Victor Niederhoffer: The Biggest Stock
Greetings, my name is Dave Goodboy, I’m executive producer of Real World Trading. This week, I am truly honored to be joined by Victor Niederhoffer and Laurel Kenner. Victor is a legendary speculator, market philosopher, gamesman, and racquet sport champion. He worked directly with George Soros and was ranked the number one hedge fund manager in the world for several years then disaster struck. In 1997, an overly expansive speculation in the Thai stock market caused spectacular losses in his accounts. Due to extensive leverage, his losses were magnified over and above his 50% loss in Thailand, and spillover effects from that debacle caused his fund to be well over its head in U.S. equities when they closed down limit on Oct. 27,1997.
In short, a combined sequence of events – huge declines in individual Thai stocks,losses in the Thai currency and the closing of the U.S. stock market and extensive up moves in the prices of options the fund was short; all came together in one day, in a short and disastrous coincidence. The loss, over and above profits made and withdrawals from the fund, totaled approximately $50 million. In addition to the losses in the funds, Victor had invested heavily in his own trading. To cover his debts and living expenses, after much soul-searching, he took out a mortgage on his house at an interest rate of 18% a year and sold his liquid assets, including his entire silver collection and his holdings in private and publicly held companies. He started again from the bottom. He scraped together a small trading stake and started plying his trade, slowly building back what was lost, determined never ever to allow the same mistake to happen twice. In a true example of the human spirit and his will to be a champion again, he is back in the game at a top level.
Since inception in February 2002, Vic’s current fund, “Matador, ” had a three-year annualized return of 31%, placing it among the top five offshore funds. In 2004, Matador had a 50% return, the best of all offshore funds with more than $45 million in assets, according to the TASS rankings. Here’s a gentlemen who came from materially meager beginnings, rose to the top academically, athletically, and financially---lost it all, and is now back on top. He is truly someone we can all learn valuable market and life lessons from, since he has been and suceeded on the front lines in all capacities and levels .
Most investors and traders don’t realize the extent of the subterfuge, con games and outright deceit that occur daily in the financial markets. Victor and Laurel have extensively studied, researched and tested the commonly held beliefs of market participants. As described in their recent book “Practical Speculation”, they have discovered that many of these beliefs simply do not stand up to rigorous testing and are merely delusions that result in losses. In this interview, we will examine the biggest market con games and how you can profit from these popular delusions.
Dave: Welcome, Victor and Laurel, to Real World Trading.
Victor: Thank you for having us.
Dave: Let’s start off by talking about what first perked your interest in “stock market cons”.
Victor: Laurel and I have been working together on the philosophy of markets over the last 8 years. The ideas I will present are our joint work and some of them are touched on in our book, “Practical Speculation”. Laurel, would you please enlighten Dave as to the genesis of our research into the “Invasion of the Body Snatchers” concept.
Dave: Invasion of the body snatchers!? Isn’t that a sci-fi movie from the 1950’s?
Laurel : Yes, It’s a Jack Finney film from 1954. We believe it’s the perfect allegory for an introduction to the big market con. The film is about invaders from outer space that take over people’s bodies, making them hopeless and listless, ready to accept whatever propaganda they hear. It’s a perfect analogy of how investors are misled by market cons
Dave: I see. You believe that the public has been duped by the market’s propaganda machine, so to speak?
Victor: Part of the backdrop to our research was the concern about financial reporting and the corruption of corporate executives, as well as the normal issues with the economy like interest rates and international affairs. But there is always something wrong with the backdrop of the market, the economy and individual companies. The problem is, the public is generally mistaken in its enthusiasm for determining whether factors are bullish or bearish
Dave: Are you saying that it’s impossible to tell how the market will interpret various factors as positive or negative?
Victor: Yes. Retrospectively, after the market has gone down, it’s generally assumed that we are in a bear market and conditions are terrible. This causes the public to lose hope and refuse to take on risk.
Dave: Do bear markets even exist?
Victor: Bear markets only exist in retrospect. This is one of the greatest fallacies in the market. One of the main philosophical points in our book is that it’s guaranteed to happen.
Dave: What’s guaranteed to happen?
Victor: The public must always believe absolutely, with the strongest conviction, the idea that will make them contribute the most to the market and one of the things the public has to do is sell low and buy high.
Dave: That makes sense. It’s how the market feeds and supports itself .
Victor: I wrote about this extensively in my first book, “Education of a Speculator”. The dead weight costs of the market are tremendous. In terms of ecology, there’s a huge loss of energy in the market. This loss of energy, in market terms, is commissions, communication costs, salaries, fancy offices, etc.. These things need to be paid for the market to continue. The public pays these costs, the same way the sun provides the energy for the earth .
