have to give a bit on some inventory to get the action going, get the customers interested.

Hopefully the costs won't exceed the ultimate rake in, but you've got to spend a little hopefully to make a little. I'm not a gambler, but I guess you have to get the mark interested in the game by giving him a few pots before the rake. The problem is, I can never tell who the sucker is at the table when I play. Hmmm.

# Google’s Book Project, from Alston Mabry

Just discovering Google's book project. They're scanning in books from various libraries and have an ambitious plan to scan every book ever published (New Yorker article by Toobin).

A search for "speculator" brings up these full, searchable texts (among many others):

Arthur Crump: The Theory of Stock Exchange Speculation; London, 1874, John Hill, Jr. (of the Chicago Board of Trade).

Gold Bricks of Speculation; Chicago, 1904, A Study of Speculation and Its Counterfeits, and an exposé of the methods of bucketshop, and "get-rich-quick" swindles.

Harrison H. Brace: The Value of Organized Speculation; New York, 1913. A prize-winning essay from a contest run by Chicago, Columbia, Michigan, NYU, and Harvard, and sponsored by, "…Hart, Schaffner & Marx, of Chicago, who have shown a special interest in trying to draw the attention of American youth to the study of economic and commercial subjects."

## Jim Sogi writes:

Thanks to Alston Mabry for pulling this one up. It will surely be a favorite of the Chair.

Arthur Crump appears to talk about the English markets, but the lessons are the same. Crump charges out of the gate with some great formulas for risk, such as, "…the sum risked must be only such proportion of the possible gain as the mathematical probability of gaining it is of unity." This is brilliant. "A man should not hazard his all on any terms."

Imagine this quantitative risk measurement in the 19th century. Closer to current one-day drops he speaks of typical drops of 2-3% a day with very gradual gains, familiar scenario indeed.

Crump identifies the pitfalls that await the unwary.

A typical reason many beginners convince themselves speculation is simple is they say to themselves the market can only go up or down and his chances are at least 50-50. Their mistake is overlooking path dependency in calculating the odds, thinking reversing position might have avoided losses.

"The outsider's stakes are too large a proportion of their means."

"Multiply each gain or loss by the probability of the event on which it depends; compare the total result of the gains with that of the losses. The balance is the average required and is known by the name of mathematical expectation."

It follows from this that the player must be able to stand a number of plays to realize the expectation. Furthermore, the gains must be greater than the expenses.

"Those whose only business it is to be in the stock markets must of course know that the outside public are always dropping their money."

"If a speculator has not learnt the alphabet of recurring intervals, he has not learned the alphabet of his business."

More later, but this is fun and good book in nice quaint old print.

## More Crump Quotes from Jim Sogi:

"Any jackass can take a profit, but it requires a devilish clever fellow to cut a loss. After he has once realized the importance of having his accounts open and ready for the periodic haves to carry him in and land his profit, the difficulty is to get him to realize the importance of keeping out while the water weeps back, carrying with it the gray speculators who were not content to take their profits"

Good advise these last few days.

"It is as necessary to the success of his operation that he posses no more regard for the feelings or pockets of other people than a hungry tiger would for him, if he were airing himself unconcernedly in a Bengal jungle. He has a purpose in view, just as a surgeon has when the amputation of a leg has been decided upon."

"Deception in all its form will be found in the armory
of the professional speculator, and the weapons, two-edged, are employed."

"Then there is the fatal blunder made by almost every inexperienced speculator, of never being satisfied with a moderate profit. If he buys, and the price rises 1/2, he cannot make up his mind to take it, but must wait for 3/4th. When it has reached that he must have 1 per cent and when that rise has been attained too, he wants another 1/8th to cover the commission. Like a dog in attempting to grasp the shadow of his bone, he loses all."

# Negative Feedback and Trend Following, by Victor Niederhoffer

February 8, 2007 | 9 Comments

There has been entirely too little thought given to the mechanism, pathways and reasons that negative feedback works in markets. Perhaps the main reason is that the feeding web is based on a reasonable stability in what and how much is being eaten and recycled.

The people who consume and redistribute must maintain a ready and stable supply of those who produce. They develop mechanisms to keep everything going. One of them is the specialization and great efficiency in their activities. If markets deviate too much from the areas and levels within which the specialization has developed, then much waste and new effort and mechanisms will be necessary.

Aside from the grind that trend following causes (i.e. the losses in execution), and the negative feedback system of movements in the supply and demand schedules that equilibrate, which Marshall pioneered and are now standard in economics, and the numerous other reasons I've set forth (e.g. the fixed nature of the system and the flexibility to profit from it), this appears to me to be the main reason that trend following doesn't work.

Here are a few interesting articles on the subject:

How Great Traders Make Millions in Up or Down Markets

Does Trend Following Work On Stocks?

Why I Don't Believe in Trends

Briefly Speaking . . .

## Bill Rafter writes:

Dr. Bruno had posed the idea of beating an index by deleting the worst performers. This is an area in which we have done considerable work. Please note that we do not consider this trend-following. The assets are not charted, just ranked.

Let us imagine an investor who is savvy enough to identify what is strong about an economy and invest in sectors representative of those areas, while avoiding sectors representing the weaker areas of the economy. Note that we are not requiring our investor to be prescient. He does not need to see what will be strong tomorrow, just what is strong and weak now, measured by performance over a recent period.

What is a market sector? The S&P does that work for us, and breaks down the overall market (that is, the S&P 500) into 10 Sectors. They further break it down into 24 Industry Groups, and further still into 60-plus Industries and 140-plus Sub-Industries. The number of the various groups and their constituents changes from time to time as the economy evolves, but essentially the 500 stocks can be grouped in a variety of ways, depending on the degree of focus desired. Some of the groupings are so narrow that only one company represents that group.

Our investor starts out looking at the 10 Sectors and ranks them according to their performance (such as their quarterly rate of change). He then invests in those ranked first through fourth (25 percent in each), and maintains those holdings until the rankings change. How does he do? Not bad, it turns out.

www.mathinvestdecisions.com/Best_4_of_10.gif

From 1990 through 2006, which encompasses several types of market conditions, the overall market managed an 8 percent compound annual rate of return. Our savvy investor achieved 10.77%. A less savvy investor who had the bad fortune to pick the worst six groups would have earned 7.23%. Those results are below. (Note, for comparison purposes, all results excluded dividends.)

www.mathinvestdecisions.com/Worst_6_of_10.gif

How can our savvy investor do better? By simply sharpening one's focus, major improvements can be achieved. If instead of ranking the top 4 of10 Sectors, our savvy investor invests in a similar number (say the top 4, 5 or 6) of the 24 Industry Groups, he achieves a 13.12% compoundedannual rate of return over the same period. Note that the same stocks are represented in the 10 Sectors and the 24 Industry Groups. At no time did he have to be prescient.

One thing you will notice from the graphs above is that the equity curves of our savvy and unlucky investors mimic the rises and declines of the market index itself. Being savvy makes money but it does not insulate one from overall bad markets because the Sectors and even the Industry Groups are not significantly diversified from the overall market.

Why not keep going further out and rank all stocks individually? That clearly results in superior returns, but the volume of trading is such that it can only be accomplished effectively in a fund structure - not by the individual. And even ranking thousands of stocks will not insulate an investor from an overall market decline, if he is only invested in equities. The answer of course is diversification.

It is possible to rank debt and alternative investment sectors alongside equities, in the hope of letting their performances dictate what the investor should own. However the debt and commodities markets have different volatilities than the equities markets. Anyone ranking them must make adjustments for their inherent differences. That is, when ranking really diverse assets, one must rank them on a risk-adjusted basis for it to be a true comparison. However if we make those adjustments and rank treasury bonds (debt) against our 24 Industry Groups (equity) we can avoid some of the overall equity declines. We refer to this as a Strategic Overlay:

www.mathinvestdecisions.com/Strategic_diversification.gif

Adding this Strategic Overlay increases the returns slightly, but more important, diversifies the investor away from some periods of total equity market decline. We are not talking of a policy of running for cover every time the equities markets stall. In the long run, the investor must be in equities.

Invariably in ranking diverse assets such as equities, debt and commodities, our investor will be faced with a decision that he should be completely out of equities. It is likely that will occur during a period of high volatility for equities, but one that has also experienced great returns. Thus, our investor would be abandoning equities when his recent experience would suggest otherwise. And since timing can never be perfect, it is further likely that the equities he abandons will continue to outperform for some period. On an absolute basis, equities may rank best, but on a risk-adjusted basis, they may not. It is not uncommon for investors to ignore risk in such a situation, to their subsequent regret.

Ranking is not without its problems. For example, if you are selecting the top 4 groups of whatever category, there is a fair chance that at some time the assets ranked 4 and 5 will change places back and forth on a daily basis. This "flutter" can be easily solved by providing those who make the cut with a subsequent incumbency advantage. For a newcomer to replace a list member, it then must outrank the current assets on the selected list by the incumbency advantage. This is very similar to the manner in which thermostats work. We have found adding an incumbency advantage to be a profitable improvement without considering transactions costs. When one also considers the reduced transaction costs, the benefits increase even more.

Another important consideration is the "lookback" period. Above we used the example of our savvy investor ranking assets on the basis of their quarterly growth. Not surprisingly, the choice of a lookback period can have an effect on profitability. Since markets tend to fall more abruptly than they rise, lookback periods that perform best during rising markets are markedly different from those that perform best during falling markets. Determining whether a market is rising or falling can be problematic, as it can only be done with certainty in retrospect. However, another key factor influencing the choice of a lookback period is volatility, which can be determined concurrently. Thus an optimal lookback period can be automatically determined based on volatility.

There is certainly no question that a diligent investor can outperform the market. By outperforming the market we mean that he will achieve a greater average rate of return than the market, while limiting the maximum drawdown (or percentage equity decline) to less than that experienced by the market. But the average investor is generally not up to the diligence or persistence required.

In the research work illustrated above, all transactions were executed on the close of the day following a decision being made. Thus the strategy illustrated is certainly executable. Nothing required a forecast; all that was required was for the investor to recognize concurrently which assets have performed well over a recent period. It is not difficult, but requires daily monitoring.

## Charles Pennington writes:

Referring to the MathInvestor's plot:

At first glance it appears that the "Best" have been beating the "Worst" consistently.

In fact, however, all of the outperformance was from 1990 through 1995. From 1996 to present, it was approximately a tie.

Reading from the plot, I see that the "Best" portfolio was at about 2.1 at the start of 1996. It grew to about 5.5 at the end of the chart for a gain of about 160%. Over the same period, the "Worst" grew from 1.3 to 3.2, a gain of about 150%, essentially the same.

So for the past 11 years, this system had negligible outperformance.

One should also consider that the "Best" portfolio benefits in the study from stale pricing, which one could not capture in real trading. Furthermore, dividends were not included in the study. My guess is that the "Worst" portfolio would have had a higher dividend yield.

In order to improve this kind of study, I would recommend:

1.) Use instruments that can actually be traded, rather than S&P sectors, in order to eliminate the stale pricing concern.

2.) Plot the results on a semilog graph. That would have made it clear that all the outperformance happened before 1996.

3.) Finally, include dividends. The reported difference in compound annual returns (10.8% vs 8.0%) would be completely negated if the "Worst" portfolio had a yield 2.8% higher than the "Best".

## Bill Rafter replies:

Gentlemen, please! The previously sent illustration of asset ranking is not a proposed "system," but simply an illustration that tilting one's portfolio away from dogs and toward previous performers can have a beneficial effect on the portfolio. The comparison between the 10 Sectors and the 24 Industry Groups illustrates the benefits of focus. That is, (1) don't buy previous dogs, and (2) sharpen your investment focus. Ignore these points and you will be leaving money on the table.

We have done this work with many different assets such as ETFs and even Fidelity funds (which require a 30-day holding period), both of which can be realistically traded. They are successful, but not overwhelmingly so. Strangely, one of the best asset groups to trade in this manner would be proprietarily-traded small-cap funds.

Unfortunately if you try trading those, your broker will disown you. I mention that example only to suggest that some assets truly do have "legs," or "tails" if you prefer. I think their success is attributed to the fact that some prop traders are better than others, and ranking them works. An asset group with which we have had no success is high-yield debt funds. I have no idea why.

## A comment from Jerry Parker:

I wrote an initial comment to you via your website [can be found under the comments link by the title of this post], disputing your point of view, which a friend of mine read, and sent me the following:

I read your comment on Niederhoffer's Daily Spec in response to his arguments against trend following. Personally, I don't think it boils down to intelligence, but rather to ego. Giving up control to an ego-less computer is not an easy task for someone who believes so strongly in the ability of the human mind. I have great respect for his work and his passion for self study, but of course disagree with his thoughts on trend following. On each trade, he is only able to profit if it "trends" in a favorable direction, whether the holding period is 1 minute or 1 year. Call it what you will, but he trades trends all day.

He's right. I was wrong. Trend following is THE enemy of the 'genius'. You and your friends can't even see how stupid your website is. You are blinded by your superior intelligence and arrogance.

## Victor Niederhoffer responds:

Thanks much for your contributions to the debate. I will try to improve my understanding of this subject and my performance in the future so as not to be such an easy target for your critiques.

## Ronald Weber writes:

When you think about it, most players in the financial industry are nothing but trend followers (or momentum-players). This includes analysts, advisors, relationship managers, and most fund or money managers. If there is any doubt, check the EE I function on Bloomberg, or the money flow/price functions of mutual funds.

The main reason may have more to do with career risk and the clients themselves. If you're on the right side while everyone is wrong, you will be rewarded; if you're on the wrong side like most of your peers you will be ok; and if you're wrong while everyone is right then you're in trouble!

In addition, most normal human beings (daily specs not included!) don't like ideas that deviate too much from the consensus. You are considered a total heretic if you try to explain why, for example, there is no link between the weak USD and the twin deficits. This is true, too, if you would have told anyone in 2002 that the Japanese banks will experience a dramatic rebound like the Scandinavian banks in the early '90s, and so on, or if you currently express any doubt on any commodity.

