Daily Speculations The Web Site of Victor Niederhoffer and Laurel Kenner

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January 2006

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Daily Speculations is dedicated to the scientific method, free markets, ballyhoo deflation, value creation and laughter. The material on this Web site is provided free by us and our readers. Because incentives work, each month we reward the best contribution or letter to the editor with $500 to $1,000 to encourage good thinking about the market and augment the mutual benefits of participating in the Daily Speculations forum. Prizes are awarded at the end of each month by the Chair and the Collab. Read the winning December posts!

1/31/2006
God Never Plays Dice, from Sushil Kedia

Though Einstein said this may be looking at a grand design in the configuration of all possible observations, might I be allowed to look at the other possible meaning of this statement. One who does not play dice and takes up sure situations or nearest to sure situations is the Almighty - one who has all the might.

What situations other than a so called perfect arbitrage produce a niche of an idea in the markets where the reward to risk ratio is really highly favourable as a continued process to apply? If situations of no risk are a concept as difficult to comprehend as God or Almighty, are the ones who ride to and then hold to positions of highest strength in markets for ages, like the palindrome or such of his rare few equivalents, creating edges as the creator might have?

If the final extension of finding edges is to finally create them, then do the ones who get into creating market moves not end up as the brothers who hunted gold?

What is the sublime dividing line which should be the endeavoured goal of finding edges but not bordering beyond creating self-fulfilling prophecies? To bother about such questions cannot be irrelevant even if one is riding the ocean of the markets with a paper boat, for all boats of any size could prove to be built of paper only.

1/31/2006
Tyler McClellan on Eugene Fama

The Chair has frequently noted the intellectual environ from which he arose in the turbulent decade. The windy city, the south side, Jim Lorie, George Stigler and a lost car or two seem to have imparted a unique vigor to those graduating classes. Below however is excerpted the investment philosophy as written on the website of Eugene Fama's DFA of a sometimes intellectual adversary. My question is what is so fundamentally wrong with the position below? In contrast to the many billions America would lose should the majority of her investors fund the Sage's selections instead of Google, Intel, Yahoo, (yes even corrected for the retrospective bias and always picking winners), investors who follow the advice of DFA seem to get it more or less right. I await my comeuppance.

Quoting:

"The efficient markets hypothesis holds that markets are full of people trying to make a profit by predicting the future values of securities based on freely available information. Many intelligent participants compete to trade at a profit. The price they strike in trading a stock is the consensus of their opinions about the stock's value. Since the price is the same for everyone, so is the value. The price the market strikes is therefore based on all the available information about a stock, everything the investors know that has happened in the past and everything they predict will happen in the future. In this sense, markets assemble and evaluate information so effectively that the price of a stock is usually our best estimate of its intrinsic value."

"Prices are not always perfectly correct, nor is that a condition for market efficiency. The consensus view of investors can temporarily result in prices well above or well below a stock's intrinsic value. The only condition efficient markets require is that a disproportionate number of market participants do not consistently profit over other participants. Since "mispricings" tend to occur in both directions and since managers seem to over- and under perform with random frequency when adjusted for risk and costs, markets seem to be efficient."

GM Nigel Davies adds:

I'm reminded of a particular talented but food-loving Grandmaster who goes to tournaments to eat rather than perform. He once persuaded the organiser of a particularly tasty tournament to give him hotel and board from rounds 4-9; due to a prior engagement he couldn't make the first 3. Of course this meant that he had no chance of winning one of the top prizes, but he'd still get 5 lunches and dinners.

The real game has been not to beat the indices at all, but rather to feed fund managers with the money they charge the public. So another of Fama's assumptions is wrong.

Dennis Vako comments:

The efficient market hypothesis is a brainwash, alike the purpose of the current educational system; that is to make a Chicken Little out you, so you won't even try and will have plenty of eggs to give away for free.

It does not adjust, at least for the following:

  1. Not all see alike - that is process information, interrelationship, causation in the same way.
  2. Even when one sees, one may have legal constraints, other obligations and the size going against one.
  3. Performance evaluation horizon could be a big handicap.
  4. Nothing even mentioned about incentive, I hypothesize that fed and hungry will have different risk profiles.

Laurel Kenner asks:

Might the distinguished student from Yale consider the possibility that the famous professor has fallen prey to the part-whole fallacy?

Do swings from wild optimism to despairing pessimism necessarily mean that individual results are random?

Could a student seeking to Niederhoffer the market come up with a method that counts inefficiencies while weighing the presence of randomness?

1/30/2006
A Letter on ROE, from Reader Aaron Koral

Dear Dr. Niederhoffer:

I just came across your post on ROE. I just wanted to bring up some quick points regarding your inquiry. The first point is that ROE is calculated in a number of different ways. One way is to simply take net income and divide by average shareholder's equity. Another way to calculate ROE is by taking net income, subtracting preferred dividends and dividing by common equity. Finally, there is the DuPont method to determine ROE.

I guess what I'm trying to get at is, if you plan to test whether ROE is a predictor of future stock returns, make sure you identify the methodology by which ROE is calculated. The results of your study may differ by the methodology used to calculate ROE.

Another point, as you mentioned, is a company's payout ratio. An excellent paper by Cliff Asness and Rob Arnott called "Does Dividend Policy Foretell Earnings Growth?" delves into the issue of payout ratios and whether they foretell future earnings growth. The math is a little difficult to comprehend for a poet like myself, but one can definitely understand the qualitative results in their work.

Finally, you asked "...what other factors beside industry...might affect the relations posited above." I would argue that total asset turnover, from the DuPont method of calculating ROE, would be a very important factor that can affect the growth in a company's book value. One would need to ask whether a company with high asset turnover and low profit margins (think supermarkets) is worth paying more for than those with low asset turnover and high profit margins (think software manufacturers).

Here's hoping your next trade is a profitable one.

Sincerely,

Aaron Koral

1/27/2006
Website Musings, from Shane James

Dear Dr. N.