Dave: The public needing to buy the tops and sell the bottoms plays right into your aversion to the “trend following” concept of trading. You actually have it listed as number 3 in your 10 big cons of the market. Why?
Victor: I have an aversion to all fixed systems and purportedly easy ways of making money in the market because the market learns and adapts to allow flexible, sagacious and strong decision makers to profit at the expense of the weak .
Dave: OK, why “trend following” in particular?
Victor: The public needs to be tricked or deceived out of their basic role of buy and hold. If they follow the buy and hold mantra, they are going to achieve the Dimsonesque [editors note: Elroy Dimson, Paul Marsh and Mike Staunton co-authored “Triumph of the Optimists, ” a 2002 book that documented for the first time the 100-year returns of the world’s stock markets] returns of 10, 000 fold per century. I am particularly averse to trend following methods because of the following reasons: 1. They are often untested. 2. If tested, their variability is too high to rule out randomness, and 3.If tested relative to uncertainty, they assume past seemingly non-random movements of prices are predictive of what’s going to happen in the future.
Dave: Is this strictly for the stock market or all financial markets?
Victor: When trend following methods are tested on the stock market indexes, they tend to show that the correlation of past returns and future returns is negative, and that the number of runs of price changes in the same direction is less than would be expected by chance. I have never seen an example of a real life movement in prices that would allow trend following to work retrospectively that does not also show positive serial correlations and an observed number of runs in the same direction that is greater than would have been expected by chance.
Dave: Are you able to support this view with actual numbers?
Victor: In my book “Education of a Speculator”, I report that the correlation between weekly stock price changes in the S&P futures during the 1990’s is approximately -0. 08. The correlation between daily changes is approximately -0.04 over almost all relevant periods. The chances of a rise following a series of 2, 3, 4 or more consecutive declines, in stocks, is approximately 10% higher than normal. Therefore, trend followers in the stock market averages would appear to be playing in a game heavily stacked against them.
Dave: What about the other markets? Do the same studies hold true?
Victor: No. I hasten to add that such tests would not show similar biases against trend following in other markets such as fixed income, or foreign exchange.
Dave: Then what is your objection to trend following in these markets?
Victor: In general it’s the philosophical objection that the followers of long term trends don’t take into account one of the fundamental rules of economics, which is that incentives matter.
Dave: Please explain what you mean.
Victor: The supply curve moves outward and to the right when prices rise, and inward to the left when prices decline. Moreover, trend following does not take into account the fundamental tendency of the market to abhor upsetting the apple cart by moving prices to permanent new level, thereby creating threats to its tried and true tendency to make the public lose more than they have any right to by constantly buying too high and selling too low. If the public were all trend followers, and the vast majority of them are, then prices would be constantly moving to permanently higher or lower levels, and this would be bad for the well-heeled upholders of the market infrastructure who must survive for markets to continue.
Dave: This all seems to make sense in theory. However, how do you explain the fantastic track records of the major trend followers reported in books on the subject or the economic argument that speculators on big moves are paid an economic return by hedgers and equilabrators?
Victor: Well, I would look as a criterion at the total profits that all trend followers have made over time for their public clients rather than the personal profits they have made for themselves. I would also compare the past high returns that the publicly cited great exponents have made to the total dollar amount that their clients have made or lost. In addition, I would look at the actual total dollar returns to the public of those who invested in some of the greatest trend following funds who admittedly have had much inferior results, lawsuits, and tragedies in their publicly reported and audited results versus the legendary stories of great past performance. Another thing I would like to point out is the publicly reported results of the famous trend followers in the last two years, when money at their disposal is at the maximum. I dare say that billions upon billions have been lost as a review of the rankings of CTA’s would show. But, of course, that’s guaranteed to happen. Looking at the April TASS Flash report, I’d estimate the average trend fund is down 20-40% over the last 2 years, and some are really getting killed. Please bear in mind that the big CTA’s typically offer 8 or 10 different “programs”, so that they can quietly close down the worst performers, or just stop reporting their result.
Dave: Wow, that’s some indictment of trend following. Is there anything else on this subject?
Victor: Of course, I am just getting started! I normally don’t like to talk about this subject since it foments much hatred against me. Many of the proponents of trend following are attempting to market systems, seminars and funds based upon the concept and I stand as a reasoned voice against their profits and thus must be discredited for their own survival. With that said, my major objection to trend following is that it doesn’t take into account one of the most important regularity of the markets, aside from the laws of incentive, and the immense degree of deception and big cons---i.e. the principle of ever-changing cycles . The public is always behind the form. I would even go so far to compare the concept of trend following to a cult like scientology. It’s impossible to have a rational discussion with some of its proponents since so many people have vested interest in perpetuating the myth.