So go with the flow, and give them what they want! It makes life easier for everyone! If you can deal with your conscience of course!

The worse is that you tend to get marginalized when you express doubt on contagious thoughts. You force most people to think. You're the boring party spoiler! It's probably one reason why the most successful money managers or most creative research houses happen to be small organizations.

## Jeremy Smith offers:

Not arguing one way or the other here, but for any market or any stock that is making all time highs (measured for sake of argument in years) do we properly say about such markets and stocks that there is no trend?

## Vincent Andres contributes:

I would distinguish/disambiguate drift and trend.

"Drift": Plentifully discussed here. "Trend": See arcsine, law of series, etc.

In 2D, the French author Jean-Paul Delahaye speaks about "effet rateau" (rake effect), here and here .

Basically, our tendency is to believe that random equals equiprobability everywhere (2D) or random equals equiprobability everytime (1D), and thus that nonequiprobability everywhere/everytime equals non random

In 1D, non equiprobability everytime means that the sequence -1 +1 -1 +1 -1 +1 -1 +1 is in fact the rare and a very non random sequence, while the sequences -1 +1 +1 +1 +1 +1 -1 +1 with a "trend" are in fact the truly random ones. By the way, this arcsine effect does certainly not explain 100% of all the observed trends. There may also be true ones. Mistress would be too simple. True drift may certainly produce some true trends, but certainly far less than believed by many.

For those who don't believe trend following can be a successful strategy, how would you explain the long-term performance of the No Load Fund X newsletter? Their system consists of a fairly simple relative strength mutual fund (and increasingly ETF) model where funds are held until they weaken enough in relative strength to swap out with new ones.

The results have been audited by Hulbert and consistently outperform the S&P 500 over a relatively long time frame (1980 onwards). I think their results make a trend following approach worth investigating…

All you are saying is that you're not smart enough to develop a trend following system that works. What do you say about the billions of dollars traded by trend following CTAs and their long term track records?

## Steve Leslie writes:

If the Chair is not smart enough to figure out trend following, what does that bode for the rest of us?

There is a very old yet wise statement: Do not confuse brains with a bull market.

Case in point: prior to 2000 the great tech market run was being fueled by the hysteria surrounding Y2K. Remember that term? It is not around today but it was the cause for the greatest bull market seen in stocks ever. Dot.com stocks and new issues were being bought with reckless abandon.

New issues were priced overnight and would open 40-50 points higher the next trading day. Money managers had standing orders to buy any new issues. There was no need for dog-and-pony or road shows. It was an absolute classic and chaotic case of extraordinary delusion and crowd madness.
Due diligence was put on hold, or perhaps abandoned. A colleague of mine once owned enough stock in a dot.com that had he sold it at a propitious time, he would have had enough money to purchase a small Hatteras yacht. Today, like many contemporary dot.coms, that stock is essentially worthless. It would not buy a Mad magazine.

Corporations once had a virtual open-ended budget to upgrade their hardware and software to prepare for the upcoming potential disaster. This liquidity allowed service companies to cash in by charging exorbitant fees. Quarter to quarter earnings comparisons were beyond belief and companies did not just meet the numbers, they blew by them like rocket ships. What made it so easy to make money was that when one sold a stock, all they had to do was purchase another similar stock that also was accelerating. The thought processes where so limited. Forget value investing; nobody on the planet wanted to talk to those guys. The value managers had to scrape by for years while they saw their redemptions flow into tech, momentum, and micro cap funds. It became a Ponzi scheme, a game of musical chairs. The problem was timing.

The music stopped in March of 2000 when CIO's need for new technology dried up coincident with the free money, and the stock market went into the greatest decline since the great depression. The NASDAQ peaked around 5000. Today it hovers around 2500, roughly half what it was 7 years ago.

It was not as if there were no warning signs. Beginning in late 1999, the tech market began to thin out and leadership became concentrated in a few issues. Chief among the group were Cisco, Oracle, Qwest, and a handful of others. Every tech, momentum, and growth fund had those stocks in their portfolio. This was coincident with the smart money selling into the sectors. The money managers were showing their hands if only one could read between the lines. Their remarks were "these stocks are being priced to perfection." They could not find compelling reasons not to own any of these stocks. And so on and on it went.

After 9/11 markets and industries began to collapse. The travel industry became almost nonexistent. Even Las Vegas went on life support. People absolutely refused to fly. Furthermore, business in and around New York City was in deep peril. This forced the Fed to begin dramatically reducing interest rates to reignite the economy. It worked, as corporations began to refinance their debt and restructure loans, etc.

The coincident effect began to show up in the housing industry. Homeowners refinanced their mortgages (yours truly included) and took equity out of their homes. Home-buyers were thirsty for real estate and bought homes as if they would disappear off the earth. For \$2000 one could buy an option on a new construction home that would not be finished for a year. "Flipping" became the term du jour. Buy a home in a hot market such as Florida for nothing down and sell it six months later at a much higher price. Real estate was white hot. Closing on real estate was set back weeks and weeks. Sellers had multiple offers on their homes many times in the same day. This came to a screeching halt recently with the gradual rise in interest rates and the mass overbuilding of homes, and the housing industry has slowed dramatically.

Houses for sale now sit on the blocks for nine months or more. Builders such as Toll, KB, and Centex have commented that this is the worst real estate market they have seen in decades. Expansion plans have all but stopped and individuals are walking away from their deposits rather than be upside down in their new home.

Now we have an ebullient stock market that has gone nearly 1000 days without so much as a 2% correction in a day. The longest such stretch in history. What does this portend? Time will tell. Margin debt is now at near all-time highs and confidence indicators are skewed. Yet we hear about trend followers and momentum traders and their success. I find this more than curious. One thing that they ever fail to mention is that momentum trading and trend following does not work very well in a trendless market. I never heard much about trend followers from June 2000 to October 2002. I am certain that this game of musical chairs will end, or at least be temporarily interrupted.

As always, it is the diligent speculator who will be prepared for the inevitable and capitalize upon this event. Santayana once said, "Those who cannot remember the past are condemned to repeat it."

## From "A Student:"

Capitalism is the most successful economic system in the history of the world. Too often we put technology up as the main driving force behind capitalism. Although it is true that it has much to offer, there is another overlooked hero of capitalism. The cornerstone of capitalism is good marketing.

The trend following (TF) group of fund managers is a perfect example of good marketing. As most know, the group as a whole has managed to amass billions of investor money. The fund operators have managed to become wealthy through high fees. The key to this success is good marketing not performance. It is a tribute to capitalism.

The sports loving fund manger is a perfect example. All of his funds were negative for 2006 and all but one was negative over the last 3 years! So whether one looks at it from a short-term one year stand point or a three year perspective his investors have not made money. Despite this the manager still made money by the truckload during this period. Chalk it up to good marketing, it certainly was not performance.

The secret to this marketing success is intriguing. Normally hedge funds and CTAs cannot solicit investors nor even publicly tout their wares on an Internet site. The TF funds have found a way around this. There may be a web site which openly markets the 'concept' of TF but ostensibly not the funds. On this site the names of the high priests of TF are repeatedly uttered with near religious reverence. Thus this concept site surreptitiously drives the investors to the TF funds.

One of the brilliant marketing tactics used on the site is the continuous repetition of the open question, "Why are they (TF managers) so rich?" The question is offered as a sophist's response to the real world question as to whether TF makes money. The marketing brilliance lies in the fact that there is never a need to provide factual support or performance records. Thus the inconvenient poor performance of the TF funds over the last few years is swept under the carpet.

Also swept under the rug are the performance figures for once-great trend followers who no longer are among the great, i.e., those who didn't survive. Ditto for the non-surviving funds in this or that market from the surviving trend followers.

Another smart technique is how the group drives investor traffic to its concept site. Every few years a hagiographic book is written which idolizes the TF high priests. It ostensibly offers to reveal the hidden secrets of TF.

Yet after reading the book the investor is left with no usable information, merely a constant repetition of the marketing slogan: How come these guys are so rich? Obviously the answer is good marketing but the the book is moot on the subject. Presumably, the books are meant to be helpful and the authors are true believers without a tie-in in mind. But the invisible hand of self-interest often works in mysterious ways.

In the latest incarnation of the TF book the author is presented as an independent researcher and observer. Yet a few days after publication he assumes the role of Director of Marketing for the concept site. Even the least savvy observer must admit that it is extraordinary marketing when one can persuade the prospect to pay \$30 to buy a copy of the marketing literature.

"I attribute much of the success of the selected bigs to being net long leveraged in fixed income and stocks during the relevant periods."

I humbly corroborate this point. If one eliminates long equity, long fixed income (and fx carry) positions, most trend-following returns evaporate.

Metals and energies have helped recently, after years of paying floor traders.

## Victor replies:

I don't agree with all the points above. For example, the beauty of capitalism is not its puffery, but the efficiency of its marketing and distribution system as well as the information and incentives that the prices provide so as to fulfill the pitiless desires of the consumers. Also beautiful is in the mechanism that it provides for those with savings making low returns to invest in the projects of entrepreneurs with much higher returns in fields that are urgently desired by customers.

I have been the butt of abuse and scorn from the trend followers for many years. One such abusive letter apparently sparked the writer's note. Aside from my other limitations, the trend following followers apparently find my refusal to believe in the value of any fixed systems a negative. They also apparently don't like the serial correlation coefficients I periodically report that test the basic tenets of the trend following canon.

I believe that if there are trends, then the standard statistical methods for detecting same, i.e., correlograms, regressions, runs and turning point tests, arima estimates, variance ratio tests, and non-linear extensions of same will show them.

Such tests as I have run do not reveal any systematic departures from randomness. Nor if they did would I believe they were predictive, especially in the light of the principle of ever changing cycles about which I have written extensively.

Doubtless there is a drift in the overall level of stock prices. And certain fund managers who are biased in that direction should certainly be able to capture some of that drift to the extent that the times they are short or out of the market don't override it. However, this is not supportive of trend following in my book.

Similarly, there certainly has been over the last 30 years a strong upward movement in fixed income prices. To the extent that a person was long during this period, especially if on leverage, there is very good reason to believe that they would have made money, especially if they limited their shorts to a moiete.

Many of the criticisms of my views on trend following point to the great big boys who say they follow trends. To the extent that those big boys are not counterbalanced by others bigs who have lost, I attribute much of the success of the selected bigs to being net long leveraged in fixed income and stocks during the relevant periods.

I have no firm belief as to whether such things as trends in individual stocks exist. The statistical problem is too complex for me because of a paucity of independent data points, and the difficulties of maintaining an operational prospective file.

Neither do I have much conviction as to whether trends exist in commodities or foreign exchange. The overall negative returns to the public in such fields seem to be of so vast a magnitude that it would not be a fruitful line of inquiry.

If I found such trends through the normal statistical methods, I would suspect them as a lure of the invisible evil hand to bring in big money to follow trends after a little money has been made by following them, the same way human imposters work in other fields. I believe that such a tendency for trend followers to lose with relatively big money after making with smaller amounts is a feature of all fixed systems. And it's guaranteed to happen by the law of ever-changing cycles.

The main substantive objection to my views that I have found in the past, other than that trend followers know many people who make money following trends (a view which is self-reported and selective and non-systematic, and thus open to some of the objections of those of the letter-writer), is that they themselves follow trends and charts and make much money doing it. What is not seen by these in my views is what they would have made with their natural instincts if they did not use trend following as one of their planks. This is a difficult argument for them to understand or to confirm or deny.

My views on trend following are always open to new evidence, and new ways of looking at the subject. I solicit and will publish all views on this subject in the spirit of free inquiry and mutual education.

## Jeff Sasmor writes:

Would you really call what FUNDX does trend following? Well, whatever they do works.

I used their system successfully in my retirement accounts and my kids' college UTMA's and am happy enough with it that I dumped about 25% of that money in their company's Mutual Funds which do the same process as the newsletter. The MFs are like an FOF approach. The added expense charges are worth it. IMO, anyway. Their fund universe is quite small compared to the totality of funds that exist, and they create classes of funds based on their measure of risk.

This is what they say is their process. When friends ask me what to buy I tell them to buy the FUNDX mutual fund if their time scale is long. No one has complained yet!

It ain't perfect (And what is? unless your aim is to prove that you're right) but it's better than me fumfering around trying to pick MFs from recommendations in Money Magazine, Forbes, or Morningstar.

I'm really not convinced that what they do is trend following though.

For those who don't believe trend following can be a successful strategy, how would you explain the long-term performance of the No Load Fund X newsletter?

## Michael Marchese writes:

In a recent post, Mr. Leslie finished his essay with, "I never heard much about trend followers from June 2000 to October 2002." This link shows the month-to-month performance of 13 trend followers during that period of time. It seems they did OK.

Not only is trend following invalid statistically but, looking at the bigger picture, it has to be invalid logically without even running your unusual tests.

If wealth distribution is to remain in the range of 20 to 80, trend following cannot exist. In other words, if the majority followed the trend (hence the concept of trends), and if trend following is in fact profitable, the majority will become rich and the 20-80 distribution will collapse. This defeats logic and history. That said, there is the well-covered (by the Chair) general market upward drift that should also come as no surprise to the macro thinkers. The increase in the general population, wealth, and the entrepreneurial spirit over the long term will inevitably contribute to the upward drift of the general market indices as is very well demonstrated by the triumphal trio.

While all world markets did well over the last 100 yrs, you notice upon closer examination that the markets that outperformed were the US, Canada, Australia, and New Zealand. The one common denominator that these countries have is that they are all immigration countries. They attract people.