I have previously conversed with you from Australia and now I am back in the UK to set up my Hedge Fund. Having been an avid observer of/convert to the Niederhoffer style over the past decade I must now say a few things:

Does it not concern you that many of the posts to your (and Ms. Kenner's) site by various contributors have become/are becoming a little 'touchy feely' and too long on metaphor ?

Back before 1997 when you were having 20 straight months approx. of gains there was no website, you were not encouraging others to count etc. Has encouraging others degraded the art ? (I know that Matador's returns are also exceptional. However, I know of two analysts at significant trading houses whose primary role involves trying to figure out what you do)

I guess when you started your idea was to help the small investor trade shares but now because of your recent numbers smart people/elephants are coming for you.

What I am saying, respectfully, is:

1. The website is losing its edge for me (but that's just me)
2. They have deeper pockets and they are coming.

From one trader to another,
With Respect,

Shane James

1/27/2006
A Letter on the Yield Curve, from Steve Leslie

Mr. Tar questions the validity of a flat or inverted yield curve. He infers that explanations with respect to the bond market from unnamed individuals and other sources are somehow wrong and that the economy is nowhere near to slowing down. Is he suggesting that there is a conspiracy underfoot? Was there actually someone else on the grassy knoll with a gun?

He further posits that somehow the markets are wrong this time and they should not be this way. His anthropomorphism with respect to the market is very flawed. One cannot give life to something that in essence does not exist outside of your mind. It is a canard. An illusion. Securities are by definition intangible therefore they are impalpable, and as such not to be identified by the senses. It does not make sense nor nonsense. Without becoming too esoteric or bellicose let me explain.

First to quote Bill Parcells, coach of the Dallas Cowboys " Your record is what it is." So therefore the markets are neither right or wrong rational or irrational, they are what they are. They are a dynamic collection of instantaneous mass thought and sometimes hysteria. and it is up to the speculator to work within the framework of the markets and discern the direction of the vehicle, not its validity.

Trust me, fortunes have been lost by arguing with the markets whichever markets one chooses to argue with. It is truly the six hundred pound gorilla at the bar. As the joke goes, where does a six hundred pound gorilla sit in a bar? Anywhere he likes.

Second, as I have stated many times with my clients, cash in and of itself is valueless until it is converted to something. And then converted to cash again to be converted to something else. A conundrum to say the least.

So the speculator takes said cash, converts it to a bond, a stock, real estate, collectible, etc., in the expectation and hope that he has discerned the correct direction of the price of the asset, so ultimately the value of the asset will have changed in his favor and he can then convert it to cash and then again to something else. Thus the cycle never ends and if it is a game then neither does the game. And by the way, if it is a game it is one that cannot be ultimately mastered nor conquered -- kind of like golf.

So in summary, respect the game for what it is and nothing more and try not to become promethean during the interlude.

1/27/2006
A Letter on Pitching Strategy, from Rodger Bastien

Stop already with the baseball thesis, compliments of Mr. McDonnell! As a former baseball player in college and the minor leagues I can say that about the only thing he has right is that baseball players possess a very difficult skill set. Though his description is harmless, it is neither informative or descriptive, so sophomoric and simplistic is its content. The game he describes is the game he played and is played by most amateur ballplayers. Good college and professional players indoctrinated to sliders and split-fingered fastballs would salivate at a nice juicy curveball once in a while. With all due respect, if Mr. McDonnell hit inside pitches as he described ("stepping in the bucket") it's no wonder his fledgling baseball career ended prematurely.

In reading this post I do see a useful application to our speculative endeavors, however. Realize that reality is not the sum of your own speculative experiences unless your own resume is long and varied. It's not only what you don't know that will do you in, it's what you THINK you DO know.

J.T. responds to Mr. Bastien's Bashing of his friend Phil

You know I collect baseball cards so I thought I would try to find this guy, Rodger Bastien . He evidently played baseball at Michigan St. in college and was drafted by the Texas Rangers. From 1976-79 he played very well and got Conference Honors for that play. He was in the top ten in Runs and Doubles for the school in those hitting categories and top 10 in assists for double plays (he was a Shortstop). Also, on a Google search I found that he was named Big 10 in baseball a few times.  Most notably, he once went 5-6 w/ two homeruns and hit for cycle in that game against Wayne State on April 25th 1979. He didn't have a baseball card, not that that matters, but as he stated he was in the minors.

The thing I am most envious of though is the fact that he hit a hole-in-one on April 26th '05. I've played half my life and haven't gotten a hole-in-one.

I looked up this background out of anger at his lashing out against Phil. I consider Phil a friend and he has helped me tremendously. Oh well, Mr. Bastien is definitely entitled to his opinion and I guess he is definitely qualified to talk about hitting! The big question is "can he trade"! I'll put my money on Phil, unless it's in the month of April where this guy seems to have lady luck on his side when it comes to right tail outliers!

Mr. Bastien responds to J.T.

Sir,

My intent was not to bash your respected friend, Mr. McDonnell but rather correct some glaring misperceptions while hopefully adding to the enlightenment of the readers of these posts. I love baseball, although creaky knees and arthritic elbows have reduced my participation to mostly coaching these days. (By the by, you did short-sell me a little bit by not mentioning one of my proudest achievements which was All-America recognition in 1978 and three holes in one to my credit :-)). My knowledge of the game is second nature to me, established through thousands of repetitive actions and experiences over several decades, something I am sure Dr. Brett would understand and appreciate.

As for my own trading, I do quite well using the same types of disciplines honed on the baseball diamonds. That said, I gravitated to these pages hoping to improve my knowledge and abilities and understanding how much, even after 30 years of trading, I still need to learn. That is the lesson to be learned both in baseball and in speculation, I believe.

Kind regards,

Rodger A. Bastien

Phil McDonnell explains:

Who knew baseball could be so controversial? The phrasing used in my earlier post was "(the batter may) possibly step toward his power field". The word "possibly" was chosen to acknowledge that there are differing schools of thought on the matter. For example one modern school of thought is to target your hits from "gap to gap" meaning the left center field gap to the right center field gap. The reduced target requires less foot movement and some would say none at all. In that sense Mr. Bastien and I have some common ground.

