Washing MachineI have been refining a model of stock market emotional cycles for several years . The key phases of the model, from the long perspective:

Bottom, Relief, Distrust, Courage, Anxiety, Confidence, Hubris, Complacency, Top, Shock, Denial, Recognition, Anger, Depression, Prayer, Acceptance Bottom, Repeat.

I believe we are currently in the anxiety phase. Although fear plays a role, combined with other sentiments, in each of the phases, it is dominant in the anxiety phase. As a result, this phase is sometimes a breakpoint.

If market participants are willing and able to cross through the anxiety phase, confidence builds and the uptrend continues. If it cannot be crossed, the uptrend aborts, returning “safer levels,” shorting the cycle. 

The anxiety phase is analogous to a child's losing sight of its mother, or a sailor's losing sight of land.  Beyond here, there be dragons.

I refer to the series of phases prior to the anxiety phase as the recovery period, and the series of phases after the anxiety phase as the heroic period, Throughout the cycle, fear of being left out and fear of being wrong are powerful motivating factors.

The most consistent sentiment indicator is the early morning National Public Radio broadcast.

As an aside, mild fear is a more effective motivator than strong fear. If the feared outcome is too horrible, it cannot be accepted, and is either rationalized away or blocked out completely. This is sometimes discussed in advertising books.

Kim Zussman extends:

There is the same sequence in dating:

Recognition, Anxiety, Courage, Acceptance, Top, Bottom, Shock, Repeat Bottom, Relief, Confidence, Hubris, Complacency, Distrust, Denial, Anger, Depression, Prayer.



 Background: I once described how I use fellow engineers as contrary indicators. Engineers nearing retirement are best. When they walk up on their toes, sell. When they shuffle with their heads hanging, buy. One engineer in particular was such a precise indicator that, for example, he bought his first (and last) block of NASDAQ stocks on the day before the bottom fell out in 2000, and traded an economy car for a new Chevy Tahoe just before gas began to rise. As he came within 10% of the nest egg value he had targeted for retirement his moods intensified and he became a precise contrary indicator for stock market swings. Unwittingly I had even improved his precision by clueing him into the correlation. After that he would try to resist his own tendencies, only to betray himself a few times per year at major inflections.

Update: Well, he retired, and for a while I was partially blinded. But as luck would have it, he has come out of retirement to work part time. So, last week he bears down on me and loudly pronounces that the market is about to tank for three days and then run up. Why? He had committed to pull $28K out of a mutual fund to finance the purchase of a hybrid car and it would take three days for the transaction to clear. As I pondered whether or not he had given me a valuable stock market tip, it became clear that gas prices had peaked.

I know that many here are confident in their quantitative analysis. But I have to tell you that when I witness the ability of the human subconscious to process countless diverse inputs and arrive at precisely the wrong answer, I suspect that quantitative analysis is a distant second.

Alan Millhone asks:

I wonder what input your fellow engineers will offer on the current Minneapolis bridge collapse? Something I suspect in the way of construction repairs and one lane traffic triggered this horrible disaster. 

Rick Foust replies:

There has been no mention of a bridge collapse among our engineers. But your email gave me quite a start. My permanent residence is in Minneapolis, a small town I affectionately refer to as Mayberry, where 1500 souls live, in north central Kansas. I am away from home four days per week and don’t turn on the TV, so it came as a quite a shock to hear that one of our two tiny bridges had finally collapsed.

OK, I am not quite that naive, but the thought did cross my mind. Regarding an engineering assessment of the catastrophe in a somewhat larger Minneapolis, it may be a while before the engineering collective falls into sync with speculation on this event. 



 Since I try to make money by taking advantage of the stupidity of large groups, I nearly made the mistake of disregarding Michael Mauboussin's recent essay Explaining the Wisdom of Crowds: Applying the Logic of Diversity. But I did read it, if only to delight in proving it wrong in my own mind. And, to my surprise, I found it valuable.

Mauboussin correctly assumes three conditions are required for crowds to make superior judgments: diversity, incentive and aggregation.

The diversity assumption keys on the expectation that the ignorant will cancel out and the knowing will prevail. This reminds me of the old saying that a committee could have come up with the theory of relativity, but Einstein would have had to be on the committee.

The incentive assumption keys on the expectation that the smarter guessers will be drawn off the sidelines. This has me wondering about the electoral process.

The aggregation assumption keys on the expectation that there is an efficient means for combining the opinions of the crowd, in a fair and balanced manner. That seems obvious enough, but unlikely. I am reminded of Keynes characterization of the market as traders attempting to guess what others will guess that others will guess.

So, it seems I should keep an eye out for investments priced by a narrowly focused group, where there is little incentive for broad based participation and where the method of combining the opinions is broken or subject to substantial distortion. An example would be an inactive investment (no incentive) priced according to a commonly held (mis)belief (group think) in a poorly communicated market (little aggregation of opinions). That works for me.



