It is curious that in the last week or two we've seen the sudden redemption of long-held doers of bad/evil/wrong: "The Boss" by death, a flexion-laden firm by settlement, BP by capping the well, central bankers harvesting more power even as the economy crumbles in the shadow of their initiatives; a cosmic whitewashing seems afoot. Meanwhile, those who could long seem do no wrong: AAPL, a former community-organizing law professor *cum* agrarian politico, gold, LeBron James (at least in terms of public sentiment) etc. are facing reversals of fortune and downward revision of their overall estimation.

I will be looking to see if, among the handful of strategies I employ, those which have been underperforming revive while those which have thus far been adding value stumble.

David Wren-Hardin writes:

So you're saying I should take Tiger to win the Open?

Peter Earle responds:

Not at all; I would say, though, that Tiger's (self-inflicted, albeit with media and feminist help) extremely short-term transformation from cherished, model athlete to one-stop scourge of mankind is precisely the sort of inversion which seems to be occurring in cluster form over the last few days.

Also, [i]inconvenient[ly], the public perception of a particular ([n]oble) pseudo-climatologist.



the announcement At $25 million a year, plus a larger amount in endorsements, of course Lebron James chose Miami over New York, LA and Cleveland. Florida has no income tax. While those other states are among the highest tax states in the country.

Scott Brooks comments:

But that tax wouldn't make up the money he lost ($30 million) by signing with Miami over Cleveland.

J.T Holley writes:

The math is 12 million in difference for the length of his contract in State Taxes saved. That's over 35% saved in my book, better supporting cast, nice climate (Miami has never had a 100 degree weathered day recorded), So. Beach, he gets to finally be a man and leave home, and the insiders could've shorted MSG from let's say 21 to 19 leveraged? I'm just sayin'.

The King seems to be following the advice of his consultants rather well. In the Navy the ole' sayin' is "loose lips, sinks ships". I was quite surprised that MSG didn't spike more than it did and go a few more deviations to the upside. The tight lipped coverage and suspense was brilliant and had to be hard to keep up. This is especially amazing to me considering Wade and Bosh were also involved in the dealings ultimately in the decision.

There has to be a study of "high profile" free agents and "warm weathered" correlation to be done when it comes to money and choices. Does anyone know of a high profile athlete that choose a "cold weathered" city when the initial contract was up? Just sayin'?

David Wren-Hardin comments: 

Jody Rosen over at Slate had a short piece that I think nails it.

New York is no longer the hip place to be. For a young, minority millionaire, the post-racial (or allegedly post-racial) melting pot of Miami is the place to be. Everyone scratching their heads about tax breaks, endorsements, and culture is living twenty years in the past.



 Just got in from a basketball game at Ohio University vs. Lamar. Noticed the basketball coaches wear suit and tie. The baseball managers wear the team uniform. The majority of football coaches dress casually (except Tom Landry). I wondered why the difference in dress among these three sports?

Victor Niederhoffer adds:

And what is significance of the terrible millhonian fact that 99% of the people in any mid-level restaurant these days are wearing black? Is it the consequence of a lagging response to a recession — a harbinger of a deep pessimism, of a boat about to capsize, a conventicle of worship for the higher blackness in our midst, a signal that stocks are still not invested with much of a risk premium, or whatever cultural straws in the wind are you seeing of this subdued nature? And what does it mean?

Dan Grossman replies:

1. On the coaches, it's much colder outside on the football field and easier to dress warmly in casual clothes. A suit and overcoat would look ridiculous.

2. In the restaurants, dressing all in black signals the maitre'd and staff you are someone not to be trifled with. You are more likely to get a table without a reservation, or a faster/better table with one. Black says you are from town, perhaps even an artist, writer or in the fashion industry, not from the sticks or the burbs.

Dean Davis writes:

Supposedly black is a slimming color. Perhaps those that frequent comfort food restaurants like those found at the mid-price level have something to hide. I have heard that the quality of diets slide in poor economic times.

David Wren-Hardin writes:

Baseball has a longer, and more recent, history of player-managers. Pete Rose was, I think, the last one. Football seems to reflect the average dress of the time. Back in the fifties, all men wore suits. It may look formal to us now, but the suits were probably pretty standard, not the same as Pat Riley's Armani suits, for example.

As our culture has become more casual, so has the football coaches' dress, especially since they are outside. I think they may even be prohibitied from wearing suits. I recall a coach last year (Jack Del Rio?) who wanted to wear a suit to honor his father, and either had to get a waiver, or paid fines.

You can see similar dress cultures in trading. Traders associated with banks tend to dress more formally than traders in hedge funds. In my current firm, wearing jeans and t-shirts is an expression of pride. If I wear khakis, everyone wonders where I'm going after work. At my last firm, a European owned group, we never wore jeans, and if the bosses from Amsterdam were in town, we wore suits.

Essentially, it seems to have settled out where if you deal with customers, you wear a suit, and if you are a trader, you dress down. The more powerful/profitable you are (or think you are) the more you dress down.

To make it more personal, does how we dress affect how we trade? If I'm more formal, am I less prone to risk-taking? If I'm dressing down, am I more relaxed and making better decisions?

Steve Ellison shares:

That has been the case at MIT for years. From Fred Hapgood's 1993 book Up the Infinite Corridor: MIT and the Technical Imagination:

In his time Ernesto Blanco has designed robot arms, a lens for cataract operations, steerable catheters (that can navigate inside arterial branches), a microstapler for eye surgery, a stair-climbing wheelchair, a forklift truck, film-processing equipment, high-voltage transmission line connectors, a helium pump, and a raft of devices for the textile industry — from pile stitchers to faulty needle sensors. So he has earned the right, which he exercises, to dress his barrel chest and ramrod carriage in rich blue blazers and snowy shirt linens, silk ties, Italian leathers, and flawlessly crease flannels. In this he faces against the winds of fashion at MIT, where an Armani suit suggests not success or achievement but a serious problem with self-esteem, a lack of confidence that the product, the work, will be adequate to win the desired rewards. The psychology expresses itself as a fashion paradox: at MIT you dress up, you dress for success, by dressing down. So in this sense Blanco is like a banker who wears jeans to work; he is good enough to wear what he likes, and what he likes is Fifth Avenue.

Phil McDonnell comments:

The black-is-slimming meme has been around for several years. The older Seattle Grunge look may have spawned an idea that casual is good and, perhaps more importantly, colors that blend in are good. Some time ago I ate at one of the nice Google restaurants and did a quick Galtonesque count of the number wearing black. It was nearly 100%. I was the exception. Many of these young people are from India, China, Russia and elsewhere so it is not just California. In some circles they say that gray is the 'new black'.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008



S EllisonA recent Wall Street Journal article discusses findings that children born in the winter do worse in school and earn less than children born at other times of year. The first reaction was to search for environmental factors. Did lack of sunlight in infancy cause lasting damage? Did being in the same grade with younger students limit achievement?

Further research showed that heredity might play a role. Births to highly educated women peaked in May each year, while births to less educated women peaked in January. The likelihood that a woman giving birth was married was 2 percentage points less in January than May.

Nigel Davies reacts:

I learned recently that 75% of a child's IQ is from the mother, so it may be purely an IQ thing. As May minus 9 months = September maybe smart women tend to schedule their baby production after their summer holiday!?