He is quite right about my failings as a hitter. Even when I had the very dubious distinction of the highest batting average on the team they still made me bat ninth in the order. The Cal coaches just said something about pitchers always bat last.

It saddens me to reflect upon the four Little League teams I coached. On each of those teams of 12 players at least one player was later selected in the Major League draft. Of the eight teams I coached, every one placed first or second out of from 10 to 34 teams depending upon the league we were in. The two years I spent coaching (girls) Little League Softball we finished first and second in the State. We can only wonder how much better the kids might have done if I had actually known something about the game.

**Please note that aside from their differences Mr. Bastien, Mr. McDonnell and Dr. Steenberger all agree that hitting is an art and that Ted Williams's The Science of Hitting is a great book with many market applications; many of which Victor and Laurel have addressed.

Mr Bastien continues on Vic's review of 'The Science of Hitting'

I read and enjoyed your piece from MSN on this book. For someone who professes to be an inexperienced ballplayer you have a tremendous insight to the the game beyond the game. Or is it because there are common threads that run throughout all of our games, including speculation and even life itself? I am working on "augmentations" to the baseball/speculation scenario which I hope to forward in the near future. It has sparked a memory of 1982 which began my apprenticeship into my 2nd greatest love and passion, this investment business ... I was a humbled, suddenly ex-ballplayer, sulking, quite grudgingly giving up on my dream. I picked up the financial pages one morning and stared at the stock quotes and became immersed in the similarities to these and the batting averages of the Big Leaguers I memorized from each Sunday's newspaper. Funny where the spark comes from sometimes.

1/27/2006
A Permabear Perspective, from Mitchell Jones

If I read you correctly (in your article of Jan. 23, entitled "A Horn of Plenty of Bearishness"), you believe that the so called "permabears" i.e. those who expect very bad things to happen to this country, and have had such expectations for decades--"hate life itself."

Well, I strongly disagree with that judgment. In my view, the vast majority of such people, myself included, are motivated by a belief in moral law -- to wit: that evil deeds have evil consequences.

Hopefully I do not need to recite to you a list of the evil deeds that have been perpetrated by U.S. political authorities in the last hundred years, or to describe the paroxysm of pure, vile, monstrous evil unleashed by the two most recent American presidents. As a literate person who presumably reads the newspapers and keeps up with current events, you should be fully aware of these matters already.

Well, to those of us who believe in the action of moral law, such a gathering of darkness must have very bad consequences, not merely for the specific victims of specific misdeeds, but, ultimately, for the country itself. Hence believers in moral law are guaranteed to see the present world "through a lens darkly." They don't do that because they "hate life itself," but because they understand what evil is, and where evil ultimately leads.

1/26/2006
A Letter on the Trade Deficit, from Donald Boudreaux

To the Editor of Boston Globe:

Political cartoonist Dan Wasserman misses the mark in blaming Alan Greenspan for the trade deficit and the government's budget deficit (Jan. 26).

First, contrary to Mr. Wasserman's claim, the trade deficit itself isn't debt. Although America's trade deficit rises when foreigners hold dollars, for example, no American has any debt obligations as a result. Second, the budget deficit (which IS debt) is caused by reckless spenders in Congress and the White House. Indeed, we should thank Mr. Greenspan for not reducing this debt by monetizing it. Had he done so, we would now be in the throes of high inflation

1/26/2006
A Letter on the Recent Market Moves, from Steve Leslie

I know little about baroque music and I would be hard pressed to differentiate a movement from a sonata. That said, I think on your hypotheses.

I submit a few thoughts to you. Freud said, and I may be paraphrasing, "Sometimes a dream is just a dream." My point is can it be possible that there may not be a deep explanation to the actions of last week in the U.S. markets? Doctors tell me that during their gross anatomy classes, they find veins, arteries and nerves that weren't supposed to be in certain places were. They call these anomalies.

Could it be that a butterfly fluttered its wings in Japan and caused an emotional tidal wave that hit Wall Street? Is it possible that there was an extraordinary concurrence of sunspots on Friday or that some numerological sequence occurred? It's possible of course, and I am sure that there are some very bright people who might run it through Deep Blue or Hal 9000 and come up with a Monte Carlo simulation to formulate a probability.

Or is the market in its inestimable wisdom telling us that it is tired of fighting the Fed's umpteenth interest rate increase and needed a Southeast Airlines vacation? Need we look no further than the inverted yield curve to supply us with the answer to our question? In any case, I believe in the dictum that the market is smarter than any of us and if there is no current news to explain an event, stick around, there soon will be.

To Mr. Sears' write-up on trade executions, I recall John McKay's comment after his Tampa Bay Buccaneers lost another game on the way to the longest-losing streak in professional football. He was asked about his offense's execution and he replied sardonically "I am all in favor of it."

1/25/2006
George Zachar on Warren Buffett and 1984

The U.S. trade deficit is a bigger threat to the domestic economy than either the federal budget deficit or consumer debt and could lead to "political turmoil," billionaire investor Warren Buffett warned.

"Right now, the rest of the world owns $3 trillion more of us than we own of them," Buffett told business students and faculty Tuesday at the University of Nevada, Reno. "In my view, it will create political turmoil at some point. ... Pretty soon, I think there will be a big adjustment," he said without elaborating. Article continues ...

In Orwell's 1984, Winston Smith's girlfriend, Julia, theorized that the periodic bombing of London was done by its own government to maintain a level of desperate tension in the populace that made them easier for the Party to control.

I wonder how much of the Doom-meme bombardment is a parallel psychological gambit, to ease manipulation in our contemporary economic and political spheres.

1/24/2006
J.T. Holley on Asking the Right Questions

Your post on asking the right questions was highly useful, I deeply appreciate such a gem. Constant reminders of the basics and the principles are the keys to success. The ability to ask the right questions is something I think people on Wall St. veer away from. It is more often than not seen as a sign of weakness. I feel that most of those on top of their pedestals and perched high in their ivory towers have trouble asking questions out loud in fear of denting their pride and embarrassing themselves. It is like the very degrees they attained are roadblocks from being youthful and inquisitive.