Hunter and hunted or predator-prey relations are pervasive in the animal world. We're accustomed to observing and reading popular summaries and videos of the dynamics and techniques of survival for such pairs as lion & gazelle, wolf & squirrel, fox & lynx, coyote & seal, osprey & smelt, pike & minnow, and spider & fly. Such studies have been extended to romance and health among humans. Predator-prey relations are also common in markets. For example, the relation between market maker & day trader, dealer & ephemeral trader, flexible & inflexible, large trader & small trader, informed & uninformed, vig taker & vig payer.

Many studies in the field are based on the Lotka-Volterra model. This is a set of simultaneous differential equations relating to the rate of growth of the predator and prey populations to each other. A typical set of equations relating rabbit growth to fox growth states that dr/dt = ar-brf and df/dt = ebrf-cf where a is the natural growth rate of the rabbits, c is the death rate of the foxes, b is the death rate of the rabbits whenever they meet a fox and e is the proportional gain in growth that a fox gets from eating a rabbit.

Such equations do capture the main idea that as the rabbit population increases, the foxes gain in number because rabbits are easier to find and eat, and this provides a homeostatic mechanism to stabilize the rabbit population. Similarly, as the rabbit population declines, the number of foxes decreases because they have less food, and this helps increase the rabbit population which in turn tends to increase the fox population. As might be guessed, small changes in the assumptions of the model, such as time delays, lead to widely divergent behavior involving cyclicalities, instabilities and sharp changes in the dynamics that do not correspond to what we observe in most real-life populations.

A similar critique could be made of the two other standard methods of studying predator-prey relations, which are the functional response curve and the optimal foraging theory. The basic regularities there are that the costs and benefits of gaining prey vis a vis future reproductive success determine the extent and energy with which the predator seeks the prey. The key dependent variable is how much the predator eats as a function of the difficulty of converting the prey into food. An increase in the search time, handling time, or consumption time, reduces the predator's desire to eat. Certainly this leads to insights.  The problem here is that all these parameters are subject to estimation, and they are interrelated and subject to different hypotheses as to their function.

A good book for studying these techniques at an elementary level is John Alcock's Animal Behavior, and a good summary of the ecological approach to these dynamics can be found here.

Methods of studying the factors that enable predators to be successful have always been important to me as I, like other numerous individuals not at the top of the food chain, are often prey to much larger predators. I have often wanted to learn how to avoid capture, and even considered the possibility of sometimes turning the table on the predators and bagging them once or twice just to make the game a little more even sided. Thus, when I came across a cover story in Outdoor Life titled "Predators' Deadly Tricks," which describes how hunters go about capturing the most elusive predators in real life such as the coyote, the bobcat, and the mountain lion, I was very attentive and decided that I should try to devise principles from the practical and theoretical literature that might help other prey like me in their incessant battle with those who would devour them. 