David Wren-Hardin queries:

I read the same article, and saw nothing in there about heredity playing a role. It did say, as you say Steve, that the winter-born babies tend to be born to less-educated women. Education is, obviously, something someone does, not something someone inherits.

And to Nigel: Who told you 75%?!

Nigel Davies replies:

A reliable source.

Alex Castaldo adds:

I think I could guess the source's gender.

Gordon Haave is not amused:

Obviously none of you have read The Bell Curve by Richard Herrnstein and Charles Murray.

David Wren-Hardin comments:

David W-HI've read parts of the book. There are some interesting conclusions, but they fall far too far on the intelligence is pre-determined and we can do nothing about it spectrum. Are we blank slates? No, but our intelligence is highly tuned by our environment. That's actually great news — we don't have to simply accept that some people are "stupid", shrug our shoulders and move on. Everyone can become smarter and realize more of his potential.

A more recent book that analyzes some new studies and takes a fresh look at old ones is Intelligence and How to Get It by Richard Nisbett, a Distinguished University Professor at Michigan.

More and more study is showing that IQ is much more malleable to environment than previously thought. For example, twin-studies had been used to state that IQ must be inherited since twins raised in different environments have similar IQs. However, once you control for the selection bias in adoptive parents — people who adopt tend to be more highly educated and have more resources — a great deal of the "heredity" effect goes away. It's still there, just not as strong as previously assumed.

There have also been studies showing how the "culturally unbiased" tests, the ones that are supposed to tease out untaught learning from innate intelligence, are actually highly affected by previous exposure to various spatial concepts.

Yishen Kuik summarizes:

YishenFrom what I remember about studies of intelligence, the key findings were:

1) The correlation of IQ scores by adopted siblings & their natural siblings was 0.0 (ie no different from strangers), whereas those between natural siblings was about 0.6.

2) The correlation of IQ scores of monozygotic twins separated at birth was 0.9 vs dyzygotic twins raised together at 0.6.

Those were the strong conclusions used to argue that environment had far less impact on how well someone scored on an IQ test, compared with their natural endowment. (Note that this does not imply they inherited their intelligence from intelligent parents). How does Prof. Nisbett's findings about cultural biases or the fact that adopters tend to be well educated / wealthier alter these findings?

Stefan Jovanovich writes:

This may not answer Yishen's question directly, but what follows is the sum of what my father told me about IQ tests. Dad had, I think, some credibility on the subject; he made his fortune from running the only for-profit publisher who competed successfully with ETS. He was also smart enough never, ever to voice these opinions to anyone until the year and a half before his death when he decided that he would indulge himself in the luxury of telling himself and anyone who would listen the absolute, unvarnished truth about what he knew from half a century in the book and test trades.

1) IQ tests are unpopular precisely because they are brutally honest and cannot easily be rigged. No one likes their results. The students hate them because they show us all how rare exceptional intelligence really is. The teachers hate the IQ tests because they find that the brightest students are most often not the diligently obedient pupils who copy down everything the teachers say and repeat it back to them on the exams. Instead, the tests suggest that really bright people are unruly and more interested in their own thoughts than other people's. The parents hate them because the test results shout that money alone cannot buy brains. The school boards and administrators hate them because the test results indicate that most of the time spent in class is utterly wasted.

2) There are only three reliable correlations between inputs and measurable academic achievement — the IQ of the child, the IQ of the parents and the IQ of the teachers. Every other metric — class size, spending per pupil, curriculum models (new, new vs. old, old math) have not statistical importance. Dad would hardly have been surprised by Dr. Nisbett's findings since the IQ of adoptive parents is significantly higher than the general population. He would, I think, have disagreed strongly with the assertion that "a great deal of the 'heredity' effect goes away." By far the most important single cause of success was the IQ of the child.

David Wren-Hardin replies:

I agree with most of what you said earlier; IQ is measurable, and people don't like that. What I want to add is that it is modifiable. But past certain points, it may not make a difference on life outcomes. Other traits, such as persistence and the ability to delay gratification, may have greater effects.

I'm not going to speak for Dr. Nesbitt, but on this last point I'd say that the child's IQ has already been set by the environment he came from. My argument doesn't necessarily help the education debate, it may, in fact, it may make it bleaker: Compared to the effect of a child's surroundings in his early years, public education comes in with too little, too late. "Low IQs" are still the parents' fault, but not necessarily because of genetics.

But the take home message to me, and what I tell my kids, is that they can always be better at something than they are now, if they apply themselves at the limits of their ability.

Stefan Jovanovich sums up:

Dad would certainly have agreed with David. He thought that modern teachers' refusal to "teach to the test" was an indication of how corrupt education had become. IQ can be "taught" in the same way that people learn alphabets and sums; be repeated trial and error — taking tests again and again. It appalled him that school was made over into something that was "fun" and "self-discovery." Learning was work, and that is why the students should be paid for their results, even as early as kindergarten. That would, Dad thought, teach persistence and the ability to delay gratification — which, as David notes, are "lessons" that are vital to the growth of human happiness and accomplishment.



I don't ski, but I do like to watch it on TV. And just about everybody I know is at Big Bear or Whistler or some such right now. Which makes me think of skiing as a market analog. You take the chair to the top, and that's the overnight gap up/down. And then you slalom back down the slopes. And there are bunny runs, and intermediate runs, and those black diamond runs — I've hiked them in summer, and man, some of them are way, way steep. Each class of run has a certain risk/reward ratio. You gotta know what you can handle and what might wipe you out. And when the pros do it at the World Cup level, they use every bit of leverage they can get.

David Wren-Hardin recounts:

David W-HAlong with knowing what your limits are, you have to know what run you're actually on. I went skiing last week at Snoqualmie pass in the Cascades east of Seattle. I'm an intermediate skiier, and have never skiied west of the Mississippi or anything as big as Snoqualmie. I was there with a friend, and we headed up to the top, intending to take a blue trail (intermediate) across the top to some blues down the left side of the mountain. The top of the mountain was engulfed in cloud, but we headed off to the left, looking for signs of the trail down. Soon the trail was hemmed in on both sides by trees, then went off to the left. It looked a little steep, but we obviously had gone as far as we could. Off we went. Bam, I went down and slid down almost 200 yards. One ski joined me at the bottom, the other was two thirds of the way up. My friend lost one ski altogether.

Ski patrol came along, and helpfully went to the top and brought my ski down. Meanwhile my friend found his. As we brushed our egos off, we asked ski patrol "Just what did we go down?" "Oh, that's Free-Fall, a black diamond (expert)."

When it cleared up, and we could see where we went wrong, it became even more laughable. The trail we meant to follow was broad and clear. But in the fog, we had drifted left, hitting a fairly small clump of trees at the top of the diamond runs. But with our view obscured by fog, our unfamiliarity with the slopes, and our preconceived notions of where the trail we were looking for was, we launched ourselves down a trail that was much beyond our abilities. For what it's worth, during the entire rest of the day, I didn't see a single person go down Free-Fall.



If there really were a Plunge Protection team why didn't they come save the world this week? Could it be there isn't one, as certainly this week they were needed?