Dave: We are on a roll on this subject, let me see if I can dig a little deeper into your thoughts on the concept of market trends. Do you believe that trends don’t exist at all or simply that an existing trend is not tradable?
Victor: Any trend that exists can be quantified and its departure from randomness can be measured with the usual statistical procedures, such as confidence intervals and likelihoods. Serial correlation coefficients, regression coefficients of current changes versus past changes, and magnitudes of the impact of past moving averages on the future, distributions of the length of runs, the correllelogram, the expected waiting times between peaks and valleys, survival statistics. All these techniques are very good at discovering any non-random elements.
To join a proper debate, such measures must be quantified for various markets and various times, and the degree of uncertainty and departure from randomness must be ascertained. I have never found a movement in prices that anyone could make money with by a trend following method that didn’t also show a major departure from randomness revealed by the standard statistical measures I mentioned. The tragedy is the mysticism and blind acceptance of trendism, that trend following exponents proclaim, without any evidence as to magnitude and uncertainty. No self-reported results that selected individuals or leaders might have made in the past shed light on the debate.
Dave: Your well known saying, “If it can be tested, it must be tested” comes into play here . Exactly what testing have you done to prove the above idea?
Victor: These tests can readily be performed My group of colleagues performs these tests maybe 2-3 thousand times a year over different markets and time frames. Those of a cognitive bent and those with their feet on the ground are always open to the existence of trends, but they test them with the best statistical methods existing. If you apply these tests to stock market moves, you will find that all such tests show negative serial correlation. In fact, they indicate a tendency for reversal.
Dave: What about the upward bias in stock prices? Why can’t that be interpreted as a trend?
Victor: Well, all proper statistical tests take into account this upward drift. They would look for serial correlations over and above the basic drift of the market. One of the other market cons is the permanent bearishness of some of market pundits, and I am the last person to say that this upward drift, evidenced over the last 200 years, does not exist. This in no way refutes, but it does refine the statistical tests required for the stock market. However, I hasten to add that no such upward drift exists in any other market.
Dave: Very insightful, Victor. Your last sentence opens up the next big market con—commodities are better for the long term than stocks. Can you elaborate on this topic?
Victor: This con is very closely related to the trend following big con. There is no upward drift in commodities.
Dave: That idea really flies in the face of the recent increased interest in commodities as promoted by a certain world traveling commodity fund manager.
Victor: Yes, I believe you interviewed him recently. This type of renewed public interest seems to be indicating a top soon. The fact that money was made in the past buying commodities in no way indicates that this will continue. The Niederhoffer/Kenner camp believes in the principle of ever changing cycles. It’s one of our hallmarks.
Dave: Wait a second, Victor. Ever changing cycles? That sounds like a contradiction to me. If a cycle is ever changing, it’s no longer a cycle. What am I missing?
Victor: That’s an excellent question, Dave. The idea of ever changing cycles comes from a racetrack bettor whose insights and value to the public are far superior to even the greatest stock market experts. His name was Robert Bacon, and he wrote a book called “Secrets of Professional Turf Betting”.
Laurel : Bacon also called the concept the principle of ever-changing trend. His great insight was that even if the public ever managed to overcome the crazy urge to gamble and got wise to a winning idea, the principle of ever-changing trends would quickly and drastically change the results. As he wrote, “The would-be professional player must always understand that the form moves away from the public’s knowledge.”
Victor: Unfortunately, the book is out of print and has become very difficult to buy. We also recommend “Horse Trading” by Ben Green, and that is much easier to obtain.
Dave: Horse racing and trading, Victor, Laurel? Isn’t that stretching things a bit?
Victor: Not at all, the concepts are very similar. There are two things that happen—the payoff goes down if the horse wins, and the payoff reduction is such that even if the horse were to win with the same probability the system becomes unprofitable. The horse racing business is very similar to the stock market in this way. Strangely enough, most of the major horse racing systems of the 1930’s have the same philosophical underpinnings as trend following systems . They basically say take the horse that’s winning the most, bet on him, and stay away from the horse that’s losing the most . The horse racing people actually have a much higher standard of analysis than the proponents of the current stock market systems. The horse bettors always demand workouts, unlike many practitioners of the trend following systems .
Dave: Let me see if I understand how the horse betting systems relates to trend following . Everyone bets on the horse that is in a winning trend, thereby reducing the payoff should that horse win again?