Contrary to what one hears about the negative effects of immigration, and how immigrants cause recessions, the people who leave their homelands looking for a better life generally have quite developed entrepreneurial spirits. As a result, they contribute to the steeper upward curve of the markets of these countries. When immigrants are allowed into these countries, with their life savings, home purchases, land development, saving and borrowing, immigration becomes a rudder against recession, or at least helps with soft landings. Immigration countries have that extra weapon called LAND.

So in brief, no - trends do not exists and can not exist either statistically or logically, with the exception of the forever upward drift of population and general markets with some curves steeper than others, those of the countries with the extra weapon called land and immigration.

A rereading of The Wealth And Poverty Of Nations, by Landes, and the triumph of the optimist may be in order.

So Mr. Parker's real objective was simply to insult the Chair, not to provide any evidence of the merits of trend following that would enlighten us (anecdotes and tautologies that all traders can only profit from favorable trends prove nothing). I too lack the intelligence to develop a trend following system that works. When I test conditions that I naively believe to be indicative of trends, such as crossovers of moving averages, X-day highs and lows, and the direction of the most recent Y percent move, I usually find negative returns going forward.

Bacon summarized his entire book in a single sentence: "Always copper the public play!" My more detailed summary was, "When the public embraces a particular betting strategy, payoffs fall, and incentives (for favored horsemen) to win are diminished."

## Trend Following — Cause, from James Sogi:

Generate a Brownian motion time series with drift in R

WN <-rnorm(1024);RW<-cumsum(WN);DELTAT<-1/252;

MU<-.15*DELTAT;SIG<-.2*sqrt(DELTAT);TIME<-(1:1024)/252 stock<-exp(SIG*RW+MU*TIME) ts.plot(stock)

Run it a few times. Shows lots of trends. Pick one. You might get lucky.

## Trend Following v. Buy and Hold, from Yishen Kuik

The real price of pork bellies and wheat should fall over time as innovation drives down costs of production. Theoretically, however, the nominal price might still show drift if the inflation is high enough to overcome the falling real costs of production.

I've looked at the number of oranges, bacon, and tea a blue collar worker's weekly wages could have purchased in New York in 2000 versus London in the 1700s. All quantities showed a significant increase (i.e., become relatively cheaper), lending support to the idea that real costs of production for most basic foodstuffs fall over time.

Then again, according to Keynes, one should be able to earn a risk premium from speculating in commodity futures by normal backwardation, since one is providing an insurance service to commercial hedgers. So one doesn't necessarily need rising spot prices to earn this premium, according to Keynes.

## Not All Deer are Five-Pointers, from Larry Williams

What's frustrating to me about trading is having a view, as I sometimes do, that a market should be close to a short term sell, yet I have no entry. This betwixt and between is frustrating, wanting to sell but not seeing the precise entry point, and knowing I may miss the entry and then see the market decline.

So I wait. It's hard to learn not to pull the trigger at every deer you see. Not all are five-pointers… and some will be bagged by better hunters than I.

## From Gregory van Kipnis:

Back in the 70s a long-term study was done by the economic consulting firm of Townsend Greenspan (yes, Alan's firm) on a variety of raw material price indexes. It included the Journal of Commerce index, a government index of the geometric mean of raw materials and a few others. The study concluded that despite population growth and rapid industrialization since the Revolutionary War era, that supply, with a lag, kept up with demand, or substitutions (kerosene for whale blubber) would emerge, which net-net led to raw material prices being a zero sum game. Periods of specific commodity price rises were followed by periods of offsetting declining prices. That is, raw materials were not a systematic source of inflation independent of monetary phenomena.

It was important to the study to construct the indexes correctly and broadly, because there were always some commodities that had longer-term rising trends and would bias an index that gave them too much weight. Other commodities went into long-term decline and would get dropped by the commodity exchanges or the popular press. Just as in indexes of fund performance there can be survivor bias, so too with government measures of economic activity and inflation.

However, this is not to say there are no trends at the individual commodity level of detail. Trends are set up by changes in the supply/demand balance. If the supply/demand balance changes for a stock or a commodity, its price will break out. If it is a highly efficient market, the breakout will be swift and leave little opportunity for mechanical methods of exploitation. If it is not an efficient market (for example, you have a lock on information, the new reality is not fully understood, the spread of awareness is slow, or there is heavy disagreement, someone big has to protect a position against an adverse move) the adjustment may be slower to unfold and look like a classic trend. This more often is the case in commodities.

Conversely, if you find a breakout, look for supporting reasons in the supply/demand data before jumping in. But, you need to be fast. In today's more highly efficient markets the problem is best summarized by the paradox: "look before you leap; but he who hesitates is lost!"

I would posit there is no long-term drift to commodities and thus we have a huge difference in these vehicles.

The commodity index basket guys have a mantra that commodities will go higher - drift - but I can find no evidence that this is anything but a dream, piquant words of promotion that ring true but are not.

I anxiously stand to be corrected.

## Marlowe Cassetti writes:

"Along a similar vein, why would anybody pay Powershares to do this kind of work when the tools to do it yourself are so readily available?"

The simple answer is if someone wishes to prescribe to P&F methodology investing, then an ETF is a convenient investment vehicle.

With that said, this would be an interesting experiment. Will the DWA ETF be another Value Line Mutual Fund that routinely fails to beat the market while their newsletter routinely scores high marks? There are other such examples, such as IBD's William O'Neal's aborted mutual fund that was suppose to beat the market with the fabulous CANSLIM system. We have talked about the great track record of No-Load Fund-X newsletter, and their mutual fund, FUNDX, has done quite well in both up and down markets (an exception to the above mentioned cases).

For full disclosure I have recently added three of their mutual funds to my portfolio FUNDX, HOTFX, and RELAX. Hey, I'm retired and have better things to do than do-it-yourself mutual fund building. With 35 acres, I have a lot of dead wood to convert into firewood. Did you know that on old, dead juniper tree turns into cast iron that dulls a chain saw in minutes? But it will splinter like glass when whacked with a sledgehammer.

## Kim Zussman writes:

…about the great track record of No-Load Fund-X newsletter and their mutual fund FUNDX has done quite well in both up and down markets… (MC)

Curious about FUNDX, checked its daily returns against ETF SPY (essentially large stock benchmark).

Regression Analysis of FUNDX versus SPY since inception, 6/02 (the regression equation is FUNDX = 0.00039 + 0.158 SPY):

Predictor    Coef         SE Coef           T             P
Constant    0.00039    0.000264        1.48        0.14
SPY            0.15780    0.026720        5.91        0.00

S = 0.00901468    R-Sq = 2.9%   R-Sq (adj) = 2.8%

The constant (alpha) is not quite significant, but it is positive, so FUNDX did out-perform SPY. Slope is significant and the coefficient is about 0.16, which means FUNDX was less volatile than SPY.

This is also shown by F-test for variance:

Test for Equal Variances: SPY, FUNDX

F-Test (normal distribution) Test statistic = 1.17, p-value = 0.009 (FUNDX<SPY)

But t-test for difference between daily returns shows no difference:

Two-sample T for SPY vs FUNDX

N          Mean      St Dev       SE Mean
SPY      1169     0.00041  0.0099       0.00029
FUNDX 1169     0.00045  0.0091       0.00027   T=0.12

So it looks like FUNDX has been giving slight/insignificant out-performance with significantly less volatility; which makes sense since it is a fund of mutual funds and ETFs.

Even better is Dr Bruno's idea of beating the index by deleting the worst (or few worst) stocks (new additions?).

How about an equal-weighted SP500 (which out-performs when small stocks do), without the worst 50 and double-weighting the best 50.

Call it FUN-EX, in honor of the fun you had with your X that was all mooted in the end.

## Alex Castaldo writes:

The results provided by Dr. Zussman are fascinating:

The fund has a Beta of only 0.157, incredibly low for a stock fund (unless they hold a lot of cash). Yet the standard deviation of 0.91468% per day is broadly consistent with stock investing (S&P has a standard deviation of 1%). How can we reconcile this? What would Scholes-Williams, Dimson, and Andy Lo think when they see such a low beta? Must be some kind of bias.

I regressed the FUNDX returns on current and lagged S&P returns a la Dimson (1979) with the following results:

Regression Statistics
Multiple R                0.6816
R Square                 0.4646
Standard Error        0.0066
Observations           0.1166

ANOVA
df         SS          MS         F            Significance F
Regression       4      0.0444    0.0111   251.89    8.2E-156
Residual      1161      0.0511    4.4E-05
Total           1165      0.0955

Coefficients  Standard Error  t-Stat        P-value
Intercept  8.17E-05     0.000194           0.4194        0.6749
SPX          0.18122      0.019696           9.2007        1.6E-19
SPX[-1]    0.60257      0.019719         30.5566        6E-151 SPX[-2]    0.08519      0.019692           4.3260        1.648E-05 SPX[-3]    0.04524      0.019656           2.3017        0.0215

Note the following:

(1) All four S&P coefficients are highly significant.

(2) The Dimson Beta is 0.914 (the sum of the 4 SPX coefficients). The mystery of the low beta has been solved.

(3) The evidence of price staleness, price smoothing, non-trading, whatever you want to call it is clear. Prof. Pennington touched on this the other day; an "efficiently priced" asset should not respond to past S&P price moves. Apparently though, FUNDX holds plenty of such assets (or else the prices of FUNDX itself, which I got from Yahoo, are stale).

## S. Les writes:

Have to investigate the Fund X phenomenon. And look to see how it has done in last several years since it was post selected as good. Someone has to win a contest, but the beaten favorites are always my a priori choice except when so many others use that as a system the way they do in sports eye at the harness races, in which case waiting for two races or two days seems more apt a priori. VN

I went to the Fund X website to read up, and the information is quite sparse. It is a very attenuated website. I called the toll free number and chatted with the person on the other line. Information was OK, but, in my view, I had to ask the proper questions. One has several options here. One is to purchase the service and do the fund switching themselves based on the advice of their experts. The advisory service tracks funds that have the best relative strength performance and makes their recommendations from there, www.fundx.com.

Another is to purchase one of four funds available. They have varying levels of aggressiveness. Fund 3 appears to be the recommended one.

If one purchases the style 3 one will get a very broad based fund of funds. I went to yahoo to look up the holdings at www.finance.yahoo.com/q/hl?s=FUNDX.

Top ten holdings are 47.5% of the portfolio, apparently concentrated in emerging markets and international funds at this time.

In summary, if money were to be placed into the Fund X 3 portfolio, I believe it would be so broad based and diversified that returns would be very watered down. Along with risk you would certainly be getting a lot of funds. You won't set the world on fire with this concept, but you won't get blown up, either.

My 2002 book, Right Stock at the Right Time, explains such an approach in the Dow 30. The losers were the overvalued stocks in the Dow.It is a simple and elegant idea…forget looking for winners…just don't buy overvalued stocks and you beat the idex.

This notion was developed in 1997, when i began actually doing it, and written about in the book. This approach has continued to outperform the Dow, it is fully revealed.

## Craig Cuyler writes:

Larry's comment on right stock right time is correct and can be used to shed a little bit of light on trend following. This argument is at the heart of fundamental indexation, which amongst other points argues that cap weighting systematically over-weights overvalued stocks and under-weights undervalued stocks in a portfolio.

Only 29% of the top 10 stocks outperformed the market average over a 10yr period (1964-2004) according to Research Affiliates (this is another subject). The concept of "right stock right time" might be expressed another way, as "right market right time." The point is that constant analysis needs to take place for insuring investment in the products that are most likely to give one a return.

The big error that the trend followers make, in my mind, is they apply a homogeneous methodology to a number of markets and these are usually the ones that are "hot" at the time that the funds are applied. The system is then left to its own devices and inevitably breaks down. Most funds will be invested at exactly the time when the commodity, currencies, etc., are at their most overvalued.

Some worthwhile questions are: How does one identify a trend? Why is it important that one identifies a trend? How is it that security trends allow me to make money? In what time frame must the trend take place and why? What exactly is a trend and how long must it last to be so labeled?

I think it is important to differentiate between speculation using leverage and investing in equities because, as Vic (and most specs on the list) point out, there is a drift factor in equities which, when using sound valuation principles, can make it easier to identify equities that have a high probability of trending. Trend followers don't wait for a security to be overvalued before taking profits. They wait for the trend to change before then trying to profit from the reversal.

As a user of both the newsletter and the FUNDX mutual fund I'd like to comment that using the mutual fund removes the emotional component of me reading the newsletter and having to make the buys and sells. Perhaps not an issue for others, but I found myself not really able to follow the recommendations exactly - I tend to have an itchy trigger finger to sell things. This is not surprising since I do mostly short-term and day trades. That's my bias; I'm risk averse. So the mutual fund puts that all on autopilot. It more closely matches the performance of their model portfolio.

I don't know how to comment on the comparisons to Value Line Arithmetic Index (VAY). Does anyone follow that exactly as a portfolio?

My aim is to achieve reasonable returns and not perfection. I assume I don't know what's going to happen and that most likely any market opinion that I have is going to be wrong. Like Mentor of Arisia, I know that complete knowledge requires infinite time. That and beta blockers helps to remove the shame aspect of being wrong. But there's always an emotional component.

As someone who is not a financial professional, but who is asked what to buy by friends and acquaintances who know I trade daily (in my small and parasitical fashion), I have found that this whole subject of investing is opaque to most people. Sort of like how in the early days of computing almost no one knew anything about computers. Those who did were the gatekeepers, the high priests of the temple in a way. Most people nowadays still don't know what goes on inside the computer that they use every day. It's a black box - opaque. They rely on the Geek Squad and other professionals to help them out. It makes sense. Can't really expect most people to take the time to learn the subject or even want to. Should they care whether their SW runs on C++ or Python, or what the internal object-oriented class structure of Microsoft Excel is, or whether the website they are looking at is XHTML compliant? Heck no!

