Daily Speculations The Web Site of Victor Niederhoffer and Laurel Kenner


Dec. 15-31, 2005


Write to us at: (not clickable).
Please include your full name, and omit attachments.


Steve Ellison Reviews "Evolutionary Catastrophes"

Over the holiday break, I resolved to study mass extinctions. I hypothesize that one of the reasons for changing cycles is that market participants change. Cataclysmic market events accelerate the turnover and pave the way for greatly changed market conditions. Here is my review of Evolutionary Catastrophes: The Science of Mass Extinction by Vincent Courtillot.

Courtillot presents evidence that at least seven major hotspots have emerged under continental plates in the past 300 million years. The initial emergence of each of the seven hotspots resulted in clusters of massive volcanic eruptions that coincided with large numbers of extinctions. Courtillot theorizes that major hotspots originate deep in the mantle, at the boundary with the core. This layer of the earth's interior is also associated with the magnetic field. Intriguingly, the two greatest mass extinctions in the period studied, at the ends of the Permian and Cretaceous periods, each occurred after abnormally long periods of magnetic field stability. Usually, the earth's magnetic field reverses polarity every few million years, but it went 35 million years between reversals in the Cretaceous period. Courtillot theorizes that the lack of reversals might have been due to the boundary layer between the core and mantle growing to a greater than usual thickness, which might have inhibited polarity shifts while at the same time becoming more unstable and leading to a more dramatic "correction", i.e., formation of a more intense hot spot, than usual.

Many scientists believe that an asteroid collided with Earth at the end of the Cretaceous period. Courtillot acknowledges there is much evidence for this view, but argues that any asteroid impact would have been merely an aggravating factor to the massive volcanic eruptions during the same general period whose lava flows created the Deccan plateau in western India.

The effect of the mass extinctions was to introduce an element of chance into evolution as otherwise superbly adapted organisms such as dinosaurs could not survive the extreme conditions resulting from the heightened volcanic activity temperature reductions of as much as 10 degrees Celsius, acid rain that completely destroyed the ozone, increases in atmospheric carbon dioxide of as much as 10 times, and widespread destruction of ecosystem "producers" such as plants and plankton. "In general, it was the larger and the more 'specialized' animals that vanished, while the smaller ones and the 'generalists' pulled through rather well. Those with the broadest geographical distribution in the most varied environments survived better than others." Organisms living in shallow water were particularly hard-hit as sea levels changed; those that lived at high latitudes or could burrow underground fared better.

Despite the periodic mass extinctions and the ongoing normal rate of extinction, the number of species has steadily drifted upward through the eons. Courtillot presents a graph of the number of marine families on which the abrupt drops of the Permian and Cretaceous mass extinctions look somewhat similar to the 1929 and 1987 stock crashes on a chart of the 20th century. Similar to the "creative destruction" of capitalism, there have always been many extinctions, but usually the replacement rate of new species more than compensates for the extinctions.

Dying with Your Boots On, by GM Nigel Davies

Tigran Petrosian was once asked about the current position in a World Championship match. His answer was interesting: "When I knew the answer I was up there playing and not down here spectating."

What a difference from the 'coaches' who never move a piece in anger, the 'armchair analysts' and others. It's so easy to describe what's happening from the safety of the sidelines, neatly hedging the comments to sound wise whilst covering all the bases. And this kind of 'old dufferdom' is so popular with the public because it allows them to feel wise too without exposing them to the risk of stopping a bullet. Or even, heavens above, forcing them to think.

It's all to easy to be an old duffer, a glass of port too many at lunchtime whilst spouting generalities to a captive audience. Which brings me to my thought for the New Year and beyond; may the intelligent interventionist allow me to the simple dignity of dying with my boots on.

Pit Trading, by Victor Niederhoffer

Inspired by witnessing the wild activity at the breaking of a round number during my recent visit to the Chicago Merc pit, I have been reviewing some of the better descriptions of same and came across the following from The Pit by Frank Norris:

As he heard the distant striking of the gong, and the roar of the Pit as it began to get under way, with a prolonged rumbling trepidation like the advancing of a great flood, he threw his cigar away....

For from the direction of the Wheat Pit had come a sudden and vehement renewal of tumult. The traders as one man were roaring in chorus. There were cheers; hats went up into the air. On the floor by the lowest step two brokers, their hands trumpet-wise to their mouths, shouted at top voice to certain friends at a distance, while above them, on the topmost step of the Pit, a half-dozen others, their arms at fullest stretch, threw the hand signals that interpreted the fluctuations in the price, to their associates in the various parts of the building. Again and again the cheers rose, violent hip-hip-hurrahs and tigers, while from all corners and parts of the floor men and boys came scurrying up. Visitors in the gallery leaned eagerly upon the railing. Over in the provision pit, trading ceased for the moment, and all heads were turned towards the commotion of the wheat traders.

"Ah," commented Crookes, "they did get it there at last."

For the hand on the dial had suddenly jumped another degree, and not a messenger boy, not a porter not a janitor, none whose work or life brought him in touch with the Board of Trade, that did not feel the thrill. The news flashed out to the world on a hundred telegraph wires; it was called to a hundred offices across the telephone lines. From every doorway, even, as it seemed, from every window of the building, spreading thence all over the city, the State, the Northwest, the entire nation, sped the magic words, "Dollar wheat."

A few things strike and questions emerge. Wheat circa 1900 was $1.00 a bushel. Today 100 years later, it's $3.30 a bushel. That's a 1.1% annual gain, about half of the CPI. Does that shed light on a likely future price for oil? Does it explain why so many in related inflationary vehicles will turn out to be so lucky that their path to Cerberus was detoured albeit partially expedited by the unfortunate turn of events in October? When will similar cheers and hip-hip-hurrahs emerge for Dow 15,000?

Herdlike Behavior, by Victor Niederhoffer

The tendency of humans is well covered in Natural Faculty by Galton where he talks about the difficulty of finding an oxen to lead the pack in his African travels. From EdSpec

Galton learned about the herdlike tendencies of humans from his travels with oxen in Africa. The oxen all rushed into enclosures in the evening. The main problem in using them to carry packs was the difficulty of finding one to lead. If one ox was separated from the herd, it exhibited agony, until it found the herd and plunged back into the middle. This if nothing else provided comfort for the herdsman: They knew that the entire herd was safe if but one ox was sighted.

I saw a vivid double demonstration of the herdlike tendency on my visit yesterday to the scene of the battle, in the pits of the S&P. As I entered, carved in stone, a vestige from the original Chicago Merc of 1907, was the motto "Integrity is the Foundation of All Commerce," so I must admit I was in a very flexible and risible mood. What I saw seemed like complete somnolence, total lack of activity, doubtless caused in part by the year end holidays until a rush of activity at 4 PM when the market broke below 1260. Torrents of screaming, feverish activity, mad gesticulations, competitive dashes to be first on a trade, spinning and jumping like whirling dervishes in a religious dance, broke out if in a mad rush to escape a thunderstorm or fire broke out. It was all due to a pivot being broken, and a round number and a 20 day low at the same time. And this was all due to the downward draft created by the inversion of the yield curves.

How many ways can it be said that the fundamental lesson of economics these past 25 years is rational choice? That when something is widely known in advance, it is correctly acted upon by decision-makers. That people know that long-term rates are an average of current and future expected rates with a bit of a liquidity premium thrown in. That they know that when the two rates are close together that there is an expectation that the short-term rate average in the future will be less than the current rate. The current inversion is caused by the knowledge that the market has that the Fed will soon stop raising short-term rates, and when this happens the expectation will be for the next 10 or 15 qualitative moves, such as discount rates to be downward.

How many times must one tell the herds that if they follow fixed rules like selling the stock market when x is above y, that they will be prey to the flexible decision makers who will buy from them in weakness and take all their spare money, forcing them to lose so much more than they have any right to lose.

Of course, rational or not, the orgy of madness that was engendered by the break below 1260 did give one the opportunity to reflect again that standing in the way of a herd can get one crushed . It brought back vivid memories of all the oxenlike people who sold the market on October 19, 1987, and October 16, 1987, knowing that the moves in the previous months were similar to those that happened in the first 10 months of 1929. One of the most amazing things to me is that one of the most successful speculators of all time, a former colleague of mine is proud to be quoted that he felt like an idiot on October 16, 1987, because he hadn't shorted when he realized how close to the October 1929 scenario the situation looked. Charts comparing the two paths had been making the rounds for many months.

The most amazing thing to me is that people like that have not as of yet lost all their chips. One hopes that they will be encouraged by the relative stasis of the 6% or so gain in US stocks this year to continue their herdlike tendencies.

The Mistress Leads in the Dance Macabre, from Bonnie Lo

One day during the summer, I got off work and got home around 9:00...after a 12 hour day, I was pleasantly surprised by the sound of music from a square near my apartment. It was a local group playing piano orchestra. The conductor was introducing the next piece, a piece from the middle ages, Dance Macabre and I apologize for forgetting the composer. I'm sure the piece is eerie already performed with the regular instruments, but having a dozen pianos with 24 players in duet really brought out other aspects of the piece - the keys knocking as bones dancing in the graveyard while lead by the ruling skeleton. But in the swirl and tumult of the macabre dance I heard the song of the mistress laughing as she lead players and dancers to ruin, unable to stop as long as she continues to sing and play. Caught in the dark, otherwise unfeeling cool headed puppets rise, called up by the music but dropped as soon as the music stops, and the market dances along, up and down, up and down along the jagged edge of life, waiting for a smoother path to come. The tune should change soon...I don't see that the players are the same now. I think by the time I build up enough money again in the springtime it should be good to join in the dance.

Curve Lunacy, by Russell Sears

Perhaps not a magazine cover, but yesterday I heard a piece on the radio about the yield curve inversion meaning imminent demise of the economy. The announcer doing the interview was so giddy with excitement it spilled out of the radio. The arsonistic broadcast company doing this reporting was NPR. Now, why would a capitalistic investor would take investment advice from a socialistic radio station.

What is a Trend? by Dr. Phil McDonnell

You would think that something as simple as a straight line would be easy to define. By my count there are at least four very good ways to define the "best" line to fit a given set of data. But then, that count probably overlooks a few.

First there is the traditional least squares fit. It minimizes the squared error of the points above and below the line. It also has the very happy property that it is the maximum likelihood estimate for the line given the usual assumptions of normally distributed errors. It also has the property that large errors are weighted more heavily. Unfortunately it has the property that when you calculate the least squares solution for all the y data as a function of x you cannot just turn that around and use y data to predict x. You need a second and different equation.

For those that are bothered by the fact that least squares lines do not follow the basic rules of algebra we have orthogonal regressions. These are simply translations and rotations of the data about the axes so as to give the best fit for both x and y. However orthogonal regression does not have the maximum likelihood property.

After Mandelbrot (erroneously) claimed that the variance was infinite a Professor Barr Rosenberg at the UC Berkeley Business school argued for the use of minimum absolute distance of the observed y values from the x's. If one couldn't be sure of the existence of a finite variance then using only first moment statistics was the way to go.

Another way to fit a straight line is with Chebyshev approximation or min-max approximation. The key idea is to find the line through the data which minimizes the largest (max) error. It can be found by crunching the numbers or by a simple graphical technique whereby points are substituted sequentially.

In any event if one is looking for a technique to find trends there are many pitfalls. We have the usual issue as to whether a trend has been around long enough to be reliably identified. We have the usual concern that a trend may have been around too long once it is finally found and may soon change. Thus line fitting techniques are most useful somewhere in the middle when applied to Goldilocks trends. Despite these issues one daunting challenge remains. Ultimately we must resolve the question from the famous quiz show "Will the real line please stand up?".

Russell Sears comments:

Phil did a fine job of defining the lines used by quants. Yet, I believe that he left out the most common line used by non-quants, or chartist. When you pull up a chart the most prominent feature is the start an end point. It would seem to me that the mind naturally draws a the Point to point form of a line.

With this line drawn is how I suspect most people in retrospect define "bear" "Bull", "trending " and "range bound" markets. I suspect this is largely done my, visual estimating, by guessing at the area above and below the line, and the chart, the times this line has been crossed. Further, I would suggest that the most recent crossing of this line is highly weighted for the chartist. Both estimates of when the line was last crossed and the area since the last crossing.

Now perhaps quantifying these things, for common chart time length (or measuring marks such as calendar year, quarters) rather than visually estimating may detect weaknesses in a chartist thinking.

Mutual Fund Investors, by Ckin

Dollar cost averaging has done wonders for my 401k over the past several years. My investment choices are a remarkably dull collection of brand name mutual funds, but I try to select the ones that are the most volatile (diversified) options with a minimal amount of correlation. Not that there is much that isn't well correlated, but the regular investments have caused the total returns to significantly exceed the results of bonds or cash, while the equity products have just barely kept up with cash in the five-year period ended in mid 2005.

And as for what financial planners do, I one had the pleasure of / got stuck talking to a mutual fund wholesaler who claimed that the investors in his load-funds tended to do better than the typical no-load investor because there is a reluctance on the part of the investor to sell or reallocate during market declines. They also stay longer with load funds in order to "get their money's worth from the sales charge." So they tend to be longer-term holders despite their tendency to overtrade, and this is the source of the outperformance. Note that there is no claim that the underlying portfolios actually do any better.

Scott Brooks Replies:

As someone who has dealt with both investors and wholesalers for almost 19 years, I can tell you a few things about both groups.

  1. There are very few wholesalers that are really worth spending time with.
  2. You have to take most things that a wholesalers says with a 10 lb. bag of salt
  3. Some wholesalers are very talented individuals
  4. The average mutual fund investor is not very knowledgeable and will jump between funds and families, chasing returns like a teenage boy pursuing girls, each achieving about the same results. Both the investor and teenage boy start out with high expectations, get worked up into a lather watching/pursuing their goal, and end up very unsatisfied, many of them deciding that its just easier to be a "do it yourselfer".

But in the case of Ckin's wholesaler, there is some merit to what this wholesaler is saying. People that actually stick with a mutual fund, even the mediocre ones, end up getting a better return than the average mutual fund investor.

Remember, the average mutual fund investor gets a substantially lower return than the actual return of the fund. Why? Because most investors buy high and sell low, which is one of the side effects of chasing hot returns. They sell their mutual fund that they perceive as underperforming to buy the fund that they wished they had bought last year.

Le Moribond, by Hany Saad

When Jacques Brel discovered he had few days to live (or so goes the story), he wrote "Le Moribond". In Le Moribond, Brel gathers around him the people that mattered to him the most. His best friend (Emile), the priest, Antoine (his wife's lover and Brel's friend), and his wife who he confronted with her long lasting affair with Antoine for the first time and he then said adieu to all. You know you are in deep trouble when you daydream a scenario like the above with yourself as the Moribond. How would have I done things differently from Brel? May be instead of gathering people around me, I'd go to my quote machine and decide to play the stock market with a different twist. Just one last time. A total different twist. May be a foolish one. May be this time, instead of selling my naked puts on down days and legging into a bull credit spread collecting money for thin air, I will buy calls with all my net worth paying for thin air.

If I live long enough to find the outcome of my bet, I'll probably say my adieus then.

I would only play this game if I had few days to live.

Makes me think sometimes that those betting on rare events by buying thin air are somewhat suicidal or feel they have little time left.

I remember the chair saying once that if he was on board of the unsinkable titanic, he would take the last few minutes to perfect his squash game. My understanding is that the chair assumed there will be no quote machines available.

Now, how would you have done things differently? Is it appropriate to speculate in markets as if you have few days to live? They say (I don't know who "they" are) that you should never take the same risks in your retirement years that you took in your youth. Is this a valid idea? I personally think it's hogwash; but again, I am yet to cover my margin call.

Dr. Kim Zussman Responds:

This does not add much to Hany's poetic thoughts, but there are many intriguing connections between money, risk, and mortality.

For example, what if risk is always conserved? Might risk, which appears to be subjugated by cleverness, really only be changed in form or location in time? Such that a volatile portfolio with gradual gains is equivalent to a smooth rapid increase with intermittent disaster in the distant future.

If risk is moved to the future, one way to game this is to move it so far that you die before disaster comes calling. This necessitates the absence of an afterlife, to spare the hellishly helpless grief of watching one's successors suffer with your mortal consequences.

Another way risk is conserved is that few young people, who can most afford risk, can afford to invest. For them profitable financial risk-taking is shifted to the future; when they have money but little time left to compound it and at great peril if ruined.

So risk tries to locate itself where people are least able to tolerate it.

Market Genres, by James Tar

In sports, such as tennis or football, the competitor can make considerable strides by altering his customary style of play. Mats Wilander defeated Ivan Lendl in the 1988 US Open final by mixing his traditional defensive backcourt game with an offensive serve and volley tactic. Andre Agassi, the best baseliner of all time, saved several critical break points with the same tactic on his way to winning the 1992 Wimbledon Men's Championship. I can recall several NFL Championship teams that won by surprising opponents with the deep ball when opponents were commited to stopping the run.

