Feb

28

PhilWhen taking a bath one of the better ways to circulate newly added hot water is to swirl the water in the tub. One hand paddles backwards, the other goes forward and a giant wave soon circles the tub. At any given moment there is a limited volume of water in the tub. The goal is to circulate the water around to each point in the tub equally.

Our friend Sushil Kedia has posited that the Indian market leads the US market. Perhaps this is an application of the bathtub theory. To test this we might wish to look at simple correlations between INP, the Indian ETF, and SPY, the S&P 500 ETF. If in fact the Indian market leads we would expect that there wold be significant correlations at some lag. Following are the recent correlations of the INP with SPY at various lags:

Bath

Notably, five of six are strongly negative and the sixth is insignificant at 1.2%. So it would seem that the globe is a giant bathtub and that water does slosh around it in a non random manner. But if there is correlation then we know that a predictive regression model can be developed.

Using only lags 1, 3, 4, 5 & 6, our regression model has an overall correlation of 24.9%. All of the coefficients are negative, mostly in the neighborhood of -.04. The regression constant is -.001, reflecting the recent weak market behavior. Effectively what this says is that when money flows out of the Indian market it tends to go into the US market over the next six days or so. The converse is valid as well, in that if money goes into the Indian market it will come out of the US in the next six days. In any event the bathtub theory works reasonably well for the Indian - US markets, with India leading.


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7 Comments so far

  1. Lon Evans on February 29, 2008 3:41 am

    Yeah,

    I’m back and as contrary as ever. Can you guys ever get over the “testing” thing, or at least in embracing the practice as a portent for gain. Anything and everything that a man can come up with to secure a particular position, another can discount, immediately, in disagreeing. All markets, after all, demand a counter-party don’t they?

    The best anyone can do in this play is to locate indicators. Make your play based upon such, place your stops based upon such, and then, sit back and prey. Any one who denies the reality of such is one who spends most of his or her time attempting to separate the OP from their M.

    As general information to those who desire a fail-safe means of approaching any given market. You can take Rothschild’s suggestion and eat the hungry end of a gun. Or you can dig down deep and drag up some unexpected genius, one that allows you to create algorithms as effective as those realized by the ‘Prediction Company’ located in Santa Fe, NM. Man, of all the black boxes, these dudes have realized the blackest.

    Cheers, and please, in reply, try civility.

    lon

  2. 10kthrownaway » Blog Archive » The 8:01 Report on February 29, 2008 9:42 am

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  3. George Parkanyi on March 1, 2008 11:40 am

    “Taking a bath” represents quite accurately what most of my stocks are doing these days.

    I must say it IS a little tough in this market to maintain face when your admonitions to keep a stiff upper lip and ride it out sounds to most people like “blah blah blah I don’t CARE if it’s the Titanic, that’s MY deck chair!”

    Are visits to your blog trailing off as well … :)

    Cheers,
    George

  4. George Parkanyi on March 1, 2008 12:58 pm

    WHY DO TRENDS HAPPEN?

    For a period of time, demand exceeds supply or vice versa.

    EXPECTATION
    So what creates demand, and what creates supply? Expectation, based on some kind of information.

    More important than the information itself is the type and scope of expectation that it creates. (If you want to witness loads of expectation, look at solar stocks.)

    So certain information, in a certain environment, will create certain expectations. Depending on how that information comes out - suddenly all at once, or released outward slowly over time, there will be a certain amount of initial force and/or continuous pressure exerted by the expectation on supply or demand. For example earnings releases have a dramatic, forceful effect on expectations. (I own Formfactor and Accuray shares, so would know something about that.)

    FEEDBACK LOOPS
    But there’s more, and here is where I think trends gain their energy much like Hurricanes gain force from warm water - feedback loops. With no change in information, the effect of expectation can increase in force by virtue of the movement itself - which creates further derivative expectation.

    Passive players that are not interested in the information itself, make the assumption that someone knows something, and add that expectation to what is already there. I believe this is what pushes stocks higher than what people generally would expect, and lower as well.

    So if you can find a community of such derivate players - basically momentum investors - you have a means by which to leverage the effect of primary expectations created from actual information.

    APPLYING THIS TO SPECULATION
    A useful exercise then in speculation is to assess
    (1) the prevailing expections, and ask yourself what could change them? and
    (2) the extent of feedback loops creating derivative expectations, and what might affect those?

    EXAMPLE - WHEAT
    For example, if you thought there might be opportunity in shorting wheat, what kind of questions could you ask?