Similarly, most people don't know anything about markets; don't want to learn, don't want to take the time, don't have the interest. And maybe they shouldn't. But they are told they need to invest for retirement. As so-called retail investors they depend on financial consultants, fee-based planners, and such to tell them what to do. Often they get self-serving or become too loaded with fees (spec-listers who provide these services excepted).

So I think that the simple advice that I give, of buying broad-based index ETFs like SPY and IWM and something like FUNDX, while certainly less than perfect, and certainly less profitable than managing your own investments full-time, is really suitable for many people who don't really have the inclination, time, or ability to investigate the significant issues for themselves or sort out the multitudes of conflicting opinions put forth by the financial media.

You may not achieve the theoretical maximum returns (no one does), but you will benefit from the upward drift in prices and your blended costs will be reasonable. And it's better than the cash and CDs that a lot of people still have in their retirement accounts.

BTW: FOMA = Foma are harmless untruths, intended to comfort simple souls.
An example : "Prosperity is just around the corner."

I'm not out to defend FUNDX, I have nothing to do with them. I'm just happy with it.

## Steve Ellison writes:

One might ask what the purpose of trends is in the market ecosystem. In the old days, trends occurred because information disseminated slowly from insiders to Wall Streeters to the general public, thus ensuring that the public lost more than it had a right to. Memes that capture the public imagination, such as Nasdaq in the 1990s, take years to work through the population, and introduce many opportunities for selling new investment products to the public.

Perhaps some amount of trending is needed from time to time in every market to keep the public interested and tossing chips into the market. I saw this statement at the FX Money Trends website on September 21, 2005: "[T]he head of institutional sales at one of the largest FX dealing rooms in the US … lamented that for the past 2 months trading volume had dried up for his firm dramatically because of the 'lack of trend' and that many 'system traders' had simply shut down to preserve capital."

I saw a similar dynamic recently at a craps table when shooters lost four or five consecutive points, triggering my stop loss so that I quit playing. About half the other players left the table at the same time. "The table's cold," said one.

To test whether a market might trend out of necessity to attract money, I used point and figure methodology with 1% boxes and one-box reversals on the S&P 500 futures. I found five instances in the past 18 months in which four consecutive reversals had occurred and tabulated the next four points after each of these instances (the last of which has only had three subsequent points so far). The results were highly non-predictive.

Starting        Next 4 points
Date      Continuations  Reversals
01/03/06        3            1
05/23/06        1            3
06/29/06        2            2
08/15/06        2            2
01/12/07        1            2
—–        —–
9           10

I had intended to write a post or two on my recent two week trip to Cairo, Aswan, and Alexandria. There is nothing salient to trading but Egypt seems to have more Tourist Police and other guards armed with machine guns than tourists. It is a service economy with very few tourists or middle/upper classes to service. Virtually no westerners walk on the streets of Cairo or Alexandria. I did my best to ignore my investments and had closed all my highly speculative short-term trades before leaving for the trip.

While preparing for taxes I was looking over some of my trades for last year. Absolute worst trade was going long CVS and WAG too soon after WalMart announced \$2 generic pricing. I had friends in town and wasn't able to spend my usual time watching and studying the market. I just watched them fall for two days and without looking at a chart, studying historical prices and determining how far they might fall, decided the market was being stupid and went long. Couldn't wait to tell my visitors how "smart" a trader I was and my expected profit. It was fun, until announcement after announcement by WalMart kept causing the stocks to keep falling. The result was panic selling near the bottom, even though I had told myself before the trade that I could happily buy and hold both. Basically, I followed all of Vic's rules on "How to Lose."

Trends: If only following a trend meant being able to draw a straight line or buy a system and buy green and sell red. The trend I wrote about several months ago about more babies being born of affluent parents still seems to be intact. I have recently seen pregnant moms pushing strollers again. Planes to Europe have been at capacity my last two trips and on both trips several crying toddlers made sleep difficult, in both directions. Are people with young children using their home as an ATM to fund a European trip? Are they racking up credit card debt that they can't afford? Depleting their savings? (Oh wait - Americans don't save anything.) If they are, then something fundamental has changed about how humans behave.

## From James Sogi:

My daughter the PhD candidate at Berkeley in bio-chem is involved in some mind-boggling work. It's all very confidential, but she tried to explain to me some of her undergrad research in words less than 29 letters long. Molecules have shapes and fit together like keys. The right shape needs to fit in for a lock. Double helices of the DNA strand are a popular example, but it works with different shapes. There is competition to fit the missing piece. They talk to each other somehow. One of her favorite stories as a child was Shel Silverstein's Missing Piece. Maybe that's where her chemical background arose. Silverstein's imagery is how I picture it at my low level.

Looking at this past few months chart patterns it is impossible not to see the similarity in how the strands might try fit together missing pieces in Wykoffian functionality. The math and methods must be complicated, but might supply some ideas for how the ranges and strands in the market might fit together, and provide some predictive methods along the lines of biochemical probability theory. I'll need some assistance from the bio-chem section of the Spec-list to articulate this better.

## From Kim Zussman:

Doing same as Alex Castaldo, using SPY daily change (cl-cl) as independent and FUNDX as dependent gave different resluts:

Regression Analysis: FUNDX versus SPY ret, SPY-1, SPY-2

The regression equation is FUNDX = 0.000383 + 0.188 SPY ret - 0.0502 SPY-1 - 0.0313 SPY-2

Predictor     Coef           SE Coef       T        P
Constant     0.000383    0.00029      1.35    0.179
SPY ret       0.187620    0.03120      6.01    0.000*            SPY-1        -0.050180    0.03136     -1.60   0.110           SPY-2        -0.031250    0.03121     -1.00   0.317 *(contemporaneous)

S = 0.00970927   R-Sq = 3.2%   R-Sq (adj) = 3.0%

Perhaps FUNDX vs a tradeable index is the explanation.

# Coffee Roaster, by James Sogi

February 4, 2007 | 1 Comment

With this last year's crop of parchment back from the millers in the form of fresh green beans, the old Zach and Danni (now known as Nesco) coffee roaster bit the dust, and in shopping for a new one, discovered a good review of roasters here. I decided on a programmable I Roast 2. The review says that Nesco did not do a good dark roast as well and was a bit slow making a 'dead' cup, which I did experience with the Nesco. In the meantime, roasting is done on the Wok on the stove. Cast Iron fry pan is what the old time farmers used and it gives a very complex flavor but kicks off some smoke. The fry pan allows graduated programmable roast also, but requires standing there stirring the beans. Hopefully I will have heavenly coffee, better than a millionaire's money can buy. Fresh roast is the best way to go.

## Alan Millhone writes:

Interesting article. My Daughter likes to grind her own fresh coffee and likes Caribou for grinding. My Wife and I are lazy and have been members of Gevalia for a number of years. Each month we get our standard shipment of 4 to 8 oz. boxes.

Every so often we get an additional special of some coffee. In front of me I have Maragogype from Mexico, Papua New Guinea, and Antigua that have come as additional shipments. Recently from Gevalia we got a nice coffeemaker and two boxes of coffee for \$10.00. Another time or two I notified them that our pot went on the blink and we were shipped a new pot for no charge. They also sell teas, but to date have not tried them. In Belpre this morning the wind chill was three below zero, and I am currently having a cup of Bigelow brand Constant Comment tea . It's an old favorite of my grandfather's and mine. He started me drinking it many years ago. I readily admit there is nothing like the aroma of fresh ground beans being brewed. My best friends are Greek and they like Bravo brand of coffee from Greece.

On vacation in Florida this week, I was driving on I-75, yawning like crazy. I knew I needed coffee and MCD saved me. I didn't even have to get out of the car to buy it and I thought about the Chair's earlier post about McDonald's coffee. I would have had some food too, if my wife weren't with me!

## James Sogi reports:

Reporting back on the new coffee roaster, I-Roast-2, which produced a beautiful cup, roasted to perfection medium dark with a hint of sheen. Highly recommended over Nesco. What is interesting is that it has different programmable temperatures for first crack and second crack and finish so the oils don't come out too soon. It came with a nice variety of exotic green beans from Sumatra, Peru, Guatemala, Mexico, East Africa, Timor, so it will be fun to try the different varieties. The roast finished in less than 15 minutes, as coffee should not roast longer at the risk of getting flat.

# Kids’ Games, by Victor Niederhoffer

February 3, 2007 | 1 Comment

I have been thinking about kids' games. The purpose of these games is to prepare them for a productive and happy life. The game they seem to play first is one where they take something out of a bag and put it back in. I wonder how many market situations are like this in which the game prepares you. The gap to a new level is one. The refusal to go up a certain large amount is another. The inability of a market to be number one is another. Other situations include when the price hasn't been fulfilled, and when the stop hasn't been hit. I will attempt to quantify this and other lessons that we can learn from kids, and would appreciate your help and suggestions.

While you're on the subject of kids' games, you might want to check out zoooos here. It's an educational interactive toy/device that three year olds can use to interface with educational DVD's rather than plopping in front of a tv.

## J.T. Holley offers:

I have been thinking about kids' games. The purpose of these games is to prepare them for a productive and happy life.

When my three kids were each around one or two, my favorite activity was to play the interaction/game Peekaboo. That purpose, it seems, is to spawn and draw out those beautiful smiles and giggles in that specific stage of development. But it also could very well be the initial training of anticipation for earnings announcements, IPO's, government figures, AP headlines, CNBC guests talking, and spin offs. We all know what's coming within a half a deviation most of the time, but we so easily giggle and get all bent out of shape with enthusiasm and expectation. It's as if the Mistress places her hands over her face knowing that she can make us all giddy and put a smile on our faces. She controls our giggles.

My younger daughter learned to read whilst playing Role Playing Games (RPGs) where there's a lot of dialogue popped up for everyone to read aloud. Many games are also good for hand/eye control improvement. That said, Grand Theft Auto is NG and other M-rated games are not for kids. Excessive use of games and videos as babysitters is also bad. It's also no good for kids to be so booked up with sports, tutoring, music, et al after school that they don't have any free time and can't have a social life!

But not everyone can afford a nanny and parents need some rest once in a while. What parent hasn't envied the DVD player in the minivan? What parent hasn't plunked down their child in front of the TV to watch Lion King so they could rest? A kid with a Gameboy in the back seat of the car lets you concentrate on the road rather than having to concentrate on the child's needs while driving. A kid reading a book in a car may throw up. And checkers in a car? Well, maybe magnetic checkers …

Many video games teach logic and thought in the same way that chess or checkers do. For example, strategy games where you battle various players against the AI in the game. You move around players and pieces which have various move types and capabilities - and the game tries to knock your players out. These games are very much like chess in spirit.

Both my kids have had an unrestricted diet (but a well selected choice!) of video games and computer use (but no games on school nights so I get a chance to play) and they're intelligent children & excellent students.

Parents have to modulate choices for children, but it's too easy for Grups to blanket-condemn a whole lifestyle and genre because some parents are too lazy to monitor what their kids do. Guidance and monitoring is what's important. Kids deserve to have some fun of a type that they choose. We don't need to control everything down to the last molecule.

On our ACF website I always say: Checkers — the mental sport alternative to video games. Children of today are too addicted to video games and TV as babysitters. Children's minds have to be challenged in any way we as parents and grandparents can.

On our ACF website I always say: Checkers — the mental sport alternative to video games. Children of today are too addicted to video games and TV as babysitters. Children's minds have to be challenged in any way we as parents and grandparents can.

OK I'll speak up on this one. Now guys, really, I'm not a spring chicken and I grew up with a Stretch Armstrong, Green Machine, Red Rider, various board games, Cable TV, microwaves, and yes Atari. I also had a Commodore 64 that I won in a raffle from a minor league baseball fund raiser, and I also had my favorite 64 in one electronics kit from Radio Shack. That was only to establish background.

My point is "the ole gray mare ain't what she used to be." I do not, repeat, do not allow my children carte blanche the ability to watch hours and hours of tv, but have ya'll watched what is out there for children these days? I mean in the 70's when I watched tv it was Captain Kangaroo, Electric Company and Sesame Street and all those lingering cartoons from the 50's and the 60's that had smoking, gun shootin', Popeye's tatto's, and fist fights. These days it's Dora teachin' Spanish, Wonderpets dishing out principles, Little Einsteins introducing Classical Music to three year olds, Bear in the Big Blue house teaching four year olds to "Clean up the house," and my favorite on Discovery Kids Prehistoric Planet educating my children about dinosaurs that we were never told about! The bottom line is that it's good stuff and educational in content and delivery as long as you stay away from old man Turners Cartoon Network (junk) and be selective with duration and channel.

Now having said that, tv is no substitute for reading, flipping index cards with numbers and letters, and interacting with your children in the traditional sense. Heck, my little Addie loves reading Dick and Jane.

On the topic of boardgames, I'm an addict and I will say that we've advanced to higher levels as well, as far as education and skills. To once again show my lineage, I grew up with Risk, Stratego, Checkers w/ Grand Daddy Holley, Connect Four, Monopoly, Chutes & Ladders, Pay Day, Perfection, Simon, and Axis and Allies, my favorite game around 16 years old. These board games today made by Cranium are out of this world. If you want to see your children ages three to eight stimulated and become a ball of laughs while learning competition and creativity, then go buy Cranium's Hullabaloo either on DVD or with the Simon-esque plastic voice box. The other that I highly recommend is a newer game called Zingo! It is a mix of Memory and Bingo. Once again, the bottom line is that kids these days have far greater choices and boardgames to play than the classics that we had. If you play enough of these newer boardgames, you'll see that children at an earlier age are picking them up than it seemed before.

I won't even go into Leapad, Leapster, and the other computer stuff that exists out there in the electronics world today. It ain't all Doom, Drive-by Shoot 'em up either!

Yes, myself and my children spend countless hours walking paths identifying trees, birds, rocks and such. We run, bike, hike, and swim too! We also do Tae Kwan Do, Soccer, Golf, Bocce, Badmitton, Croquet, and Kick the Can.