Novelists, too, become more creative and accomplished when the try something new. In the books, The Walking Drum and Last Of The Breed, Louis L'Amour went outside his famous western genre to take his following on thrilling new rides.

Stock traders in a rut might consider trading some Copper (long only I hope). Currency pros might think about trading a few lots of Corn. With acknowledgement of the Chair's mantra that markets will adapt and turn winning systems into losing ones, not all markets trade the same, and by transfering what worked in one market to a new one, speculators might get more longevity and success with their methods.

Agincourt: The King, The Campaign, The Battle, Reviewed by Edward Talisse

Agincourt: The King, The Campaign, The Battle, by Juliet Barker offers many useful lessons in the art and science of survival. An under-armed, under-nourished and far from home English Army of 6,000 defeated a heavily favored French force of over 40,000. Estimates of the French numerical advantage vary widely, but many professional historians believe it was at least six to one. The English carried the day largely due to preparation and leadership. Henry V directly led the English forces into battle against the French. He expertly took advantage of the terrain and lethally employed his archers. In contrast, the French King Charles VI was absent from the battlefield due to mental instability. French forces were plagued by aristocratic rivalries, questionable loyalties and a lack of leadership. They were routed. So much for safety in numbers and betting with the odds! For quant-minded historians and specs, the book details the problems associated with accurately dating mediaeval events. An early modeling problem due to the many different calendar and counting conventions employed during the 15th century.

Contingency Tables, by Jim Sogi

I have 12 different surfboards, for big, small, medium, glassy, wind conditions. Each fits best in certain conditions. The difficult question is which one to bring to the beach. It's like different golf clubs for different parts of the course. Like surfboards and golf clubs, statistical models each work best in certain conditions. Parametric testing assumes certain models, for example, a normal distribution, exponential distribution, a binomial model. Sometimes it is obvious that a normal distribution and the standard parametric tests might not give an accurate reading, for example when the sample size is small, or is given as ordered, factorial or binomial responses. The difficulty is determining which test and which model is best to determine the needed information. Wrong assumptions can create wrong answers. John Rayner and John Best, A Contingency Table Approach to Nonparametric Testing, describes ideas for testing such situations. A few examples of models they use are related to marketing research, such as which milk tastes better using four different styles of milk container ranked on a scale of one to four, taste testing whiskey by age and grade, and even happiness ranked by years of education and number of siblings. The data are set up in tables, and the columns and rows are summed. Using the formulas and the various tests described, surprisingly accurate results can be obtained from seemingly sparse data. Many of the tests are based on the chi-square approach rather than a log-linear approach. Unfortunately, there are few pictures in the book and it is difficult for the uninitiated to slog through formulas to code these up. The key is to pick the one or two models in the book that apply to market data. Often an entire book might have a few applications that are relevant to markets, as opposed to chocolate tasting in Japan and Australia.

I'm looking at the application to markets, especially at the big ranges since late November, and even the small ranges this week. If a range could be set up as a contingency table, some of the methods could be used. Markets are not dissimilar to marketing products. Set up a contingency table to describe the range. Assume that the speculators/investors are the judges, and the S&P is the product. Divide the range into four areas, high, medium-high, medium-low, and low. The data is order sensitive since prior data affect later data, what I call the second ice cream cone effect. If we count the bars in each level by period, this will give a distribution about the range and reveal some aspect of the data, its distribution, skewness, linearity, etc. that may reveal information or lead to parametric testing with adjustments for the non-normality. The preference for high priced goods might lead to the conclusion of prosperity, spending habits and thus an eventual breakout to the upside. A penurious interest in low priced discounted goods, with no sales at marked-up values, especially at a late time, might indicate a depressed market heading for a drop. This is in progress and comments and corrections are appreciated.

Noteworthy, from GM Nigel Davies

Until recently chess players were allowed to write their moves down before playing them. Many players actually did so because the 'announcement' of their move somehow got them to look at the board differently and often they'd pick up on whether or not it was a mistake (I wrote about the Blumenfeld Rule many moons ago).

I only used this with 'big decisions', finding that it made me 'too wooden' if I did it on every move. Though now the powers that be have decided that this practice constitutes 'making notes during the game' and the penalties you can suffer are only surpassed if you forget to switch your mobile phone off.

Put vis a vis markets, there are no arbiters and you can make notes, so it might be worth writing down trades before making them and going through a checklist of questions (eg 'How does this particular market scenario test?' or 'Are my palms sweaty?'). The effect might be to curb impulsive and emotional actions.

Roll Out The Barrel, from Prof. Gordon Haave

While I love the people of Oklahoma, it is not often that I get to promote its cuisine. However, there are a few fantastic German restaurants here. One, which is quite pricey, is called Keller in the Castle.

The one I want to recommend, though, is called Royal Bavaria. It is in Moore, just north of Norman (University of Oklahoma), and just south of Oklahoma City. It is owned by a German woman, and she brews her own beer on the premises. The beer is excellent, and you can order it in a regular beer mug (as I do now) or in a big glass boot (as I did when I skipped class with my pals at OU). I wouldn't recommend the pricey dishes (go to Keller in the Castle for those), but go for the sausages, brats, bread, kraut, and 2, 3, 6 or 8 (if you are not driving) liters of beer. It is a fantastic experience. The restaurant is like an Alpine lodge, and there is a live band most nights.

I lived in Zurich for a while, and while there is no restaurant in the US that can match the full range of German cuisine available in Germany and northern Switzerland, the brats at Royal Bavaria are better than anything I have had in Zurich or Germany, and the beer is on par with German beer.

John Kuhn adds:

A few years ago my wife and I flew to Tulsa and rented a car to drive to Powhuska, OK, and thence across the country all the way to my childhood home in Boise. Passing through the Tallgrass Prairie Preserve in Kansas, we arrived in Alva, OK. It's not a large place, population around 5,000. One of the few spots to dine is the VIP Lounge near the airport and down the road a bit from the WalMart. Nondescript, so we were quite surprised to see an almost unending display of amazingly varied Jim Beam collector's bottles; as it turned out, the largest such collection in the world and worth around $500,000. Fish, army helmets, soldier's boots or tanks or automobiles, weaponry, furniture, nature's wonders; no end of objects deemed worthy of capture in the form of a bottle of Beam.

A small mecca of Americana, and only around 20 miles from Slapout, OK. My other recollection from the VIP is the waiter's saying, "if you pass through Slapout, tell them Archie says hi." "How will they know who you are?" I asked. "Oh, they all know me down there" he replied. "there are only 12 people who live in Slapout."

Ski Report, from James Humbert

I am told that in Aspen a Japanese industrial conglomerate has people all over the place on assignment, studying the layout, taking notes, sampling local food, etc. What appear to be modern miniature cameras are actually devices that satellite-relay 3D images, temperature, and snowfall density, as the conglomerate plans to replicate Aspen above the hills of Kobe, Japan. What is scary is that the Chinese government, too, has deployed forces and I'm told tensions are particularly high in the late evenings as tempers flare in bars over song choice for karaoke machines.

Inversion Humbug, from George Zachar

Despite my best efforts to not focus on the markets while I'm on holiday, I've found myself getting emails from nonmarket pals asking about "the inversion". I won't regurgitate all my prior pontification on this topic, but will simply note that the interest rate swap curve is now far more important to the economics and math of the credit market than is the Treasury curve.

The US interest rate swaps curve is not inverted in 2s-10s, though there is a kink at the less drama-prone 1 year tenor:

3MO   LIBOR-USD Fix            M 4.5206
6MO   LIBOR-USD Fix            M 4.7000
1YR   LIBOR-USD Fix            M 4.8506
2YR   USD SWAP SEMI 30/360 2YR M 4.8010
3YR   USD SWAP SEMI 30/360 3YR M 4.7930
4YR   USD SWAP SEMI 30/360 4YR M 4.8080
5YR   USD SWAP SEMI 30/360 5YR M 4.8230
6YR   USD SWAP SEMI 30/360 6YR M 4.8360
7YR   USD SWAP SEMI 30/360 7YR M 4.8475
8YR   USD SWAP SEMI 30/360 8YR M 4.8605
9YR   USD SWAP SEMI 30/360 9YR M 4.8775
10YR  USD SWAP SEMI 30/360 10Y M 4.8960
15YR  USD SWAP SEMI 30/360 15Y M 4.9760
20YR  USD SWAP SEMI 30/360 20Y M 5.0180
30YR  USD SWAP SEMI 30/360 30Y M 5.0400

My casual perusal of market analysis in the popular press leads me to think that "the curve" is simply joining "the twin deficits" and "the zero savings rate" as a reflexively spouted reason to hate the capital markets.

Bah. Humbug.

Charles Humbert replies:

Interesting how the Eurodollar futures strip implies that the inverted yield curve that is developing today will continue for quite some time into the future, as the columns on the right side of the EDSF table on Bloomberg show. Unfortunately, I don't have a record of what the implied forward rates were during the last inversion, but based on this, one might wonder if the developing inversion might persist for a bit longer than some market participants are hoping.

Dr. Alex Castaldo analyzes:

Let's say that an inversion has occurred if on the last day of the month the 2-Year constant-maturity Treasury yield average for the month was higher than the 10-Year yield average. The data are from the Federal Reserve H15 report. I looked at the 1990s and 2000s. There have been 13 inversions by this definition:

3 /30/1990
6 /30/1998
2 /29/2000
3 /31/2000
4 /28/2000
5 /31/2000
6 /30/2000
7 /31/2000
8 /31/2000
9 /29/2000

A month later the S&P 500 is generally lower, with an average decline of 20 basis points. By contrast, in months not preceded by an inversion the S&P rises by an average of 82 basis points. The difference appears not to be statistically significant, as t=0.86.

The post-inversion months are slightly more volatile (4.7% vs. 4.1% std dev).

Unless interest rates change very dramatically it is not likely that a 2/10 inversion (by my definition) will exist at the end of this month, since for most of the month the 2 year was above the 10 year.

A Market Glossary, from GM Nigel Davies

In Defense of George Clooney, by Ken Smith

Actors are citizens too. Money talks in America; in fact, it may be the only thing that talks. If I had money I would use it to influence politics too. An actor is entitled to broadcast his viewpoints in the same way other monied folk do.

There are brilliant folk by the thousands in our society who do not have a formal education, never aspired to be credentialed. I am one of those; it cannot be denied. I did not obtain any formal credential until in was in my forties, and graduated with honors. Was I a stupid person prior to graduation? No, I was just not credentialed.

We have plenty of folk in our society who are not credentialed and could provide advice to politicians about foreign policy. Credentialism is a pox on the landscape. I have encountered graduated, credentialed folk by the dozens who are not qualified to do their jobs, who are dysfunctional, who are poorly educated in terms of eclectic, general studies.

There are old geezers aplenty sitting around malls, tobacco shops, coffee shops, lunch counters, old folks homes, none of whom are credentialed. Many never graduated from public school beyond the eighth grade. Many a genius is out there, and genius is not necessarily encapsulated in a credential.

Clooney is entitled to his power; he earned it.

War and Peace, by Victor Niederhoffer

The paper War and the World Economy: Stock Market Reactions to International Conflicts, by Gerald Schneider and Vera Troeger, is an honest and yeomanlike study of the influence of hot and cold wars on stock markets, and is well worth study.

The paper uses a daily index of the increase in tension caused by events in the Iraq wars, the Israel/Palestine conflict and the Yugoslavia wars as a foundation for differentiating between two hypotheses:

  1. War hurts stock markets because it disrupts trade.
  2. War helps stock markets because it's good for defense-related industries.

The authors conclude that markets react negatively to increases in the likelihood and intensity of war. They contend that "international traders only welcome conflictive events whose anticipated costs lift the uncertainty over the future course of action and promise a less costly resolution of the conflict than originally anticipated." They also conclude that conflicts increase the volatility of stock markets in an asymmetric way, with increases in tension increasing the volatility more than positive developments decrease it.

There are many defects in the paper. Foremost is the use of parametric rather than non-parametric statistical tests to carry their points. Also, the authors don't discuss the magnitude of the reduction in uncertainty or prediction error of the stock market that their model provides. Nor do they take account of the multiplicity of their retrospectively-concocted hypotheses that seem to fit the data. A more direct and convincing test could have been performed with a Siegel-Tukey test. Furthermore, the lumpiness of their data relative to the exact timing of the events undercuts the utility of their analysis.

This is one of those papers where the road is much better than the inn, i.e. the path taken is better than the conclusions. Many readers will be introduced to a class of models developed by Jean-Michel Zakoian in Threshold Heteroskedastic Models, Journal of Economic Dynamics and Control, 1994, which model volatility as a function of the the surprise and the over/underestimates in the previous period, with a dummy variable to differentiate between the overestimates, which cause increased volatility, and the underestimates, i.e. the positive surprises, that have no impact. Such a model could be much more meaningfully tested by enumerating the 10 biggest surprise events that seem to account for the only meaningful reactions that the market had during the period, and seeing whether the negative events affected variance more than the positive ones. The use of headlines from Dow Jones News or the New York Times would have been a useful adjunct here. Nevertheless, the methods used would find a much more tractable and useful set of data involving the reaction of individual company news to cardinal events like earnings announcements or the reaction of markets to economic reports such as the month employment reports.

I learned many things from this paper:

  1. Wars fought on foreign soil have a much more positive impact on a country than those fought on its own soil.
  2. Cooperation versus conflict is a key variable in determining market responses.
  3. There is a group of theorists out there who are brave enough to state openly that "economic agents abhor war because it endangers mutually profitable exchanges." The extension of this idea to a quantified series of trade moves, including those relating to the Smoot-Hartley tariff bill that was a key link in the Great Depression, and the key events in the removals and increases in trade barriers since that time would be most fruitful.
  4. Markets might respond positively to violence during a war because it might signal that the worst is over.
  5. A scale of increasing tension has been developed by Goltstein and similar attempts to analyze the impact of war on bond markets has been made by Frey and Kucher.
  6. Collectivist scholars have shown that they can develop models where, depending upon the level of trust between the parties, trade in military goods can arise between warring parties themselves such as those that accompanied the Civil War and led to Rhett Butler's fortunes in Gone with the Wind.
  7. Scholars have studied the influence of wars on tourism in Israel and the degree of pessimism in England during WWII.
  8. The day-to-day reactions in the Russo-Japanese War during were limited because they were predictable. However, it seems to me that this was one of the most important wars because its aftermath destroyed the credibility of Czar Nicholas in Russia and allowed the Communist takeover for the next 70 years.
  9. Decisive actions are key, military or non-military, as they alter the beliefs about different crisis scenarios. This is something that would have been very good to test.
  10. Two modifications of the GARCH model to take account of asymmetric volatility are the EGARCH and TGARCH models.
  11. If conflict occurs unexpectedly, the reactions of the markets are most often unambiguously negative, but if conflict had been anticipated for a long time, the reaction is muted.

In short, although none of the conclusions of the Schneider and Troeger paper are carried by their data and techniques, there are many interesting facts and approaches outlined that have applicability and utility in many fields of specinvestment warfare and research.

Saving and Spending, from Prof. Gordon Haave

From the beginning of time, wisdom has taught the benefit of saving as opposed to profligacy. The classical economists knew this, and also assumed that what is good for the individual is good for the economy as a whole.

Ever since the mid-1930s or so, however, legions of economists tell us that is not the case. That it is somehow harmful to the economy if people practice prudence with their personal finances.

Those of you who think that your grandmother's teachings on the subject are more intelligent than what the modern economists and media tell you, are correct. The common man is in fact wiser than the experts.

Saving is spending. The only difference is who is doing the spending, and what it is being spent on. If one blows $50,000 on cocaine and hookers, one has infused $50,000 into the economy. If one puts $50,000 into the bank, the bank lends it out to somebody who is building a house, or a plant, or whatever. That same $50,000 goes into the economy. Actually, more than $50,000, because the bank can lend out more than you actually deposited with them.

This misunderstanding of basic economics has three causes, the three standard reasons to look for any time someone is advocating something that seems silly from an economic perspective.

  1. Not seeing the whole picture. People like to focus on the direct impact of economic activity and ignore the indirect impact. It is easy to see the $50,000 that a consumer spends, but it is more difficult to trace the outcome of $50,000 that is saved. This is the same reason that people think public works projects help the economy. They see the jobs caused by the building of the bridge, but they don't see all the other jobs that disappear as a result of paying for the bridge.
  2. Correlation vs. causation. Just about nobody really understands this basic concept. Depressions are often highly correlated with increased savings. However, the savings are a result of the depression, not a cause.
  3. Statism. Call me a conspiracy theorist, but most economic fallacies also tend to have the effect of making people more dependent on the government.