I of course have very little pride or shame, so I have no difficulty in asking questions. Where I err in is using them as a shortcut. I think that I used asking the right questions in school as a mechanism to avoid doing the work and mooched off of others labor. This is something of a bad habit that in my mid twenties I had to shed if I wanted to truly learn. This was very difficult, and being able to ask questions for inquisitive reasons is as important as breathing. It is one of those times in my life where I took the path of least resistance and it is a hard habit to break. I am working on it though, constantly.

1/24/2006
Dean Tidwell on the NBA's Kobe Bryant

The problem is this. 81 is amazing, especially in this day and age, however, what is the goal? Is it to simply win a basketball game? A conference championship? Or is it to win an NBA title? Are personal accolades more important?

Unfortunately, Kobe has made his choice. This is why 'Shaq' is no longer there too. I have a problem, even when watching an amazing feat, when the accomplishment is done in the fashion in which he performs it. Against Dallas last month he scored 62, I think in 3 quarters. What defined his performance for me though was when his teammate was knocked down hard, and while other Lakers were attending to their teammate, Kobe was looking from his bench side seat, as they had a big lead, smiling and mouthing rather looking the least bit concerned.

This is typical of my generation. It is all about one-upmanship or looking cool. Give me rap, a tattoo, a cell phone that talks, a cig, and a beer and I'll show you what is hip today. This is sad because I want my kids to look up to some athletes. Hell, my heroes were Barry Sanders, Nolan Ryan, Larry Bird, Michael Jordan, Jack Nicklaus, Ivan Lendl and my dad. I was lucky though, I had many to choose from.

01/22/2006
Steven Leslie on Laurel's Tribute to Her Mother

I read your memorial to your mother and was struck by it. What a wonderful tribute to give to her on the anniversary of her passing. Your eloquence and sensitivity reached out to me through hyperspace and innerspace, and for this I must humbly and respectfully thank you.

It was your tribute that helped remind me of my mother.

I noted some remarkable similarities. My mother also had a very difficult illness thrust upon her before her passing in December 2002. She was struck with Bulbar ALS (scientific jargon for a rare form of Lou Gehrig's disease). Her illness destroyed her ability to speak 1 1/2 years before her death. It is unquestionably one of the most brutal and vicious diseases I can imagine. I was her caregiver for the 2002 calendar year.

She, like your mother, had a great admiration for the arts, especially dance and music. She instructed me in ballroom dancing, drove me to music lessons and never missed a swim meet nor a bowling tournament that I competed in. She was an exceptional person. The strongest person I have ever met despite her diminutive stature. You see she was but 4'11" and not more than 95 pounds. Size was clearly not her long suit, but her heart was. Indefatigable and tenacious like a wolverine. Her children were her life.

I would accompany her to the theatre, and she marveled at musicals. How I remember Seven Brides for Seven Brothers with such vivid clarity. Although we went together to these events more than 30 years ago, I could tell you exactly where we sat and what I had to eat afterwards at the restaurant. As a sidebar, she always had me order for her, and pay for the tab with money she handed to me under the table.

I write to you to thank you for helping me restore these long lost memories. Your memorial to your mother was the catalyst for this epiphany.

There is no force on this planet greater than a mother's love. You understand this, I know!

Yours Truly, Steven Leslie

01/21/2006
J. T. Holley on the Pinewood Derby

I have had an unbelievable speculative/competitive experience over the last two weeks that culminated today at 12 o'clock. My son is a Tiger Cub in the Cub Scouts and he had the Troop's annual Pinewood Derby. It is something that brought out the competitive juices in all involved, to win the coveted trophies and ribbons at stake. Secrets were kept tightly over the last two weeks, monies invested in the 50 dollar range for potential edges by parents. Kids were lined up against checkered flag tape like old timers against the rail at a horse track.

The competition was tough but my son brought home the 4th place ribbon losing only by a 1/10,000th of a second to the car in the show place. If anyone wants to see this demonstrated via a movie then rent Down and Derby with Holly Hunter and the late Pat Morrito. Incredible - you would've thought that you were in the middle of a trading pit or open market exchange if present.

J. Lamberg adds:

This brings back memories. Years ago I had two sons in the same Pinewood Derby. The rules were quite lax and my sons had an engineering dad. Besides the usual center of gravity, wheel placement, weight, and wheel balance techniques, they each ran a car with modified wheels - turned to a thin edge in the center and packed with moly lubricant and a "hubcap" to keep the lubricant sealed in. The cars blew away the competition and I had to make sure they did not compete against each other during the elimination rounds. The cars took 1st and 2nd. Next year the rules changed as many of the parents cried foul. It was nice to see my sons win, but one has to consider who the race is for -- the kids or the parents.

In retrospect, I'm not sure I would do it that way again.

Kim Zussman writes:

When my daughter was in 5th grade there was a science assignment to make a solar oven capable of cooking a hot dog. One helped a bit by showing how parallel rays from the sun are reflected to a point by a paraboloid, and that to heat a cylinder (outside of Ikea), one should construct a parabolic hemi-cylinder. We used perf-board to plot the parabola, and nails along the curve to anchor the reflector fashioned out of an unrolled cookie can. The focus was determined experimentally, and marked with a long clean nail for the hapless weenie.

The year was 1999, so we named it SizzlingWiener.Com, much to the puzzlement of the teacher (who couldn't object too much since it worked).

Last summer this same daughter (now in high school), studied at a college on the east coast. She was alone in a large poorly lit dorm room, which she approached with the same resourcefulness as some spec-listers. She stacked her suitcases and boxes, covered them with sheets, and topped them with desk lamps bearing sunglasses. Many of the other kids came to see her robots, who were all named after various infamous family members, including Walt Crying. It seems that at a recent family function Walt choked up while reminiscing about the missed opportunities of his college years.