## James Sogi offers:

A favorite kid's game is "drop it." My kids would say, Dad pick it up … drop it, Dad pick it up, drop it etc. It's lots of fun.

A favorite market game is market drops. Dad picks it up … market drops, Dad picks it up … lots of fun. It's profitable too.

I'd like to put in a word for computer games for kids, which don't necessarily include shooting aliens or others with laser guns etc. You not only get strategy and problem solving in quite realistic scenarios (well kind of realistic!), but also the development of computer and motor skills. The characters can also talk in context. The 'Thomas the Tank Engine' series are especially good, especially 'Thomas Saves the Day.'

Even with board games I think they can be made much more fun if they're on a computer with nice graphic presentations, warnings about illegal moves, ready made opponents etc. You and your child can take the same side against computer generated play, much better than having you beat them or letting them win I think.

My son's a bit young for chess right now but when I do start him off, it will be with Chessmaster, not a strong program but with nice graphics and teaching facilities.

# Remember General Custer, by James Sogi

When a small scouting party goes out at night and gets ambushed in the early predawn hours, they need to try and hold out since the ambush party is often also small, especially when in new territory, or at least territory that has not been visited for many years, until the cavalry comes to the rescue. The cavalry can fend off the ambushers long enough to get most if not all the scouting party back to the fort. Undoubtedly, there may be some minor casualties and injuries since that is the name of the game. But if most of the troops make it back to the fort, there will be good new intelligence, some progress in the campaign and the troops will be safe with a draw or win rather than an ignominious defeat caused by poorly planned strategy and bad execution. It helps to have a large force ready at all times on stand by for rescue missions. Ideally, a regular posse can make surgical tactical strikes with laser precision and perfect timing, hit and run, and return to the fort with the objective achieved and with no casualties. It is harder for a large force to do so without undue risk except once in a while when an obvious and good opening appears when the enemy capitulates and the force can move in. However, always remember General Custer.

# Time, by Ryan Carlson

The competitive side of me says push on and make more money (make hay while the sun is shining). Don't change the model (assuming your model works) and press on.     -Scott Brooks

A point Jon Krakauer wrote about in Into Thin Air is that mountain climbers need to haul ass when the weather is good since they have to expect bad weather rolling in at some point and they won't be able to move. In my experience, good markets are infrequent and that's the time to trade with full effort. When the opportunities dry up, it's best to hunker down and spend the day surfing the internet or taking a vacation.

I've seen many traders ease up when the goings good and then be in a desperate position to trade when the market is quiet. Being wrong in both situations always leads to an early exit in the business.

Suppose it is February 1st, which it almost is, and suppose that already, your fund is up 20%.  This is amazing for any given month, and pretty good for the YTD as well.  I don't know what 20% sounds like to everyone here but that is double the drift of the market as a whole, so I will assume for this writing that ending the year up 20% is seen as a pretty good year.  This being the case, how long should one go without making a trade?  Should the fund close up shop for the rest of the year?

How does one measure time as risk?  At some point, it becomes illogical not to make another trade.  We can think of this on the maximum scale — the length of our lives, and realize that if we never make another trade for the rest of our lives, nor any investments, our money would start to be riddled away by various expenses, taxes, and inflation.  What are the concerning factors such as having a good year early, the possible closing of the fund next year and the desire to try for a record year, etc.? What is a good formula to value time as risk?  How many hours of non-involvement in the market should one percentage of our total capital buy?

## Russell Sears offers:

Don't invite me to Vegas … I can't take it, too nerve racking. Everything within me rebels the longer I stay, knowing that the house will grind me down. Every loss hurts twice, once the wallet, second the mind.

However, stocks are different. You have the edge. You are the house and time is on your side.

At the start of 2006, I believe I counted the average return when the economy is not in a recession, and when it is in a recession. The bottom line is that unless you expect a recession, stocks are the place to be. If 2007 gives the average return of no recession, which I think is likely, the S&P would be at 1602, which is very close to what Markman predicted in his MSN money column.

At the start of 2006, I believe, I counted the average return when the economy is not in a recession, and when it is in a recession.

This is an excercise that I believe a reader should do by hand, at least I found it a learning experience.

My father began building spec homes in 1955 and he always did remodeling and insurance repairs. I began working with his crew when I was 13 during the summers and he always expected more out of me than his regular crew of carpenters. I have had new employees who were amazed that I could tell them how long it should take to move a dump load of gravel or sand by wheelbarrow or how long it takes to tar coat a basement wall and then install a French drainage system around the perimeter of a home. I do have years of experience in construction and I mostly learned from the ground up, and have been around several good contractors over the years and have always listened to what they expounded on 'tricks of the trade.' Owning and renting apartments is another 'niche' in the market that is not for the faint of heart! Most think all you have to do is collect the rent … However, you have maintenance of units, renters who will not pay, and you have to legally evict them. You need to be a little bit of a handyman if you own units, so it is not for everyone. Also, you have to know when to raise rents. I was asked once by a fellow who owns a lot of rentals if I knew the best time to raise rents. He told me at Christmas time! … People cannot afford to move then. Yes, a bit cold harded, but many renters will not give you any breaks. The best time to raise rent is when a unit becomes empty. I always scout around the area and get a feel of what other apartment owners are charging. I would not mind building a few new units, but material prices are currently too high to make the numbers work.

Now in return for my treatise on renting, I expect the spec. list to help educate me a little on investing.

## Victor Niederhoffer responds:

You seem to do very well in real estate. For someone who knows the field, I imagine real estate is as good as stocks. Jim Lorie once told me that the main difference between the returns of stocks and real estate was that you could get a very good return from stocks through index funds without knowing anything about it, but in real estate to get that return, you had to know a lot about it.

It's up 20%.

How can one maximize gains? Say if it's up but it does not want to liquidate, could a trailing stop on a portion give a synthetic option? We've discussed them and they are inefficient, but path dependency prevails, so they might have function. Another way to think about the question is say you are up 2% on a trade on your margin, do you liquidate with the idea of buying back lower? Let's assume your risk factor has gone up. Do you lighten up? I think our conclusion last time was to adjust leverage in a market with drift to protect gains. That seems to be the answer to catching further gains, but reducing risk ala. Gardiner Principal: be small when wrong and large when right. The corollary of which is to adjust leverage to the probabilities thereof.

# Chords and Hidden Melodies, by James Sogi

January 24, 2007 | 1 Comment

In my band, the big joke is that the talent I lack as a guitar player, I make up for in equipment. Anyway, while listening to DVDs of famous guitar heroes on advanced techniques, the guitar master, Eric Johnson said the following about chords: "Don't look at chords as rigid patterns, rather try to think of them as hidden melodies." The idea of structuring the chords as a fixed system, so to speak, takes away some of the creativity and spontaneity. Rather, use the chords to add 7ths, 9ths, 11ths, augmented 4ths, invert them, move them around the keyboard, and use substitute chords. Often for example, a B minor will sound the same as an E6 and so on. From these substitutions and passing phrases, melodies which are hidden in the structure of the chord emerge to the ear. There are far more advanced musicians here such as Flam, Klosek, Glazier and the new spec, Todd Tracy, so I will defer to them on this. But the idea is that market patterns should not be viewed as rigid patterns, but rather as hidden melodies. As the day trades out, the variety of bars is endless and new. Rather than lock into fixed systems, it is good to see the hidden melodies in the market music, let them play out, and hopefully get in tune and be able to play along without being totally out of time, and out of tune. Figure out the market's scales and chords, and like Maria in the Sound of Music, once you know the notes to sing, you can sing almost anything. Ear training helps the musician hear what key is being played, what chords, and what scales without looking at sheet music, and only by listening. Market training, by watching it everyday, seems to help the training of the eye as well.

I agree with Jim. There is no telling if a model shift has occurred without hindsight. Certain musicians or markets players might have tendencies and regularly use familiar notes to bridge the music into another scale. The Euro cruising past 1.30 could be the root note for a new song or just a suspended 4th of the 1.2950. However, there is always that moment when the mistress has to decide whether she's staying in G major or going for D major. There is no d flat in G major, so if you hear that note, the change has occurred.

As someone who has made a living for years with TA and pattern recognition, I can relate to this. Since I've added quantitative analysis to my management processes, I've been able to empirically test my prior pattern recognition skills.

What's interesting to me is that I've been able to better fine tune patterns by testing them, and now, I see them in a whole new way. I see things that I wouldn't have seen before. I'm a very visual person and the charts really help me!

As I've said before, my charts are just a visual representation of my calculations.

Some people find it helpful to look at blue prints. Some people like to look at what the finished building will look like. Regardless, quantitative analysis is required to create whatever visual image you prefer.

# Path Dependence, by J.T. Holley

January 22, 2007 | 3 Comments

Yes, there are two paths you can go by, but in the long run, there's still time to change the road you're on and it makes me wonder.          –Led Zeppelin's Stairway to Heaven

I've since felt that those lyrics were trading lyrics. What a song that has such sweet convergences and divergences. Many references to the Mistress, and yes, what a capitalistic ending that she's actually "buying" the Stairway.

From a dialogue this weekend:
A: It was nice we met 35 years ago. It was like fate.
Q: What if you had a little GPS unit that told you where in life you were?
A: Well it wouldn't matter because things would be fated and you would go where you would go no matter what.

Well, there is no fate, but there is causation and timing, so the question always arises, "When is the best time to jump in and the best time to jump out of a trade?" Or in navigation, "what is the best course to take and when?"

While reading "Cake Cutting Algorithms" this weekend by Robertson and Welsh, I discovered that there were a few main methods of dividing a cake or object of desire among two or more fairly, which is applicable to markets as well. There is the basic cut and choose. The other is the moving knife. Variations include multiple cuts and choices. The parties yell stop when they feel their fair share has come, but if they wait too long, someone else will yell stop before them, leaving the waiter with less. The net result is to evenly divide the pie based on each person's self interest, but the individual's goal is to get the most cake. There is the trimming variation where one party goes away happy with a piece and the remaining trims up the remains. As in life and in the markets, the question is, when is it not in the abstract, but in competition with others? The path dependency would be simple in isolation, i.e. deciding when to eat dinner by yourself is easy, but with a group of eight is very hard. Try to arrange a meeting with six people.

## Kim Zussman offers:

Isn't this directly related to regression to the mean?

A student gets 100 on the first exam, but the next three are 80's and 90's, i.e. the first result was "luck" (good day, coincidental study with questions, etc.), but over many trials he approaches his true position in rank. This is discussed often with kids in school to help with setbacks and to point out how long it takes to become truly accomplished.

Life is like that. There is little you can do about who your parents are, where you live, who you meet; there are so many paths. But if you are consistently honest, hard working, and you try to get along, on average and in the long run, you will wind up approximately at the correct level.

Occasionally, I think back and forth in my life and everything that happened since is related to that. For example, Gail Niederhoffer, was a very good impersonator and used to call up people when she was nine and pretend she was someone famous. She did this with a reporter four times, and told him that he should investigate those people at NCZ who forecast stock prices with an accountant. Graham loves reading the article. He had traded for the palindrome. After we were introduced, I started trading bonds and currencies and stocks for him, and one of my jobs was to vet quant things there. And one such quant through the palindrome came to my office to discuss his sure thing for options. Ha. The rest of the story … but if Zeck wasn't my tutor at Quincy House, I wouldn't have met Gail at his wedding, nor would I have met Susan nor would any of my subsequent seven been born. It's like that for everyone and for every trade. But for causation, it's a very tricky thing. What's unseen is what would have happened without those forks. If I hadn't ever sent Doc Bo to visit the brothels of the SE Asian country with the PHD from northwestern in key posts, I might be still playing tennis with the Palindrome, and having a home in the Hamptons. Path dependence in markets is a key factor to consider and deserves to be modeled and systematized.

Morgan, a devout Episcopalian, believed that character was fate and that one's character was shaped by the people one knew and worked with and their characters, and in turn, by the people they knew and worked with. In that regard, he seems to have been like the man who believed that the cosmos rested on the back of a giant turtle. When asked what the turtle stood on, his reply was "It's turtles all the way down." Morgan thought it was character all the way down. His religious belief, IMNSHO, was formed most by the faith of his first wife.

# Counting on War, by James Sogi

Dr. Gerald Patterson's paper, "Contingency Models for Interstate Wars and for Individual Violence," proposed the key hypothesis that both individual and societal acts of violence can be predicted using a behavioral and statistical approach. Dr. Patterson has studied, quantified and predicted the variables that lead to aggression in individuals. The major issue in state warfare is whether there are models for predicting the behavior of groups that make war. The question is whether behaviorist principles work for the behavior of groups and can they be modeled and quantified. This reviewer proposed the query that behaviorist analysis of groups such as markets provide a workable model.

Take a smaller step first. Take a sports team dynamics. Does the reinforcement of the team win override such individual concerns that a star such as Reggie Bush may have? Will the individual give up his glory for the team win? What are the independent variables and the model. The team should be first, and the unit will be stronger with team considerations over the individuals. What are the variables that predict team wins? The jump to economics is hard because the capitalistic model of Adam Smith is that each individual who acts in his own interest, within limits, will ultimately benefit the society. In the broad markets under the law of large numbers, the large number of market participants and companies tends to the mean. A behavioristic model of markets or societies and war will use each individual and each transaction. The approach to individual stocks differs due to idiosyncratic behavior and small numbers.

A market model to test this is to test whether foreign markets behave differently than US markets due to differences in foreign culture, rules, attitudes, economies, time of day, weather, seasons, cross effects of other large global markets, national policies, interest rates … or do all humans behave similarly worldwide? Do the different currency pairs work differently? My father has noted that in Japan, they tend towards orderliness and everyone does the same thing. Does that cultural tendency create market trends as opposed to the contrariness typical of Americans that is reflected in the US markets? Are there model variables that govern the behavior of global markets that differ from the US? Given that we are at an inflection point in the interest rate cycles and the Austrian cycles, and the Presidential cycles, opportunities might arise in looking at group behavioral models.