  1. Signaling is key.The signals that the prey send out to show that they are not easy to digest prevent the predator from even considering attacking, and this saves much energy for the escape. Colors and scents indicate that the prey contain poisons. Stotting, the jumping behavior of gazelles when about to be chased by a cheetah, indicates that they are very mobile and not worth eating. Indeed the essence of the article is that the best way to attract a predator is with an electronic duplication of the distress call of its enemy. Amazingly, the coyote will often show himself within one minute of hearing the rabbit's call, especially when it's made with a "Foxpro FX5 that has a 200 sound capacity, one gigabyte of memory, recall buttons to switch between sounds, remote control functions, and a 700-yard range. Less than a minute later (after the call), a pair of coyotes charged in and we handily dispatched them." Market prey often indicate that they are ready, willing and able to defend themselves by the placement of limit orders in large size, but cancel if they are near just to prevent the larger predator on the other side from even thinking of going after them. The talk with your counterparts is how much more is available for adding to my line when you well know that one more grain of salt would be enough to topple you over.
  2. Vigilance is essential. The herding animals all find that 100 pairs of eyes with 50 always awake are enough to warn them of danger. Noses are always sniffing, ears are listening, and the antennae are always feeling. Indeed, some ducks can sleep with one eye open so as to never be victimized by a surprise attack. The hunter uses a telescope so that he can always perfectly see the adversary. He never lets the prey's vigilance work to his advantage by approaching stealthily, parking his equipment a mile away from where he's going to hunt, and setting up in a blind with proper camouflage. The prey in the market doesn't leave the market for a moment, as that might be the time that the enemy attacks.He cancels all orders when they don't get filled so that a surprise news announcement that's worth a limit move won't catch him just a few ticks from the last price. He has his computer set to wake him, which buzzes around in his private area so he never sleeps through a dangerous situation or lets the predator devour him totally.
  3. Deception is essential. My goodness, the moth blends in with the bark and orients with the grain of what he's sleeping on. The flies disguise themselves to look like bees, and the octopus can change 100 colors in one second. The spider uses a million deceptive lures to entice the fly into its web. The golden orb weaving spider spins a web that's so enticing that even when a bee breaks free, it will dive right back into it after it has escaped. (I am reminded here of the system player who, after a very bad trade on one side, doubles up on the other side for the next trade.) The chapter on deception in Education of a Speculator details other areas of deception in the world. "Quality camouflage is a must; select the pattern that most closely matches the foliage and landscape." Whatever you do, don't make any news. As a prey trader, I don't even like to type out that I'm thinking of exiting a trade, for fear that a predator might have my screen bugged or that the keystrokes are programmed to signal my intention. I never let the other side know what my stop point is because I know that it will always be hit. If I'm really hurting, I'll try to act 5,000 times stronger than I am, and I won't even begin to reduce my position by one contract for fear that my camouflage will be found out.
  4. Proper equipment is a must. Predators are constantly sharpening their claws and teeth. Prey must always practice escape maneuvers. Over many generations, most prey have adopted advanced techniques of escape that include the full range of methods used by individuals in their cohort from the beginning of time to elude capture, be it poison, scent, or cry. Their bodies are perfectly suited to the escape in size, color, speed and strength. The properly equipped hunter, in addition to his Swaroski binoculars and Foxpro FX5 caller, currently has a Gerber Epoch Pack, a Stoney Point bipod, Cabela coverup pants, and, of course, the obligatory Ruger bullets in a Browning rifle, a Bushnell scope, motion decoys, and a set of shooting stocks.
  5. If all else fails, try the unusual. Be prepared to shout if the predator attacks. The proper equipment for the trader starts with a proper price feed, perhaps one that's within a foot of the source of the prices so as not to lose out by the speed of light that it might take to get to you one-thousandth of a light second away.  Next, one should have a computer that's always set to trading and that isn't interfered with by email. Finally, have an office where no one can distract you from the job of survival with the cares of the world or a bill from the Service.
  6. Never give up. The cries of animals often save them from death. If nothing else, they serve to alert family members. The squirting of poison and the enlargement of the body is a common tactic of the caterpillar, and the gyrations of the weasel in extremis are often enough to ward off death. The hunter is told to scream if a predator attacks him and to have a spare set of guns and knives. As a trader, I try to follow the rules of a good competitor in sports who never gives away the last point of a game if there is still an iota of energy left in his body. There is always someone you can call on to help you fight back. On occasion, I've even asked a'la the Boy Wonder for the other half to help me out in a time of crisis, and so far the trust funds are still intact.
  7. I would recommend studying the literature on predator-prey relations by reading a few good books, following up on some of the hundreds of thousands of citations on the search engines, reading the Outside Magazine article in the December-January double issue and then trying to apply these techniques to make yourself impossible to detect, fruitless to waste energy on, and impossible to digest when caught. If all else fails, fight to the death.

J. Klein adds:

One Predator - One Prey; if it was ever so easy. 

It is more like Many Predators - Many Preys - Many Parasites.  Symbiosis. Competition among different parasites - how to maximize exploitation without killing the organism parasited. How to use a competing predator to one's benefit. Mixed situations: One is a predator and a prey at the same time but to different kind of critters.  How a steady state equilibrium evolves. 

In my opinion, however, we humans have already won nature's battle and rule the ecology to our benefit. We easily see through the animal world's tricks and catch them as we want. But the market is wholly made up by humans, who presumably have all been exposed for generations to nature's tricks and have become resistant to them. Situations like those that nature presents to us are no longer relevant, and we have moved to a higher level. It is a different game here.

Since we are part of the game, it is very difficult to see what is going on and much more how to manage it.  It is said that even the big winners know how they did it and why they succeeded. It seems to me that those winning have more useful memory, are able to calculate more precisely, see the present and the future more clearly, can formulate better plans, and execute more rapidly and precisely. In the market, nature's tricks don't work any more. This is a play of pure and cold intelligence.

Scott Brooks comments:

I've thought about this predator/prey relationship for many, many hours as I was sitting in a deer stand and I have several thoughts on this issue. I'll share some in this post. 

One of the biggest things to recognize in a predator/prey relationship is the opportunity that exists. One of the biggest things that we need to look at is the difference between instinct and reason. Whether prey or predator, if you are instinctual, you are acting out of some deep seeded genetic conditioning that causes you to run when faced with adversity. 

Think about it. If there are seven lions chasing a herd of 200 gazelles and the gazelles had the ability to reason, they would say, "Lets stick together and as a group go over there and trample those seven lions to death." The 200 gazelles would win that battle, and probably over time could condition the instinctual predator lions to leave them alone. The cost of messing with those gazelles is just too high. 