A Reader demurs:

Dr. Haave,

Have you read Dr. Brett Steenbarger's piece from the SpecList section of the site lately? He finishes it by stating: "At periodic intervals, perhaps we can ask ourselves, 'Would Francis Galton approve of our postings? Are we truly searching and re-searching for truth? Are we relying upon lazy opinion and first principles rather than hard statistics on the table?'"

"Lazy opinion" aptly describes your post on saving and spending. You have assumed that we are ignoring the multiplier effect on the spending side of the equation. Though some money laundering may be required, surely the hooker and the drug dealer will spend their hard-earned, though ill-begotten, currency. Then the car dealer, furrier or restaurateur is sure to have to pay wages and other costs and, if anything is left after expenses, spend the profit elsewhere and so on and so on. Where are your facts, Sir. Where is the testing? Where are the "hard statistics on the table?"

Best regards,

Terry M. Pfeifer

Prof. Haave replies:

Hmm, I confess to being lazy there. It does not, however, change the point of the post, which is that people look at consumer spending because it is visible, but ignore the spending that results from savings.

The Duration and Prevalence of Recessions, by Victor Niederhoffer

According to the official data, the economy has spent 57 months in expansion since the last recession ended in March 2001. The data from NBER permit the derivation of a table that puts the recent paucity of contractions into perspective:

Decade          Months in Contraction
1900-1909       48
1910-1919       54
1920-1929       50
1930-1939       51
1940-1949       19
1950-1959       18
1960-1969       11
1970-1979       26
1980-1989       22
1990-1999       08
2000-2009       08*

NBER summarizes similar information in an average contraction and expansion time from 1945 to 2001 of 10 and 57 months, respectively, versus average contraction and expansion times of 20 and 40 months in previous cycles. The old way of measuring recessions was a decline of two consecutive quarters in GNP. This has been superseded by monthly work that takes account of the three Ds of recessions: duration (how long), depth (how much) and diffusion (how many industries suffered declines in employment).

Another line of approach is real business cycle theory, which attributes the movements in output to rational responses to external shocks caused by productivity gains and losses in the economy. Such an approach would look to the changing value that workers place on leisure as opposed to work and the changing pace of technological progress as the key factors causing these changes in output.

Several questions emerge. Are these data completely consistent with randomness -- with, say, a quarter-percent per month drift and a standard deviation of 0.25%?

Since the last trough occurred in March 2001, 57 months have passed. The expected lifetime for continued expansions conditional on having reached that number is an additional 34 months (note that the March 1975 to January 1980 expansion lasted exactly 58 months, thereby lowering the average current conditional lifetime). Have recessions become smaller in duration and depth in recent decades? Would an analysis of such factors as hazard rates and conditional lifetimes of monthly rises and declines in the stock market classified by duration, depth and diffusion among companies along the lines of the out-of-date business cycle theorists provide employment for those theorists or profits for the cross-the-fields researcher?

What's Good for the Goose, from Prof. Gordon Haave

As I just got done putting my Christmas goose into its brine, I thought I would mention the up-coming year-end goosing of stocks.

First, when will someone goose a stock? If you are a hedge fund, you might start a few days before the end of the year. If you are a traditional money manager, however, you will wait until the last day of the year. That way, the trades won't be settled at the end of the year and anyone looking at the custodian reports might not notice them. Also, one doesn't want to systematically goose an entire portfolio. The point is to get your portfolio returns up with as little expense as possible. Therefore, you will choose to goose stocks that are a large percent of your portfolio, and also have low daily activity. Also, you will only goose the portfolio if you need to, i.e. to wind up at the end of the year ahead of some benchmark or hurdle rate.

The ideal stock to look for:

If you find those stocks, there might be an artificial run-up that you can sell into.

Variations on A Christmas Carol, by Victor Niederhoffer

"Come then," returned the nephew gaily. "What right have you to be so dismal? What reason have you to be be morose? You're rich enough. Don't be cross, uncle."

Ghosts of the Past. My first partner, Frank Cross, was a brilliant arithmetician and clerk who discovered, among other things, the Friday down-Monday down effect. He died at the age of 35 some 20 years ago from excessive morbidity and alcohol. But I often think of him on Christmas Eve, especially after a good year. Whenever we'd make a good profit, I'd call him up to relay the good news, and tell him about his share. But that only made him more depressed. "If you could make a million in one day," he'd say, "then you could lose a million also. And that's more than we should have on the table." How right he was. My firm has had a pretty good run, indeed a relatively unprecedented one, according to any fair reading of the ratings service. And that's when we must be ever vigilant not to lose it according to the same Lobagolan path that we made it with. The market hasn't has a decline of more than 6% from peak to trough or a decline of more than 2% in a day in more than three years. What a field day it would be for the doomsdayists, the black swannists, the prudents, the abelflecbuffeterosoroses, the shilleroids, if they could put a nice sustained series of back-to-back declines in the hopper before the inevitable April 15 revulsions.

An Unhealthy Asymmetry. I find that I have been very prominent in the news the last few months, having been starred in Institutional Investor for giving a terrible talk on musical speculation that people walked out on at U. Penn, symbolizing everything that's wrong with hedge funds, and of course receiving more prominence than everything else in my life combined for supposedly being a key link in the R#fco debacle. The trader sites love to talk about how I am a poster boy for how to go under, having done so so many more times than is commonly believed, and having contributed much more to the market than I made cumulatively. Even to try to defend myself against these completely false accusations admits unduly their verisimilitude, but I have so many hoops that I must fit through vis-a-vis performance claims that it would be untenable and unsustainable for me to mount such a defensive even if I wanted to. Somehow I have been mentioned a million times as a key link even though I have had no contact or financial connection of any kind with R#fco for seven years, but a personage who received a billion-dollar distribution before the firm's 2005 public offering has only been referred to as "an undisclosed party." I wonder why not one of the hundreds of publications that have covered my activities these past years has considered it newsworthy to consult any of the dozen performance reporting services for managed account firms. So I must be content to say, "What else can I do, when I live in such a world of fools such as this?" or to respond, as Scrooge did, "Bah, humbug."

The Seizing of the Ruler. When an employee regaled Scrooge with, " God rest you merry, gentlemen, may nothing you dismay," Scrooge seized a ruler with such energy that the singer fled in terror. Yes, that's how I am. About a hundred times a year, I call out in the trading room: "Silence in the office. What's all this excessive exuberance? We're in crisis mode. It could be life or death in an instant."  I find that whenever the animal spirits are too high, my traders tend to get too relaxed. They are more prone to give up the extra edge on the trade. To use market orders rather than limits. To accept the first bid or offer without haggling. To overtrade. To allow the other side to get out of their rare losing positions with me without undue hardship to them. I have traded about 30 million contracts in my career in speculation averaging about $150,000 a contract in face value. If I paid $30 more for each contract, or just 0.02% more, I would be a dead duck. If I regularly allowed my operatives "to make excessive provisions" for the hardships of the liberal brethren among the dealers and front runners on the other side of my trades, why, I would have spent my entire life on the treadmill or the poor house, and my family and I would be in want of the common necessaries and comforts of life.

A Ghost Appears. Ghosts often appear in Wall Street. They hung out around Trinity Church in the old days, but nowadays they are more likely to hang in cyberspace. "What do you think of LU at 20?" The Collab and I always hear questions like that when we try to deliver a talk about meals for a lifetime to unhearing ears. Bull operators often depart from the speculative arena, penniless and heartstruck, like Morse in the 1860s. "He had now only the shadow of a great name. He was pointed out in the streets as the man who had once set the market in a blaze, but now capitalists shrink form him as if he had the leprosy. One day , more than a year after his failure, he was seen on the street and Fort Wayne rose 5%. Then came disease gnawing at his nerves and heartstrings. No longer blithe and gay of mien, but morose and irritable."

An old supporter describes Morse after seeing him at a gambling house:

A gaunt, pallid face, the features sharpened by the fell disease under which he was suffering and wearing those death-like lines with which consumption makes its prey. Alas, how changed from the Morse who had but the year before led the dashing ranks to the summits of the market.
-- Ten Years in Wall Street, Wm. Worthington Fowler, 1870

The rest of the story is too sad to tell, as it involves some friends stepping up to pay his landlady the trifling debt he owed so that "the funeral rites could be performed over all that remained of what was once a king of Wall Street." I know the situation. Once I was like Morse, and I came back. I notice that after up years the market is much less volatile than after down years. After an up year in 1919, the market dropped 37% in 1920. After an up year in 1936, the market dropped 40% in 1937. After an up year in 1961, the market dropped 25%. The only other big drops after an up year were like those of 1957, 1973,  2000, when the market dropped about 16%. I believe it being 11:30 p.m. Christmas Eve, I will close the counting house.

Irony of Scrooge, from Dr. Kim Zussman

The irony of Scrooge was not that he ought to have been happy with all his money. Rather, it was that he was so wrapped up in his miserable existence that he failed to notice the good in the world (there is also a socialist theme omitted here). And it took ghosts, proxies of his own mortality, to drive the lesson home.

A real life irony witnessed on many occasions is the question of how differently to live if one (or a loved one) had only a short time left. Usually such are asked in hindsight, after a passing, as if to grab a little of what is lost. And the irony is that no successful person is incompletely absorbed in their challenges, because the sum of all attentions (outward and inward) is finite.

It is also ironic how considerations to avoid regrets, along with successful competition, must be derived of the hard-wired genetic programming of evolution. And such natural risk-avoidance, which got us this far up the tree of evolution, is the antithesis of successful investing.

These are among the best of times, and in the past times have been worse. Using DJIA daily closes since 1930, and counting days where the prior 10 days have a cumulative decline more than 10% recalls these times. The number of such days within each year:

2005     0  1986     0  1967     0  1948     0
2004     0  1985     0  1966     0  1947     0
2003     0  1984     0  1965     0  1946     4
2002     4  1983     0  1964     0  1945     0
2001    11  1982     0  1963     0  1944     0
2000     0  1981     0  1962     2  1943     0
1999     0  1980     0  1961     0  1942     0
1998     6  1979     0  1960     0  1941     0
1997     1  1978     1  1959     0  1940    13
1996     0  1977     0  1958     0  1939     2
1995     0  1976     0  1957     0  1938     8
1994     0  1975     0  1956     0  1937     9
1993     0  1974     9  1955     0  1936     0
1992     0  1973     0  1954     0  1935     0
1991     0  1972     0  1953     0  1934     3
1990     0  1971     0  1952     0  1933    12
1989     0  1970     1  1951     0  1932    52
1988     0  1969     0  1950     0  1931    44
1987    12  1968     0  1949     0  1930    22

Such occurrences were common in the 1930s, but much rarer since. The number of years between these large declines ranges from 0-15, with average lifespan of six years. It has been three years now since visitations of such spirits.

James Humbert adds:

Without ruling out the possibility of me being a complete imbecile, I believe the people that accuse the Chairman of this or that, or sparking the collapse of a R#fco, are from the same school of those Abelflecwhatevers. It is a twisted irony that while they are a necessary component in the market if a speculator is to profit, one's character is under constant insult as a price for it.

Christmas Tree Supply/Demand Curves, by Jim Sogi

On December 22 we were belatedly searching for a Christmas tree. Every two years there is a cycle: too many trees one year, then when the merchants have excess supply, the next year they cut back and there are too few trees. The first three places we went to were sold out. Finally we called Home Depot and the friendly sales rep told us that they had just marked their trees down to $9.99 and they had Noble firs. We went there and there were many trees left, nice ones, all different types. We got one of the nicest, biggest trees ever for only $9.99. We laughed about the incongruous idea of getting two since the price was so low. I pondered the supply/demand curves and how demand dropped off a ledge to zero as Christmas came and went. I pondered the odd thinking behind reducing the price of the trees since we, and most anyone who did not have one and who wanted one, would pay the full retail markup to get one. The reduction in price did nothing to increase the demand since no one is about to buy two Christmas trees.

A Memorial Christmas Letter, from Stefan Jovanovich


My father-in-law Buster Turner died a little more than a year ago. His birthday was Christmas Eve, so the holidays for the last two years have been a sad time. He was an independent oil driller in the Little Texas Basin in southern Indiana and Illinois and western Kentucky. He was also my first teacher about the stock market.

After the Libyans nationalized their oil fields and Buster lost a large packet on his investments in Occidental Petroleum and some other oil stocks, his only comment was "Well, I guess I will have to put off the rewards of leisure for a while."

He found that there were two groups of people with whom he could never sign an oil lease - teachers and preachers. No matter what price and terms he offered, they could never bring themselves to say yes, shake hands and stick to the deal. If they did say yes, the next day they would call back and want better terms. If Buster accepted their counter-offer, they would call back again and want to change them.

He did not think they were so much greedy as scared. They could never bring themselves to accept the emotional risk that tomorrow or next year a friend or neighbor got a better price for their lease. They were also frightened at the idea that Buster might possibly make some money on the deal.

Buster would have included journalists in his list if there had been any who owned land where he drilled. He would not have wondered "Why not one of the hundreds of publications that have covered (your) activities these past years has considered it newsworthy to consult any of the dozen performance reporting services for managed account firms." He would have told you that, for the journalists, the fact that you could lose money in a spectacular fashion was comforting but the fact that you could make it back and keep on working was and always would be terrifying.

I hope you put off the reward of leisure for many years to come.

Merry Christmas.


In Honor of the Holidays, from Dr. Victor Niederhoffer and Dr. Alex Castaldo

Here are a few quotes from a 135-year-old book, "Ten Years in Wall Street," by Wm. Worthington Fowler, 1870:

According to the proverb of the racecourses, everybody on the turf or under it is equal and the same is true of the field of stock speculation; a common interest on one side of the other seems, for the time being, to level all social distinctions. All classes and grades are represented here - rich and poor, gentle and simple, learned and illiterate... A certain harmony reigns among these discordant elements... The bankrupt elbows the millionaire, and ask him the price of Fort Wayne, and the millionaire replies with utmost suavity "eighty-five, sir, at the last quotation".

In the present decade, among a host of lesser operators Cornelius Vanderbilt and Donald Drew are the central Titanic figures. These men are the Nimrods, the mighty hunters of the stock market... Sooner or later, the money of the smaller tribe of speculators finds its way into the pockets of these financial giants.

No one who has entered the precincts of the stock exchange, will have failed to notice certain nondescripts who constantly frequent the market. They are the men who have seen better days. [They] are the ghosts of the market... They flit about the door-ways, and haunt the vestibules of the exchange, seedy of coat, blackless of boot, unkempt, unwashed, unshorn, wearing on their worn and haggard faces a smile more melancholy than tears.

It is the first venture in speculation which costs, as many a man has found to his sorrow. Lucky is he whose first flyer of one hundred shares shows a loss, for this is a warning and a lesson sufficient often to turn him from the career of a stock-operator. But when the first flyer shows a profit, ah! that first profit! The first sip of the cup, this is delight, then comes rapture, frenzy, stupor and the deadly wakening, in quick succession.

What a tremendous moral engine is the New York press. Every day this engine spreads before a million readers a record of facts. To say that the money articles of the Daily Journal of Traffic, the Daily Harbinger, the Daily Orb, etc. etc. are written with great ability, would be but simple justice. If they sometimes make mistakes in their views of money matters, still, it cannot be denied that they see as far into the financial grindstone as any one.

Time fights on the side of the man who buys a lot of stock at a fair price and pays for it, inasmuch as the material interests of the country are steadily advancing, on the whole, and the value of the stock becomes enhanced. Time too fights on the side of the man who speculates, if he is fortified by large margins, because he is protected by these margins from the losses incidental to the constant vibrations of the market. The man who can keep his position in spite of the temporary condition of prices is the man who, in the end, wins.

The frequency of operations is a fruitful cause of losses... If instead of buying and selling every day, and giving all his money to his broker in the shape of commissions, he would only buy three or four times a year, when stocks are low and after the panics which periodically occur, and then hold for a 10 or 15 percent rise, he would find himself ahead of the market when he came to make up his yearly accounts.

The practice of selling stocks short will be found in the end, to be an invariably losing business... akin to gambling in which the bank has a percentage in its favor.

Secrets and Lies, by John Kuhn

For the biggest of the older bucks, it's the stock market front and center now and forever. And the biggest of the bigs not only own stocks, they own investment management companies, venture capital companies, and now LBO companies. The maximally moneyed types have been doing VC investing at least since I was in my teens, 40 years ago. That's in the US. Also I had a wealthy Swiss client 20 years ago who kept a rolling stable of a dozen money managers around the globe, weighting the contributions on performance and strength of the local currency. When I was sacked, the agent comforted me with, "Well, you outlasted all but three of the of the dozen on board when you started." They paid the highest fees, found the best managers and those that did not keep up, "aufwiederluege." Hundreds of millions in the old days, when that amount could really spend.