I have long believed in using demographic models to establish a macro-overview of investing. The study of demographics, as I use them, is to determine, based on births and immigration, what a group of people are likely to do over any given period of time. For instance, we know that in the US on average, people start working at around 20.5 years of age, get married at around 26, have kids at around 28, buy their first starter home at around 32, upgrade to a nice home at around 45, spend the most amount of money between the ages of 45 - 50 (it's 50 - 55 for the more affluent), and dramatically shift their spending as they age to a point where their spending decreases immensely, just to name a few characteristics.

Since young people buy different things than older people, spending patterns will be different over time as certain age groups dominate, or at least have a plurality of the spending for a given economy.

The dominant spending group in the US is the baby boom generation.

Different countries have different spending patterns than the US, which can be attributed, in many ways to demographics, but there are some cultural differences … and I am no expert on cultural differences, so I won't comment on that.

The study of demographics is quite fascinating and can give some key insights into the future.

However, it will only give a macro glimpse. And the unfortunate part of a macro glimpse is that it very rarely helps you make a good return today, i.e. since changes in spending cycles are not like a light switch, switching from "on" to "off" in the blink of an eye … they seem to be much more gradual … happening slowly so you don't notice until it's too late … kind of like the story of "how to boil a frog."

I strongly caution anyone using demographics not to use it as a replacement for micro-economic models. Demographics will not help you make a good return this year, let alone this quarter. For many in this group, making a good return in any given quarter is important and making a good return in a calendar year is absolutely vital!

# A Review of GaveKal Research, by Victor Niederhoffer

January 16, 2007 | 3 Comments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

## Gabriel Ivan replies:

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

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

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

# Part Time Farmer: Full Time Philosopher, by James Sogi

Although coffee farming is a part time job, being a philosopher, just as being a speculator, is a 24 hour day job. On our subsistence coffee farm, January is the end of the picking and the season for pruning and fertilizing. Pruning clears away the dead wood, and leaves room and energy for the young shoots, which have the most flowers and the most beans. Fertilizer helps the formation of new shoots and flowers so that next season there will be beans to pick. It is work in the hot sun for no reward, except a season away. So during the manual labor, there is time to philosophize.

Farmers seek their reward in the future, despite the present labor, and the risks of the weather and of price fluctuations. In the fullness of the seasons, his crop comes to fruition and can be harvested. There is no rushing it. He depends on the vagary of the rains, and he is confident that he will produce. He hedges his risks in various ways: in land, in futures, in other crops, in his family, in community activity. It is a good life.

The speculator's job is to clear away the dead wood, the non-productive uses of capital to make way for young growth that will bear flowers and fruit. The speculator is the fertilizer that contributes capital to produce new products and efficient systems of capital use. He works hard and seeks his reward in the future. There is no rushing a trade. He depends on the vagaries of the markets, of world events, of politics, and even the weather, confident that his speculation will bear fruit. He hedges his risk in many ways: in his lands, in a steady portfolio of bonds, in his family and community activity. It is a good life.

# When You are the Prey Not the Hunter, by James Sogi

"High surf advisory remains in effect for north and west facing shores. Surf along north facing shores will be 15 to 17 feet, with occasional sets to 22 feet through Saturday," said the surf report. The waves were big and so after the market closed I looked at the surf spots from my house to see which ones were breaking best with the least surfers. Honokohau National Park looked best. Paddling out the quarter mile out to the break, a guy yells out to me and says, "Aren't you James?" This was funny because the only time I see this guy is out in the ocean. There was just this other guy, me, and this guy on a stand up surf board with a paddle, which is a new thing.

The guy's name was Jack. Jack, being on the stand up board, could see better because he was standing. While we were out, he saw a shark cruising by. Honokohau is the sharks' favorite place to go to eat the fish guts the fisherman throw out.

We don't freak out, and here's why. For one, they usually cruise on the ledge just outside the surf since they can't handle the big waves. Second, they are usually just cruising through for food and looking for weak wounded fish or blood. They won't mess with an adult guy paddling a board aggressively and flying along the surface of the big waves at 25 miles an hour over the water. Even still, I kept a good look out under my feet, which were dangling in the water. It's a good thing to know the risks and to know the predators in the area when you are the prey not the hunter. The trick (I've heard) is to punch them hard, right in the nose to make them go away if they charge at you. So despite the threat, the waves were nice, the weather was nice and it was a good day.

# Symmetry in Nature and in the Market, by James Sogi

I'm reading a book, the Hidden Messages in Water by Masaru Emoto, about snowflakes. The author claims that thoughts affect the creation of snowflakes and the patterns of the water crystals. It reminded me of symmetries in nature. Snowflakes are constructed in a binary process. Similar are the formation of cellular automata described by Wolfram in A New Kind of Science whose ideas have been trashed on this list in past years. In each of the processes, a simple binary process is used to generate complex structures, each with a strong degree of symmetry in the multitude of generated forms. It is said that no two snowflakes are alike. In addition to the broad claims of the authors, the symmetry principles also apply well to the market, which is constructed in a binary process similar to the cellular automata and snowflakes.

Take Friday's drop and range and look at today's morning range and afternoon pop and see the symmetry being formed. The process of winding down buys and sells within a system, and the subsequent release of those same energies in a consistent system tend to form symmetrical structures. There is of course a random element and also new sources of energy which add a noise factor, but there is some tendency towards symmetry in the markets which could be tested. It could be considered the hidden messages in the price data.

Speaking of the space telescope and symmetry, here are some images of (rather symmetrical) planetary nebulae from HST:

These are luminous shells of gas expelled by average stars (like our sun) at the end of their lives. The gas of spent stars can be swept up into nebulae capable of forming new stars.

Large stars end their lives as supernovae. There is a huge explosion following an implosion, in which elements heavier than oxygen are formed.

The biggest stars blaze short and brilliant, and in their corpses germinate the seeds of new beginnings.

(now hum the 2001 Space Odyssey tune…)

# Using Conditional Probability to Predict Behavior in Money Markets, by James Sogi

The problem is predicting behavior in the money markets using conditional probability. One theory, though not a necessary one, is that the path of prices directly reflects the underlying psychological states or utilities of the participants. There are non-random patterns that can be identified that are predictive of future price paths, just as three shouts might lead to a hit in a coercive family. It's the scientific approach. Qualitative models are used to create statistical models. We have looked at various models of frustration aggression in the markets, war, strategy, sports, survival, revulsion and release, evolutionary adaptive models, game theory, physics, mechanics, electrical theory, hunting, Tversky and Bayes. I believe that you have some theories about war and broader human tendencies using a statistical analysis. The markets and market data capture these broad human characteristics in an amazing way and the data is there ready made.

It had never occurred to me that the frustration aggression theory might have some relevance to behavior in the money markets. I was intrigued by your approach of applying conditional probability analyses to the problem. My understanding of economics is that one of their major problems in prediction is that none of the parameters in the prediction models contain terms based on measures of human behavior.

This comes close to laying out a problem that would interest a psychologist. In fact the Nobel prize in Economics last year went to Kahneman and Tversksy–two psychologists who spent their life calculating conditional p values describing risky choice.

From last week's performance, I believe the question for 2007 will be "how does the market perform 'when good news is bad'?" Psychology mixed with counting should get you far.

Vincent Andres mentions:

One prior side of the "patterning" job is quantitative statistics–finding non-random behaviors. Another side concerns the "whys" of the behaviors of the "mass market" entity. Concerning this second point, I found the following books of K. Lorenz very penetrating and enlightening: The Foundations of Ethology (For example, you should read II.I.7, which discusses stimuli levels reduction. The French version of this book can be found here.), Studies in Animal and Human Behavior (Many thoughts also concern fear, aggression, frustration, etc.)

I believe that the non-randomness of the mass markets, for example, its behaviors as an entity, emerges precisely at common denominator points of all its individual human components. Common denominator points are not cultural/sophisticated ones, but primitive, for example, animal ones. That's why ethology, and especially the work of Lorenz, may concern those of us interested in the "whys."

Trying to answer the "whys" may be useless, but it could help to define/find patterns we won't think about otherwise (and understanding, at least trying, cannot harm).

# My Sister’s Thoughts on Mastering One’s Craft, by Nat Stewart

Below are excerpts from two letters my younger sister, Bethany, recently sent me. She is a practicing artist and has been since her childhood. I believe the excerpts below inspired her current study, which is under one of the world's most accomplished realist artists/painters, who runs an Atelier in NYC.

The spirit of accomplishment runs deep on the list, starting with the Chair, who has been inspirational as both a great practitioner and a teacher. It also includes everyone else who lives a life of continual learning and self-betterment. For this reason I thought others may enjoy reading the excerpts below, even if the full context may be missing.

I think the late 20s, early 30s is the perfect time to focus one's energy on understanding how to master one's craft…

I finally figured out that things that matter in life are in fact lifelong pursuits that are to be obtained through years of study and devotion. One must grow, learn, and struggle. One must walk in one's own path at the right pace. I think it's awesome to understand this and to honor it. I think in doing so, it is the highest honor to the self, and to one's own life. I had spent a month working on a single pencil drawing, as the masters had done, and it's really awesome that I have this sort of patience now. I think that mastery is the sum of time, focus and love all put in.

I think it is the right time for persons in their 20s to experience unease, spirited desire and impatience. These years have certainly led me to some good discoveries about the limits of my skill and focus. I am not angry at my younger self but I am actually grateful for my shortcomings and the impatience of my early 20s. It was the right place to be at the time.

…And now I see that I had a deeper experience, a gradual process of lifelong development–I do not treat immediacy as god anymore.

Some may be surprised to learn that the techniques required for artistic mastery are no longer featured or prevalent in most art schools. Mastering one's artistic medium or tools is almost frowned upon or even acknowledged as a goal, as modern art typically does not require this … It is viewed as stifling or restrictive. In the mainstream of the art world, the mastery of traditional artistic mediums is almost a lost art itself. My sister has the following to say about her current studies:

This school is an incredible opportunity and for the first time in my life I actually feel like I belong somewhere. It feels like I am surrounded by like-minded people who are all quietly and intently studying a craft that they are really serious about. There is no b-ll—t in art school. This is not about self expression, it is about mastering an age old craft in order to have boundless skill someday at executing your ideas. It's humbling in the most inspiring way.

The best thing about it is that it is such a quiet, deeply focused technique of teaching. It's the rebirth of a classical style of learning/teaching of the old masters that has been all but completely extinguished in our day. J—- C—– is a true visionary. He has a vision of that rebirth, of classical realism being taught in the traditional atelier again. It is awesome. The amount of patience and focus and reverence it requires is awesome too. The fact is that it is not a bunch of self important art school teachers, rather it's these really cool, focused, breathtakingly talented guys–most of them in their 30s who all studied under J—- C—— for years throughout their 20s and mastered the technique–who are teaching.

I for one found meals for a lifetime in her letters.

One of life's greatest challenges is aging. Even in later years the thrill of learning new things such as statistics, programming, markets, new books, keeping the love of knowledge, new frontiers is fulfilling and give great meaning to life. The mastery of existing skills can be deeply satisfying.

# Psychological Barriers, from Allen Gillespie

Does anyone have any comments or suggestions on breaking through psychological barriers? I have been stuck at a particular equity level now for an extended period and each time I start to break through I get sucked back down. So everyone can thank me for yesterday’s volatility, as I came in long the NASDAQ ran up to my wall, so I then sold at the peak, only to buy back too soon or else too heavily into the decline. I have tried sneaking through this wall with small trades. I have tried jumping through with larger trades. I have tried not even looking at my equity for a while.

I am beginning to feel as I did when I was a little kid and my brother (who is five years my senior) used to play goal line defense against me. I would try to make it over the couch while he pushed me back, but I never could.

I think one of the keys to overcoming psychological barriers is to have a clear and specific a vision (vs. merely the desire) of where you want to get to, that is both compelling and convincing to you over a prolonged period of time. That is usually necessary to generate the requisite commitment (i.e. focus, concentration, persistence and perseverance when you hit walls). Then have a step by step plan for getting there with back up plans for any and every setback you can imagine. Then re-evaluate periodically whether you’re staying with that plan and don’t change it without good reason (especially true for plans you have checked with trusted advisors whose input you listen to).

My personal vision is to develop deep, sustained and mutually rewarding relationship with some of the most respected and powerful people and then influence them in a way to make the world better. Maybe a little idealistic, but I’ve become friends with Warren Bennis from USC and am working on relationships with Jim Sinegal from Costco, Bob Eckert from Mattel, Frances Hesselbein from the leader to leader institute (formerly Peter Drucker Foundation), and Marshall Goldsmith the internationally renowned executive coach, so I think I’m off to a pretty good start. A big help has been my partnering with Keith Ferrazzi, author of best selling book, Never Eat Alone which I urge all of you to buy and read.

I believe the key to psychological barriers in most fields is down to our expectations of ourselves. Kids and adolescents haven’t learned ‘their limits’ so they tend to improve very rapidly. Older folks (20+) have a problem in that they ‘learn their place’. So typically you see acts of self-sabotage by players who are outperforming (see Icarus) whilst those having a bad tournament will fight like tigers to reach their norm.

The feedback one gets from one’s peers can tend to reinforce these feelings. So to improve it’s useful to acquire an excellent peer group for whom success is normal. For this reason I always tried to hang out with the Russians rather than the weak Westerners, and they normally tolerated me because of wanting to improve their English. And I posit that we are in the right place for similar reasons.

But what you may be experiencing may not be this kind of psychological barrier. The problem I’ve found with markets is adjusting to the ‘phase shifts’ when it starts to behave quite differently. A model which suggests that individual striving is the key may be too one dimensional, and perhaps what is required is to dance.