Think of an instinctual predator like a bear. Almost any bear could take a human if they wanted too, especially the bigger varieties like Grizzlies. Humans are simply not equipped to deal with them physically. But for the most part, we've conditioned bears to stay away from and fear us. That's only because we have the capacity to think and reason at a level that the Grizzly doesn't. We've figured out a long time ago that taking some animal gut and stringing it on one bent stick, and then taking another straight stick and putting a sharp tip on it, gave us the advantage. Then along comes names like Remington, Browning, Winchester, Anshultz, Benalli, etc. and the odds are stacked in our favor. 

When I played poker back in the 80's, I looked for certain types of players to be at a table before I would play. They were the prey. They weren't thinkers. They were gamblers. They let the cards fall as they may and "hoped" that things would go their way. But they had no real system or methodology to identify when to hold'em and when to fold'em. Most of them could not name three cards that had been played and subsequently folded (I'm talking seven card stud). So they had no idea what cards were still available to be played or not. I can't even count all the times when I could tell what hand someone was trying to build or bluff me into thinking they had and yet had no idea that the key card was already burned in the deck because someone had folded earlier. I guess I was a counter of sorts even back then. I'm not sure that qualifies me as a counter yet, maybe it just makes me someone who paid attention and kept track of things. 

These "gamblers" were hopeless gazelles at the table. I'm not saying that to be braggadocious. They simply didn't know what they were doing … they were nearly instinctual prey. They "needed" to win. They were always one card away from catching a break. They relied on luck. The reality for these guys was that the only way they could truly win was to quit and stop playing. Otherwise, ruin awaited them all. 

Those are the guys that I played against. I did not play against other good players. If there was more than one other good player at the table, I would find another game. I had nothing to prove by beating another good player. I was there for one reason and one reason only: to win money

For the same reason that lions don't usually attack other lions to eat, I was not interested in paying the price associated with trying to win money from other good players. The cost and risk/reward was just too high. 

To apply this to the markets, it is important to figure out where the instinctual investors are playing and those that don't have a thinking system, and use that to one's advantage. 

What are the masses going to do when "X" event happens? What is their likely "non-thinking" irrational emotion based response ("quick, run, the lions are coming"). 

Unfortunately, as I've said before, the masses left the markets after 2000, 2001, and 2002. They were burned so badly, and fear chased them away from what was very likely the greatest buying opportunity of their lives. It was like gazelles drinking from a stream and some of them getting snatched by an alligator. It seems to me that after a few have been snatched, that's the time to go get their drink … the alligators have enough food to last awhile now … and if nothing else, there is a few less alligators now patrolling the shores for food. The odds of success have gone up for the gazelle … but that's when they leave in fear. 

So I will be that thinking predator. I will only fight battles that I know I can win. My goal is simple. To make money! That's it. I've got no ego in this and no axe to grind. I'm not going to challenge Prof. McDonnell in the world of options, or Prof. Haave in the world of commodities, or George Zachar in the arena of bonds or Vic in the world of index futures. They are simply more skilled and knowledgeable than I am in those arenas. I could be a predator in those worlds, but I would be like the Grizzly bear, and they would be the thinking human up on the ridge 200 yards away pointing a Win, and a 300 Mag at my vitals. That's a battle I can't win. 

But there are things that I'm good, and there are arenas I can battle in. Since I only want to make money, I will only play in the arenas with the best risk/reward ratio for my success, and I will stick to those arenas (but I'll still learn the other arenas … and who knows, I may show up there one day and dip my toe in … but only when I think I'm ready … and then only with a small amount of money to make sure that I'm really ready). 

So, Phil, Gordon, George and Vic, be careful, I may show up in your arena one day … and I'm a good stalker who knows all about how to properly deceive with camouflage …

Tim Humbert comments:

Over Christmas I heard a wonderful recipe for pike:

-preparation: gut and de-scale, rub rock salt and pepper onto flesh, squeeze some lemon juice, insert some herbs into fish, wrap in aluminum foil and cook for 30 minutes

-consumption: throw pike in the bin and eat the foil

Rick Foust adds:

The largest predators (e.g. lions) are much smaller than the largest grazers (e.g. elephants). The largest grazers have much longer life spans than the largest predators despite having inferior camouflage. Certain large houses come to mind.

Small grazing animals (e.g. rabbits) do not survive long despite having excellent camouflage. Their numbers are maintained by fertility (replenishment). New, poorly bankrolled traders come to mind.

Bruno offers:

Professor Sorin Solomon, of the Racah Institute of Physics, has produced some very interesting market models based on Lotka-Volterra. Here is his homepage.

He showed that a generalized Lotka-Volterra model for the market yields a truncated levy distribution for index returns!

See for instance his 1998 paper: "Stochastic Lotka-Volterra systems of competing auto-catalytic agents lead generically to truncated pareto power, wealth distribution, truncated levy distribution of market returns, clustered volatility, booms and crashes."