Charles Pennington comments:

Government likes plunges because they provide an excuse to seize new powers and enlarge the government footprint. It certainly worked out that way during the plunge of the 1930s.

If there were a government Plunge Protection Team, the government would heavily publicize it and its heroic role in stopping plunges. The Hong Kong government openly stepped in to buy stocks in the midst of the 1998 Asian market collapse — the intervention was announced in August 1998 — and to my surprise, the announcement just about coincided with the market low.

My theory, then, is that governments relish plunges and would only intervene if done with great fanfare to take credit. 

Kevin Eilian writes: 

Sometimes "plunge protection" can take the form of a wink and a nod, like the 1998 Russian meltdown/LTC deal. The knight gathered together the biggies from all participating banks (so I understand) and "asked" them to "coordinate" a de facto bailout. Now with huge consolidation among world financials, this type of pp (reminds of me of JP's role in the 1900s) should be easier.

The government will use plunges to assume new power - if it lasts (i.e., the 30s or the late 60s/70s for example). Since most of the world's politicians do not really understand economics (growth causes inflation, static budget analysis, cap gains balance the budget, etc.) the attempt to gather more power in light of a prolonged plunge is worrisome ("double whammy" potential).

I think most politicians dislike the uncertainty and potential shorter term election implications of a typical plunge and/or dislocation, so they'll do what they can to bring in a plunger. To me, whether it’s explicit (like r*bin), informal (like the knight in 98) or just day to day (central bank coordination) they are around. We just need to be careful what we wish for! 

David Wren-Hardin writes:

We're in just the first episode of a multi-episode drama. It's like in the comic books or cartoons where the evil overlord rises up, and a second tier superhero team from another country like Alpha-Flight or Justice League Europe tries to take him on, only to be crushed. Then the real superheroes come in.

We saw Plunge-Protection Team Europe take a swing. Bernanke is still ensconced in his Fortress of Solitude, waiting to call on the rest of PPT-USA. 



Regarding short interest as posted by Bloomberg, has this been tested? That IWM short interest being the highest, is that an indication for buying since a squeeze is possible. How would this be tested?

Bill Rafter replies: 

We have done considerable testing of short interest data. I am on vacation and must speak anecdotally, but let me give our generalizations. The results suggested that half the time the shorts were dead right and the other half they were dead wrong. Very little middle ground. An exceptionally large SI value had no particular significance. That is, it gave no edge to the trader to pick subsequent direction.

Our research was attempting to approach the data differently from the way Phil Erlanger approaches it. Erlanger first identifies market direction, and then looks for possible short squeezes that will extend a rally to a more substantial level. Since we found no edge doing it our way, we have to conclude that until shown otherwise, Erlanger's approach was valid. We did find that it took a long time for short interest to be covered. That is, the rally durations were substantial as to both price and time. The shorts were slow to believe they were wrong. Sell-offs of stocks with high short interest tended to be less substantial as to both price and time.

One might simply conclude that drops occur fast and rallies take longer, and that the SI figures were of no significance at all. We disagree. That is, we think SI is certainly a contributing factor. It may not be a meal, but it certainly is seasoning.

We also watch and calculate some other sentiment indicators, including a price-based intra-day sentiment value. Looking at subsequent market performance with it is identical to what we learned from observing and testing SI: Sentiment indicators have an extending effect when they are wrong and a moderating effect when they are correct. 

David Wren-Hardin writes:

In this case, you have to think about what IWM is. Most of the time when people short a company, they do so because they think it isn't very good, that it should be priced lower. IWM, however, isn't a company. It's an ETF tied to the Russell 2000 index. So now you have to ask "Why would someone sell this?"

Some sellers, I'm sure, think the Russell should be lower, and happily sell IWM. But others might just be doing it as a hedge. If you wanted to hedge your Russell 2000 exposure with a basket of stocks, getting clean fills would be a nightmare, as would tracking the 1900+ individual names, most of which trade by appointment. You think it's hard to borrow IWM, try borrowing some of these tiny names. But with IWM, you can get the entire index in one shot. One can even spin a tale that if people are selling IWM against a net long exposure, that the IWM short interest is, in fact, a reflection of overall long sentiment.

The other thing to consider is that you can't look at short-interest in IWM purely in terms of percentage short vs. amount out there. An ETF is created when someone hands the trust the complete basket of stocks, getting the ETF in return. Now, IWM may be short equal to the float of all the stocks in the index, but more likely, given the basket example I used above, it's simply a pain in the rear to assemble complete baskets of stock and turn them into more ETFs. 



The USA is by far the top global destination for economic migrants and political refugees. The notion that we're hated is absurd and countably false. That foreign elites with hands on bureaucratic and media levers hate the USA, for easily understood reasons of envy and competitive fear, is equally obvious.

USA elites who wish to subsume American power into a global cauldron of "expert" rule, simply exaggerate the nonsense spewed by their overseas sympaticos.

David Wren-Hardin responds:

In some ways I agree with the critics, though not to a great degree. But if everyone in the world is against us, why did France just elect a president who ran on a platform of increased cooperation with America?

Shui Kage replies:

I am not aware of any French military cooperation with the US in Iraq. If the new French president has decided to do so, then I cannot understand why the French elected such an insane president. 

Marion Dreyfus remarks:

The US is envied and lusted for. Big Bro is so powerful it dwarfs the modest claims of the littler countries. And France's new president is not "insane" because he professes more support for a country that has in the past done a great deal for the people of his modest state.

Chirac was a nasty bit of work, and we are deserving of a man whose raison d'etre is not hatred of the US for no particular reason other than to regain the Sun King reputation France lost so very long ago and has been striving to recapture foolishly and with an ugly complexion. 

Stefan Jovanovich adds:

I don't think that we Americans should spend much time being unhappy about the world press's not liking us. We are the only country that has the military capability to destroy every major city on the planet. That is hardly the kind of power that makes people want to say nice things about you. China has been bent on expanding its "sphere of influence" for quite a while. Notably, its East Asian neighbors are pushing back. Taiwan, South Korea and Japan are all undergoing major military expansions in their naval and air capabilities. On balance, the Chinese, even with their expansion, have less relative clout in the region than they did five years ago. Then, political reunification seemed a distinct possibility for Taiwan, given the presumption of China's military dominance. One does not need to like the Russians to concede that, from their point of view, enlarging NATO and establishing military bases in Central Asia could be seen as threats to their diminishing territories. But there is little the Russian Federation can do except bluster. The decline in the capabilities of the great conscript People's militaries of the Marxist world (first China, then Vietnam, then Russia) is the most important change in the past third of a century. Then, the U.S. had trouble invading the island of Grenada, and the Soviets could, simply by hinting at their strategic capabilities, force the IDF to let the Egyptians walk away from the east bank of the canal. Now, both the Chinese and the Russians have extreme difficulties in attracting even half-bright people into their militaries. They know that conscription does not work, but they have no ready alternative to it. They both have the money, but they are not willing to spend it. Both the Russians and the Chinese think their foreign currency reserves are more potent weapons than an all-volunteer military. 



I would be really grateful for answers to the following …

  1. When there is a sudden increase in demand for an ETF do the managers have to buy the constituents and thereby push up the price of those so that the EFT's price continues to reflect that of the constituents?
  2. Is this different from a closed-end fund?
  3. Is the price of an ETF a function of sudden changes in volume in the same way that the price of a typical share is influenced by sudden changes in volume?