Jim Sogi offers:

The New Year kicked off a new phase shift, or a return to the old. Anecdotally, regular people are starting to get interested again in the new market highs and small cap techs after having stayed away during the steady but slow gains of the last 4 years of worry. Even the hoodoo who lost all his money is getting people at the beach to trade on hot tips. Things that make you go Hmmm.

Different tactics may need to be considered and tested. The issue may not be psychological.

In “Secrets of Professional Turf Betting,” Bacon proposed varying tactics through the year based on the improvements of 3-year-olds, variances in weight allowances, effects of mating season, etc. For phase shifts such as the shift from winter to summer tracks, Bacon proposed general methods that could be used at any time, but were particularly useful at times when data was insufficient to evaluate the new regime. One such method was to pick the horse with the highest percentage of races won in the past year. Another was to note which horses had begun working out earliest at a new venue and study their workout times.

# Flags of our Fathers & Letters from Iwo Jima, by Dylan Distasio

I was fortunate enough last night to see Eastwood's two films on the Battle of Iwo Jima back to back at the Jacob Burns Film Center in Pleasantville, NY. As an aside to anyone in that area, the Film Center is a fantastic resource for independent, art house, foreign, and classic movies.

It was a very interesting experience watching the two movies back to back. It was great being able to compare the second with the first so fresh in my mind. I enjoyed both movies greatly, and found them both incredibly moving. I found Letters from Iwo Jima, which tells the story of the battle from the Japanese perspective (and is entirely in the Japanese language) to be one of the most powerful anti-war pictures (in my opinion) that I've ever seen. It was also the better movie of the two in my opinion, although the emotional impact of Flags ran much deeper for me.

I suspect that was due to two reasons. The obvious first one is that I'm an American, and we tend to sympathize with our own countrymen. The second is that my deceased grandfather who I was very close to, was a fighter pilot in the European theater of WW II, and the movie brought back memories of him, and imaginings of the incredible sacrifices that must have been required of all during that time.

Anyways back to the movies … I found them to be two very different films for the most part. One thing they do have in common is an examination of the theme that war literally is hell, and that actions on the battlefield are often brutal, and amoral no matter which side claims the moral imperative.

'Flags' which purports to tell the story behind the famous picture of the flag raising over Iwo Jima will inevitably be compared to 'Saving Private Ryan' for its battle sequences. Eastwood manages to capture the randomness and chaos of war vividly in the battle scenes. In particular, the opening assault on the beach near Mount Suribachi (where the flag would eventually be planted) is very impressive.

'Flags' is shot as a series of flashbacks between the battle itself, the present day, and the war bond drive immediately after the battle where the three survivors of the flag raising captured in the photograph are trotted out by the US government to raise money for a near bankrupt US. The movie raises a lot of questions over what it means to be a hero, the reasons behind actions on the battlefield, and their often unthinkable nature, and shines an uncomfortable spotlight on the war propaganda machine. One can't help to have some thoughts of the current situation in Iraq, and Bush's infamous picture on the carrier with 'Mission Accomplished' overhead when watching the spin during the bond drive portions of the film.

Some reviews have complained about the way 'Flags' cuts back and forth between past and present, but it didn't bother me at all. I'm not sure it necessarily adds a great deal to an already powerful film though.

The acting in 'Flags' is generally very good, but I thought the actor who plays one of the flag raisers, a Native American named Ira Hayes, steals the show. His performance is heart wrenching. He is a soldier that has seen and done unthinkable things in the battle. He is literally dragged into the spotlight unwillingly and trotted out as a hero for the flag raising during a series of appearances with the other two survivors during the bond drive.

'Letters' begins in 1944 before the battle, during the early Japanese preparations on the desolate island of Iwo Jima (Sulfur Island in Japanese). Ken Watanabe does an incredible acting job as the general in command of the operation, Tadamichi Kuribayashi.

Kuribayashi had spent time in America before the war, and was against it but was obviously overruled. He knew that the industrial output of the US at the time was unmatched, and would likely be unbeatable. He certainly knew that he and his 20,000 troops were doomed going into battle, but he strategized for maximum impact on the American invasion. He turned a lot of traditional Japanese battle planning on its head, which led to dissension in the ranks of his underlings both before and during the battle, and definitely contributed in some cases to a quicker death for some Japanese units. By the end of the battle, there were around 1000 Japanese left between battle casualties and suicides to avoid surrender.

Watanabe captures a man torn between duty to family and country, and between his love of homeland versus a friendly view towards Americans in general.

The other star of the show is the actor who plays a simple baker with no interest in war, and is forcibly conscripted into the Japanese war effort and sent to Iwo Jima while his pregnant wife watches powerlessly. His performance, at times comedic, always powerful, is very well done.

'Letters' is clearly an anti-war picture. Its emotional impact is different in some ways because you know from the beginning that most if not all of the characters are going to be dead by the end of the film, and they all know it themselves. The island is inhospitable, and hot. There is little food or water, and dysentery everywhere. Yet, they manage to build a series of tunnels and reinforced positions that go so deep, they are eventually immune to American air bombing campaigns. Despite the brilliant strategy of Kuribayashi, the Japanese are far outnumbered, outmatched, and have been essentially abandoned by the Japanese mainland in terms of reinforcements. It is a very difficult movie to watch knowing the ultimate outcome.

It manages to humanize the face of the enemy like few war pictures have done. I would be interested to see the reaction to it in Japan.

Anyways, I would strongly recommend seeing both movies. As movies, they are both very well done, but I feel like 'Letters' is a crowning achievement for Eastwood, while 'Flags' is not quite at that same level. They will definitely give you many things to think about as we begin a new year.

I don't do war movies any more so I can't comment on the films that Dylan saw. The last uniform, splatter film I saw was "Saving Private Ryan." Compared to the memoirs and documentary photography made by the people who fought on D-Day and in the weeks after the landings, Spielberg's epic was so completely meretricious that it cured me permanently of any curiosity about what contemporary filmmakers have to say about WW II or any other war.

What I would like to question is the presumption that Americans were destined to win the war because of our material superiority or, as Dylan puts it, "the industrial output of the US at the time was unmatched and would likely be unbeatable." In the actual combat against the Japanese army and navy in the Pacific, the weight of numbers and equipment was rarely a decisive factor for the Americans who did the fighting. The reason for this is painfully simple: until the summer of 1945, the Pacific theater always had last priority. Supplies and reinforcements were first sent to Britain and North Africa and then - after 1944 - the European continent. Even Lend Lease to Russia usually had a greater priority than the Pacific theater.

It is only at the very end of the war, with the arrival of the B-29 and the invasion fleet for Okinawa that material superiority became a significant factor; and that was countered to a large degree by the Japanese use of kamikaze tactics. (The U.S. Navy lost more sailors in one month, off the island of Okinawa, than it had in its entire history before that time.)

The triumph of the Americans over the Japanese Empire came far more from intelligence and courage than it did from having more equipment. That eventual victory began with the neutralization of Japanese naval superiority at the Battle of Midway in 1942. 12 bombs destroyed 4 aircraft carriers and - far more important - the elite cadre of Japanese aviators on those ships.

Both Japanese and American scholars agree that, at Midway, the Japanese had more and better aircraft, ships and torpedoes. Their pilots and sailors had greater technical skills and far greater combat experience. Nevertheless, they lost - because of luck and the willingness of the American commanders, Nimitz and Spruance, to go against the odds. Even after the Japanese lost their absolute air superiority at Midway, they still retained the tactical advantages of being on defense. They assumed - not without cause - that the vast distances of the Pacific would make it impossible for the Americans to defeat them. What destroyed that assumption was the success of the American submarine forces in literally choking off supplies of fuel and other materials to the Japanese.

Like the United States Navy, the Army and Marines were able to capture territory for the establishment of forward bases in the mid and Western Pacific, and the submarine forces were able to reach the shipping lanes that converged in the seas around Luzon. The submariners were able to use the information, which the U.S. Naval Intelligence had gathered by successfully breaking the Japanese Naval cipher, to hunt down the Japanese merchant fleet. (The Japanese naval command cooperated by requiring each merchant ship to report to its position daily.)

By 1945 the naval blockade had been so successful that the only targets left were lighters and other coastal vessels; the entire oceangoing Japanese merchant marine - all 5 million tons - had been sunk.

When the battle of Iwo Jima began, the fuel supply to the entire home islands and the military was 10% of what the fuel requirements for the Japanese Navy alone had been in 1942. To suggest that the Japanese troops on Iwo Jima were "abandoned by the Japanese mainland in terms of reinforcements" is to fail utterly to understand how desperate the situation was for the Japanese. It is also to imply - yet again - that the Americans could have been expected to win because of their material advantage. Iwo Jima was - even more than Okinawa - considered part of Japan itself; and Japan's soldiers, sailors and airmen had sworn to protect the homeland at the cost of their lives. Defeating them required a sacrifice equal to their own.

What should also be remembered is the price paid for American submariners: 52 subs and 3,505 officers and crewmen. One last quibble: if, as the filmmakers imply, the U.S. was "near bankrupt" after the Battle of Iwo Jima, it must have been as part of a previously unreported planetary repo out of the pages of Douglas Adams. The near fatal hubris of post-WW II Federal Reserve and Treasury policy had its origins in 1945 - a time when the U.S. dollar was considered not only as good as gold but better. For the next 2 decades everyone in the world would take our checks without ever asking for ID.

Dylan Distasio responds:

Thanks to Stefan for the informative analysis. The above section in particular got me thinking about the validity of the statements in the movie. I happen to have a copy of Milton Friedman's A Monetary History of the US 1867-1960, which is an interesting tome in its own right. I'll quote some of the section in it on WW II deficits below (with the caveat that access to internal Fed documents from 1940 onwards during the war was apparently limited when Friedman was writing his book).

From A Monetary History:

Period of Wartime Deficits, December 1941-January 1946

…By early 1941, however, the deficit had begun to rise sharply. For calendar 1941, cash operating outgo exceeded cash operating income by \$10 billion or nearly half of total expenditures. Pearl Harbor brought a sharp intensification of these tendencies. Government expenditures nearly tripled from calendar 1941 to calendar 1942, and rose a further 50 per cent from 1942 to 1943, reaching a peak of \$95 billion in 1944. Tax receipts also rose but more slowly and in no greater ratio. As a result, the cash deficit rose to levels without precedent, either in absolute amount or as a percentage of national income; to nearly \$40 billion in calendar 1942, over \$50 billion in 1943, over \$45 billion in 1944, and over \$35 billion in 1945—sums averaging nearly 30 per cent of the contemporary net national product.

From the Atlanta Fed's website, here's another tidbit:

The war whipped Reserve Bank operations out of the doldrums of the late 1930s in a spectacular manner. A great deal of the war financing bypassed the old and suddenly cumbersome system of supplying credit through the Federal Reserve System by allowing member banks to rediscount eligible loans. In stark contrast to World War I and its postwar years, rediscounts dwindled and finally disappeared during World War II. The Atlanta Bank's portfolio of earning assets at the end of 1944, for example, consisted almost entirely of Treasury securities distributed from the System's account. There were no discounted loans from member banks. The Reserve Banks became almost exclusively holders of government debt. Commercial banks financed \$95 billion of the \$380 billion war debt, as the Fed augmented their asset capacity by supplying ample reserves. The money supply more than tripled between June 1940 and the end of 1945, and U.S. government debt increased from one-fourth to two-thirds of all U.S. debt. Thus a large portion of the banking resources of the nation, which had seemed so plentiful and so neglected in 1938, fueled the war effort, and both the activity as well as the assets of the Atlanta Fed soared.

It's also interesting to note that commercial banks were disallowed from most of the bond drives resulting in banks attempting to buy them from individuals on the black market.

Stephan, have you read Embracing Defeat: Japan in the Wake of World War II (Hardcover) by John W. Dower?

It is an amazing, but quite depressing description of utter devastation to the cities, the economy, the industry, and the people and society of Japan during WWII. The fire bombs in Tokyo and in other industrial cities had an even greater capacity to kill and destroy than even those nuclear bombs, which destroyed over 40-80% of all residences and major industrial areas. Japan lost 1/3 of its net worth, and it suffered a 35% decline in urban living standards, and a 65% decline in rural living standards. It also lost 4/5th of all its ships. Furthermore, the feudal system ended. 4% of the entire population of 74 million was killed. In addition, 1/3 of the population of Okinawa was killed.

MacArthur's occupation force of 245,000 would have had great lessons for Iraq. Bremmer totally destroyed any hope and chance of stabilizing the Iraqi government by dismissing the entire bureaucracy and army in Iraq in three days with ill conceived and poorly planned action. In Japan, they kept the bureaucracy with tremendous efficacy.

It's quite amazing how prosperous they became. Now the Nikkei is 17245, which shows that it doubled in the last three years.

I share James Sogi's appreciation of Dower's book, Embracing Defeat; it is an extraordinary story. What the people of Japan have accomplished in 60 years is without historical parallel. To understand the extent of the devastation to Japan from the B-25 and B-29 raids at the end of WW II, you would have to take the recent hurricane devastation of Louisiana and Mississippi and multiply it 50-fold. You would then have to kill 3 million people from blast, disease and outright starvation, and leave the country with no fuel or food. Sadaharu Oh, the great baseball player, remembers sheltering with his mother in the canal near their home during one of the firestorms. They considered themselves lucky that the fires from the surrounding homes were not so intense that they raised the water temperature beyond the point of endurance. Others were not so fortunate; their bodies were found boiled to death. Oh was 5 years old at the time.