Still, one of the best way to make big money is to print it. That's VC with other people's money, ownership participation and performance fees. If you can hit a really long ball, it can become a gift that keeps on giving. I just Googled the first WASPy VC name I ever came across, Greylock Partners, and up popped a list of three of its best competitors, and on top of that list was the second VC name that had come to mind, Accel Partners, much younger but of similar lineage. I think too of Bessemer and Morgan Stanley. Even J. P. Morgan. It may not take money to make money, but it sure helps. When William Weld ran for the governorship of my fine state of Massachusetts. he was asked by a reporter, "Where are you going to get the money to finance your campaign?" Weld, displaying his intuitive grasp of the common touch, replied, "We don't get money, young lady. We have money!"

The old rich get blasted for a variety of reasons, not all without merit. But whatever their faults, they endure, as they've long known the basic secrets in plain sight about the stock market, not only about the long-term upward compounding of the market, but also the huge benefits available with leveraged compounding that redounds from the judicious application of huge chunks of other people's money.

When I was about 40 I started to wonder, "If the market mostly always goes up, why aren't there more management companies out there owning stocks and claiming the pleasing increases in clients' portfolios were the result of the intense sweat of their own brows?" And collecting the ever-increasing fees the market mistress hands out with pleasing generosity irrespective, within tolerable limits, of whether one's relative heap had been "naughty or nice." Now that there are more mutual funds than stocks and the hedge fund population is at all time high, what was in my youth a mysterious and seemingly almost private realm is now the province of all.

It reminds me of professional golf. We see the names of a handful of top players, and are ignorant of the others in the top 150 beavering away in the sun, making from one to several million a year. In the money management game, there are thousands of me-too companies, nowhere near the top 150, providing tens of thousands of portfolio managers and analysts and support staff with very nice lifestyles despite the well-broadcast reality that investing directly in the S&P is available almost for free and does better than most of the money managers. The market supports so many. I'm most amazed by the crumb feeders: remora getting paid for their variations on the books "Four Market Secrets the Professionals Know," or "Point and Figure for Profit," or the always popular Sagiographic "Make Money the W#rren B#ffet Way," "Prosper by Finding Your Inner W#rren," or "Seven Keys from the Sage."

To the Editor, NY Times Book Review

Jon Meacham correctly argues that Christianity did not alone trigger western capitalism and constitutionally limited government ("Tidings of Pride, Prayer and Pluralism," Dec. 25). He points to western Europe's geography, modes of agriculture, and traditions as contributing factors.

But he misses the west's greatest advantage, namely, competition among different sources of authority. As Harold Berman documents in his book Law and Revolution, while in eastern Europe church and state merged into a unified power, in the west church and state constantly battled each other for dominance. And at the same time each battled yet other sources of law, such as merchant courts, manorial courts, and independent cities. By preventing any one source of authority from becoming absolute, freedom and other pre-conditions for prosperity were the unintentional yet glorious fruits of these often-bitter jurisdictional rivalries.

Competition among power-mongers liberates; absolute competition liberates absolutely.

Sincerely, Donald J. Boudreaux
Chairman, Department of Economics
George Mason University, Fairfax, Virginia

The Academic Calendar, by Victor Niederhoffer

The University of Michigan sentiment indicator for once was bullish, coming in at 92 versus 89 expected, and my immediate reaction was that the professors must be on Christmas vacation and they'll have to revise it down next month when they come back, as they always seem to report bearish numbers, especially before elections, to help their liberal brethren.

Letter From a Future Visitor to Stockholm


I have just started reading Practical Speculation. It's full of information, beautifully written, and a lot of fun. Thus far I have completed only three chapters. I admire your ambition in taking on an industry.

Let me add a story/observation. I'd lived through the Japanese bubble of the second half of the 1980s (for about a hundred years I have been a one-week-a-year Japan expert). In February 1997 I was teaching my winter quarter international finance course at the GSB, and there was a newspaper story from Hong Kong about the property market that read as if it had been written in Japan in 1989. So I got on the plane in March 1997 and went to Hong Kong. My first meeting was with a group of real estate people, arranged by a former student, and after fifteen minutes I was convinced there was a massive bubble in stocks and in real estate. I visited Kuala Lumpur and B#ngkok in the same trip, and came to the same conclusion. I vividly remember sitting in the red carpet club in Tokyo on the return trip to the United States, writing emails to friends in Washington, New York and Chicago: there is a massive region wide bubble, it is going to implode, and here is what is going to happen to currency values, asset values and trade balances.

The last thirty years have been the most tumultuous in monetary history, as measured by the collapse of 100 banking systems, the swings in exchange rates, and the number and scope of asset price bubbles.

I look forward to finishing your book and hope that in one of the chapters you bring together the randomness of short run changes in prices with the long run macro phenomena.

Bob Aliber

Hobo Keeley

This Christmas give yourself a gift that attracts enduring friendships, business riches, self-discipline and peace of mind for a lifetime. It will put something into your step and handshake that was missing before and give your spoken words a resonance that draws attention and respect. It is something only you may give yourself and that you can control despite what everyone else says to the contrary. Replace love with a spectrum of feelings. The range runs from neutral to esteem. Love is anti-life.

James Lackey: "Get the Joke" Posts: The Year in Review

"This is another interesting thing. A good partnership is one of the most important success factors in bridge, yet almost no book deals with it. Same with trading. 99.9999% of the books are geared to the individual trader. However, a lot of professional trading is being done as a team member. You're on a desk, you're part of a team, you get judged on the team's P/L." -- Bruno, a stroke past midnight, Jan. 1, 2005.

Tsunami post: "The elders told us that if the water recedes fast it will reappear in the same quantity in which it disappeared," 65-year-old village chief Sarmao Kathalay told the paper. So while in some places along the southern coast, Thais headed to the beach when the sea drained out of beaches the first sign of the impending tsunami to pick up fish left flapping on the sand, the gypsies headed for the hills." -- Gibbons Burke, Jan. 1, 2005.

"Other anecdotal evidence of a Euro Top Jan 18th Mercedes C230: 25,1% cheaper (incl. taxes, transport, etc...) when reimported from the USA Porsche Cayenne: 19.6% cheaper Toyota Celica: 26.5% cheaper The economist Burgernomics index is showing 25% overvaluation of the euro (for the last 15 years it has been a fairly good indicator for the performance of currencies-- at least better that the trade balance/budget deficit combo)" -- Jean Paul Schmetz.

headlines crossing Bloomberg: "Gates says he is "short the dollar." Gates: $ to "go down" "I recall no precedent for him commenting on asset prices." gz.  "Perhaps Warren is trying to unload his humongous $25 billion short onto his good friend Bill." -- TonyC, Jan. 28, 2005

"There is only one book that really matters and IT'S YOUR RECORD. Not too simple at all if you have a documented record of making money over both LONG 15-10 years and short 1-3 years you have been tested by time price temperament sentiment and logic. The best education is when you put into practice all you think you've learned. Then and only then will you start to have a record that will demonstrate you know something worth repeating to others. The spec list is the right mix of students, amateurs, hobbyists and pros. All of us, myself included, at different points in time and experience have morphed through all stages when I talk about a new venture in, say, trading ISHARES where we are HUGE, I assure you I was an amateur when it all began...BECAUSE I HAD NEVER DONE THAT BEFORE. You pay the price if you think you can read a book on this topic that will show you how to make money from day one...if that was so, then there would be no industry no product no market no endeavor that had a barrier to entry." -- Mr. E, Feb. 10, 2005.

"Last night I was reading the newspaper with the wife and laughed out loud throughout this Times article (link below) on the poker-playing Princeton student. I read her the following quote:

"I'm playing this game, treating it like a job," he said. He predicts that he could make up to half a million dollars a year, just playing on his computer every day. "Even with the bad runs," he said, "I haven't had a losing month or even too long of a losing session. I think I'm a pretty smart guy, and I'm only going to get better at cards."

"Poor kid," I said. "As an Ivy League senior you'd think he'd be aware that all gamblers die broke. She gave me a quizzical look. "All gamblers die broke? But you gamble on horses!" "That's true," I said. "But I really enjoy it." "How can you enjoy it if you know you're eventually going to die broke," she asked, sounding startled. "That's easy. I don't do it for the money." -- Kevin Depew, March 15, 2005.

"I understand the point being made, but how should one take a loss? The usual prescription advocated in trading books is a stop. I find when backtesting trading strategies that stops often reduce profits by prematurely killing trades that would have turned profitable." -- Steve Ellison, March 17, 2005.

"May I suggest that mentally the trader often has a similar 'style' that he excels at, and finds it mentally difficult to run when the course conditions are against him. And rather than spending his time defending his style would do best finding the right mental exercise to expand his abilities. In running, I have never found this to lessen my instinct to pounce when the conditions are favoring my style." -- Russell Sears, March 28, 2005.

"Who is more bullish? Is it time zones, or holding/folding, or something else that causes the phenomenon noted by the Chair? Things have changed to some extant, because of online trading and VWAP-type programs. In the past, the little fish showed up at the open. That's when the sharks ate them. The close was when the whales hunting plankton scattered the sharks" -- Bruno, March 29, 2005.

"I'm with Mr. Schneider on this one. The market is similar to the secular bear market as it stood on Dec. 8, 1994, with the S&P at 445. At that point the S&P was about 5% below where it had been one month earlier. The decline was plain for all to see, unsanctioned by the church, and clearly secular. Three years later the market was at 982." -- Prof. Charles Pennington, April 1, 2005.

On Boston Scientific conference call: Question: "Given that your stock price is sitting at a 52-week low, would senior management [who have sold some $200 million of stock over the last two years] consider using some of their own money to buy back shares?" Answer: "I don't care how cheap it is. I've got $6 options so buying at $30 is a bunch of bullshit. In answer to Victor (and of possible interest to other questioners): The 'buying at $30 is a bunch of bull----' answer was the ONLY candid and honest statement in the entire conference call. Perhaps he was tired after an hour of dissembling." -- Daniel V. Grossman, April 19, 2005

"I am just sick to death of elites or others who claim to be in the know making sweeping generalizations about people and deciding that they know best for me. -- Pamela van Giessen, April 29, 2005

"A modest attempt to bring the record up to date:"

1982: Double-digit unemployment
1983: Record budget deficit
1984: Technology new issues bubble bursts
1985: Dollar too strong
1986: Dow at 1800 - "too high"
1987: Stock market crash
1988: Worst drought in 50 years
1989: Savings & loan scandal
1990: Iraq invades Kuwait
1991: Recession
1992: Record budget deficit
1993: Clinton health care plan
1994: Rising interest rates
1995: Dollar at historic lows
1996: Greenspan "irrational exuberance" speech
1997: Asian markets collapse
1998: Long Term Capital collapses
1999: Y2K problem
2000: Dot-com stocks plunge
2001: Terrorist attacks
2002: Corporate scandals
2003: Gulf War II
2004: High oil prices
2005: Trade deficit  

-- Steve Ellison, May 8, 2005.

"I was coached in the philosophy of, "Just don't swing at bad pitches,' rather than, 'Wait for the perfect pitch.' The problem with waiting for the perfect pitch: E.g., Barry Bonds lifetime stats. After 1-0, .340. After 0-1, .235. After 2-0, .299. After 0-2, .123. I propose trading is not altogether different. It's not the perfect pitch we want -- just a good pitch to swing at." -- Tom Ryan, May 20, 2005.

"The beautiful thing about mortgages is this: the collateral behind them is NOT MARKED TO MARKET. As long as you can pay--there is no margin call. Things might be a little leaner for me later--but I won't get forced out of my home as long as I can write the checks. Should I be less bullish on myself, perhaps? Well, if I am, then where am I, and what am I doing here? I am able to adapt, and I will find a way to survive and earn and provide for my family. We close tomorrow on the new place." -- Justin Klosek, May 19, 2005.

"The only thing that Mr Dow 5000 ever said that made any sense to me and that I could count was his remark about the risk-adjusted return of moving out of 30-day (money market) paper into paper of 90-180 day duration and how it was among the best risk-return moves one could make. Everything else reminds me of that joke about stock traders having strong opinions about bonds and bond traders having strong opinions about stocks." -- Tom Ryan, May 25, 2005.

"It takes a cold, logical evaluation of whether the trade is a good trade at the current level. In other words, if the market is a short, it shouldn't matter that you've already carried it up a few points unless a) you're out of money or b) past your pain threshold. My rule of thumb is that it's never wrong to cover half a trade if you're in so much pain you can't think rationally. If you find yourself saying "Let it get back to even and I'll cover" or "Please oh please Mistress of the Markets, if you let me out of this trade I'll never sell a put/sell short/buy GM again" then you are in a bad trade and should bail." -- David Wren-Hardin, June 10, 2005.

Trader 1: "The idea of having an opinion that is useful or superior on a consistent basis is an illusion. Or, better yet, is a delusion. Better to just develop the skills to trade the market without an opinion. When you say that to most people, they look at you and you realize they don't have any idea what the hell you're talking about." REPLY: MORE LIKELY THEY HAVE REALIZED THAT *YOU* DON'T KNOW WHAT YOU ARE TALKING ABOUT! If you are long for whatever reason (a hunch, or a technique, discretionary or mechanical, simple or sophisticated) then you are bullish. And if you are short you are bearish. And you will make money only to the extent that in the future you are right (i.e. conditional expectation is positive). Conversely if you don't have an opinion then you must stay out of that particular market (flat). You may say you don't have an opinion, but your brokerage firm knows whether you are bullish or bearish on a particular market, and can even quantify the extent of your bullishness/bearishness." -- Alex Castaldo, June 19, 2005.

"This has been one of the greater truths of market ecology as public participation in the market has increased over the last 20 years. Anomalies that existed for decades disappeared overnight. Trading strategies that worked since the dawn of time stopped working. As capital in extraordinary amounts chase whatever worked last year, the strategy was doomed. we've seen it in the last five years in risk arb where returns went from a steady, almost clockwork double digits to sub 5 for any serious amount of money. In distressed securities the amount of new money literally forced the larger more established players to invent new ways of capturing the returns at the expense of the newbies .And except for an exalted few -- the likes of Tepper and Ross come to mind -- returns went away. I think we will now see this with stat arb, pairs and statistical pattern trading." -- Tim Melvin, July 1, 2005.

"The reason is something of great value to us and our freedom, namely, freedom of the press. The press does not have a fiduciary relationship with its readers and its readers would be foolish to expect to have the same degree of professional from financial writers in the press that they might expect from an investment advisory service. There are those of us who question whether the SEC should have as much power as it does over the securities industry, but it is clear to most Americans that the true press should be free of government interference as to who may be a reporter and what they might write. For once that power is extended to one area of the press what is to stop it from being applied to other areas and soon the government might be in a position to curtail freedom of expression through such regulations. Even with regard to financial areas such powers might cause corporations to use their political powers to get government to restrict unfavorable commentary on their activities to the detriment of the free flow of information which is so important to properly functioning markets." -- Rudy Hauser, Aug. 12, 2005.

"The only way to survive as a spec is to be aware of the *context* markets operate in. You can't trade debt off economic data without knowing "the Fed is on the move", for instance. Yes info flow and market microstructure are important, but failing to grasp the meta-environment in which prices are set is bound to be fatal." -- gz, Aug. 25, 2005.

"Speculators perform an indispensable service for the country and the world financial system. In times of panic, disruption or disaster, when many are looking for or need cash at any price, speculators provide the liquidity and take the merchandise. Cash Money is worth more in times of panic or disaster when the funds are needed for other than capital projects. For this valuable and indispensable service, they are paid a higher rate of return to compensate for the valuable nature of their service. For the speculator, the service aspect can be as rewarding as the profits. A friend commented that trading is very painful and stressful and a mistake can result in serious loss. Other professions are no less painful nor less stressful.. A mistake in any field will result in serious loss, even loss of life, or loss of the job. The stress is as great as are the length of hours or years spent mastering and performing the skills. Practice develops the mental and physical toughness to perform the daily task in any area." -- Surfer Sogi, Aug. 30, 2005.

"Wise words indeed from Dr Zussman, to which I'd add: The original query was about a child, and children have an amazing radar for hypocrisy. They learn (or don't learn) the values Dr Zussman enumerates (and others: courage, honor, loyalty, empathy, courtesy, respect, integrity, patience, fairness, dependability et al.) not through parental advice (if only it were so easy!) but through observing parents' actions. A parent is a 'living textbook" to which a new page is added every day. And as Dear Abby says, the best advice is that which is requested. I've found unrequested advice to my children has a zero or negative 'coefficient' (but maybe I'm a subpar parent). Note that adults value (as in, 'pay for')advice about specifics: from the attorney, doctor, or tax-accountant. But when did you last consult a $500/hr philosopher? Children are the same, their requests are concrete, advice on how to tell minnows from tadpoles, or how to pronounce a multi-syllable word in a reader." Stephen Wisdom, Sept. 7, 2005.