Kim

1/20/2006
A letter on underestimating your hand, from Steve Leslie

Living in Florida I learned how to play poker on the daily cruise ships the so-called trips to nowhere. Described as such because they have to travel beyond the 3 mile limit along the Florida coast before they can offer gambling activities. Then they wander aimlessly in the ocean, not unlike many of the souls who were passengers on the ship.

The most popular poker game offered then was seven card stud 8 or better. This was long before the huge popularity of hold-em poker took over. Now unfortunately, one would be hard pressed to find 7 stud 8/better spread anywhere in Florida.

I learned the way most poker players learn, I suspect, by losing and losing often. Thankfully the stakes were small, so the curve was not too expensive. One thing I began to notice after a few sessions was that there were plenty of action players, guys who threw money around, the conversationalists, but the ones who accumulated the chips were the old guys, the real quiet ones. They spoke little, drank coffee, played just a few hands per hour and neatly stacked their chips in front of them. You hardly even knew they were at the table.

Once I gained a clear knowledge of the game, the fundamental aspects, I adopted the old guy style, and magically my win percentage went way up.

As I think back on those days and I am sure many of those old guys are gone now, I smile inside knowing now how they felt to drag a few well deserved pots their way.

Steve Leslie,
Melbourne, Florida.

1/20/2006
A Letter on the old Friday-Monday Relationship, from Martin Lindkvist

Are you still doing that up-and-down Friday-Monday stuff you used to, or have you progressed? Before I could answer", Soros chimed in, " I am afraid he's doing exactly the same, hasn't progressed at all." Ed. Spec p. 272.

"The next extension was to combine momentum with seasonality. For example, the action on Monday might be particularly bearish after a Friday that acted less favorably then the norm." Ed. Spec p. 274.

With S&P data from one of Steve's files, covering the period Jan. 1, 1996 to Sept. 30 2005, I find the following:

Monday return after up Friday: 0,1155%
Monday return after down Friday: -0,0018%

Cycles have changed and Monday is not as bearish as it used to be when the Chair used this phenomena to make "my immediate and extended family of customers a substantial nine figures" (Ed. Spec p. 274). Indeed, there was during the tested period a slight positive bias for Monday to be up if Friday was up, but it is not statistically significant with a t of about 0.6. Also it is not a big enough bias to trade on. There are however, many applications for the combination of momentum with seasonality, and there are many meals to be found with this method. Now, if I only had a big plate (of capital) to put my meals on.

1/20/2006
"Absolute price is like hitting a curve ball," A Letter from Joe Hughes

Absolute price is directly correlated to one's level of risk tolerance and their distance physically and mentally to a successful transaction.

i.e. Who has not said, "Get me out of this long/short now!" And subsequently puked in the nearest waste basket at the booked loss and subsequent price reversal?

Or pushed the "I'll get gas at the 'next exit' envelope, on a bitterly cold winters evening, only to have to suffer the mental machinations of watching the needle hover perilously close to certain disaster, or worse, actually run out of petrol on that freezing cold highway? Ten bucks or more a gallon is the absolute price at that moment.

Supply and demand. Perception and reality. That is what drives prices. And the absolute price is whatever one is willing to pay or receive at that moment. And then it changes. More buyers or sellers at the same or different levels of need or price/risk tolerance. No magic. No voodoo.

Many individual variables figure into "one's own" absolute price, transaction time frame, objective and risk tolerance come quickly to mind. "The Chair" has graciously made public the best method I was ever shown; by one of his students some 20 years ago, and statistics and counting will not fail very often. And one can tell fairly quickly if your entry or exit point was correct, as you will not get filled, and you can now proceed to hit bids or take offers with confidence, for at least the short term.

Outside of sitting on a desk with a big stack of orders, coupled with my fellow trader buddies orders across the street where we decide the absolute price is here and now. "The Chair" has provided undoubtedly through experience.

Although I confess to being a recovering TA, I do allow myself to slip and combine statistics and counting in combination with viewing charts. This provides a couple of advantages, it helps to visualize the anticipated price action primarily, and secondarily, long ago I learned that just because I do not utilize or ascribe to a certain method of analysis, that does not mean I should not be aware of the exit and entry points that maybe generated by such methodology. Even full moons. And the bigger the players that use the methodology that one does not ascribe to the more one should be aware of the signals they generate.

Finding absolute price is a lot like hitting a curve ball, one first has to be able to identify it as such. The minors are littered with ballplayers that can't hit a curve, the same can be said of traders. Know the count, and you are more likely to be able to guess what pitch is coming, and if not make solid contact, you can at least foul it off.

1/20/2006
A Letter on Teddy Roosevelt, by Steven Leslie

I remember the famous statement by the Chairman of the U.S. Open Golf championship who in response to a question as to the difficulty of a particular course remarked " We are not trying to embarrass the world's greatest golfers, we are attempting to identify them."

This leads me to my discussion.

Presidential historians generally consider Lincoln, Washington and Jefferson as our greatest presidents. It is by more than coincidence that they are forever enshrined by their busts on Mount Rushmore. Although they had many accomplishments, for my money I will take Theodore Roosevelt everyday of the week and double down on Sunday. I will not bore you with the details of his accomplishments however lengthy and impressive as they are. If you really want to know the man, I would recommend Edmund Morris's account on his life. I would also suggest you read the Alienist by Caleb Carr an outstanding book in its own right but Roosevelt's character appears in an interesting and semi-biographical role.

I would like to briefly mention some overlooked but interesting facts about the man. He was born sickly and asthmatic. His father died when Theodore was 20 years old. 5 years later his wife and his mother died on the same day in the same house and two days after his wife gave birth to his only daughter Alice.

He then moves to South Dakota and has his herd of cattle wiped out by a blizzard and his entire $60,000 investment in one cruel winter.

Through it all he returned to New York, buys his estate in Oyster Bay fathers 5 more children and establishes an enormous career as a public servant a politician adventurist and statesman.

We all get dealt some cruel cards in life. Some worse than others. We have no control over what they are and when they shall come. Some are dealt more cruelly than others, but it becomes the true test of the man as to what he does after he receives the wicked slap of fate and his response that will forever define him and exhibit his true character.