David Wren-Hardin explains:

  1. An ETF is just a container for a basket of stocks. I'm not sure whom you mean by the manager. If you mean the trust, the trust holds the stocks, but doesn't have to do anything if people buy ETFs on the open market. If people are buying an ETF, though, and a specialist or marketmaker sells them, he will typically hedge with the underlying basket or with the equivalent future. So the buying pressure is passed on. But no one has to buy the underlying.
  2. I believe it's different, because ETFs can be created and redeemed. You can hand the trust the basket of stocks and get ETFs, or you can break up your ETF and get the basket of stocks back. Potentially, the number of ETFs is limited only by the amount of underlying stock in the open market. Mismatches in demand can lead to impaired rebates of ETFs for those who are short, especially around dividend times. Clearing firms will then sometimes create ETFs to ease the impairment for their customers. Or customers will create ETFs themselves to cover it.
  3. The short answer is yes. The ETF and its underlying stocks trade as an arb, and changes in demand quickly move back and forth between the two universes.

Kevin Depew adds:

From the iShares Web site:

iShares ETFs are traded like stocks on an exchange where investors buy and sell them just as they would any other publicly traded security. And because iShares ETFs trade like a stock, investors can benefit from features like intraday pricing and trading, the ability to place stop and/or limit orders, and the opportunity to sell iShares ETFs short.

Like other exchange-traded securities, iShares ETFs will trade subject to a bid-ask spread. Spreads may fluctuate in response to supply and demand forces, overall market volatility, and other factors ? in other words, the same factors that influence the prices and spreads of stocks. But unlike stocks, the ETF's creation and redemption process not only helps to minimize the bid-ask spreads, but may also reduce the premiums and discounts that can develop between the iShares ETF market price and the Net Asset Value (NAV).

ETFs are very different from closed-end funds. A closed-end fund's shares are fixed, which is why they frequently trade at a premium or discount to NAV. Although they both trade on an exchange, the ETF shares can be created and redeemed throughout the day.

Also, it's important to get a handle on the composition of ETFs. The Biotech HLDR, with fewer than 20 members, is two-thirds weighted in AMGN and DNA. On the other hand, IBB, with more than 150 members, is only about 12% weighted in AMGN, has no exposure to DNA. That's a significant difference for two funds labeled Biotech. David Wren-Hardin replies:

Kevin makes a great point. HOLDRS were invented by Merrill Lynch, and unlike other ETFs from the Spyder family (SPY, DIA, XLE, et al.), they never rebalance, and their composition does not change unless a company is taken over or goes bankrupt. That's why AMGN and DNA have taken over the BBH, as opposed to IBB, which is rebalanced from time to time.

In addition, it's more costly to create/redeem out of a HOLDR than a SPY, It costs $10.00 per 100 HOLDRS to create or redeem, That works out to a dime a HOLDR share, a pretty hefty premium. SPY, on the other hand, is a flat $3000.00 charge. The minimum creation unit is 50,000 shares, so that's only six cents, 40% cheaper already. But its $3000,00 for 50,000 or 5,000,000, and at that level the fee becomes a much smaller cost.

Also, HOLDRs pay their dividends straight through. If INTC goes ex-dividend, the owner of the SMH gets the dividend the same day as a regular INTC owner, minus a touch since fees are taken out of the dividend stream. Spyder products and their ilk accumulate the dividends over time, and pay it out quarterly.

Art Cooper remarks:

An excellent resource is Russell Wild's Exchange Traded Funds for Dummies.

Dean Parisian remarks:

I bought into the ETF story early on. So far so good with the love of my financial life, RSP, the Rydex S&P Equal Weight ETF, doing what it is supposed to do.

But all is rosy neither in love nor in the financial markets. I'd like to think I was hoodwinked in shares of USO, the United States Oil Fund. Contango has pinned me down so far, can backwardation bail me out? The fund manager said I should have read the prospectus better.



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

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

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

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

Hint … One such clearing event occured today.

Jim Sogi writes:

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

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

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

David Lamb adds: 

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

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

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

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

Vincent Andres writes: 

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

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

1. Long clearing events:

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

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

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

Maybe markets also need to rest or to cool.

2. Short/instantaneous clearing events:

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

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

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

Maybe markets have also some trigger or revelation.

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

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

Henri Poincare

Victor Niederhoffer adds: 

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

David Wren-Hardin writes: 

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

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

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

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



Here's a technical question for experts on the operation of the NYSE and Amex markets.

For listed stocks with large volume, there is a daily "open" and "close" print at which a large number of shares usually trade. Ideally one can trade with a market-on-open and market-on-close order and avoid paying the bid/ask spread.
However, it seems to me that the open and close crosses have much smaller volumes for ETFs.

I'll compare Newmont Mining (NEM) and a gold stock ETF (GLD). Both are listed on NYSE. Both average about 5 or 6 million shares traded per day.

This morning 101,000 shares of NEM traded at the opening print, and 130,000 traded at yesterday's closing print. GLD, however, had a lot of volume this morning, including pre-market, but there was no obvious opening print. The largest single trade between 9:30am and 9:40am was only a few thousand shares, and that was by no means the first trade.

Are there different rules for ETFs in terms of the open and closing crosses? Is there a way to participate in some kind of crossing trade for ETFs?

David Wren-Hardin explains:

The short answer is, yes, there are opening crosses. The issue as to why a lot of them aren't seemingly efficient as stock crosses is that a lot of ETFs are traded as an arb. If there's a large buy imbalance in the QQQQs, the marketmakers and specialist will simply skew the market to where they can get their futures off to offset the trade and lock in their profit.

Unlike a stock, where the open and closing imbalance can be seen as the market's arriving at a conclusion as to the value of the stock, with an ETF, either the market knows what the value is because of an electronically traded future, or it doesn't, because the value is determined by a basket of stocks. In the first case, someone sending resting opening orders knows he will get a fill away from true value almost by definition. In the second case, the marketmakers and specialists can't figure out what something is worth until the basket of stocks is open, which all have their own opening imbalance games going on.

So in the case of something like GLD, which includes illiquid names with all sorts of late opens, the marketmakers would be fools to lay any sort of tight market. Anyone who traded against them would be doing so because he had a much better idea of where the underlying stocks are going to open.

Charles Pennington responds:

I don't understand the argument. The GLD ETF, as you note, would be the second of your two scenarios. That means there is much uncertainty about where it should open. I add that that's also the case for a regular stock. So what's the difference between an ETF and a stock in this regard?

David Wren-Hardin clarifies:

I was thinking of something like OIH. If there are 500,000 shares to go on the open, how are the marketmakers going to get their hedges off? Typically, they will wait until all the stocks are open, so they know what the value is. Of course, by this point, the world knows what the value is, and there's no longer need for price-discovery, and the customer will get arb'ed against. So if a customer is willing to do that, then he is essentially saying he know more about the opening or the post-opening than is obvious, and the trade will only be a loser for the marketmakers. Maybe he is leaning on the open prints in the underlyings in order to pick off the marketmakers.