"It is widely understood that there are three ways heat is transferred from one thing to another: conduction, convection, and radiation. I think convection is a transfer of mass, not heat, which is where I diverge from the mainstream. I also think "change of phase," such as the energy involved in evaporation, is another form of heat transfer. Nobody seems to deny this very loudly, but they still stick with the original three and ignore this one, much to their peril when it comes to making energy and water related decisions. The large numbers of people who ignore it, and stubbornly stick to the original three, probably parallels ways in which people don't understand the forces that move markets." -- Henry Gifford, Sept. 12, 2005.

  1. LASER: Leverage Amplified Stupidity of Equity Reprisal
  2. Behavioral finance research has shown that for equal win and loss, The pain of loss is about 2.5* the joy of winning. Given that successful trading strategies typically win about 53% of the time, what conclusions can you make about trader's pharmacy bills?
  3. Which pharma companies stand to benefit from hedge-fund growth?

-- Dr. Kim Zussman, Sept. 20, 2005.

"Talking out of 10 years of basketball experience, I have never seen or heard of a team with less ability winning by shooting 3-point shots." Spec's reply:  An exception to this rule is Grinnell College. It is a small school in the middle of Iowa whose team is full of short nerdy white guys. To compensate for athletic shortcomings, they play a unique brand of basketball. The 15 players are divided into three squads of five who play 90 seconds of game time, then sit out for 180. Each 90 second stint is a flurry of full-court, high pressure defense mixed in with 3-point shooting on offense. Grinnell will give up a lay-up to have the chance at a 3 pointer. They only practice two things: running and 3-point shooting. Most teams score many easy 2 point baskets in the first half, then run out of gas in the second, and Grinnell's 3-point shooting takes over. Grinnell was featured on an ESPN2 game last year, but didn't play as well as they could have. Their system is a good way to maximize the potential of your athletes." -- Mike Ott, Oct. 13, 2005.

"What I don't like about the title 'Extraordinary popular delusions and the madness of crowds' is the implication that contrarian individuals might therefore be right. I must admit to having seen some deluded crowds in my time, but usually they're quite sensible compared to the completely crazy individuals one finds on the planet. Of course if it's down to a choice I'll pick the crazy individuals any day of the week. Why? Because they'll be so busy fighting amongst themselves that they won't gang up against you. Which I guess is why I like chess players and traders." -- GM Nigel Davies, Nov. 5, 2005.

"Dude, we are always wrong as day traders. Once you accept that fact your life will be pleasant. -- Craig Maccagno, all year long.

"I beg to disagree with the above statement that unskilled investors act randomly. In my experience and opinion most unskilled traders feel the need to be told what to do. Consider the financial media. The average financial story has some number X reported as up or down. Then a statement is included that "analysts said the the market was (up/down) because of X." The ONLY other type of story run in the financial media is a list of stocks to buy now with no reason or at most a one line reason. The novice concludes the markets are simple and one can simply buy the news and profit when the market reacts to the news. He is oblivious to the fact that the news is already discounted when he and the other newbies hear it. His actions are not random and will not achieve random results." Dr. Phil McDonnell, Dec.  22, 2005.

'Get the Joke' Post of the Year": Hany Saad, Wed., Jan. 12, 2005.

"In reference to your quote du jour, I remember few years back when I drove through a high-end Toronto suburb and looked at the houses (mansions) which at the time served as an inspiration to where I want to go and got me to think of the line of least resistance to get to my destination. I chose the stock market which turned out to be far from being the "line of least resistance."

I remember then the first thing that came to my mind was "surely the owners of these mansions took above average risks." .Risk was the keyword to me in my early twenties. My friends, however, chose to call it different things. "they must be drug dealers"..."they must be related to the mafia"...it surprised me, even at that age as it does now how people refuse to accept that someone can reach for the stars and get to the stars honestly.

I remember to this day...risk. The one thing that amazed me then was the ownership turnover of one of specific house this high end residential area. The one house/ castle that was the most elegant and spacious and definitely most pricy of all. I came to the conclusion that yes, these people took a lot of risk but they grew accustomed to the risk and couldn't  get enough of it. So when their luck turned they had to sell their real estate and live more modestly to cover their debts or their margin calls (an obscure concept to me then). so, through observation, while almost everyone I know reached the conclusion that these people are dishonest drug dealers and mafia members, I could only think of risk.

This beautiful 4 letter word that I myself grew latter accustomed to and in love with. In my trading years and years later I try to quantify this concept and find the point of maximum risk and usually find myself an entry point.

Yes Virginia, I learned the concept of risk and I made a living quantifying and trading the highest risk point, but that's not the end of the story. I also one time pawned my Rolexes and sold my car trading that same concept to pay my margin calls (a concept I am very well aware of now). As if by magic I learned the concept of risk but forgot to digest the lesson from the high real estate turnover. Why did I skip that chapter of the lesson? I  couldn't answer that when I was 20 and I still can't answer it now that I am trading the same concept...the highest risk entry...a point that I found today in the markets and could not think of anything other than finding an entry price on the long side at these levels. Nothing else mattered.. That four-letter word...

The four-letter word that is ruling my life and will either take me one day to the stars or the bankruptcy courts. Remember Gordon Gekko in the wall street movie saying to bud fox "greed is good, greed works" I would only substitute greed with risk. The real estate left an impression on me but oddly the ownership turnover didn't. 

Yes Virginia, I will take risks till the day I die...and yes, I acknowledge my poor money management skills and yes I refuse to learn and yes, "Qui ne risque rien n`a rien." I believed the French then and I believe them now...Risk, my friend, is how this earth turns. Risk took us to the moon and Mars, and risk will bring a better tomorrow...Hany"

Hany Saad inquires:

Hey Lack, Thnx for choosing my post for the "get the joke post of the year" award... ...What is the award? Do I get a check to cover my margin call caused by taking too much "uncalculated risk"? Get the joke?

Mr. Lackey responds:

I'd be happy to cover all calls for 50% of the profits over the next week. That's a huge joke there. I always took a lot of risk compared to my cohorts. Nothing compared to Vic or the real pros. Back to when I first started in the bucket shops. We had the main backer that every year either got cornered in a huge short or hammered in a panicful long. A guy named $#%@ would always bail him out. I remember the other backers, partners and traders of our firm always complaining, "That is how he makes so much more than all of us. He takes stupid risks, yet someone always bails him out. We can't trade like that." Well, I learned two things. One, you have to take enormous risk to profit in this game. Secondly, that guy $#%@ was a genius. He came in once or twice a year, bailed out the guy and took down profits off of a seemingly very risky time or trade. Yet when I thought about your post, my trading, Vic, the SpecList, all these years of panics, squeezes, etc., by the time a good trader is on the brink, it is perhaps the best time to jump in for a full profit. It's like the old men with their canes who come in once a year. I asked the $#%@ guy one time at a dinner party if he was a trader or just backed traders. He responded, "Oh, I just back traders on Amex/ NYSE and once in a while I come in the markets myself." I never caught on to what he meant until years later. He waited until everyone else was in trouble in a panic, and came in for himself and took profits down from everyone. The rest of the year he let everyone else grind it out. -- LACK

If your post did not appear here you may be in the "Book of Greatness" for 2005 spec-posts. For some reason in 2004 "greatness" and "get the joke posts" were equal. This year my saved greatness vs. get the joke posts are 10-1. Perhaps the explanation is quoted below.

Worst Failure of the Year to 'Get the Joke': LACK on R#fco

To honor 2004 'Get the Joke' post of the year: "The irony of trading, whereby you cannot boast of success lest family expect more, nor complain of failure and risk disdain." -- Kim Zussman

*(Vic was ineligible due to unfair advantage.)

Enough to Make Me Scream, by Jack Tierney

In government reports, core figures and gross figures have been a hotly debated topic. However, I believe a clear majority has come down firmly in favor of "core" rates as preferred. This has always driven me nuts as this figure, at least in regard to the CPI, neatly excises food and energy, two everyday necessities, as "too volatile." OK, for the time being I surrender to the dark side. But then something like the figures for Durable Goods expenditure is released this morning. Banner headlines and the lead story on CNBC of "Up 4.4%" and only in the closing paragraph or a mumbled aside do we discover that absent the "highly volatile" transportation products category, the "core" figure fell 0.6%.

We had a similar situation several months back when durable goods showed a 5.5% increase, but backing out transportation, especially aircraft, resulted in a core of -0.3%. At the time, Steve Leisman, CNBC's guru on government figures and interest rates, reacted quite poorly when some never-to-be-invited-back guest relentlessly emphasized that core figure, not the gross figure. Leisman's rationale was that aircraft manufacturing was "something America does well, so it ought to be included in the core." Well, apparently, Leisman discovered that eating is also something that Americans do well, so he paid a visit to a nearby grocer prior to Thanksgiving to "prove" that food prices hadn't experienced inflation. His friendly downtown New York grocer assured Leisman that the industry was absorbing cost increases. Right. A business that typically works on a 1% margin is going to absorb cost increases? The program wound up with Leisman asking about turkey prices. The grocer proudly displayed a handsome 25 lb, turkey. Leisman asked the cost. Without flinching, the response was "$75." Even Leisman seemed momentarily taken aback by this. But when he was assured "it's a very good turkey," all seemed right with the world.

Well, if New Yorkers think turkey at $3/lb. is a deal, good for them. But please don't put any of them in policy making positions! Of course, I'm spoiled. I can go out in the backwoods and shoot my own for the cost of a shotgun shell, though when this is discovered it, too, will probably be factored into the core CPI.

Dividend Increases, by Victor Niederhoffer

There are several theories as to why dividend increases are good, and since half of all big companies increase each year it's a good thing to study. One theory is that it signals earnings are going to be good. The second is that it prevents companies from squandering free cash on projects that are beneficial to the employees but not to the shareholders. A third line of research shows that companies rarely rescind dividend increases and a fourth shows that companies initiating dividends are particularly attractive. Dividends have received favorable tax treatment since 2003, certainly among the reasons for the 50% rise in the market since year-end 2002. It's amazing to see, among the many papers on the subject, that same hateful strain that so characterizes all studies of stock market behavior: that reductions in taxes have nothing to do with stock market performance, and investors and companies are completely indifferent to how much they are taxed on the fruits of their labors.

These thoughts were engendered by the 28% increase in PFE's dividend on Dec. 12, followed by the Dec. 16 announcement that their patent on Lipitor had been upheld. How fortuitous. I hypothesize that dividend increases in certain months are particularly salubrious.

Kevin Eilian says:

One of my B School finance profs put it this way: "A company that increases its dividend is like a guy who walks into a bar, sits next to a desirable woman, and shows off by lighting up a smoke using a $50 as cigarette paper."

Prof. Ross Miller offers:

Dividends are a way of transporting money outside the corporate shell. Money within the shell can be forfeited in the event of default, money outside the shell is untouchable except when fraudulently conveyed. Most business school finance professors assume that default does not exist. Paying dividends is like leaving some of your money at home before going on a date. (By the way, the unnamed professor's remark would be considered sexist at most major U.S. universities -- I suspect U. Chicago is an exception -- and could lead to serious administrative action, including dismissal.)

On Trade Deficits, Stock Market Crashes and the Spread of Rumor, by Victor Niederhoffer

It's an amazing fact that the three worst declines in the stock market in history occurred in conjunction with rumors, faulty economic reasoning, and destructive policies involving the US trade deficit. First the facts: The October 1929 crash occurred in conjunction with an increase in import duties on casein and carbide. Some DJIA prices which are too instructive not to memorialize:

Date   DJIA  Date   DJIA
22-Oct  326  29-Oct  230
23-Oct  305  30-Oct  258
24-Oct  299  31-Oct  274
25-Oct  305   4-Nov  258
26-Oct  299   6-Nov  232
28-Oct  260  13-Nov  199

Jude Wanniski, in a WSJ article of Oct 28, 1977, documents the tariff negotiations news that directly triggered the attack but we will have to go back to the newspapers ourselves for proper timing and correspondences with the DJIA. Fast forward to Oct 27, 1997, a day that will live in infamy when among other things the stock market closed early for the first time when it declined more than the allowed 6% as of 2:30 pm. I was there. Ahem. Not mentioned was that at 2:00 pm, the fates had it at knife edge with the Gods playing with the balances the way they usually day late in the day after a previous crash (see the Iliad for the comparable decision on the Hector Achilles battle). And at exactly 2 pm, a news story flashed across the screen that trade talks between Japan and the US had broken down, and a senator had said that a military war between the two countries would be appropriate if not resolved. Of course, it turned out that this has been said 6 months before in another context but what the H, it was good enough for an immediate 3% decline in the market the next one half hour.

Fast forward to Oct 19, 1987. Many of us were there as the average dropped 15% that day after 6% the previous day. And I was there the previous night also when Secretary of State Baker initiated an immediate 5% decline in overnight futures, and a crash in Hong Kong, and served as the proximate cause by stating that we would lower our dollar unilaterally unless Germany reduced their trade surplus. "Baker did it", the Chair of the Bundesbank said the next day, and the whole situation is documented in EdSpec.

Now the beautiful thing is that the greater the trade deficit the better it is for the US. The more we can buy cheap goods from other countries, the greater the spending power of our consumers. And the greater the advantages of specialization and free trade documented by Adam Smith in 1776 and known by all economists and almost every economics student since that time. Another way of thinking about it is that when conditions for investment in US are good, foreigners need dollars to invest in our companies and bonds. Who wouldn't with the rest of the world in such economic shambles and weak economics and job growth relative to the US. But the only way for them to finance this investment is by running a current account surplus with the US, which is our current account deficit. The beautiful thing about rumors about trade deficits is that you can always find someone that's hurt. According to the doomsdayists and the others who didn't take Economics101, if we're buying good in one field from abroad, then the workers in that industry in the US are hurt. And the dollars in the hands of the foreign exporters could be immediately thrown on the market and cause a terrible dollar fall and vicious circle of falling US asset prices.

And if you look at it from the other side, if we arrest the trade deficit by not buying from foreigners (that's the only way other than 20% interest rates, according to the doomsdayists), why then the American consumer is up the creek because he can't buy those cheap goods that keep our inflation down and provide the jobs in those fields where the American consumer does spend his money.

The whole area cries out for some kitchen talk about the how, why, and who of these and other rumors and we will not be completely reticent about this.

P.S. Here is  good link from the Congressional Budget Office on this subject for those interested in the accounting issues.

P.P.S. The accounting for trade deficits is highly technical, and a good thing to know empirically is that in years when our trade deficit was greatest, our economic growth was the greatest, and indeed every other measure of economic welfare for the US is better. However, it's also good to know about how the three deficits interact with investment and spending. If you don't have an economics text handy, this article is a good introduction (although written by a hard moneyist with an agenda).

Advice from the Rabbi, by Jaime Klein

When he returned to Politzk after a visit to Mezerich (the site of the famous Maggid - Preacher), Reb Azriel was asked what he had learned at the Maggid's court. "The Maggid," he replied, "taught me that one must pray with a seething, torn heart, as if a cruel armed bandit were about to slay him!

Translation: An investor should invest with a torn heart, as if cruel computer-armed bandits were out searching how to rob his money.

Briefly Speaking, by Victor Niederhoffer

Managed Futures:
The S&P Managed Futures Index, an investable index representative of investments in 14 systematic managed futures hedge fund programs, had one of its most severe drops in its 3 year history, falling from 1136 on December 9 to 1077 on December 15. Perhaps this is explained by and predicted in part the shocking drops in spot gold from $528/ounce on December 12 to $491/ounce Dec 21, the decline of crude from $62 a barrel on Dec 13 to $58 Dec 20 and related gyrations in the yen from 121 yen per $ on Dec 7 to 116 per dollar on December 19. Such a fall puts the Managed Futures Index back to where it was on Jan 24, 2003, 24 days after its initiation, but still 7% above its 1000 starting value.