There are simpler explanations for TLFs, such as a random-walk with time increments that are variable rather than fixed, just like with real-world transactions … but I thought this was topical.

There could be one way to check the above, and that is the impact of random time between transactions. On Euronext, we've got a mechanism for trading very small stocks. It is called "fixing." One could compare behavior of such stocks to behavior of other stocks that trade continuously. One could also check the behavior of stocks that have moved from fixing to continuous trading or the behavior of the whole French market as it moved from all stocks fixing to most stocks continuous in the mid-eighties. There's also a possible comparison between London Gold fixing and NY COMEX.

Todd Tracy comments:

Market Set Ups

While reading Victor and Laurel's article on Predator-Prey Relations, my mind exploded with visuals: foxes hiding in the bushes waiting to pounce, predictive and instinctual reactions to events, finding myself trapped in currency positions, panic driven searches for exit strategies. I realized that I am the prey. I am the new blood that greases the gears. I am the greedy trader who walks into the trap set by smarter, quicker and more thoroughly financed predators. As with much of the information gleaned from Daily Speculations, I found corollaries not just in the markets but also to life.

But wait, I've been here before. Where have I seen these deceptive techniques in use? Spy fiction. Yes, I have read all the Greene's, the Amblers', the LeCarre's, the Clancy's, the Forsyth's, the Flemming's, the Weisman's, the MacLean's, the Harris', the Buckley Jr.'s and a lot of the Ludlum's. The spy, leaving a trail, using cut outs, drops, proprietary tools and the most diabolically elaborate set ups imaginable. Institutionalized deception, deception as a way of life, and tradecraft so efficient as to make the prey oblivious to the fact that they have even been caught.

War is serious business whether or not it be cold, which brings me to the non-fiction. The Secret History of the KGB, the History of the Mossad, the development of the Office of Strategic Services, The Wall Jumper, the techniques of SMERSH, Stalinism, Churchill's autobiographical books and one of the greatest historical accounts on the subject, A Man Called Intrepid by William Stevenson. Control will leave no stone unturned to reveal facts. Control will sacrifice lives to perpetrate false information.

Why should the markets be any different? It's scary to think that once I feel like I'm playing the charts like a marionette, it is I whose strings are being pulled. I am a novice speculator, but my eyes are widening. If only I had Victor's booklist before I read all those novels. All is not lost however because I am learning to tie strings from my life experience to the experience of the markets.



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.



December is a generally good month averaging about a 1.5% rise in the S&P, and having declined only 7 out of the last 26 years since 1979.

  • The biggest decline during this stretch came in 2002 with a 7% decline, which had been preceded by a 20% decline over the previous 11 months, and the next biggest decline was of 4% coming in 1980, following a 30% rise over the preceding 11 months. The biggest rise came in 1991 which was 11%, and followed a 10% rise over the preceding 11 months. The second biggest rise of 6% came in 1987, which was preceded by a big decline of 4% in the preceding 11 months. Thus, big declines come after big rises and big declines, and big rises came after big rises and big declines — in aggregate there is certainly not a linear relationship. All one can say about the extent to which this is non-random is that about half the moves were approximately 1% rises, and there were a few outliers that followed enormous rises and declines from the preceding 11 months.
  • An attempt to get proper percentage changes, and proper adjustments for a series like this shows the need for careful work. The S&P Index started out at around 108 in year end 1979 and now is at 1400, but the algebraically adjusted futures (the only way to go), started out at approximately 600. Any calculations that do not take into account the influence of dividends and levels on studies like this are woefully inadequate.
  • A look at adjusted S&P futures shows that, from November 1998 when they stood at 1400 to date, a buy and hold strategy would have broken even. It is no wonder that there is so much potential for people who have missed the boat — for the Abelprechflecfals of the world to join the party and create a big move or to catch one up.
  • Some of the changes this year are somewhat inconsistent with the 10% yearly volatility one would compute from extrapolation of daily variations. There is a nice 30% move in the first 11 months of 1980, a rise of 31% in 1995, and four other changes of approximately 25% for the year during the test period. The problem with selling calls and covered writes is clearly indicated by these moves, as is the reason this is all so popular on Wall Street, causing the public to lose much more than they have to lose.
  • The Astronomer Royale, Dr. Kim Zussman, has performed a nice regression with an r2 of 8%, showing that the first 11 months is positively correlated some 30% with the next month. Unfortunately, with small numbers like this, a non-linear relationship and a few 30 percenters contributing to the sum of squares, this is not overly meaningful and certainly not predictive.
  • I am often asked the proper way to learn to count. A good way to do it is to wrestle with monthly adjusted prices and unadjusted prices and do some calculating … In fact, I propose a method. Start with 1979 year end, as 1969 year end or anything else is much too far back to be relevant to anyone but the chronic bears. Consider four hypotheses as to the predictive powers of December:
    1. Compute a regression prediction of December based on all the data available up to that time. For example, in 1982 you would have two observations, 1980 and 1981. In 1983, you would have 1980, 1981 and 1982 to fit.
    2. Compute the average move in the Decembers up to that time and predict that the next month will be the same.
    3. Compute the average move in the last three Decembers, and predict that the next month will be the same as this.
    4. Take the prediction generated by the first three methods each year and find which one has the best forecasting record in the past, and use that method for the next prediction.