The difference is who trades stocks, versus ETFs, or the perception of who trades them. ETFs are driven to a large degree by speculation. People trying to get in and out, people trying to capture an arb. They are often seen by marketmakers as smart money. Stocks, on the other hand, can often be driven by a different type of customer, such as a mutual fund. Their opening or closing order is just seen as a block of stock moving at some easy to mark price where the mutual fund is assured of some level of price-discovery giving them a fair price. Therefore, marketmakers, or even other customers, are more willing to step up and offset the balance.

Charles Pennington replies:

OIH is another example of a very liquid ETF which has very little volume on its open and close. Both OIH (the ETF) and SLB (Schlumberger) trade on average about 10 million in volume per day.

This morning, SLB traded 69,000 on the open, and OIH traded only 10,500. Yesterday SLB traded 36,500 on the close. My source of time and sales doesn't show any obvious large closing trade for OIH.

So there seems to be a big systematic difference.

Another Spec asked me what I meant by "closing cross". Here's my understanding:

One type of order that can be entered for NYSE stocks is a "limit on close". (There are also "market on close" orders.) These orders must be entered before 3:40pm EST, 20 minutes before the closing bell.

All such orders are held until the close. Then the specialist determines at what price the maximum number of orders can be crossed. If I have a limit order to buy at 50, and someone else has a limit order to sell at 49, then our orders might be "crossed" at 49.50. The specialist determines the price at which the cross can take place. Ideally there will be a price such that the buys and sells balance each other, and the specialist doesn't have to get involved in buying/selling. If not, then there is an "order imbalance".

However, NASDAQ over the past few years has added a closing and opening cross for its stocks, and they call it the "closing cross". I've been very satisfied when I've used it.

J.T. Holley notes:

From the AMEX webpage,

Rule 131A-AEMI. Market on Close Policy and Expiration Procedures. The following procedures apply to stocks and closed end funds and do not apply to options or to any security the pricing of which is based on another security or an index (e.g., Exchange Traded Funds or Trust Issued Receipts, securities listed under Section 107 of the Exchange Company Guide, warrants and convertible securities).

Looks like ETFs don't have the applicable MOC trade.

And it seems that they trade till 4:15pm in "broad index" cases.

David Wren-Hardin remarks:

That might be the case for products still listed on the AMEX, but doesn't help you if you're worried about things like the iShares.

There's an informal 4:00 closing price in the SPY for brokers/customers who want to mark their SPY against the 4:00 broad market close, then a formal closing rotation at 4:15.

Kevin Depew adds:

From the iShares Web site:

iShares ETFs are traded like stocks on an exchange where investors buy and sell them just as they would any other publicly traded security. And because iShares ETFs trade like a stock, investors can benefit from features like intraday pricing and trading, the ability to place stop and/or limit orders, and the opportunity to sell iShares ETFs short.

Like other exchange-traded securities, iShares ETFs will trade subject to a bid-ask spread. Spreads may fluctuate in response to supply and demand forces, overall market volatility, and other factors ? in other words, the same factors that influence the prices and spreads of stocks. But unlike stocks, the ETF's creation and redemption process not only helps to minimize the bid-ask spreads, but may also reduce the premiums and discounts that can develop between the iShares ETF market price and the Net Asset Value (NAV).

ETFs are very different from closed-end funds. A closed-end fund's shares are fixed, which is why they frequently trade at a premium or discount to NAV. Although they both trade on an exchange, the ETF shares can be created and redeemed throughout the day.

Also, it's important to get a handle on the composition of ETFs. The Biotech HLDR, with fewer than 20 members, is two-thirds weighted in AMGN and DNA. On the other hand, IBB, with more than 150 members, is only about 12% weighted in AMGN, has no exposure to DNA. That's a significant difference for two funds labeled Biotech.

David Wren-Hardin replies:

Kevin makes a great point. HOLDRS were invented by Merrill Lynch, and unlike other ETFs from the Spyder family (SPY, DIA, XLE, et al.), they never rebalance, and their composition does not change unless a company is taken over or goes bankrupt. That's why AMGN and DNA have taken over the BBH, as opposed to IBB, which is rebalanced from time to time.

In addition, it's more costly to create/redeem out of a HOLDR than a SPY, It costs $10.00 per 100 HOLDRS to create or redeem, That works out to a dime a HOLDR share, a pretty hefty premium. SPY, on the other hand, is a flat $3000.00 charge. The minimum creation unit is 50,000 shares, so that's only six cents, 40% cheaper already. But its $3000,00 for 50,000 or 5,000,000, and at that level the fee becomes a much smaller cost.

Also, HOLDRs pay their dividends straight through. If INTC goes ex-dividend, the owner of the SMH gets the dividend the same day as a regular INTC owner, minus a touch since fees are taken out of the dividend stream. Spyder products and their ilk accumulate the dividends over time, and pay it out quarterly. 

Art Cooper remarks:

An excellent resource is Russell Wild's Exchange Traded Funds for Dummies.  



I finally read Gatheral's book, The Volatility Surface, and I would recommend it to professionals who deal with complex/esoteric options structures. He derives, explains, and sets-in-context some pretty arcane stuff, with lots and lots of equations "showing the work". It's not for newbies or folks put off by the math.

The book's bright tone, no doubt due to his excellent editor, isn't marred by the Expert's oleaginous preface.

David Wren-Hardin adds:

I agree with George's review, but I wouldn't say that the book is only for people dealing with complex/esoteric options. It describes the state-of-the-art for how equity/index options are being described now by most groups. If you trade more than simple strategies such as buy-writes or spreads where you have only one or two position per product, the ideas are something you need to know.

Reading rigorous books and papers is a great way to find my mathematical blind spots, although I also have the luxury of being able to wander over to our quants and ask, "What the heck does this mean?!"



 What do hedge funds look for in a proprietary trader?

Independent, entrepreneurial team-players. Aggressiveness, with the ability to integrate information quickly. Essentially, the ability to make quick decisions on incomplete information.

The longer the track-record the better. Consistent profitability with low volatility of profits, where "low" will depend on the fund. Some will look askance at "too low" volatility, figuring there isn't enough risk, or that you're afraid to put it on. Be able to explain the scalability of your trading, and how you can increase or decrease volatility, i.e., risk. Maybe you had to play it safe because of margin constraints, broker constraints, etc. They'll want to know how quickly and how much you can scale up whatever it is you want to do.

As to education, the traditional degrees, Finance, MBA, etc., are easier only because you don't have to explain yourself. People know what you know. An ex-scientist or ex-engineer will constantly be asked why he switched careers and the applicability of his background to trading. A different degree helps you stand out, but it also moves you from being a safe, and easily defensible choice, to a risk.

Your cover letters should be short and to the point. No one is going to sit and read a long essay from someone he's never met. Generally, funds are looking for junior people from groups they know at banks they know.

Everyone is hiring, to a certain extent. They may not be publicizing it. Almost any fund will listen to someone they find intriguing. There are recruiters all over the place, playing up their hot contacts and jobs.



 I asked the doctor, "how did evolution create vision?" His quick reply was that because of predators, individuals must be able to detect them for their survival, and thus vision developed.

Well that's quite a story. But what is behind the intelligence that creates the marvelous, intricate organ like the eyeball which coordinates perception with neurons in the brain? It is really startling to think about my vision.