I leave you with one of the greatest quotes by Roosevelt or anyone else.

"It is not the critic who counts: not the man who points out how the strong man stumbles or where the doer of deeds could have done better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood, who strives valiantly, who errs and comes up short again and again, because there is no effort without error or shortcoming, but who knows the great enthusiasms, the great devotions, who spends himself for a worthy cause; who, at the best, knows, in the end, the triumph of high achievement, and who, at the worst, if he fails, at least he fails while daring greatly, so that his place shall never be with those cold and timid souls who knew neither victory nor defeat."

"Citizenship in a Republic," Speech at the Sorbonne, Paris, April 23, 1910

Respectfully, Steven Leslie

1/18/2006
Games in Belpre, Ohio. A letter from Alan Millhone

Dear Mr. Niederhoffer,

I took an extra day last year and visited Mr. and Mrs. Fortman in Springfield, Illinois. I had no idea he had all those games for many years in his collection. Mr. Fortman and Mr. Loy did all the work on the games, etc.

Another player, Mr. Long was from Ohio, along with Tinsley and Moiseyev. Ohio has produced some of the World's best players and these three World Champions of Checkers. Our 3-Move Nationals will again be in Ohio, (Medina), this year. A fitting tribute for Ohio and its roster of champions.

This year is also the 250th anniversary of the first work in English on Draughts, in 1756 by William Payne. Do you have a copy in your collection?

On a lighter note I just now visited my favorite local sandwich shop to get 2 ham and cheese sandwiches. The owner told me that there would be no tomatoes today as her supplier quoted her a price of $50.00 for one case! Maybe tomatoes are competing with oil at $66.00 a barrel?

Best Regards, Alan

1/17/2006
President Corzine? A Letter on Political Posturing from Stefan Jovanovich

Vic, Laurel:

The move to governor is the smart one for Jon Corzine if your ambition is to be President. The record of Senators running for President is abysmal. The record of Governors is quite the opposite. There were only two Senators elected President in the 20th century who moved from the Senate directly to the White House without first becoming part of the Executive as Vice-President - Wilson and Kennedy. Given the Kennedy and Fitzgerald family's combined hold on Massachusetts state politics, you could argue that John F. Kennedy had more direct control of local precincts in his state than Taft, Coolidge or either Roosevelt ever had as governor. Wilson - like Governor Clinton - is the outlier; both men won their initial races only because the opposition party split and the election became a 3-person race.

Corzine is certainly shrewd enough to understand this fundamental rule of American electoral politics. I also think he is clever enough to anticipate that Mrs. Clinton will lose and that sometime in the next decade there will be a "slump" severe enough to make a "moderate" Democrat an attractive candidate as an economic savior, especially one who can point to his record of financial and political executive experience. I am not predicting that this will happen, but it is, if you have Mr. Corzine's ambitions, the only play.

Stefan Jovanovich

1/17/2006
Of Mirrors and Magnifying Glasses in a Flattening World, by Sushil Kedia

Company A, listed on the American Stock Exchanges outsourced processing work to another company B, for total billings of 2 Billion USD saving in the process 1 Billion USD. With a prevalent P/E ratio of 20, company A's stock saved an erosion of 20 Billion USD worth of market Cap.

Company B, whose stock trades at a P/E ratio of 30 because so much of its business is in the rapidly growing outsourcing industry enhanced its market cap. by say 7.5 Billion USD, assuming 25% Net Profit Margin on such a business.

A total gain of 20 + 7.5 Billion USD in market cap between the two companies A & B, while the wage earners employed by Company A lost out the opportunity of earning wages of 1 Billion USD.

In this exercise, the goal of Corporate Finance, i.e., enhancing shareholder wealth is achieved. In the larger so called national interests and the assessment of the economy at large does the gain of 27.5 times wealth in stock valuation surpass the shifting of wages to other corners of the system?

If such outsourcing is "outside" of the system into another "nation" a big debate and a big protest unfolds. Assuming an average Income Multiplier for an average nation of 6 or 7 the maximum GNP loss for an outsourcing nation is say 6 or 7 Billion USD in this example. Even then the gain in Value more than makes up for the loss of such wages or income. Now, this paradox rises further when company B has more than half of its shareholders in America and more than half of its market cap. listed in America.

Furthermore, if company A happens to be one company that operates from across the globe in 180 countries and may be 3600 cities and such outsourced one Billion Dollar of wages per annum are shifted from across the whole globe, the question of wage loss and GNP loss become redundant further. In an ever-more flattening world will the conventional measures of GDP and GNP lose relevance, if they already have not lost it yet? Is that one possible explanation of why worrying over rising budgetary deficits of various Governments has not helped many become better currency investors?

Also, the magnifying glass of a concept such as P/E or discounted to present future cash flows could with the use of mirrors such as these be put to serious malfeasance as well. For example, if a company A invests just 1/7.5 of the outsourced wages or 133.33 Million USD through a web of investment funds into acquiring say half of the available stock of company B listed elsewhere on the Globe, it could still gain a Billion Dollars of investment profits. If the market is not going to grant company A's other income arising in this way a P/E ratio more than half of its operation earnings, then too the market cap gain in company A would rise a further 10 Billion.

It's all great while the magnifying glasses are focused at the correct distance and the mirrors are aligned at 0 degrees. What starts happening when they start asynchronizing?

What may be the change in circumstances in which P/Es would start flattening out if the world is actually flattening? The risk of playing passively as investors in such games of mirrors and magnifying glasses really is in not being able to imagine and estimate the variables that would lead to a global shrinkage of P/Es as and when or rather if and when that comes. But before that could be answered, why if at all P/E ratios should make so much sense?

1/15/2006

A Letter by Orson Terrill, On the Similarities between Trees and the Markets.