    Now you have four methods of prediction. Does any beat just predicting the average change from month to month based on simulation, by a reasonable amount. If you want to make money, or test seasonality properly you have to use your head.

  • Some of the years are amazing in retrospect. There was 1997 where some people, I am told, lost a lot of money in Thailand and elsewhere from the bull side. Yet the market went up 26% in that year. There were the ‘5 years of 1985 and 1995 where the market pushed up 30% on the year. Also the year 1987, where the market was actually making a comeback in December. There was a run of fantastic rises in 1995 to 1999 pushing 20% or more in each one.
  • As we have seen the market went from 100 to 1400 during the 26 year period that I have reviewed. Were there any negatives in any of these years, and were they more or less than the present? Are they counterbalanced by any positives or has this been discounted, and is this more or less bullish than usual?
  • There would seem to be a tendency for the market to do well in December over the years. Is this due to the generally optimistic spirit that most of us have in December and is there more than one way to make a profit from this?
  • Year Adjusted Futures Move for first 11 Months (%) Adjusted Futures Move in December (%) Start of Year S&P Index
    1980 30 -04 108
    1981 -09 -03 136
    1982 13 01 122
    1983 15 -01 141
    1984 -03 01 165
    1985 20 05 167
    1986 20 -03 211
    1987 -04 06 242
    1988 10 01 247
    1989 25 01 278
    1990 -10 01 354
    1991 08 10 330
    1992 03 01 417
    1993 08 01 435
    1994 -02 01 466
    1995 30 01 459
    1996 25 -02 616
    1997 25 01 741
    1998 15 05 971
    1999 12 04 1229
    2000 -10 03 1469
    2001 -15 01 1320
    2002 -20 -07 1148
    2003 15 04 880
    2004 06 03 1112
    2005 05 -0.5 1211
    2006 09   1248

    Dr. Kim Zussman adds:

    Looking further at the same monthly data, December moves seem large compared to the prior 11 months. To check this (and eliminate effects of sign), for each year I looked at the ratio of absolute values:

    |Dec ret|/|J-N ret|

    One would expect each month to contribute something like 1/11 of the return of the prior 11 months. But Decembers are larger, as shown by the data:

    Year Jan-Nov Dec |Dec|/|j-n|
    2005 0.031 -0.001 0.031
    2004 0.056 0.032 0.583
    2003 0.203 0.051 0.250
    2002 -0.184 -0.060 0.327
    2001 -0.137 0.008 0.055
    2000 -0.105 0.004 0.039
    1999 0.130 0.058 0.445
    1998 0.199 0.056 0.283
    1997 0.290 0.016 0.054
    1996 0.229 -0.022 0.094
    1995 0.318 0.017 0.055
    1994 -0.027 0.012 0.450
    1993 0.060 0.010 0.169
    1992 0.034 0.010 0.296
    1991 0.136 0.112 0.819
    1990 -0.088 0.025 0.281
    1989 0.246 0.021 0.087
    1988 0.108 0.015 0.136
    1987 -0.049 0.073 1.487
    1986 0.180 -0.028 0.158
    1985 0.209 0.045 0.216
    1984 -0.008 0.022 2.733
    1983 0.183 -0.009 0.048
    1982 0.130 0.015 0.117
    1981 -0.069 -0.030 0.434
    1980 0.035 -0.034 0.966

    The attached plot depicts |Dec|/|J-N| vs. date, and though variability in this fraction has damped out over time, it still seems high. Even discarding two out-lying years of ‘83 and ‘87, the mean ratio is 0.26; almost 3 times 1/11.

    Rick Foust comments:

    I suppose that there are two major factors (amongst other smaller ones) that cause the December effect.

    The first is money flowing into IRAs prior to the end of the year. Someone on the retail side of the business could confirm or refute this.

    The second is large fund rebalancing. Some funds operate on the basis of maintaining a fixed ratio in various asset classes (percent stocks to percent bonds…). Periodic rebalancing of the ratios forces them to buy the asset class that has done poorly and sell the asset class that has done well. It seems that rebalancing predominantly takes place towards the end of the year. Surely there is someone here that could confirm or refute this.

    Scott Brooks offers:

    IRA fund flow is bigger towards the end of March thru about April 20th or so than it is in December (I say April 20th because the envelope the IRA deposit check is mailed in need only be post marked April 15th).