    (1) What are the current expectations based on known information?
    There is news about that there are shortages, and other commodities are rising, with lots of talk about inflation. The expectation still seems to be for higher prices.

    (2) Is there a feedback loop?
    Funds are heavily long, as are small specualators, and there is large open interest. Prices could still carry quite far.

    (3) What could change the expectation?
    Incorrect prior reports about shortages. Favourable weather in a major growing area. News of a large short position by a known savvy investor with deep pockets. Political intervention - an increase in margin requirements. etc…

    (4) What is the likelihood of any of these happening?
    Hmmm. Political intervention perhaps. The Fed needs to lower interest rates, but they certainly don’t need headlines about runaway inflation and a collapsing dollar. Or more bursting bubbles. So … ?

    (5) What could change the feedback dynamic?
    The higher the price, the more money and buying is required to move the same position size. Commercial entitities may be making huge profits at these levels and decide to lock them in and sell heavily. A sharp price break or wild price swings may introduce fear.

    (6) Can the feedback invert to advantage?
    There’s a large open interest, and speculators cannot take delivery, so they need to close out at some point. If the only buyers left are commercials, and speculators decide to run for the exit at the same time, negative feedback could be powerful and price drops could be precipitous.

    One possible conclusion: When the expectation changes, a short position could deliver big profits in a short time frame. The most likely thing to change expectation dramatically would be political intervention - probably manifest in an increase in margin requirements. Two things could change the feedback effect - commercial selling, and fear induced by volatility. Keep an eye out for these three factors, and perhaps put out some very small test trades after sharp rises, or sell into the first rally after the first sharp price break. In the absence of any expectation-changing information or event, the risk is still high because of the current feedback loop driving the upward momentum. Keep any initial “test” trade sizes very small.

    And so on. Especially in trading, this type of thinking process would be akin to staying a couple of moves ahead in chess. What could change expections? - especially suddenly. How likely is that to occur? And can you take advantage of re-inforcing feedback?

    Cheers,
    George

  5. Lon Evans on March 2, 2008 4:09 am

    Dear George,

    Your deck chair is very soon to become your life perserver, and one exhibiting but a modicum of buoyancy.

    As you know, I appreciate your candor, and as so often is your charm, the above is offered a bit tongue-in-cheek, but not without a concern for your future.

    I remain pessimistic, as I’ve been from the second failure up in the mid 1500’s. Back then, I believed I’d caught glimpse of a Black Swan. So I went into research mode, and to date my evaluation has yet to disappoint. It is a beautiful bird, one rarely seen, and not one wisely ignored.

    The future is God’s concern. I just muddle along to the best of my limited abilities.

    Cheers, good luck, and thank you,

    lon

  6. Martin Johnson on March 3, 2008 12:10 pm

    I have always been an avid reader of Daily Speculations due to its educational content not only about the market, but life in general. It is also my understanding that Vic and Laurel share this same idea as it is stated on the site’s Philosophy statement:

    “We are animated by a desire to apply systematic, tested reasoning to improve our understanding, not by appeals to authority or the transition of charts.
    We believe that perhaps the most important part of the scientific method is asking the right questions — rich questions that if properly validated or refuted give information of a fruitful nature.”

    Are useless and inordinate personal attacks with little or no content as posted regularly by Mr. L## Ev##s part of this philosophy? Is there any factual evidence that Mr. Ev##s methods (whatever they may be) hold any more merit than the ones presented by other readers of this site? The mere talk of “a good game” from a pedestal that cannot be confronted or refuted due to the lack of evidence or content is sure far and away from the principles of the scientific method.

  7. Lon Evans on March 4, 2008 10:17 am

    Mr. Johnson,

    As to methods, thank you for asking. Simply, I study humans, such as yourself, as a primatologist studies a bonobo. Take offense at the comparison, but one can really only do so if denying the remarkable emotional similarities shared by all G-d's creatures.

    As to my vacuity, I've been forthright as to my position from my initial comment. To date, my position has been validated by price action. Can the same be said for the opinions of all those who have gloatingly predicted my comeuppance? How do you define vacuity?

    And thank you for reiterating my frustration as to how the approach parroted by many who frequent this site begins to uphold the idea of a scientific method. As far as I've witnessed, much is merely the sort of pretentious blather cloaking that the hypothesis is the proof.

    Are you starting to get it now? Should a little button pushing really evince such a vitriolic response? What are you reacting to? Ever ask yourself?

    lon

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