David Wren-Hardin comments:

Vision almost certainly didn't arise from an attempt to spot predators, but rather as the development of a phototaxic behavior. Remember, light = energy, and if you're the sort of organism that can convert energy to light, or if you eat the plants and algae that do, then you need a way to find the light. The arms-race in vision probably began when predators on these organisms used their photoreceptors to find areas that were likely to contain their prey. Now there is pressure on the preyed-upon to evolve ways of using their photoreceptors to spot predators first.

Once you have one photoreceptor, building an eye is a snap. Nature loves adding extra features to organisms, whether it's extra segments, limbs or other peripherals. Pick up a bunch of random cats, for example, and you are assured of finding a few with non-standard numbers of digits. Once an animal has a grid of photoreceptors, it can now map visual space, and build all sorts of cool edge and looming detectors very easily.

Uncomfortably for the Intelligent Design crowd, the mammalian eye is a lousy design. The wires that carry the signal from the photoreceptors run across the surface of the eye, and leave it in a cable that forms a blind-spot in the receptive field. This would be like an engineer at Sony who decided the best way to build an LCD TV is to have each wire for each pixel run across the front of the TV. In addition, the retina is composed of many layers of cells, and the actual receptors are buried under these layers; the light has to go through them to get to the rods and cones. The octopus, however, did it differently, with its photoreceptors in front, and the outputs running out the back. So either there were a couple of intelligent designers running around, or there were trial versions, and we got the short end of the stick.



 Denny's is my kids favorite restaurant. They've noticed that the Denny's by our house is always at least 1/2 full, or more, no matter when we go. David seems to think that they have a steady clientele that is growing.

The kids like the fundamentals they've researched from the analyst.

They think the food is good, served quickly and has catchy names (Moon's over MyHammy … who can argue with that name … and Hunter likes the kid's menu).

Mr. Russell (their teacher) likes the senior menu (Mr. Russell bought Denny's in his trading portfolio two weeks ago).

David is very excited about doing this trade, but I told him we should do more research. He said, "Let's ask the spec list, they'll know what to do" (who can argue with that)

So … what is the list's opinion of Denny's?

Tom Larsen replies:

Maybe the kids should try to find someone that doesn't like Denny's and ask why.

Maybe the kids could estimate what it costs to make a specific meal at Denny's and then compare that to the price. They could count how many customers are in the restaurant. They could see what people are eating. Maybe they could have a short conversation with the local manager about how he manages the restaurant.

They could learn about the different jobs at Denny's. They could learn what a franchise is. They could also think about the company's advertising and whether it works or not. They could try to determine which restaurants are "the competition," and test the food at these establishments as well. This research could get really expensive, Scott, but if you are taking kids out to eat, Denny's is a good place to go.

David Wren-Hardin Adds:

I would have them analyze the upcoming increase in minimum wage and its possible impact on Denny's costs.

Martin Lindkvist Suggests:

 The stock could work great, but I would ask one more question: Do other investors already know this, and is it discounted? By discussing whether a restaurant that stinks and has bad food actually could be a better investment one stands a better chance not investing in something that "should" work great but that others have already invested in and driven up the price. Compare with Birinyi Research that just showed that the five least liked companies by analysts (Dow components) beat the 5 most liked by analysts in each of the five or so last years. They also beat the average of the thirty years. As I said, it can be a great investment, that restaurant you are discussing, but I think the discussion could give more meals for a lifetime including expectations.

J. T. Holley Contributes:

 A few years ago when I got to go to one of those “pat on the back” conferences w/ Paine Webber they had Lou Holtz come speak. He spoke to a crowd of folks that more than most liked modern portfolio theory and randomness. The best part was when he started to speak about investing and speculation. One day back in the 70’s or 80’s a guy asked him if he’d like to invest in a McDonald’s franchise. Lou said that he had been plenty of times but went by one that night and had a meal. He looked up at the Arches and underneath it read at the time “Millions Served”. He thought at that time that it had saturated the marketplace and probably wasn’t a good investment. Now the sign reads “Billions Served” so he said take that for what his skills were worth in speculation.

The other thing Lou mentioned in the spirit of “Racquet Sports” was when he came onto campus one day when Rocket Ismael first came to Notre Dame. He said that he knew Rocket was going to be one of the fastest players that he’d ever coach when he looked over and saw him playing Tennis. After a subtle pause he exclaimed “by himself”. I’ve probably missed out on a ton of good companies in my short investment life so far, but I had an older man tell he upon entering the “Speculative” business to stay away from Airplane, Restaurant, and Mining stocks and to this day I’ve done that (untested out of blind obedience to the unnecessary fixed rule to obey your elders).

Scott Brooks further adds: 

I just thought I'd update the group on the Brooks Kids Question on Denny's from the other day:

David is driving me crazy. He wants to buy Denny's stock and buy it now.

He is very excited about making this trade. He is cajoling, pushing, negotiating … and just short of begging me to make this trade for him. He has made up his mind and wants it now … however, I want him to wait.

I've told him that we need to do more research and figure out if this is a stock he wants to buy. He says, "Dad, you buy stocks a lot quicker than this … you don't spend this much time doing research …".

Of course he's right. I pull the trigger a lot quicker. But, as I've told him, I've been doing this a long time and I think I have a pretty good handle on what I'm doing (or at least I'd like to think I do).

I've told him that we need to wait until he gets more questions answered about the stock. I've told him that this is going to be a research project for him and the other kids. They should research this out, prepare a list of vital questions and get them answered before making the trade … or not making the trade … (as I've tried to tell him, some of the best things I've done in investing are the trades I didn't make).

But still he wants it. I've decided to wait and make him and the other kids do their research. I've concluded that it will be of more value to them to learn the details of the process (from the fundamentals on up) than to just make the trade on a little more than a whim and then see what happens.

I was tempted to let them make the trade, but decided to wait. I am not so worried about them making the trade and then losing money … I think that would teach them a great lesson. I am worried about them placing the trade and then making money … I think making money on a poorly planned and thought out trade would be far more detrimental to them.

So the trade waits for the research to be done.

Russell Sears adds:

Perhaps I missed the post, but did anybody else suggest counting, besides fundamental analysis?

While complex stats may be beyond the young ones, reading a chart and then doing some math on money should be a clear lesson when it is their own money.

A quick look at DENN max on yahoo shows they tanked big time in '98 to mid 2000 from $10 to below $1, apparently after recapitalization due to heavy debt.

You should have them count what could have happened back then.

Also I would suggest that you mark the dates of their ten Q release on the chart for the last ten quarters.

Perhaps stat significance is beyond them but I think the ideas can be grasped with some visual help. 



In the office we were talking about the repeated action of the S&P’s move to a certain level, and then it’s falling back from this level, that occurs on a day like today. This repeats until the potential energy of the market is converted to kinetic energy, and the market rises higher. We were looking for analogies for this, such as power lifting where you bounce the weight before extending it to maximum lift, or pole vaulting where you can take up to three tries to get over the bar. In the process of this we were also considering the energy transfer involved in making a child’s swing set go higher with each swing. The following brief explanation was found but I would be interested in any ideas people have on a proper model for the back and forth; the trying to get there but failing, that happens so often in the markets.