    One can also look at index reconstitution as issues are dropped and others added to the indexes. However, this has the greatest effect on the smaller issues (smaller in terms of cap weighting). Most larger capitalized stocks are going to stay in the index and could be bought in an effort to rebalance a portfolio fund back into the index weighting.

    As a result, the index funds have to go thru a flurry of rebalancing, selling the issues dropped from the index and buying those that are added….and proportionalizing those stocks that stick (again, mainly the largest capitalized issues).

    Something else to consider (for both money managers and individuals) …

    Stocks that have a loss are often sold to realize capital losses to offset the fact that …

    Stocks that managers or individuals feel have run their course and have a gain are sold.

    Another phenomenon that occurs are RMD’s (Required Minimum Distributions) for those with qualified money that are over 70. This is a forced sale for no other reason than realizing taxable income. What’s interesting is that this now becomes money in motion and as a result, opportunity to invest in other areas. As the baby boomers age, this will become more and more of a factor … especially since such a large number of boomers bought into the myth that they will retire in a lower tax bracket than when they were working.

    I’m sure there are are many other reasons that our resident bond mavens and options experts (as well as anyone smarter about the market than I) could add to this discussion

    An Anonymous Contributor says:

    In his post Kim Zussman wrote that:

    Looking further at the same monthly data, December moves seem large compared to the prior 11 months. To check this (and eliminate effects of sign), for each year I looked at the ratio of absolute values:

    |Dec ret|/|J-N ret|

    One would expect each month to contribute something like 1/11 of the return of the prior 11 months.

    No, one wouldn’t. Since you already have all the data, go ahead and look at every month relative to the other eleven months of the same year (or to the preceding eleven months, it won’t make much of a difference). My own back-of-the-envelope calculations with unadjusted data show a mean of about .22 over all months, with December being somewhat below average.

  • Nov


    I found a fun and educational Equity Curve Random Generator where you can enter values of win/loss ratios and win probabilities and see their effect on returns over time. Note that increasing the number of lines (third blank) will overlay multiple runs on the chart. Playing with this revealed rather quickly that ratcheting up the win/loss ratio in tenths only gradually improves the curve, but ratcheting up the win probability in tenths rapidly improves the curve. Even hundredths are important. Try ratcheting the probability .55, .56, .57, .58, .59, .60 and you will see. Improving odds even a tiny amount can dramatically improve returns.

    Dr. Phil McDonnell comments:

    I would caution all that the author of the web site mentioned by Mr. Foust uses the Average Win/Loss ratio as his characteristic criteria. As Rick found the criteria did not seem to be the most helpful. Part of my caution comes from the author’s apparent use of the Average Win/Loss ratio in conjunction with the Kelly Criterion. The Kelly Criterion applies only to gambling games with binomial outcomes.

    Some people have tried to extend it to multinomial outcomes such as we have in investments. They try to use the average win and the average loss as though they were binomial outcomes. In so doing they commit a basic arithmetic mistake. Implicitly they are assuming that the distributive law applies to logarithms. It does not and that is where they go wrong.

    This error has been repeated to the point of being a meme. Many books espouse it, much software is written to calculate it and articles proclaim it to the unwary. The simple fact is that the incorrect formula invariably leads to over trading and will CAUSE the ruin which it ostensibly promises to prevent.



    One of the most common phenomena that those of us who trade every day face is the delayed reaction to an event. Nothing happens when you expect it. For example the positive Employment number, seemingly so bullish, was greeted with a 1% decline from open to close on Friday. and now the election, which on the surface seems to create so much uncertainty among investors, especially vis a vis discredit of the Administration through impeachment forays and propaganda.

    These delays in electric circuits are called hysteresis and I’ve discussed the various negative feedback loops and components that ordinarily are used to create same for practical purposes, e.g. in the Schmidt Trigger, which is very succinctly reviewed in the excellent book by Michael Merchant, Exploring Electronics Techniques and Troubleshooting.

    I wonder what the general concomitants or preconditions for a delayed reaction are, whether they are predictable, and whether the seemingly fantastic positive response to the recent Democratic sweep, which was 16-1 on TradeSports from 9:45 am on Wed, Nov 7, and continuously higher at all times subsequent until the current finalization as of 11:00 pm, Nov 7, will be an example of the beaten-favorite/hysteretic reaction, and whether such delays can be predicted with similar events regarding individual stocks and or economic announcements.

    Gary Rogan observes:

    I don’t know how to quantify it but this has been my observation: often if a person or a group of people are acting out of negative emotions, such as anger, frustration, irritation, or boredom after a forced delay, they will go further than a rational observer will expect. Thus delayed action based on negative emotions seems related to hysteresis by overshooting the rational point. The voters have acted out of delayed frustration, so there is hysteresis involved in how that carried over to the markets to the extent that some of the voters are also investors. However when the realization sets in that Nancy and Chuckie will be acting out of a bit of their own frustration, and their “rational” point is a bit displaced from Adam Smith’s to begin with, I predict there will be a bit of a chill in the equity markets and it will last for a while. On a separate note, the more “bi-partisan” Bush acts, the lower the markets will go.