Victor: Correct, but, Bacon says that would be true if the percentage of wins were the same and here’s his fantastic insight: the percentage of wins does not stay the same, it goes down because the owners like to bet on their own horses. Therefore, if the odds are 2 to 1 for a win, they don’t bet as much or push the horse as much as they would when the odds are 10 to one . The chances of winning is actually greater the fewer wins a horse has.
Dave: I see how that would relate to trend following systems.
Victor: Those systems are designed to create the same situation on paper. These systems look good in the past, and they look good with small amounts of money—10, 20, 50 million dollars -- thereby luring the public to put billions and billions into it. Then they fail. There are people who must exist for the markets to survive; these are the easy money people. It’s the big players who see the exponents of easy money coming. The people who are flexible, analytical and scientific—like those who read our books and those who read your interviews trying to find the insights -- are the ones who survive and thrive in the market.
Dave: Thanks for the compliment to my readers! So, you are saying that flexibility is the key to success in the market?
Victor: That’s one key. One needs to have strength, flexibility and a foundation. People should know this intuitively. Most people understand this via playing cards or any sport for that matter. It is a fact that deception is rampant and flexibility wins the game. Those people who play the same game and are predictable are easy prey. This is another reason why even in those markets that test well for trend following, we have an aversion to accept it as a given. This all relates back to the fact that the anecdotal method does not prove anything. This “My dad can beat up your dad” nonsense is a real waste of time. Many CTA’s and hedge fund managers become very wealthy, but this does not prove that they have made money for the public. It means they make a lot on fees.
Dave: Let’s move on to the next big con, the fund of funds. It seems to make sense to me that diversifying a fund into multiple funds would be a good thing. Why is this concept a con?
Victor: I like to say that all funds of funds will converge to a Sharpe ratio of minus 1000.
Victor: Well, that is just a figure of speech. Actually, the issue is the fees. They pay fees on about 10 different levels, but that is not the worst of it. Currently, most of these funds tend to be equally weighted on the long and short side. Therefore, since the market is pretty much a random walk with a positive drift of 10% or so a year, they end up with a zero percent return . They make 10% on their longs, lose 10% on their shorts, and often pay multiple fees. It’s a losing proposition for everyone but the manager.
Dave: Moving onto another one of your favorite big market cons, technical analysis. Many traders trade exclusively with TA. Why do you consider it a con?
Victor: Everything is part of the basic philosophical backdrop that we discussed earlier. TA tends to unleash people from the fundamental foundation that they need to be successful.
Dave: It gives most traders false hope? Is that what you are saying?
Victor: That is part of it. It also gets traders to trade too quickly. It makes people fearful and elated, causing too much turnover -- and turn over is very expensive in this game.
Dave: Do you see any value at all to technical analysis?
Victor: Many of my best friends are technical analysts and I am actually a technical analyst myself. However, the kind of technical analysis I perform is scientific. I put forth hypothesis, I test them, I consider the uncertainty, I quantify them, I try to put them in an economic framework . When done in this manner, TA has value. What I don’t believe in is the idea that the visual intuiting of price charts can give much insight into the subsequent distribution of prices. This is the way most people view TA and why TA cons most traders. I do believe that the interplay of markets, and price distributions, are of a highly predictive nature.
Dave: These predictive distributions and market interplay is how you make decisions in the market?
Victor: It’s what I am most renowned for. A large part of the managed account industry in one way or another started out with this basic idea that I pioneered. Monroe Trout, Roy Niederhoffer and Toby Crabel, among many others started at my firm. A number of managers with over a billion dollars under management started with me. This makes it much harder for me since many of my former top people are using and augmenting my methods elsewhere, and of course my ideas become subject to the principle of ever-changing trends.
Dave: Correct me if I am wrong, Victor. But I think your studies have shown some value in the VIX indicator. Is this accurate?
Victor: That’s an example of a fixed system, a shooting star. In general, a good rule of thumb is when the market is looking terrible that’s a very good time to buy and when it’s looking great it’s a good time to reduce your exposure. Not to short it -- I don’t ever believe in selling the stock market short. The VIX is very highly correlated with the recent market move, so it’s very hard to separate the VIX from the current market move. A very good predictor of future VIX is the current VIX.
Dave: Explain what you mean by this, please.
Victor: If the VIX is 14% now the best predictor of where it will be in a year is 14%. There is nothing “too high” or “too low” about it. There are just as many factors that will pull it down as will pull it up. There are many statistical measures to forecast volatility. The book by F.X. Diebold, “The Elements of Forecasting, ” is excellent in this regard. Changes in VIX have a much better forecasting ability than the levels themselves.
Dave: You mean the rate of change?