Each time the swing moves forward and then returns to its starting position counts as one cycle. Using a stop watch determine the length of time a swing needs to complete say 20 cycles. Divide 20 cycles by the time and you have the swings frequency in cycles per second or Hertz (Hz).

Since a swing is basically a pendulum it’s possible to calculate its resonant or natural frequency using pendulum equations as follows:

Note that the natural frequency of the swing is not influenced by the mass of the person in it. In other words’ it makes no difference whether a swing has a large adult or a small child in it. It will have the about the same natural frequency. Slight differences can be caused by slightly different locations of the person’s center of mass. This is located about two inches below the navel. When people are sitting the center of mass is in about the same place relative to the seat of the swing regardless of whether the person is an adult or a child.

If a forcing function is applied to a swing at the natural frequency of the swing it will resonate. The amplitude of the swing will increase during each back and forth cycle. The forcing function can be provided by a second person pushing on the swing. In this case even a small child can make a large adult swing by pushing in sync with the swing’s back and forth cycle. The forcing function can also be provided by the person in the swing. In this case the person in the swing shifts her center of mass very slightly by changing the position of her legs or torso. This creates a slight pushing force which makes the swing go higher and higher. It takes a very small force but it has to be timed perfectly.

The big question is what keeps the swing from flying apart or spinning over the top of the swing’s frame and subsequently killing its rider? After all, if it is a resonating system then it should be very dangerous to keep applying force in time with the swing’s frequency. The answer is fairly simple. The equation given above is only good for small angles. When the swing goes beyond a certain height it is no longer possible for the person in it to apply the necessary small force in sync with the natural frequency because the natural frequency changes. In other words the motion of the system is naturally limited.

Jim Sogi offers:

The apparent back and forth motion around the round number is a chart artifact, and as with so many chart artifacts is an illusion. The motion is in three dimensions and only appears on the chart in two. The model is a tether ball, like at summer camp. It has circular momentum from whacking it, and tightens, then rebounds off and unwinds. The angle of the wind depends on the angle of the whack. Circular math a’la Newton might work.

The other model is a guitar string. It has harmonics and standing waves along its length as the axis of vibration meet along the string, similar to price action harmonics. The higher harmonics are recreated in the higher and lower price levels.

Gary Rogan comments:

I also view the market gyrations as something similar to a swing, except it’s nothing like a physical, earthly swing because there are two forces involved, and one of them is “unusual” for a physical-world system. In the physical world, there is only gravity (other than a small amount of friction) involved in the dynamics of a swing that results in a simple differential equation describing the motion for small deviations. I see two basic “forces” involved in market motion: “momentum” and “value pricing”. Positive momentum is the force that causes people to buy when the market is moving up (buying interest proportional to market velocity), negative momentum is the force that causes people to sell when the market is moving down. Thus momentum is a force proportional to velocity, sort of like inverse friction that doesn’t exist in the real world. Value pricing is what causes people to buy when prices are “too low” and sell when they are “too high”.

Of course all of this exists in the environment of slow upward drift and real-world-like friction of various trading costs as well as news events and money-supply formations that are not completely dependent on the immediate market dynamics. The relative amplitudes of the two forces also change with time.

Normally the two forces are balanced enough to keep the market gyrating around some sort of a temporary equilibrium that itself is slowly drifting. However, when the momentum force gets too high (as in 2000) it will break the swing.

Jeff Sasmor adds:

Another thing to consider is inertia. There is a nice article on this in Wikipedia and other sources.

The principle of inertia is one of the fundamental laws of classical physics which are used to describe the motion of matter and how it is affected by applied forces. Inertia is the property of an object to resist changes in velocity unless acted upon by an outside force. Inertia is dependent upon the mass and shape of the object. The concept of inertia is today most commonly defined using Sir Isaac Newton’s First Law of Motion, which states:

Every body perseveres in its state of being at rest or of moving uniformly straight ahead, except insofar as it is compelled to change its state by forces impressed. [Cohen & Whitman 1999 translation]

Perhaps this explains the recent upwards moves in stocks in spite of multiple discouraging memes. Humans have a lot of inertia, we’ve probably programmed a lot of it into the machines that do a lot of the trading these days.

It’s odd that this came up today, I was mulling the concept last night before falling asleep. Interesting questions that came up are:

It is a system with a lot of inputs and time-varying coefficients. Maybe it’s a reverb chamber?

David Wren-Hardin mentions:

Swings and oscillations are found throughout nature where systems on different time courses interact with each other. One obvious relationship is the classic predator-prey population dynamic. As prey animals increase in number, predator numbers rise on a lagging basis. A peak in prey animals is followed by a crash as they consume their resources, dragging the numbers of predators with them. One can cast value investors in the role of rabbits, with their steady grazing on low-calorie fare, and the momentum investor in the role of the coyote, waiting for concentrated packets of dense nutrients. Or one could place the casual investor in the role of rabbit, and the average financial professional in the role of coyote, but I’ll refrain from that comparison so not to risk defaming the coyote.

Animals also use oscillations to find out information about their environment, much like the technical analyst or trading-surfer surveying their charts. The weakly electric fish, Eigenmannia, emits an electric signal as a sort of radar to find objects in its surroundings. The problem arises when another Eigenmannia is nearby, sending out a signal at a frequency near the first fish’s signal. This results in a “beat” frequency equal to the difference of the frequency of the two signals, composed of amplitude and phase modulations. Much like the market, when the agendas of different market participants collide, the result is confusion and little information for anyone. The fish responds by moving the frequency of its signal away from the other, a process known as the Jamming Avoidance Response. The fish doesn’t know if it is higher or lower, and has to solve the problem based on how receptors spaced over its body are receiving the phase information of the two signals. In essence, each receptor “votes” on whether it perceives the signal to be leading the other, i.e., it’s at a higher frequency, or lagging, i.e., a lower frequency. Any one neuron may be wrong, but in the aggregate, the animal arrives at the correct conclusion. In classic research, the late Walter Heiligenberg termed this organization a “neuronal democracy”.

As traders, individual neurons awash in the market’s oscillations, we are faced with the same problem. Are we leading? Are we lagging? It may come as little comfort that the market will eventually get it right, even if we are wrong.

GM Nigel Davies offers:

In chess this would be quite a typical scenario. Often when you inflict some kind of permanent damage (structural or material), there is a temporary release of energy from the other side’s pieces. The ‘trick’ is to balance the gains against the likely reaction, and this is also necessary. To improve a position you often have to allow some temporary (hopefully) counter play, kind of like a wrestler letting go of an opponent temporarily so as to get a better grip.

Dr. Michael Cook adds:

Gary comments that market gyrations are “nothing like a physical, earthly swing” because there are two forces involved. How about the case of a damped oscillation, which has physical analogues? Using this analogy, momentum investors are “damped” by the “restoring force” supplied by value investors.

And what happened in the bubble was the disappearance of effective value investors, which led to an un-damped oscillation, which, when driven at the appropriate frequency, leads to wider and wider oscillations which no physical — or financial — system can sustain.

The collapse of the Tacoma Narrow Bridge is the canonical example, and here is an illustration of the math behind the phenomenon.