Your note on patterns of life inspires the following observation

The comparison from a stock to a tree (and branches in general) in terms of limbs offers more insight than at first scratch. Limbs of a tree, their structure, are representative of multiple time frames, you see a long term and a short term all in the same story. Their smaller ends of limbs are still very susceptible to the many random variations that its environment may impose upon it. The larger part of limbs may only experience change in the very improbable circumstances of some catastrophe; they are part of the longer story, and they exist where the *successful* probing of smaller shoots occurred some time before. The resources of the limb grow in length, diameter, and in number of new shoots relative to size of the previous.

I have tinkered with this between work, classes, and other "little" models that are under construction. I attempted to create a "yield curve" of a stocks percentage gains from the very long term at the left to the very short term to the right. The market cap is a sign of the successful growth, so the capitalization is assigned to the "seeking prices" of the past, not the current day to day fluctuations...I haven't had the chance to study it more across many stocks, and importantly refine, to see what it has to say more than what I may want it to say about reversion towards the longer trajectory. I am embarrassed enough by sharing any "thoughts" as is so a presentation would be premature. (though I have a feeling an expansion of the idea to price spikes (in either direction) to give an idea of what a particular stocks "branch cycle" may look like; what I am saying has greater value than what it may seem on a passing read).

Is there a ratio to which one can measure the growth pressure of a limb relative to the resources it has in the tree, and see if they are similar in dendrites, and the roads of our cities (which are like arteries leading to massive organs where we ideally serve the greater good of the organism)?

In the analogy of the road, the size of the city, the number of people desiring to take a certain path, should create pressure to widen the road, create smaller branches, which are dependent on the wider road's traffic. There are roads in poorly planned small towns that were built way out of the way for some far distant neighborhood for a town that has never seen that type of growth; and the road grows in with grass and waits. For instance a road that splinters into may branches, much more than normal, those branches would have to be shorter in length, as the demand is not the same for the distance between one or two as it would be for many.

Is there a ratio that could describe the kind of pressure in an artery and how that creates the growth of many SUCCESSFUL capillaries, and is the length/number of SUCCESSFUL capillaries largely dependent on that "pressure"? Does that ratio duplicate from veins in a leaf, highway planning in cities (though some government may be a perversion of nature.) Maybe this would be predictive of failed offshoots? Failed rallies, failed ventures within a company.... That point when the growth really was too much. Or, when there has been too much cash built up in prediction of many offshoots exploding out. Like Microsofts' huge cash holding creating pressure for many, many ventures....(alas, not necessarily a prediction of stock gains, but on which time horizon?) Also an entire market may be viewed as a tree or organism. So if there are 10 video game stocks, each one may be analyzed as a branch within this framework.... (also Value Line-esque approaches can seen in this framework; increased cash in the pipeline relative to geometric gains/interest rates/competing assets etc predict....)

For instance, my father, an intelligent engineer/botanist/painter/musician/once "homeless" adventurer can know about how many offshoots the specialty plumerias he breeds will produce over a given series of years. Of course it is dependent to its healthy growth, but it is exponential until a certain size. The plumerias thickness in its base and major stems hardly increases in thickness, encouraging new shoots to fail, and break off when they get too heavy for the plant to bear in its environment. Mergers and acquisitions can be found here in plants too, like grafting two plants together. You can watch how resources are diverted from growth in the individual plants to create a successful grafting; one which usually scars the plant over the long term. The most successful graftings come from closely related and very similar plants, right, a subject you know far more on than I. (M&A)

1/10/2006
A Book Recommendation from J.F. Allen

I haven't seen mentioned in Daily Speculations the very well written "Fortune's Formula" by William Poundstone. It entertainingly weaves gambling and the market together in support of those who have proven that there is no efficient market. The Kelly Criterion should be understood by every spec.

1/10/2006
Donald Boudreaux's Letter on Taxes to Washington Post

Dear Editor:

Sebastian Mallaby insists on "making the tax system more progressive" ("What Democrats Miss in Bushonomics," Jan. 9). Unfortunately, this task is nearly impossible. Currently, the wealthiest 1 percent of taxpayers pay 34 percent of federal taxes, even though this group's share of adjusted gross income is only 17 percent. Their average tax rate is 24 percent. The top 10 percent of taxpayers, whose share of adjusted gross income is 42 percent, pay a whopping 66 percent of taxes.

The bottom 50 percent of taxpayers pay less than 4 percent of taxes - on an average tax rate of 3 percent.*

1/9/2006
An Avid Reader responds to "The Speculator as Hero"

One line struck me from your 1989 piece.

" The increased yields have such a negative and immediate impact on government revenue, business activity, and consumer spending that governments have all but given up trying to sneak increased spending past the market."

1. Not only has the government found a way (by reporting a distorted "core rate" inflation) to spend at ever increasing levels, long term yields have not gone up. The Nash Equilibrium with Asian countries buying our treasuries, keeping rates low, so we can buy more goods from them to jumpstart their economy is the reason behind this.

2. If that stops working ( The recent runup in gold is shining a light on this no inflation farce), find another way.... hide the M3! Woops...I think they said they will!

Mike

1/9/2006
Mike Good writes in on the Heat Loss of Crocodiles

While I enjoyed your piece on crocodile investing, I want to point out an error in deduction when you state: "The basic design of the crocodile, very thin and long, a large perimeter relative to surface area seems to have great survival value. Heat loss is proportionate to surface area, and thus energy required to keep a croc going is less than for any other form."

Your conclusion is backwards: a greater surface area increases heat loss and requires more energy to sustain core body temperatures. Crocs can go so long without eating because they are cold-blooded and this explains why they are such sun-worshippers. As a business metaphor and inspiration, can we conclude that if we practice cold-blooded and remorseless genetic pruning, like the croc, then we, too, can enjoy our place in the sun?