Victor: Yes, if VIX changes in a one-month period by several percentage points, this is the kind of indicator, in conjunction with the market move, that is a proper area for testing .
Dave: Moving back into market cons. One of the heroes of investors is an individual named Benjamin Graham . His “Security Analysis” book is the bible to value investors and required reading in many business programs. What was his actual performance in the market?
Victor: Abysmal! His performance in romance was much superior to his performance in the market. The Rea-Graham fund applied Ben’s ideas over a 15-year period, and it was one of the worst-performing mutual funds of all time. He actually got out of the market when the Dow was 500, believing there was no way it could go very much higher. However, that’s anecdotal evidence. He could have very good insights even if his performance as an investor was poor. The fact is, his book is very shoddy, not scientific. I consider his basic idea of value investing one of the worst big cons.
Dave: Value investing is a con!? Why?
Victor: In general you get paid for taking risk in the market. The basic idea of value investing is to invest in companies that can’t lose money. If you can’t lose money there’s no profit, there’s no return, since there is an unchanging demand structure.The rate of return quickly goes down to the risk-free rate.
Dave: Isn’t the Sage of Omaha the best known value investor?
Victor: Yes, he used to invest in things like farm equipment, candy stores, shoe manufacturing, textile plants with tax losses. These are the kinds of companies where the rate of return is usually less than the risk-free rate. Practically speaking, I happen to know something about valuing companies. I ran the largest merger business involved with selling private companies to public companies. I visited thousands of companies. My people sold over 1500 companies. One can never sell one of these value companies above its liquidating value. If you could there would be tremendous competition to drive it down. That’s the economic argument. The real-world argument is that the kind of companies the Sage boasts about buying in 5 minutes are simply not the stocks you want to buy.
Dave: OK, growth is where the average investor should be, and avoid value stocks?
Victor: Yes. The one study that I consider superior to all others is the Value Line study. They set out to prove that value is where to be, but the study proved that growth has beat value by about 20 to 1. It’s a real-life study unlike many others .
Dave: Wow, that sure is impressive. Is this why you don’t buy stocks with a low P/E?
Victor: Yes. Low P/E stocks tend to be the “value” stocks that have a rate of return close to the risk-free rate. The average IPO is priced by the underwriters to yield 50-60% per year. This is in normal times. When people are so risk-averse, as they have been for the last few years, the underwriters discount the yield to make the IPO more appealing.
Dave: Laurel, I would like to direct this next question to you. In “Practical Speculation” you talk about an indicator that I find fascinating, it seems counter-intuitive like many of the things you and Victor have discovered—you call it the stadium indicator. Tell me a little about what happens to a company after they sign a stadium naming deal?
There were plenty of anecdotes that saw their stock prices plunge after they named stadiums after themselves. Enron's pre-bankruptcy $100 million stadium deal comes to mind, and 3Com and CMGI saw their stock prices fall from the clouds. To find whether there was any general truth to the idea, we did a systematic study. We found that stocks performed significantly worse than the S&P 500 after acquiring stadium naming rights, both that year and the subsequent year.
Victor: What we have found is that the companies that tend to be most hubristic tend to be the ones that perform the worst.
Dave: Pride goeth before a fall.
Victor: Exactly. Related to this is our baseball indicator.
Laurel : This one goes back to what we were saying about expansiveness and excess in popular culture. We found that when home run hitting records are being broken right and left, a down market tends to follow. Think Babe Ruth in the 1920s. When the rules of the game change to favor pitchers over hitters, and teams start focusing more on defense -- hitting singles and stealing bases -- that seems to portend an up market.
Victor: These indicators are cultural examples of how excesses cause the public to be betting on the wrong type of horse at the wrong time.
Dave: I can see how all these factors you mentioned tie together. Now let’s get down to the nitty gritty. How do you trade?
Victor: I am happy you see the correlations. What we teach in our book is to try to understand the forces involved the market. Pay attention to rates on fixed income versus the rates of return on the stock market. Pay attention to buybacks as signals, cash earnings versus accrual accounting, negative serial correlations in stock market indexes. But of course our book was a worst-seller. They didn’t even have a copy of it in my local book store. We are happy there are a few eagles out there who gave us a good review . “Active Trader” magazine and the “Journal of Investment Management” are two.
Dave: We are almost out of time. Is there anything you would like to leave our readers with?
Victor: I try to teach a method of thinking. We are dedicated to try to deflate ballyhoo and create a proper framework for proper stock market decision-making.
Dave: Victor, Laurel —Thank you for joining me today. I truly appreciate your time .
Victor: It was our pleasure. Thank you .