Rick Foust contributes:

Imagine a ball rolling down a slight incline that has a crown in the middle and rails on the sides, similar to a highway with guard rails. The ball seeks the nearest rail, bounces repeatedly and eventually stays on the rail as it continuous forward.

Now imagine that the roadway has an irregular surface and rough rails. The ball will once again seek a rail. But this time, it will do so in a careening fashion that depends on the roadway surface. As it encounters a rail, it will briefly run down the rail, bouncing as it goes, until it eventually hits a point of roughness large enough to kick it to the other side. The amount of roughness required to cause a change in state depends on the slope of the underlying surface.

In the market, the rails are accumulations of large and small limit orders. Rail roughness is created by variations in order size and position. The roadway surface is formed by underlying market orders that create a natural drift. The roadway surface may undulate in a rhythmic fashion, similar to the Tacoma bridge, if market participant psychology is undecided. Or it may consistently lean in one direction if there is a prevailing sentiment.

At some point, limit orders at one rail or the other are exhausted, pulled or merely absent. At that point, the ball is free to discover the location of other rails. Stops are now run, creating new market orders. New participants are drawn in. If the new rails encountered are small and scattered, the ball will plow through them and may even gain momentum until it eventually encounters a rail large enough to stop it. Until this rail is reached, the underlying roadway slope will likely increase as sentiment is self-reinforced.



In response to Professor Haave's query: "Mandelbrot does a good job attacking modern finance theory, and he does a good job explaining what the rest of us call "fat tails". But otherwise, well, is it the same merit as Elliot Waves?"

There are several things wrong with Fractal and Chaos Theory:

1. The world view is fundamentally and fatally pessimistic. Benoit Mandelbrot argues that the variance must be infinite. He drew that conclusion 40+ years ago based on the fact that cotton prices had changing volatilities over time. Based on that slim evidence he jumped to the conclusion that it must be infinite. I have yet to see a real world price of infinity. Despite the lack of even a single infinite data point, Mandelbrot completely dismisses the modern GARCH models as being too complex. In my opinion, dealing with the intractability of infinite variance is far more complicated.

2. It is non-predictive. Generally speaking, randomly generated numbers (fractals) are produced and usually graphed. Then the pretty pictures are compared to real world phenomenon in the past. The pictures do seem to resemble some real world patterns to the human eye. In my opinion that is because the eye wants to see patterns in such things as snowflakes and turbulence swirls.

3. Lack of rigorous definition. Admittedly there are some valid mathematical proofs which have come out of this area. However in general the field is completely devoid of basic metrics. For example how does one define "similar to" or "close to" for a fractal? This lack of basic metrics comes out of the fundamental pessimism in point 1. The philosophy is that the real world has infinite variance so there is no point in measuring how far we are from something because the next event could be infinitely far away.

4. Lack of goodness of fit, statistics and feedback as to how well this theory fits the real world. You will never see a statistic of any kind in a paper on fractals or Chaos theory — no estimate of probability, no R squared, nothing. In his book, Didier Sornette performs numerous non-linear fits of various market crashes and yet never presents a single probability estimate or R squared value. It is always presented as "see how nicely the chart of the model overlays onto the actual market chart".

5. The theory is non-scientific. To be scientific a discipline must make testable falsifiable predictions. These theories are not predictive and therefore not testable nor falsifiable.

Chaos theory extends these fundamental issues one step further. Most mathematical definitions of a 'critical point' involve a term something like: 1 / ( t0 - t ) , where t is the current time and t0 (t zero) is the time of the critical event. At t approaches t0 the difference goes to zero. So at the critical juncture we are dividing by zero. The entire expression goes to infinity at that point. (Strictly speaking it is undefined not infinite). The point is that even if BM is wrong about infinite variance the models of Chaos Theory create their own asymptotic behavior which means these models do exhibit infinite variance even if the real world data does not!

About the only hope I have for these theories is that some of the older generation of thinkers will pass on and a new crop will come in and invent metrics and ways to measure goodness of fit which can turn this field into a predictive and testable science.

Russell Sears responds:

Could someone explain how theses theories lead to the doomsday scenario which Mandelbrot and the Derivatives Expert are so fond of? In my mind, I have worked out the following, tell me if I am on the right track:

First, the chaos part. You can often find "meltdowns" in markets. Points in time that markets "jump" and are discontinuous, or at least "non-normal" for brief periods. A butterfly flaps its wings and you have a thunderstorm, for 15 min. or perhaps even a hurricane for a couple days. Say a 13 sigma event for a day in Oct 87.

Second the fractals. The market is pattern that can be repeated, and scaled up simply by time, say perhaps by the square root of time. Combining these, if a 13 sigma event happened in the past for a day, it's only a matter of time until it happens for say a month, or a year. Likewise if we seen a 13 sigma, it is only a matter of time until we have a 1000 sigma event.

However, to "prove this" fractal they do the opposite. They take long periods of time and scale down. Of course these long time periods don't have the "chaos" pattern  yet.

The problem is: these longer distribution are pretty much continuous. Therefore, they follow a random walk pretty closely. Of course when you take a distribution that is stable, you see these "patterns". It is the same distribution after all.

The real assumption concerning fractals is the "energy" of the markets, i.e. that people can go infinitely into craziness, an unlimited nuclear chain reaction, fusion versus fission. They simply reject all evidence of extremes as being contained fission, by saying fusion will happen.

As you said, it's not science, but it uses a lot of math terms. It's a belief system.

Dr. Phil McDonnell responds:

News can cause jumps. This may induce something like the Merton jump diffusion model. The idea is that markets are generally lognormal but a few times a year some big news happens to cause a few outlier events per year. Also remember that if the market follows a jump diffusion model that the 1987 crash should be counted in the model.

The modern GARCH and EGARCH models are better because they take into account shifts in the volatility regime. The 1987 event was say a 13 sigma event taken over a 50 year average volatility. But when you look at it in the time frame of that week's actual volatility it was only about a three or four sigma event.

The concept of self similar behavior at both smaller scales and larger scales is probably one of the more interesting aspects of fractal theory. Lo has found that the square-root scaling of volatility over time does not quite hold but it is close. He derived his own test statistic specifically to test for this in markets in a non-parametric way.

How much time? There is considerable evidence that large negative jumps are mean reverting. This is a violation of the idea of self similar. As an aside even the normal distribution is self similar regardless of scale. The normal distribution for, say, 20 trading days can be decomposed into two periods of 10 days, four periods of five days, all of which are normal and scaled proportionally to the square root of the time. This has been known for something like 200 years.

Generally speaking a philosophy of pessimism pervades the study of fractals and chaos. I believe it is direct consequence of the assumption that the variance is infinite. This requires the ineluctable conclusion that the big one is out there — hence the predilection for doomsday scenarios.

David Wren-Hardin adds:

I went to a talk Benny Mandelbrot gave at NYU, soon after his book came out. While it was interesting, it had very little relevance anyone trading on a daily basis to actually make money, or to value financial instruments. He was completely uninterested in questions of underlying mechanisms or market behaviors that might underlie his models. Attempts to get from him information on how to plug in actual market pricing into his models to give a predicted price were met by seemingly sincere shrugs of "the picture is enough, why make it more complicated?"


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