1/9/2006
A Letter on White Sharks, Food Webs and Markets from Sushil Kedia

Why do in general carnivores feed on other herbivores and omnivores? Repeated searches on Google have produced only the white shark as one specie that practices eating not only herbivores, omnivores but also other carnivores. Though, I being a vegetarian am poorly placed to guess good answers to this query, I still surmise the following for obtaining critique from more experienced minds that:

  • The body mass added to a carnivore is more than proportionately richer in animal protein structures and hence the texture and thus the taste of carnivorous meat is less inspiring
  • The amount of energy and effort required to capture other carnivorous prey is an inefficient mechanism for the sustenance of the food chains and food webs.
  • Cannibalization is an aberrational gastronomic practice in not just humans but across species. Why? No it does not appear to be emotions, as hunger is regulated by flows of energy.
  • With more appropriate guesstimates of the possible reasons for the way food webs have developed, wherein hunters do not hunt in general other hunters there are interesting bits of ideas in assessing one's own place within the market eco-system.

    Wondering, what may be a 'la the Larry Harris classifications the various specie in the market food chain that are herbivores, carnivores and omnivores. Inspired already by the Chair's thoughts of a few months ago on the classification of stocks on the lines of the Periodic Table of elements, what may be good ways to classify various roles one could assume in the market such that identification of distinct food webs becomes feasible? Within the identification of such food webs, then one could position one's attributes and re-engineer feeding habits to be at least a carnivore and in an appropriate food web for one's core attributes, the white sharks existing notwithstanding still.

    1/8/2006
    Thanks for the Junto

    Dear Victor,

    Thanks again for hosting Thursday's Junto meeting. I'm very intrigued by the notion of gathering people from diverse occupations and backgrounds to share in "a spirit of inquiry and desire to improve themselves, their community and to help others," which is something that I've been pursuing.

    Per your suggestion, I read your review of Treasure Island, although I'm not privy to the world of traders. Long John Silver is an interesting character relative to that frame since, quite apart from the other pirates, he makes long-term plans: he's a successful businessman, he owns an inn, has a wife and has money saved in his bank account. He may have been attempting to balance the risk of dying and reward from the gold, but he starts with a much higher degree of risk/loss potential -- although was likely to receive a larger reward/share for his efforts -- and keeps his finger carefully on the pulse of developing events.

    While doing research for the play I'm producing, I discovered, as you did, the influence of Blackbeard and that for Israel Hands in particular, the wily old coxswain of the Hispaniola, "Stevenson borrowed him directly from Captain Johnson's _History of the Pyrates_ in which he is described as master (or navigator) of the ship commanded by Blackbeard the pirate."

    As for Long John Silver, "Stevenson himself made it clear that Silver was inspired by his friend W.E. Henley, a writer and poet who made a considerable impression on everyone who met him. Henley, the son of a Gloucester bookseller, had contracted tubercular arthritis as a boy, which resulted in him having his foot amputated. He had traveled to Edinburgh to see an eminent doctor about his condition and while there he was introduced to Stevenson." "In May 1883 Stevenson wrote to Henley from Switzerland, 'I will now make a confession. It was the sight of your maimed strength and masterfulness that begot John Silver in Treasure Island, Of course he is not in any other quality or feature the least like you; but the idea of a maimed man, ruling and dreaded by the sound, was entirely taken from you.'"

    It's interesting that the book's introduction states that Stevenson "catches the sensation of being athletically alive, which is especially the gift of youth. In _Treasure Island_ this sense of physical action is wonderful and youth's dominant preoccupation with its own fear and courage plays naturally upon it." That's the focus of what I plan to create for the Broadway stage: an action play that conveys the excitement of Stevenson's world. Henry James predicted: "Treasure Island will surely become--it must already have become and will remain--in its way a classic." Our production will be a timeless classic that will appeal to all ages.

    I am in the process of raising $3 million to mount this production, which is one of the reasons Wendy suggested I attend your meeting. I have an information package that contains a preliminary production budget, weekly operating expenses and recoupment schedule as well as reviews of earlier productions and a FAQ that tries to anticipate risk factors and relevant issues. I'm confident this show will make an excellent investment and would love to send you the package for you to review. Perhaps you or someone in your acquaintance would be interested in investing.

    Under any circumstances, I look forward to attending the next Junto and meeting more of the people who have gathered in this cause.

    Best regards,

    Jonathan Moll

    A Letter from an Objectivist Researcher on Swan's Work

    I consider this paper to be a good example of the Rationalist/Platonist/Popperian wing of academic finance. I'm not enough of a mathematician to know whether professor Swan's functions hold up, but his general approach appears to be: I'll read some papers in which people make deductive arguments about how markets aught to work, note which ones have not yet been "falsified" by quantitative methods (per Popper), and then throw out another deductive hypothesis that might be hard to "falsify". As far as I can tell, Swan's "framework" is that investors get involved in markets not with a desire to build wealth, avoid losses, or the things that publications that cater to investors dumbly think investors care about, but rather investors enter into markets for "the joy of trading," as some sort of end in itself, with very little else on their mind.

    Swan provides no direct discussion of the nature, risk, and economic source of returns from bonds or stocks in the paper, nor is there any direct discussion or inductive observations of actual human beings' relationships to stocks and bonds in the context of their goals, fears, and uses of these items. This is even worse than the rationalism of the CAPM framework, which started with obvious divergences from reality (like all of us borrowing at the risk free rate to create a mean/variance optimal portfolio). Swan himself at the end points out that his framework fails when applied outside of the data set used to build it ( e.g. why don't illiquid corporate bonds, Beanie Babies, etc., have the same risk premium as illiquid stocks).

    1/4/2006
    A Divine Letter on Brokerage Stock Picking, from Steve Leslie

    I was speaking recently to a friend who works at a major brokerage firm and she asked me what stocks she should buy. Donna is her name. Donna remarked that her broker, a large producer at the firm, suggested several stocks to her and wanted me to look at this list. Naturally I agreed.

    Donna sent me the list in pdf format. I opened it and it was a research report on the large cap dividend paying stocks that her firm was recommending at the time. After scanning the list for a full 10 seconds I noticed that said brokerage firm had rounded up the usual suspects of large cap dividend stocks and published a research report around it.

    I called her back and asked her what commissions she had been paying her broker for such remarkable advice. It amounted to roughly 2 per cent each side. I thought back to Dante's inferno and the inscription over hell. "Abandon hope all ye who enter here." I told Donna to buy a solid no load mutual fund and left it at that.

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