Dividend increases have always signaled at least that the company's Board of Directors does not anticipate a serious decrease in earnings in the near future. And thus, the announcement by Pfizer on Dec 12 that they raised their dividend by 26% citing cost cuts, was particularly fortuitous in that it preceded by just 7 days the beautiful announcement that they had won their crucial patent suit upholding their exclusive rights to Lipitor, which must account for a very good portion of their profits. One has taken out the pencil and paper and found that such fortuitous news and concomitant price moves are not at all anomalous. Despite the abundance of studies and reports by those who hate enterprise and don't understand how important what you keep is relative to what the before "service" aspects are, the reduction to 15% service takes for dividends and capital gains since 2003 has been one of the major factors behind the 50% increase in the average since that time. A slew of academic articles attributes the impact of dividend increases on superior performance as due to a signaling effect that the earnings in the future are not headed for a decrease. And indeed, once a company has increased it's dividends, it is highly unlikely to do so. And earnings performance of dividend increasers is superior to the averages also. Another line of academic studies attributes the effect to the excess cash principal agent syndrome. If a company has too much cash, they are supposedly likely to use the overplus for their own benefit rather than the stockholders. The dividend increase reduces their ability to feather their own nest according to this hypothesis popularized by my former office mate Michael Jensen. Much more sensible is that companies that increase their dividends show their interest in improving the lot of their stockholders. Such stockholders show their appreciation and the expectation of continued increased emoluments with an increase in prices. I have had trouble getting the studies in this area past the Minister of Non-predictive studies, However, he reports as follows:

If a company's 12-month trailing dividend was zero 12 months ago and is non-zero 
now, then here are the stats for the next quarter's return: 
 Avg    Stdev     N   T-score
 3.12%   14.7%   164   2.70

For all S&P companies with non-zero trailing 12-month dividends, here are the 
stats for the next quarter's return: 
 Avg    Stdev     N   T-score
 2.10%   17.8% 12289   13.1

Cascade Effects:
The cascading effects of top-down ecosystems has been studied extensively by ecologists, particularly in protected marine areas. The idea is to eliminate the predator so the prey will increase. The problem is that when you eliminate the highest level feeder (the carnivore), the middle level feeders (the herbivores) increase in number and they are much more numerous and effective in feeding on the bottom layer (the producers, e.g. algae). A recent review (344 kb pdf) of 39 cases of trophic cascades by Pinnegar in Environmental Conservation, Vol. 27, Number 22, documents this problem with particular reference to the unpredictable detrimental effects of eliminating trigger fish, which increases sea urchin grazing and leads to less algae. Alternately, protecting spiny lobsters (as they do in the Leigh Reserve) leads to the reverse effect. The density of sea urchins then decreases, since they are food for the lobsters. And the sea urchins eat less kelp and thus the kelp cover increases. The situation becomes more complicated when human fisherman compete with animal predators, a situation particularly worrisome to me because my favorite food is involved. Protected otters compete with fishermen for abalone prey. Does a protected area for both abalone and sea otters allow for abalone fishery sustainability?

Yes, needless to say, all the articles on cascading impact of stocks show how one small decline, one small problem could lead to total disaster and Dow 500 as they are written by those who hope it will happen. But what about the reverse? Almost every market in the world is up 3 times as much as the US this year. The typical European market is up 25% with the Northern Europeans being up some 30%. And Japan is up 40% with all the others up about 20% except China, ranging from 40% in India, to South Korea and Pakistan up 50%. The median increase in South America is 25% with the biggies Brazil up 28% and Mexico up 35%. The situation is the same in almost every other market with Canada up 21% and the Middle Eastern markets such as the UAE up over 100%. When in heaven and earth is the cascade from the top of increased wealth that investors are finding in every other market except the US going to cascade down to us, with the US eking out a measly 5% this year? Surely we're not that bad, and the predators in these other markets will move to such depleted areas as our own country where the number and fatness of the prey would seem to be such easy picking.

Intention-Based Trading, by Rod Fitzsimmons Frey

I'm experimenting with a new technique. Instead of actually closing my (losing) position at a large loss, I'm simply intending to close it. Really, really hard. I'm actually bringing up the window, entering the info, and hovering over the submit. My hypothesis is that if I intend intensely enough, the market will reverse as if I had actually closed the position. I'll let you know how it goes.

From Odist John Lamberg:

No matter how hard you intend, the mistress will know it's pretend.
Once you're adequately stressed, the button will be pressed.
And the mistress will unkindly reveal the weakness in your zeal.

With apologies to poets, all I can say is, "I'm an engineer, not a poet."

It Takes Money to Make Money, by GM Nigel Davies

The premise here is one of interest to chess players, the theory according to Steinitz being that advantageous positions should, with correct play, lead to other types of advantage. But in practice any advantage is usually squandered through the mistakes borne of excessive comfort. And I suspect that those able to push an advantage home (Kerkorian, Soros, Korchnoi and others) may have developed their winning attitudes through hardship rather than any initial advantage.

Is Investing a "Loser's Game?" by Mr. Ckin

While going over some papers and textbooks that have been piling up on my desk, I came across an interesting description of a distinction between two sorts of competitive challenges:

The Winner's Game: in which most participants are expected to come out reasonably well, such as several sorts of sports, like golfing, marathon running, and perhaps investment in the bond market. Although it is highly unlikely that any individual participant will finish first, many participants will experience positive and rewarding results, and the most optimal was to play/invest is to avoid mistakes. And..

The Loser's Game: in which there is a direct challenge for dominance by another team, party, or market structure. Examples would include squash, boxing, futures markets, (generally engagements in which there is an opponent trying to subdue you) and quite possibly, the stock market.

The original description of these games in a financial sense may have originated from a book by Charles D. Ellis entitled: Investment Policy, How to Win at the Loser's Game, which I have not seen, but it begs the question: although we are well aware of the Loser's Game aspect of sports betting and futures trading (for which most participants have a negative expectancy), does the act of diversifying a portfolio, perhaps by investing in mutual funds instead of stocks, transform the equity asset class into a Winner's Game? Being an optimist, I have a reasonable expectation that consistent investment in a diversified portfolio of mutual funds will be rewarding in the long run, but what is the major determining factor of whether or not I will be successful with a portfolio of individual stocks?

The number of stocks in my selected portfolio? The time frame of investment? The amount of portfolio turnover? Dollar Cost Averaging? I am well aware of security market lines, efficient frontiers, modern portfolio theory and such, but few investment texts seem to elucidate readers on what factors change our expectancy from losing to winning while investing in a risky asset class. Is there any way to easily remove the notion of an "opponent" from a direct investment in the stock market?

Dr. Phil McDonnell Explains:

"What is the major determining factor of whether or not I will be successful with a portfolio of individual stocks?"

Time, young man! Time!

Dimson, Marsh and Staunton showed that if you held all stocks or a random diversified sample of stocks for 100 years you would make a return of approximately 1.5 million percent. The key isn't stock picking or market timing. It's time, you have to live long enough to let the compounding work for you.

Stocks are a variable sum game. If everyone invest in stocks they will go up and it is possible for all players to win. If everyone panics it is possible that all will lose. When a stock goes up wealth is created. If we were all to agree to buy stock and hold it wealth would be created and maintained. All of the stock owners would increase their wealth. In that sense stocks can be a positive sum or Winners game.

"Is there any way to easily remove the notion of an opponent from a direct investment in the stock market?"

The long term upward drift in prices is well established. Even a modest understanding of the nature of the stock market reveals that if all participants buy and none sell then stocks must rise. In that sense if participants cooperate to stay invested and never sell then stocks can only rise and all will benefit from their cooperation. Thus the stock market is no longer an adversarial game with an ever present opponent but can be seen as a sometimes cooperative, sometimes competitive game.

David Wren-Hardin Responds:

I've approached the zero-sum/variable-sum idea from the point of view of an open vs. closed system, and an ecology. If the economy were a closed system, it would be zero sum, and in fact, the economy would gradually grind itself down to zero due to the friction of trading, doing business, etc. But it isn't. An ecology, say, a jungle, isn't a closed system because the sun is constantly pumping energy into it. Animals multiply, biomass and diversity grow the whole system flourishes. Oh sure, if you're a monkey and poke your head out at the wrong time, a jaguar is likely to bite it off, but hey, it's all about the Good of the Whole, right?

I think of our economy in much the same way. There is constantly an influx of energy. At its most basic, it's still the sun, being exploited to grow foodstuffs and more and more today, energy directly. It's also the result of people's energy; in other words, their time. We are no longer on a gold standard, the unit of measure now is a person's time. How much is it worth? How much will you pay me for my time in order to enjoy more of yours? Like a happy ecosystem, everyone can be happy in this situation, and the graph is a smooth slope upward -- once we take out those annoying "outlier" extinction events.

The stock market is a way of trying to capture the heat of the economy. Like everything else in the real-world, there are inefficiencies in capturing the energy, and like any ecosystem, a fierce ecology has grown up around getting as much as you can. I think everyone should try to capture a bit of this energy. The problem comes when people mistake their place in the ecosystem and leave their niche. Just as a flying squirrel shouldn't mistake his ability to glide from tree to tree for a condor's ability to soar on thermals from a high mountain, the casual investor shouldn't think they can compete in the niche of G#ldman S#chs and their ilk.

Alston Mabry Replies:

What "sunlight" data I could get show that from 1960 through 2004:

S&P earnings compounded at 7.24% per year.

S&P dividends compounded at 5.33% per year.

Not a zero-sum game, is it?

The Judas Goat and the Markets, by Victor Niederhoffer

The Judas goat combines the reprehensible characters of the apostle Judas Iscariot who, in the guise of a friend, sold out his master for 30 pieces of silver with the capricious and wily nature of the goat. It applies to an animal or person that is trained to lead sheep or cattle up the slaughtering ramp, exiting by a side gate to repeat the process. Goats are a particularly social animal and destructive of pasture land in the wild, and it is common for a special Judas Goat equipped with a radio tracking collar to be sent out in the wild to join his wild counterparts so that they can be located and exterminated.

Jack London, who seems to know much about investments, has a nice use of this well known tendency in White Fang. A female dog lives with wolves and is trained by the wolves to be particularly attractive to the dogs on a sled. She lures them to enjoy her affections and when the individual dogs find her attractions irresistible, they are quickly slaughtered by the pack.

"Look at that, Bill," Harry whispered. Full into the firelight with a stealthy sidelong movement glided a doglike animal. It moved with commingled mistrust and daring, cautiously observing the men, its attention fixed on the dogs. One Ear (one of Bill and Harry's remaining dogs) strained with eagerness. "It's a she wolf", Harry whispered back, "and that account for Fatty and Frog (two dogs that the she wolf led to slaughter). She's the decoy for the pack. She draws out the dog, an then all the rest pitches in an eats 'em up".

Yes, but, such a common contrivance in nature (see Letters from a Self Made Merchant to His Son for a similar story), must have counterparts in markets. I invite readers to add to the following list:

  1. The January Barometer, which in two of the last three years gave terrible bearish signals: 2003, January down, then the rest of the year up 30%, and again this year, January down 2.5%, then the rest of the year up 7%. And related seasonal effects in December that caused the 10 stocks down the most in December of 2004 to lose ~20% in January 2005.
  2. At a more general level, the pattern that has worked many times in a row and is a sure thing for profits. One of my colleagues found a oil pattern that had worked 35 times in a row right before the Gulf war and bought oil based on it before we launched an attack to get the Iraqis out of Kuwait, and found that oil went down 33% over night and he lost his entire stake.
  3. The fundist who's had 10 good years in a row with a Sharpe Ratio of 100. As St#n J#nas says, the higher the Sharpe ratio, the more the fund is subject to ruin. And as I like to say, the only one that can grind is the house. (I understand that a certain firm has had the #1 performing large CTA program three years in a row, and I'll have to watch that firm's results closely to see if they can avoid the syndrome, and whether their notorious head trader has learned anything these past 8 years).
  4. The big down move after a major company like Intel or Microsoft announces earnings or sales. Invariably, the market craters and Susan says "You look worried. Do you really have to get up 100 times in the night at your venerability? Don't worry, it will be much better in the afternoon."
  5. The announcement of a natural disaster. Well, everyone knows that the San Francisco Earthquake of April 1906 led to the 50% decline in the Dow in 1907 that the Boy Plunger made a killing on by shorting, so let's sell the market down 5% whenever another such natural catastrophe occurs.
  6. The insider who buys his stock shortly after a public offering. Many know that companies bought by insiders perform some 3% a year better than the indexes. So if a insider buys, run out and buy. My goodness, I've been victimized by this many times, especially by the small cap biotechs that I buy on this signal, or the recent IPOs. What I didn't realize, until one of my friends whose firm recently went public told me, is that the underwriters and analysts are on top of them every day to buy their company's shares so the insider signal will lead to an avalanche of copycat buying, possibly even enough for the big boys to get out of their unsold allotments. A good book on this subject is Investment Intelligence from Insider Trading, by H. Nejat Seyhun.
  7. The upbeat statement by a most hubristic and famous executive. A certain technology executive from the Appalachians has become so famous for this that no matter what he says, the stock immediately tanks.
  8. The Sage's constant bearish message. He's been eschewing stocks since the 1990s, finding no good ones to buy, thereby leading millions to stay out of the market after the 2000-2002 bust.
  9. The financial weekly columnist who has been consistently bearish since 1964 and invariably has 20 very convincing reasons not to buy now, until "the last bit of bullish enthusiasm is washed out of the market" and a true selling climax occurs. "What was the crash of October 27, 1987? A beginning!"
  10. The fixed system that has amassed so many riches for its users that sports team ownership is in the cards for anyone who buys the system, attends a seminar, or participates in an investable program.
  11. The media that herald news designed to put the investor on just the wrong foot following just the wrong things such as "earnings woes causing stock market declines" that will make them contribute unduly to the massive frictional costs of the infrastructure.
  12. The guru who noticed that the market was down 30% in 1987 by using chart analysis, and knew from his charts that double bottoms are always formed, and thereby waited, who is now very bearish on the market in contrast to his previous bullishness.

You get the idea. Give us more!

Peter Gardiner Offers:

  1. An increase in alert status from yellow to orange
  2. Notification that the price of oil is up 80% in the year
  3. Reminder by financial media that an inverted yield curve portends recession but that a steepening curve suggests inflation, thereby encouraging the inference of impending doom and higher news media circulation.

...and on and on... too many and too pathetic to enumerate

From Joe Hughes:

One we will hear within the month of January: will be the Super Bowl AFC bearish, NFC bullish barometer. I can't remember the last time the NFC won, and if the Patriots can blow up a barometer, and you having lived in Boston during their puke awful days, must cringe when they bring this junk up. As if anything should've been a dead sell, flat out, end-of-the-world, going-to-zero barometer, it would've been the unlikely occurrence of the Pat's winning the Super Bowl. That's apocalyptic, (sp it's late) even more so than the Red Sox, White Sox or god forbid the cubs, who are tied to the goat.

A few from Kim Zussman:

Sell in May and go away (check what happened 5/05)

Januaries are best month (check what happened 5/05)

Santa Rally (check what happened 11/05)

Expert says buy VIX < 11 (check what happened to him)

J.T. offers his Favorite:

The best leader in the goat category for me is the very simple Vig/Spread/Grind lesson. It is so eloquently spoken of by Arthur Crump in "The Theory of Stock Speculation" via Nelson's Wall Street Library Vol. III (1900). Crump also uses so appropriately the words "decoy-duck" to explain the dilemma. Here is the paragraph from Chap. VII "Pitfalls".

"A broker, it may be said, should warn his client before putting him into a stock the price of which is wide; but unfortunately such warnings do not increase the number of commissions, and, apart from that, if a speculator does not take the trouble to inform himself accurately upon such a point, placing no reliance upon the advice of any one, he deserves to lose his money. Some markets are so small that a speculator once in, is what is called "roasted" before he is let out again. A particular man very often is the only dealer in the market in a certain stock of which perhaps the supply is also very limited. Under such circumstances a haphazard speculator who may chance to have observed some rather violent fluctuations thinks there is a good opportunity to make some money, and he sells a little bear a couple of thousand pounds nominal of stock. The round sum, and the channel through which the sale comes, helps the jobber to read the operation. The decoy-duck in the shape of the fluctuations in price, lures two or three more sportsmen on to the dangerous ground, and when they want to get out the price is put up against them, and they are quietly mulcted of 50 lbs. each, without a chance of getting even a sight off their enemy, or any value for their money but experience."

Sushil Kedia Forwards A Story About the Economics of Goats

A Judas lesson from David Wren-Hardin:

The I Think I Know More Than I Do Goat. This goat entices someone with expert knowledge in a field to think that gives him an edge in valuing a company that uses that knowledge. As a new trader fresh from graduate school in biology, I eagerly bought Celera during the human genome sequencing race. After all, I could evaluate the science, and knew that they "had a good technique." I paid $200.00 a share, close enough to the top to be the same thing. This goat also led people enamored with their new Palm device to pile into that stock ("Look at me! I'm Peter Lynch, buying what I know!").

I learned my lesson after Celera, and rarely buy individual stocks. When people hear I'm a trader, they frequently ask me for my investment ideas. I quickly say I'm the worst investor I know, that I have 97%+ of my stuff indexed. Sure, I may trade thousands of shares a day, and can price some things to the penny. But fundamental analysis? Forget it.

In Memory of Chris Whitley, by Prof. Mark McNabb

Chris Whitley, the best guitarist of recent times, passed away last month. He played vintage National resonator guitars as a seething fuse.

Ironic that his latest CD, Soft Dangerous Shores, marked a slight return to the roots that were in his commercial success, Living With the Law. He was never comfortable playing the popular part, only moving forward from it. Whitley amazed with a fiercely independent style, melding the muses of Cobain and Robert Johnson. Only the hoodoo John Campbell and the late Stevie Ray Vaughan could compare in performance. If you never had the fortune of hearing Whitley play, one of his last performances is freely available on his website.

A tormented talent.