The blame for the failure of U.S. - Japanese relations in the 20th century has to be placed at the feet of Teddy Roosevelt, Woodrow Wilson and their fellow Social Darwinists (authors of that wonderful contribution to American jurisprudence - Plessey v. Ferguson). Their racism was eventually matched and exceeded by the members of the Kodaha and Tosei-Ha, but the Americans went first. In 1914, Japan was a more genuine democracy than the German Empire. The Emperor's political authority was far closer to that of George V than William II. Nevertheless, none of the Western allies - not the Americans, French, British or Italians - thought that their Japanese counterparts had the right to claim equal status at the conference table at Versailles. When that humiliation was followed by the Asian Exclusion Act of 1920 and the ending of the Anglo-Japanese alliance in 1922, the Socialist and Social Democratic parties in Japan and their policies of "Westernization" were deeply weakened. They might yet have prevailed, but the devastation of the Tokyo Earthquake and Fire created the same loss of faith and desire for a new, "strong" Japan that the Depression did in Germany.

I share James' scorn for the use of a civilian pro-consul instead of a military one in Iraq. Tommy Franks and the U.S. Army would have been a much better choice than Bremer and the State Department. But I think the historical analogy with Vietnam is the more appropriate one with regard to whether the Baathist bureaucracy and military in Iraq should have been left in place. In 1945 the Japanese forces in Indo-China had removed the French from all positions of military and civil authority just as the Germans had taken over in Italy in 1944. Roosevelt had wanted to require the Japanese forces there to formally surrender, as the Germans did in Italy; but he was persuaded to allow the Japanese to continue to govern the country until the French colonial authority could be reestablished. In the eyes of the Vietnamese, the French never overcame the double shame of defeat, followed by outright collaboration with a hated enemy. If the U.S. forces had allowed the Baathists to remain in power, the situation in Iraq would have been a second Indo-China War. I would offer instead the Philippines after the Spanish-American War as a historical comparison. The Spanish authorities were clearly discredited. Rather than leave them in place, the Americans established a joint military and civil authority. To T. Roosevelt's deep frustration, William Howard Taft, who was the pro-consul, committed the United States to granting the country political independence. (One of Roosevelt's strongest motivations for his later 3rd party run for President as a "Bull Moose" was his disdain for Taft's willingness to disestablish the fledging American Empire. He also thought Taft's fondness for baseball and his willingness to be seen throwing out the first pitch at an opening game was "common".) The U.S. Army and the Marines had to battle both the Moro and the Aguinaldo insurgents for nearly a decade after Dewey's dramatic success in Manila Bay. The chapters of General Pershing's memoirs dealing with his negotiations with village chiefs in the Philippine islands are being written again by successor American officers in the field in Afghanistan and the Western Provinces today.

## From Roger Arnold:

I finally watched Flags of Our Fathers on Saturday at home with my 13-year-old daughter. As the movie was playing I was explaining the background of the story and of the men's lives to her. I knew some of the story because I was a Marine. The non-public parts of the story were told to me by James Bradley, even before he wrote the book. He had a passion for this story and for getting it told. This wasn't just a movie, made from a book, authored by a chop-shop writer.

Jim willed this movie into existence. Without his singular determination to tell the story it would have been lost to history. And that story too is worth hearing. As far as I can tell the movie relates the story pretty much as Jim told it to me 10 years ago, especially as pertains to Ira.

There were some peculiarities and omissions that raise questions for me. But as they pertain to private issues that readers and viewers would otherwise not be aware of, I will not relate them here.

# 1001 Ways to Lose Money, from Jim Sogi

There are 1001 ways to lose money in the markets. Starting with the deceptions, but continuing with methods of snatching defeat from the jaws of victory. Chair mentioned a number of them in Ed. Spec. and Prac. Spec. including his Uncle Howie’s methods, his Grandfather’s methods, sexulation, hubris, hoodoos, fixed systems, trend following, technical analysis, the propagandists methods, Abelprectorish bearishness, body snatcheritis, everchanging cycles, and trading during times of personal or family events.

There is also Livermore’s most expensive last 1/8th of a point, and the other Livermorean folly of asking the market to buy a coat or a car, making the danger of trading the P&L and not the markets. We should never forget the Expert Professor’s good warning not to confuse luck and skill which was echoed by Professor Diebold’s discussion of alpha and beta. The greatest way to lose money of course, is the weak hand syndrome, whose symptoms strike both on the bailout and on the failure to capitalize on the rise after the fall, which is more of the loss of opportunity variety of losing money. A good number of ways to lose money involve the use of, failure to use, or the over use of leverage or capital. All in all there are 1001 ways to lose money, and I invite you to add to the list.

Vic responds:

One way not to lose as much money as usual is to eschew forums where the agenda is controlled by someone who you are not convinced has the ability to make a profit in real life. Also, do not assume that each day of the week and hour of the day has the same regularities.

Try not to take flyers on other people’s trades as you will become weak, not knowing how convinced they are of their prospects, and will tend to bail out at the worst time.

Do not read books by people with get rich schemes, as if they had one (other than selling books) they would not share it with you. Nor for that matter should you read books talking about how great a personage was in the past. The question is always what is the going forward reason that this method of thinking/methodology should have an edge, not already discounted, in the future.

Do not put on trades where there’s only one way for you to get out at a profit. For example buying at 3:50 p.m. with the idea that you have to close it at 4:00 p.m. because the close looks strong. The same for moves in the first ten minutes.

Be careful about going against near the ends of the day, and the ends of periods, because the strength of the other side increases in proportion to their profits on a trade.

Never be overconfident. You can sink in a moment on a boat, and lose everything with one bad trade in the market. Try not to be overly pessimistic either though, as the market is very resilient, and the infrastructure is designed so that the system can continue and capital can be raised and entrepreneurs will reap returns for their creativity.

Do not ever brag about your trades, or have too big a position relative to the total money flows in and out of your niche, as you will tempt others to run over you. And after a long period of abstinence, when all the moving averages look the worst, that is when you should test whether the expectations and risk reward are in your favor.

Always be flexible and strong in your thinking and money management. Do not have positions where you might expect on average to fluctuate by more than 4% a day on your capital. Stay away from news stories that put you in the same frame of mind as the average public, that lose so much more than they have any right to do. And when you have a big unrealized loss, and the position comes back to break even, test the odds of a continuation as opposed to a reversal.

Do not ever play another persons game. If you are set up to speculate, speculate. if you are set up to grind, grind. Do not make markets or engage in arbitrage where banks and dealers have about a million times the capital availability that you do.

Make sure that your costs suit your occupation. If you are day trading, be sure that your commissions and borrowing costs are in line with your competitors’. If they are much more low cost or quicker than you, how do you really expect to compete with them.

Many of these rules seem like those that Poloinius gave to Laertes … Above all others, remember that the only one that can really grind is the house.

Steve Leslie offers:

I will mention one sure fire way to expose yourself to loss and one to potentially expose yourself to complete financial ruin.

Firstly, the best way to lose money is to focus on your winners and forget about your losers. Mentally we like to watch our winning trades more than our losing ones. The reasons for this have been described in great detail on this list by many.

Another way is to own too much of one thing. I always tell clients, friends and anyone else who will or will not listen, not to over expose yourself financially to any one stock, no matter how appealing it is. I don’t care if they claim to have the cure for cancer, don’t own too much of it. I personally believe 10% of an individuals portfolio should be the maximum. I cannot think of any scenario where you want to own more, unless you know more than the general public. Now this is where you get the Bill Gates, Larry Ellison, Paul Allen, Andy Grove Arthur Blank, Sam Walton and others argument that this is how they became fabulously wealthy. My reply is that you ain’t them! The interesting thing about these overnight wonders is that it took years for them to become overnight wonders. 25 years from where Sam Walton opened his first store to his second. Some of them also had more than one bankruptcy in between their successes, so beware the headlines. Paul Allen incidentally used to have a terrible record in investing in companies. I have lost track of what he is doing now.

For every Microsoft and Intel, I will point out Enron, World Com, Calpine, Tyco, Imclone and many many more. The best regulators, analysts and money managers in the world never saw Enron coming. What makes you immune from such an event showing up in your portfolio?

The sand can shift very quickly, especially in stocks that have technical expertise. Two and a half years ago, Biogen Idec was flying high and their stock was at 65. Then they found that several patients with MS who were taking their drug developed a rare form of a brain disease called PML, and the stock dropped from 60 to 35 in two weeks. After an exhaustive study, the drug returned to the market and the stock is now 50. It has yet to recover its price fully.

Peter Lynch said that if you want to find one good stock you need to research 10. If you want to find 10 you need to research 100. Now be realistic. Who is going to research 100 stocks. Who has the time, energy, resources, knowledge. etc to play on this field. Most of us are involved in other things such as running a business, earning a living, running kids to soccer, helping with homework, holding together a fragile marriage, watching the next American Idol …

To take poetic license, I paraphrase Ratzo Rizzo in Midnight Cowboy “You know what you need Joe Buck? You need management. Money management that is.”

Andrew Moe contributes:

As corollary, take care when playing in other people’s markets. Strong runs in energy, then metals has made it look easy to profit from commodities. And with incessant reminders on increasing global demand from all the experts, folks are lining up to add oil, gold and wheat to their portfolios. I can just see old Ben on the floor of the exchange, reluctantly agreeing to sell some of his contracts, “When it’s beans in the teens, I’ll sure look foolish for having sold so low…”

# The True Zen of Derivatives Trading, Found on a Poker Site by Sam Humbert

Q: A problem I seem to be having when I play hold 'em is that I am chip leader by a lot, but then somehow it always seems my chips disappear, as was the case in the last tournament I played with my friends. I know the basic rules of what the chip leader should do, like being aggressive and betting a lot. But it seems that every time I do this, I eventually lose all my chips.

Jim Sogi responds:

As we come to the end of the year, the issues of risk and return and performance metrics are of great interest. Absolute dollar returns, yield and risk measures are the most important measures. Diebold said risk is a part and parcel of return, and understanding the type of risk as measured by the new measure of realized volatility is key. He mentioned that other forms of risk are as important as market risk, but are less discussed, such as operations risks. Here is where performance metrics enter. Thank you to erudite specs for great contributions on the subject, In studying performance metrics the issue of the relationship between such things as return and Sharpe or Sortino ratios arises. What is the sweet spot in a particular market cycle to achieve high returns and high Sharpe ratios or high Sortino ratios? What is the performance metric that has the greatest effect on maximizing the 'sweet spot'? Dr. Phil mentioned that a high percent win/loss has a very high leverage effect on yield and risk measures. he trade off is average gain per trade drops. Chair advises to hold longer and go for greater average gain, but the price is larger drawdowns. Diebold said that the Sharpe itself is a time series and will vary across the cycles. How can one adjust trading parameters to maximize metrics for varying market cycles? In other words how does one milk the maximum out of the current market, and how does this change as cycles or days changes. Can one boil this down to expected yield targets for a particular volatility regime, day, hour? How many percent, points, days, weeks, hours should one stay in the trade or use as goals to get the maximum expected utility? This will all vary according to preference as discussed under the Bayes Utility hypothesis, but within the preference, what is the best key to maximum utility for maximum return, and lowest risk? This relationship should be able to be quantified and to act accordingly, as athletes do to win. How would this relationship be quantified? It appears to be the relationship of more than just one metric.

# Deep Waters from Jim Sogi

My best friend is a true Hawaiian master waterman with 50 years experience in the water. When we go out and push the envelope on the far corners of the deserted parts of the island by boat and canoe, he is the best. Whenever we go into the water diving he always brings a spear, and before he goes in he always sticks his head in the water with his dive mask on and looks all around for sharks that might have been watching us. Before getting into 'deep waters' which are abound in the markets in the multitude of niches, it is a good idea to take a real good look around. There is some deep water and big sharks around, straddles that ought to go up but go down 50% in a day near expiry, 4-9% spreads, Vix futures that trade one price each day and have huge gap and traps, strangles that ought to go up but go down with the square root of time, all when equity futures rocket up one percent in 20 minutes. Not quite like the textbooks say it should be. Its wild out there. You option book-runners must have your hands full.

It might be better to think of the "market" as a huge regatta, with multiple dimensions of distance (sprints, 1500m, 2000m, Head races, etc.), experience (high school, college, elite, masters, etc.), and equipment (fours, eights, quads, singles, etc.). So, if you want to take on G0ldman Sax at their own game, that's like rowing in the heavy eights at the Worlds. But you can also win a national championship coaching a women's lightweight four.

Along similar lines, I read a children's science book with my boys last night that said house cats use litter boxes because their relatives, the big cats, are very fastidious about burying/hiding their scat so as not to alert nearby ungulates, who might pick up the scent and quickly make themselves scarce. In Sogic terms, the thought would be "where do G01dm@n et al hide their traces?" I have some thoughts on this (albeit inchoate and disorganized; unworthy of mention) from day-in, day-out praxis in the derivatives markets. A subject for an essay one of these days.

## Jim replies:

Steve, Do you remember the Lone Ranger and Tonto, or Broken Arrow? They would come across tracks in the dirt and say, "3 men on 4 horses were here 3 hours ago, and they were riding fast to the East." Or Daniel Boone would look down and say "Big bear was here yesterday with cubs traveling west. Just ate berries and salmon, so will not be hungry." It would be great to be able to read the tracks or the scat … How.

# Jim Sogi on Fed Retail and Options Strikes

Speaking of ephemeral matters, the Fed obviously knew before their statement what the retail figures would say, and thus maintained their neutral stance in the face of a wall of negativity. The Fed announcement was a non event, so when the retail numbers came out, again pre-market, the boys gapped them up 6 points. Why some random manipulated inaccurate guesstimated revisionist government numbers should affect the true state of the economy and the market predictions by half a percent does not make sense.” The equity market agreed.

Secondly, commenting on how strikes operate as round attractors, would not structural pressures of the various strike holders competing try to drive the price to the middle strike — say the current 1425 in the case of the ES option — and create a range on either side. The 1430’s would be bearish, the 1420’s, 1425’s would be spit bullish and bearish, and divided, and drive the price to the middle where we’ve been swinging around for a week now. Study of options as cycles change to augment the arsenal and battery seems worthwhile, and it is a deep subject, so we may need to draw on the expertise here.