A Canadian Spec Writes:

U.S. pundits bash 'retarded cousin' Canada
Dec. 19, 2005. 04:11 PM
WASHINGTON -- Canada has been described lately by a conservative U.S. television host as "a stalker" and a "retarded cousin."

The CME pit clearly didn't know about our little handicap, eh? The joke's on them, eh? Isn't it?

Slippery Slope? by George Zachar

I came back from a rare lunch off-the-desk to discover gold was back below $500...

T  12/20 492.75
M  12/19 503.80
F  12/16 503.24
T  12/15 502.98
W  12/14 506.50
T  12/13 518.70
M  12/12 528.00

While debt implieds took another tumble...

12/20/05  7.59
12/19/05  7.73
12/16/05  7.72
12/15/05  7.82
12/14/05  7.85
12/13/05  7.99
12/12/05  8.11

And VIX hung near recent lows:

T  12/20  11.20
M  12/19  11.38
F  12/16  10.68
T  12/15  10.73
W  12/14  10.48
T  12/13  11.11
M  12/12  11.47

I'm moved to wonder aloud if, amid the usual bearish patter, calls for presidential impeachment, universal calumnies against the housing market, and the upcoming replacement of the maestro by the chopper pilot, we're seeing a blow-off decline in risk premia.

Wil Kenney Gets Started on His Resolutions Before the New Year

The past couple of months I've been training in competitive mixed martial arts. It's fairly intense and has made a huge difference in my strength, endurance and flexibility. Interval training is something I've found to be particularly effective. this is really just a burst of exercise followed by a short rest period, then repeat. Two minute exercise, 20 second rest. If someone spent 30 minutes a day (no reason not to do it six days a week) with this he would look like a new person within a couple of months. Jumping jacks, situps, leg lifts, basic stretches and the like can also get the job done, but having an external timer makes all this difference. Getting involved with a martial arts studio is a good idea. Even if you take a low/no contact route the results will be surprising.

People Watching, by Jim Sogi

Observing personal characteristics leads to a judgment of how a person will react. The juror in the box with the hat and the sunglasses, reading Atlas Shrugged, the intense angry witness, the glib expert: how will they react, what will they do as the situation develops? Jury selection is its own field of study. Mike Bloomberg elevated electioneering and campaigning to a science. An enjoyable pastime when out and about is people watching. What do the person's clothes, body language, physical appearance, way of relating to their companions, mannerisms, all say about that person, tell what he is like, what he believes, what he thinks of himself? The observables display what group they identify with, where they are from, and what and how they might react as the situation develops. None of this is from the horse's mouth. None of the information is told directly from the subject, but gathered indirectly. Some interesting parallels from intelligence and counterintelligence gathering come to mind in the process of discovering secret information without cooperation from the subject and without the subject being aware of the investigation.

This type of intelligence gathering occurs in the markets. In the market there are many observables. First is the tape record of the transactions. The tape reveals many things to the careful observer, and some say all that there is worth knowing. Like surveillance, much of the time is spent watching mundane random actions, but all of a sudden an anomaly is either noticed or discovered through analysis. The suspicious move, the unnatural condition, or the familiar move or set up appears.

But there is more. There is company information disclosed in reports, and financial, public information, governmental proclamations, press releases, news, inside in formation, industry gossip and the talk on the street, laws rules, rulings, policies, estimates, analysis, insider actions. Much of the possible information available to the observer is not conveyed expressly but as meta message or through analysis. We've talked about this in news. Other examples include the contrarian sentiment indicator, put/call ratios. Another example is the recent cited study about the analysis of clustering of certain words in company reports indicating positive or negative prospects. A silly example is the fake doctor's brief case indicator some years ago. The point is there is information above what is said directly by reading between the lines, reading the body language of the market and its participants, sifting through the spin. Observation is helpful in avoiding losing more than you have a right to lose and avoiding some of the more obvious traps being set for the unwary and gullible.

Growth and Value, from Stefan Jovanovich, of Applied Heuristics, Inc.

We use a variant of forward P/Es in our model. However, the time frame is not one year forward but five. In one of his rare public comments about methodology, Sir John Templeton said that he tried to figure out what a company would be earning five years from now because that figure was a better indicator of the intrinsic value of an enterprise.

We have found that using fifth year forward P/Es tends to capture both "growth" and "value" stocks while valuations using present year and one year forward P/Es limit selections to "value" stocks only. Among the current "Top 20" stocks in our portfolio, the present P/Es range from 21 to six and the one year forward P/Es from 15 to six.

I realize Dr. Niederhoffer generally writes about the overall valuation of the market rather than individual stocks, and, clearly, his variant on the Fed Model has merit. However, in using earnings vs. bond yields as a measure, he might want to have Mr. Downing recalculate the earnings yields so that they have match the maturity used for bonds.

I would also suggest that, while the use of near-term (present and one year forecast earnings) valuations is certainly better than chance, its relation to the fluctuations in the stock market over the same time period is still rather tenuous.

Near-term fluctuations seem to be ruled much more by sentiment than logic. Even though we still find a number of companies in the market that are very good value, we have limited our current long equity position to 20% of our total portfolio because the measures of public and investor sentiment that were so pessimistic in October and November are now much less so.

By the way, last month, after 30 years as a member, I resigned from the State Bar of California. I feel the way I imagine Sisyphus did when the Gods allowed him to stop pushing the rock. The snares of the Bar now resemble those of the FDA that you've described.

Life in the Undergrowth, from Riz Din

I remember not so long ago that Jim Sogi wrote a nice short piece on a David Attenborough nature documentary on ocean life. The BBC is now airing a new Attenborough series called "Life in the Undergrowth" that makes excellent viewing. I wrote about it on my blog; the associated web-links are worth checking out.

Victor Niederhoffer Reviews Timing the Market: How to Profit in the Stock Market

A book comes along about timing the market using the yield curve, technical analysis and cultural indicators and I hope fervently that it's not another version of the Beardstown Ladies' report of their successful trades without regard to their losses.

I hope if the author makes calls that rely on calling the entire market, that the book will not retrospectively examine the market data and come up with a handful of buy and sell dates over the last 50 years that would have just happened to coincide with the best times to buy and sell.

I hope that the author will not leave out the bad trades or fine-tune and restrict the buying and selling so that the rules are even more perfect than a retrospective attempt to pick such limited points from 50 years of data might be. I hope that the author will not base conclusions on data that are no longer relevant like P/Es below 5 or the DJIA below 100 that Ben Graham and Warren B#ffett and Ben Stein like, or VIX above 30, or 10-year bond yields above 10%.

I hope that the author will not recapitulate a history of financial speculation based on secondary sources reminding us that there were booms in stocks in France and England in the early 18th century or excesses in tulips in the 17th century to fill the book out.

I also hope that the authors will take into consideration such things as the uncertainty of their conclusions, the consistency with randomness and the likelihood that rational people who are aware of the general relations adduced might change their behavior in the future. A book from John Wiley might even be expected to understand how the principle of ever-changing cycles might mar or damp any conclusions about fixed ways of making money, since one of their best-selling books, and its sequel, treat this topic extensively.

I also hope that the author will at least have learned something from the emphasis that modern authors have placed on the difficulty of overcoming the positive drift in the market with short sales, and the absurdity of trying to beat dealers with much lower transactions costs than yourself at zero sum game activities.

Finally, barring all this I hope that the author will at least motivate the conclusions and approach within the framework of the kind of microeconomic or macroeconomic theory taught at all good colleges in their elementary economics classes.

I was therefore sorely disappointed in Deborah Weir's Timing the Market: How to Profit from the Stock Market (Wiley: November 2005), regrettably part of the Wiley Trading Series, as it contains all these defects.

There are two good parts of the book: an appendix that contains monthly data on the three-month bill and ten-year note, with corresponding S&P 500 Index data from January 1961 to January 2004. The author reports profits and losses from a blind rule of buying when the three-month yield is below the ten-year and selling when it's above. Regrettably she leaves out the sell that would have occurred on November 1969, the update of her results for the loss from buying the S&P on January 2001 at 1320 and holding through the decline to the 780s in 2002 and the four years without profit as we write. She also fails to note that all the inversions since 1966 came with 10-year bonds above 5% as follows:

Inversions (10-year note yield above 3-month bill yield)
Date        10-year yield    S&P 500
Sept 1966         5.2           77
July 1969         6.7           98
June 1973         6.9          105
Dec  1978         9.0           95
Nov  1980        12.7          106
Aug  2000         5.8         1430

The date she reports are from a Federal Reserve site. Presumably, on that site the Fed reports how and when during the day or month the yields were calculated and whether they are adjusted in some retrospective way.I eschewed using all such series for many years because they turned out to be based on averages and intraday prices rather than level and end-of-day prices) like the useless retrospective P/E statistics that the doomsday people use.

You might think that a sapient author might have considered that a rule that only gave one sell in 20 years and then was superseded by a buy on Jan. 1, 2001, when the market was at 1320, right before one of the greatest crashes in history, without one further sell, might not be overly useful or relevant. Also that with 10-year yields during her points of inversion averaging some 80% above the current levels, that the conditions and utilities today might be different from the past; but no, such reflection is not made. Instead there are some references to ripples in the term structure from three-month to one-year that the author would have used in retrospect to fine tune the six sell signals she reports to make them even better.

There is an interesting table of monthly bust, waist and weight sizes of Playboy playmates from 1960 to July 2004 that illustrates the descriptive coterminous correlation that during good economic times busts become bigger but during bad times busts become smaller, accompanied by a vogue for less circular cleavage styles.

Victor in a Madison Avenue boutique offering bullish (L) and bearish (R) cleavage styles.

However, even the author seems to know that her use of the data is "designed to entertain rather than to forecast." Perhaps the author of this book, a NYU business school graduate after her school teaching days ended, will learn from all the gaps and weaknesses in her book and will not be visited with the same fate in posterity as the Beardstown Ladies.

Tex Hesselsweet remarks:

The Beardstown Ladies claimed an average annual return of 23.4% over the 10 years ending in 1993. Upon discovering that their actual returns were 9.1%, some 6% below the S&P return for the period, Beardstown senior pattern Betty Sinnock suggested that the ladies, (like Volker, B#ffett et al) were unfamiliar with computers and had confused a 2 year return for a 10 year return. More nefariously, others suspected that their computations failed to account for periodic contributions to the fund.

M#lcolm Gl#dwell: What a Card!, from Collab

NEW YORK POST Page 6, December 19, 2005 -- BEST-selling writer Malcolm Gladwell identifies with New York Times fraudulist Jayson Blair. The other night, the "Blink" author was on stage at the Players Club as part of the trendy storytelling session known as the Moth. Gladwell admitted he once got a buzz after he wrote up an earnings report incorrectly as a cub reporter and the affected stock plummeted 10 percent. He also inserted the Australian capital, Sydney, into a story about where an annual AIDS conference might be held because he wanted to go there and thought no one "would mind." His hilarious performance at the Moth, with Harvey Keitel and Moby in attendance, climaxed with a manic description of his competition with another scribe to get the phrase "perverse but often baffling" into print — a feat he eventually achieved when writing about the economics of health care.

Five Gems of Wisdom from the Senator, by Sushil Kedia

  1. Go Slow.
  2. Allow the mediocre in the world to prove it themselves. Give them time and space.
  3. Focus on what you need to do. Being smart is O.K., but having focus is important.
  4. Decide if your objective is to trade or to get rich.
  5. Reveal your cards after others have, this being the basic courtesy of good play.

These are the five most important gems of wisdom, out of the many that I picked up from the Senator while I had the good fortune of meeting him in Delhi and Mumbai during his recent visit to India. His achievements both as a trader and as a teacher are increasingly getting more and more people amazed here. This Land of Gurus is preparing itself to be dazzled by yet another who is uniquely his own kind.

Initial Conclusions, from Laurence Glazier

It's getting toward two years since I became involved in this great endeavor and, armed most fortunately with insight from this List, I have come to think:

  1. Pundits who forecast the market on CNBC do not know the future -- there is always another expert who can be wheeled on with exactly the opposite view.
  2. Options, by and large, are fairly priced, as the kind market-maker at the other side of the board would also like to win. Therefore the notion that it is best to buy low implied volatility and sell high is over-rated.
  3. This being so, assuming random results, one would expect a beginning trader's results after one year to be equal, on average, to a loss amounting to the total of bid/ask spread costs and broker fees, plus any other costs, (time, education, software, etc).
  4. Any positive strategies I may have discovered for trading options are vulnerable to changes in conditions in the future, and I am especially aware that, were the quantum between options prices reduced from .05 or .01, it would make the market more efficient and perhaps reduce profit potential.
  5. Money is a linear scale and despite all the fine mathematics that I have seen I am unconvinced that derivative values live naturally in one dimension. Pricing models are a method of curve fitting that has made an industry work, with an extra Greek letter to help if they get out of line; a bold measure of emotion. There would appear to be a circular argument though, with Vega both defined by the model and used to support it, a little like posited dark matter. Electronics made a paradigm shift with Maxwell's use of complex numbers, we are still in early days in economics, in the early days where superstition is prevalent.

A Christmas Present from Victor Niederhoffer

The time has come to shed light on the P/E versus return speculations that are so dysfunctional and misleading, as a Christmas present to all our readers, despite the urgent pleas of the Minister of Non-Predictive Studies that the results are too currently useful to qualify for inclusion in a site which is devoted to meals for a lifetime rather than meals for a day. On the other hand, the armchair investigators, those who come up with hypothetical defects of studies that rely on earnings, or are masters at throwing layers of noise on results, or look at charts, or look at results from the 1900s to come up with conclusions relevant for today, have the world so much in their grip that no matter what I say, people won't be swayed. So, Minister, let it be.

The question on the table is whether P/Es can be used to predict earnings. A raft of publicity has been disseminated recently about how P/Es are overstated, because they use predicted earnings, which tend to be greater than actual earnings, and thus lead to an underestimate of some kind. And that this is somehow bearish for the market. For example, if the earnings in the last 12 months are $60 per share and the price is 1200, the P/E is 20. But suppose the forecast is for earnings in the subsequent 12 months to be 75. Then the P/E based on forecasted earnings will be 1200/75 = 16. Great. P/E based on forecasted earnings is lower than using actual earnings. And if the forecasted P/E were then compared to the average realized P/E, there would be a bias to compare a number that is lower, based on a forecast, to one that tends to be higher, because it's based on an actual.

So what? What does this have to do with whether P/E itself is predictive of anything? Such a divergence always exists. Is it greater or less than usual and does it have anything to do with subsequent returns? Indeed, how about some direct study of this phenomenon. Do realize that stocks and bonds are substitutes for each other, and that the value of an ownership interest is related to the discounted value of what you get by virtue of owning it. To see how much earnings are worth in any period, the earnings must be compared to interest rates. Right now earnings in the S&P for the last 12 months are $67 a share. The price is 1272. That works out to a E/P of 5.27%. But bond yields on the 10 year bond using the most active current 10 year bonds are 4.43%. There's a difference of 0.84% in favor of stocks. Is that bullish or bearish?

To study this, let's be direct rather than sit in an armchair. Let's take the actual earnings for the past 12 months for the S&P that were reported as of the year-end, from 1979 to 2004. In other words, as of year-end 1979, let's look at the last 12 months earnings of S&P as they were reported. The last earnings reported would be those for the 12 months ended September 1979. We'll use the contemporaneous report of those earnings, available in the S&P Stock Guide available at the time. These are reported without adjustment in the S&P Statistical Service. We'll compare the earnings yield calculated from this earnings to the year end 1979 price to come up with an E/P ratio. This E/P ratio will be compared to the then current 10 year bond yield so that a contemporaneous yield differential is possible. For example in 1979 the earnings for the last 12 months were 14.63, the price as of year-end 1979 was 107.9, so the E/P was 13.6%. The 10-year bond yield was 10.3%. The differential was 3.2%.

In order to see how the differential level affects future returns, we divided the data into three groups based on the differential and examined the returns of the the groups. The groups are: Low (differential < -1.6%),Medium (differential between -1.6% and -1.0%), and High (differential > -1.0%). Returns for next 12 months for stocks, based on the actual earnings yield, less the bond yield, contemporaneously calculated 1979 to 2004, were as follows:

Yield Differential     MEAN     N      T 
------------------     ----    --    ----
High (> -1.00 %)        19%     7     5.4 
Med (-1.6% < x < -1.0%) 11%     9     2.0 
Low < -1.60 %)     	 6%    10     1.0

The results are clear. When the yield differential was high ( above minus 1.0% in stocks' favor) the average return for stocks the next 12 months was 19%. When the differential was low ( in favor of bonds) the returns for stocks was a mere 6%. A good regression forecast of the return is:

Subsequent return = 16.5% + 4.0 * Earnings differential
R-squared = 0.12

To determine a forecast using this regression, calculate:
Current S&P (as of 12/16/05) stands at 1272.00
Realized Earnings = Reported Earnings for 12 months ended 9/30/05 = $67.00
Earnings Yield = E/P = Realized Earnings / S&P = 67/1272 = 5.27%
10.Year.Yield = Y = The Current Yield on 10-Year government note = 4.43%
The Earnings Differential = E/P - Y  = 5.27 percent - 4.43 percent = 0.84 %
Substituting these numbers into the regression formula :
0.165 + 4.0 * 0.0084 = 19.9 percent
Therefore, the adjusted P/E model yields a forecast of about 19.9 percent for next 12 months.

Thus, using actual realized earnings, available without forecast, and comparing it to interest rates, a relatively accurate and statistically significant prediction of returns in S&P is possible for the last 26 years. Such a difference is in the High class right now, so the prediction is for a 19% return in 2006. No armchair speculations. No hateful anti-enterprise biases. No attempt to talk a book. Just the facts.

*To see a somewhat more accurate method for forecasting returns, see our work on the Fed Model. The Fed Model utilizes forward earnings (which tend to be higher than realized earnings) and thus encompass a greater amount of information for forecasting.

Year End
10 Year
Yr Perf
E/P - Y
1979107.914.6313.6% 10.3%25.8%3.22%High
1980135.814.6410.8% 12.4%-9.7%-1.65%Low
1981122.615.2712.5%14% 14.8%-1.52%Med
1982140.613.569.6%10.4% 17.3%-0.75%High
1983164.913.38.1%11.8% 1.4%-3.74%Low
1984167.216.569.9%11.5% 26.3%-1.61%Low
1985211.315.237.2%9% 14.6%-1.78%Low
1986242.214.856.1%7.2% 2%-1.09%Med
1987247.115.866.4%8.9% 12.4%-2.44%Low
1988277.722.738.2%9.1% 27.3%-0.95%High
1989353.423.76.7%7.9% -6.6%-1.23%Med
1990330.221.776.6%8.1% 26.3%-1.47%Med
1991417.117.764.3%6.7% 4.5%-2.44%Low
1992435.718.044.1%6.7% 7.1%-2.55%Low
1993466.520.414.4%5.8% -1.5%-1.42%Med
1994459.327.325.9%7.8% 34.1%-1.87%Low
1995615.935.185.7%5.6% 20.3%0.14%High
1996740.7364.9%6.4% 31%-1.56%Med
1997970.440.644.2%5.7% 26.7%-1.55%Med
19981229.238.473.1%4.6% 19.5%-1.52%Med
19991469.343.963%6.4% -10.1%-3.45%Low
20001320.353.74.1%5.1% -13%-1.04%Med
20011148.128.312.5%5.1% -23.4%-2.59%Low
2002879.830.043.4%3.8% 26.4%-0.4%High
20031111.938.583.5%4.2% 9%-0.78%High
20041211.957.774.8%4.2% 5%0.55%High
20051272675.3%4.4% ?0.84%High
Sources: S&P Security Price Index Record, Bloomberg
*Differential Class determined as follows:
     Low : Differential <  -1.6 %
     Med : -1.6% < Differential < -1.0%
     High : Differential > -1.0 %
Thanks to artful simulator Tom Downing for his calculations, regressions, and contemporaneous data collection.

Sam Eisenstadt, a Young-Hearted Giant, Offers a Seemingly Helpful Solution:

I'm aware of your strong preference for the 'Fed Model'. With respect to the above post, I have a question. When looking at Earnings Yield minus Treasury Yield, aren't you in fact including market price on both sides of the equation? P(t) as part of the Earnings Yield and P(t+1)/P(t) as your dependent variable?

To avoid this problem using your numbers, I related E(t)/E(t-1) to P(t+1)/P(t). I know this correlates future change in price to past change in earnings. For the period of your analysis, it produces the same r-squared, (0.122), and with one less variable, (Treasury Yield).

Roundabout, by Victor Niederhoffer

As year-end approaches, I note a large number of markets near vivid points: S&P 500 at 1275, near 1300; DJIA at 10881, near 11000; gold at $507, near $500; oil at $60; Euro at $1.20; VIX at 10.7, near 10.0; copper at $2.00; soybeans at $6.03, near $6.00; corn at $2.07 and oats at $2.03, both near $2.00; FTSE at 5508, near 5500; Nikkei at 15254 and Hang Seng at 15059, both near 15000. As the Palindrome is reported to have said early in his career "I've had such a good year this year, why not even make it better -- you pay the bill." I predict that these markets will end at their round numbers at the end of the year, at least to an inordinate extent.

Yossi Ben-Dak comments:

I adore your need to and perseverance with observing phenomena without any prejudice as to what is the substantial foundation producing its derived nomothetic value. The very idea that roundness, for example, means something, is something too many "experts" in academia, government, military and intelligence would be giving zero value, and therefore pay the price of knowing less, undervaluing their prediction "acts" .

The reason I love your prisms is that when immersed in the need to predict over many data fluctuations I find it best to cast my bread across the water in the biblical sense. In other words you cannot predict what good will come your way when you make an effort on behalf of somebody you do not know; or a collectivity in need that would never expect your coming to grips with their suffering.

What is the relevance of this "Pay it Forward" predicament? I find it fascinating to work with methodologies that allow me to find new patterns and/or match together unforeseen patterns of causality, even when my comprehension of why is not at all clear at the outset, obvious, or even rational. Our Knowledge of pattern matching as humans is always flawed and lacking as the old Psychology of Egon Brunswik and its modern manifestations teach us. Most veteran analysts get hooked to a few working systems of base knowledge that they are mentally committed to. The conceptualization of social perception, called the "Lens Model" suggests that these lenses insure that the field of knowledge needed for prediction is nearly always less rich than it appears to be.

The case of round numbers, so well known to stock traders, (Practical Speculation p.299), has at least three immediate connotations.

  1. Regarding at what level a seller would consider reducing the price for someone they dislike. Or a buyer paying more in similar circumstances - with implications of tenderness and agility as to how to present yourself.
  2. The round number that defines a neighborhood of acceptable latitude to buy and sell - with implications to guesstimating it or testing its presumed latitude, which would not be too far apart from a given round number.
  3. The collective perceptions of target numbers that would dictate a perception of movement that may go beyond comprehended profitability or movement - with again, the implication of having the power to relate to terms of round numbers because they are easy to conceive, easier to remember, easier to communicate, and a product of memory based repeated behavior from other areas of human conduct and learning.

I have found it to be less understood or utilized in prediction within a few other fields than in speculation. For example, thinking about terror events makes me more effective than other analysts in predicting because I assume that a round number perception exists in the mind of evil planners. When setting close choice margins for a pass or fail test, round numbers are always in the mind of the designer-author.

Vic's prediction regarding the mental return of figures and their behavior to a certain round number in a defined annual cycle is, thus, particularly elegant when you still have hypotheses as to why, but not a final validation as to why. The moment you do, you may want to cast your bread across the waters again.

December, by Victor Niederhoffer

I have never believed in charting or the predictability of seasonality. However, it is instructive to consider the moves in December of the S&P 500:

Date         S&P500 Dec%Chg
12/31/1975    90.19   -1.2%
12/31/1976   107.46    5.2%
12/30/1977    95.10    0.3%
12/29/1978    96.11    1.5%
12/31/1979   107.94    1.7%
12/31/1980   135.76   -3.4%
12/31/1981   122.55   -3.0%
12/31/1982   140.64    1.5%
12/30/1983   164.93   -0.9%
12/31/1984   167.24    2.2%
12/31/1985   211.28    4.5%
12/31/1986   242.17   -2.8%
12/31/1987   247.08    7.3%
12/30/1988   277.72    1.5%
12/29/1989   353.40    2.1%
12/31/1990   330.22    2.5%
12/31/1991   417.09   11.2%
12/31/1992   435.71    1.0%
12/31/1993   466.45    1.0%
12/30/1994   459.27    1.2%
12/29/1995   615.93    1.7%
12/31/1996   740.74   -2.2%
12/31/1997   970.43    1.6%
12/31/1998  1229.23    5.6%
12/31/1999  1469.25    5.8%
12/29/2000  1320.28    0.4%
12/31/2001  1148.08    0.8%
12/31/2002   879.82   -6.0%
12/31/2003  1111.92    5.1%
12/31/2004  1211.92    3.2%

Considering the average variability of months during the period, and the drift in S&P from 91 in 1975 to 1280 today, it seems to me that December is inordinately balmy. I tested the joint distributions of good and bad months for the stock market for randomness, from 1870 to 1996, with a reasonably robust simulation procedure in EdSpec, and concluded that "January and August have been the most bullish months, and September and October have been the most bearish months." The hypothesis needs updating and focus for modern times, but I would tentatively propose that December is an inordinately mild month with a non-random tendency for stock prices to close near highs of the year, and a general tendency for markets to close near round numbers. The artful simulator Tom Downing, who is sorely missed at his previous employer, will be busy investigating this today.

Yossi Ben-Dak comments:

When it comes to dealing with predictability and pattern matching, especially when the alternative is improving on an already robust simulation, (to test randomness of joint distribution of good and bad months over more than 120 years), certain updating of the hypotheses, as Vic suggests, can be best achieved by applying statistical procedures and checking for patterns over many rich data sets. These context related or mainly would-be-related-but-as-of-now-unrelated, and "uncontexturized" data sets can be subjected to a procedure that looks out for patterns that are definitely pre-comprehension of cause or causality. When found these can trigger more refined hypotheses and hence a validation of insight. One major potential for these types of inquiry exist in "conexturizing", which is what I call a system that that meets the need of a specific time series while correlating processes and/or events such as a bearish season. Svivot provides such a system, "Contextor". They define their work as:

When we use the word "application" in reference to Contextor, we mean the contribution of the system to meeting the needs of a specific intelligence activity. In some cases, building the technological side of the application may take only a few hours, including installation of the system and defining basic parameters. Other more complex applications may require detailed systems analysis of the solution, customized development using Contextor's SDK (software developer's kit), integration with other systems and sophisticated implementation.

An application may begin with a single workstation used by one professional up to a solution encompassing an entire organization and intended for a wide range of activities and employees with an emphasis on sharing as well as compartmentalization.

Many different types of applications have been built using Contextor and its technology. In addition to the technology itself, these applications have a number of additional common characteristics. The major ones are as follows:

  1. Utilization of the system for making intelligence inferences in their widest sense.
  2. Access to multiple heterogeneous data sources.
  3. Systematic collection of material according to the context to which it belongs, including assigning an individual piece of information multiple relevant contexts.
  4. Search and retrieval of pieces of information according to multiple categories: free text search, date constraints, filter by creator, type of information resource, etc.
  5. Build context maps using visual and logical representation of links between entities in a specific context and multiple contexts.
  6. Automatic creation of contexts using Contextor's powerful inference engine.

Another potential, perhaps much better for testing end of year regularities and their nuances, exists in a very promising global provider of IT infrastructure and security solutions, Comodo. Their mode of dealing with the Internet and telecommunications is second to none and they are known these days more as provider of certificate issuance tools. These enable Comodo to provide infinitely scalable security deployment to individuals and Enterprises alike. Their draw back is that they too are into "contexturizing", which can be useful mainly if one wants to come closer to understanding the predictability of round numbers or other patterns of significance in speculation.

A Little Story, from Philip J. McDonnell

About thirty five years ago I did a rather comprehensive project for an investment/finance course at Berkeley. The project involved an elaborate multiple regression of dozens of fundamental variables from the CompuStat tapes. About a year later I did an out of sample follow-up study to see how the 20 most undervalued stocks had performed. As I recall they were up about 28% in a year when the S&P was down.

I was referred to a certain very young Professor, then at Berkeley, if I wished to pursue my interests in investment research. He was reputed to be a quantitative whiz fresh from the University of Chicago. So I knocked on his door at his designated office hours carrying my three boxes of punch cards and my 100 page thick listing of my study. The whole thing probably weighed about 50 pounds.

I told him about my study and explained that my goal was to do further investment research. We looked at the results of the study. He seemed genuinely impressed by the out of sample results. However he gently popped my bubble when he said that the idea of using regression with many variables was unsound. The critique went on to include phrases like "degrees of freedom", consistent with randomness, multi-colinearity and others. He asked which regression package had been used. I explained that I had written my own - that's what was in the three boxes of punched cards. He then went on to describe the retrospective sample bias and the retrospective data adjustments which undermined any study done with the CompuStat data base. In the end my supplication for sponsorship of my project was turned down for reasons which I did not fully understand at the time.

Mr. Dude, I feel your pain!

I now know what the failings of that study were and could probably write the book on it. In fact I have written on almost all of those issues in this forum on previous occasions. The lesson seemed painful at the time but has helped avoid many pitfalls ever since. The lesson to be learned from an experience such as this is not to eschew all industriousness. Rather the lesson is to do it right. Put some of that industry into planning a good research project which will allow data mining and multiple hypotheses but still yield valid statistics at the end. The key is good planning.

Is there a better way?

I find that I like to data mine. Sometimes it will show interesting results even in a non-linear environment. I even have a program which can compute the cross correlations of all 2,000 data series which I follow. That would be about 4 million correlation coefficients and some 200,000 of them would appear "significant" by chance. The downside is that data mining almost always turns up a seeming good result. Such a result is hideously untrustworthy for all of the usual reasons.

Given that I like to data mine I divide the data into old sample and new sample. I mine away on the old sample. I try lots of things, tweak parameters at will and try combinations of variables. In the end pick a single hypothesis and test it on the new data with the hypothesis unchanged.

By the way, after Professor Niederhoffer turned me down to pursue my multi-variable fundamental study, he did hire me to be his Research Assistant.

A submission to the Errors Department, from Patrick Killian

I remember back in ’96 making my only major trade error when I was newbie over the phone right before an economic number came out.

I Called the ML CME desk, "Where is the EDZ6? Where is the EDZ7?"
ML said “The spread is 99-101?"
I say, “OK, buy 250 Dec7 and sell 250 Dec6 at 102.”
ML says, “You want to buy the spread?”
I say “Yes”
A half-second later, ML says “Filled at 102”.
I am looking at the screen and the prices are not moving. I say “OK, buy another 250 at 102 “
ML again quickly says “Filled at 102”
Still the screen isn’t moving, “Ok, buy another 250”
Again I was filled immediately. Thanked him and hung up. What a strange trade. I easily have a tick or two locked in here.

About 5 minutes later, I get the fills. Then the shock hit. I called up the floor desk, “Hey, you guys made a mistake”
ML said, “We did what? No, you wanted to buy the spread.”
I said “Correct, I wanted to buy the Dec7 and sell the Dec6.”
ML said ”Then you wanted to sell the spread,”
Meanwhile I am watching the screen and watching the spread move to 101-104. I said” What do you mean sell the spread?”
ML said, “Quotes are always quoted front month first?”
I said “But ahhh, uhmmm, I told you the months I wanted to buy and sell…. Get me out now.”
I hear some loud screaming over the phone. ML "Ok, you're out at 104 and a few at 105”
I said” Call me back and let’s review the phone tapes.”

Then I amazingly found out the company I worked for didn’t record any of the phone conversations. I could only wait for the return call. Now, I know what I said over the phone, but when they played back that message it was all total gibberish. You couldn’t hear a single word. My god, the feeling I had in the pit of my stomach. ….My boss yells, ”Hey, who do we call for a recording device?“

We evolve until the next error hits.

A song from Rod Fitzsimmons Frey

To the tune of Cole Porter's "I'm Always True to You, In My Fashion"

If my screen shows its a buy,
Or it just catches my eye
As oft as not, the thing gets bought that day!

But I'm always true to you, Galt'n, in my fashion
Yes, I'm always true to you, Galt'n, in my way.

I've a dear but clueless friend
Likes to hop aboard a trend,
As my friend gets rich, I watch my finger twitch -- it's judgement day!

But I'm always true to you, Galt'n, in my fashion
Yes, I'm always true to you, Galt'n, in my way.

There's a list of plutocrats
Who like to give some diamonds back
I must concentrate, but that sell looks great -- and now I pay!

But I'm always true to you, Galt'n, in my fashion
Yes, I'm always true to you, Galt'n, in my way.

Some that sell their market dross
Counting makes them mad and cross
When their math shows cracks, there's always Amazon hacks -- One star, they say!

Still I'm always true to you, Galt'n, in my fashion
Yes, I'm always true to you, Galt'n, in my way.

I can count the S&P
And the bumps of corn and beans
And if oil's a bore, and the west's a chore -- Nikkei!

But I'm always true to you, Galt'n, in my fashion
Yes, I'm always true to you, Galt'n, in my way.

We all love to count and sum
And I trust those meals will come
And when the meals roll in, I'll thank you, Galton -- Hurray!

'Cause I'm always true to you, Galt'n, in my fashion
Yes, I'm always true to you, Galt'n, in my way.

Daily Spec Archives