    Jay Pasch adds:

    This election day reaction is reminiscent of FOMC report days but with a wider timeframe; it so often ’seems’ on FOMC announcement days there is an immediate reaction, then a brief counter move, followed by the real deal, a trending move in the direction of the initial reaction. Admittedly descriptive and uncounted…

    Rick Foust replies:

    Years ago, when I watched tick by tick, I noticed the same pattern on FOMC days. A quick knee jerk, then a larger head fake, and then an extended run in the direction of the knee jerk. I suspect it also happens in longer time frames for larger events (such as elections).

    The knee jerk could be up or down. It usually lasted only moments and could sometimes only be seen on a tick chart. The head fake was a longer movement in the opposite direction and lasted a few minutes. The final move typically finished out the day. The duration and magnitude of the moves varied from time to time. These were days when the the market treaded water waiting for the the Fed to announce the next interest rate move.

    This three step process reminds me of a simple but effective Judo technique. First comes a quick and subtle jerk to freeze the uke (throwee). Then a push to get the uke to instinctively lean against the push and into the throw. Lastly, a long pull to guide the uke through his flight.

    A 16 year old Japanese girl appeared at our dujo one day. I had worked with girls before, and I had learned to go easy on them. She was a foot shorter and a 100 pounds lighter. As a warm up, we were to alternate practice throwing each other. Being of the highest rank, she went first. Even though she was a blackbelt, I expected to have to help her throw me (that is, jump). Suddenly, and without warning, I found myself doing an airborne somersault. A split second after that I was lying on my back looking up at her with an astonished look. Her execution had been so skillful that all I had felt was a bump and then weightlessness.

    The key to most Judo throws is to stiffen and off balance the uke, fix one part of their body in place and then rotate the rest of the body about the fixed point. A well-executed Judo throw relies more on finesse than strength.

    Scott Brooks replies:

    I believe the question that Victor is asking is “how do we know how the masses are going to react to news or an event that is possibly a surprise, or at least, not known in advance.

    I’ll let those who are better counters than me handle the quant side of this. I’d like to explore the personal side of it.

    How do I (or you) choose to react to an unexpected event or news. As investment professionals, or as speculators running our own money, I believe that one of the things that is incumbent upon all of us is to be prepared for the unexpected. One of the ways we can do that is to know the numbers….to calculate in advance what are the odds of “X” happening, and if it does, what are the most likely resulting reactions to follow….then….

    What do we do from there? There is nothing worse than not being prepared.

    My secretary (excuse me, she prefers to be called my “executive assistant”) has asked me on more than one occasion if I’m going to be doing any work that day. She’ll walk into my office and catch me staring up at the ceiling, or just passing around my conference table, making hand gestures at invisible people.

    I tell her, “I am working”. I’m role playing in my mind scenario’s. I’m trying to cover every possible path the scenario may take. I’m trying to see problems before they occur, and then figure out how to solve them…but solve them in my mind before they actually happen so I don’t have to deal with the unexpected later….and if I can’t find a solution, I ditch that course of action and move on.

    Since I’m up at the farm deer hunting this month, I’ll use a deer hunting analogy.

    One of the biggest problems that many hunters have is buck fever. When they see a big buck, they come unglued. They can’t stabilize the gun, they can’t concentrate or hold the crosshairs on the vitals, and in some cases, get so nervous that they can’t even raise their gun. In some cases their knee’s shake so bad that they can’t even stand.

    I have never had that problem. Oh sure, when I see a deer, I get excited. If its the buck that I’m looking for, my heart may skip a beat and leap up into my throat.

    But then I go into the zone. My mind focuses in on the task at hand. I begin to assess the situation. I wait for the right moment and BAM. I do what I came out to do.

    Why is this so seemingly easy for me to do? Because I’ve killed that buck thousands of times in my mind before the moment of truth came. I’ve visualized him coming from that exact direction hundreds of times. I know every possible path he could take before moving into a killing position. I’ve falsified hundreds of situations in my mind and role played them to figure out how to overcome the obstacles (i.e. is the buck alone, or is there another deer with him? What is the wind….blowing to or away from him? etc.).

    I practice in my mind slowly squeezing the release on my bow and watching the arrow leap forward at 300 fps right toward his vitals, or slowly squeezing the trigger while staring at the crosshairs right on the bucks shoulder and actually seeing the bullet (thru the scope) hit the deer at the exact spot where I was aiming.

    You see, just like I don’t know exactly where the deer is going to come from, or exactly what the conditions are going to be when he shows up, market events and news comes at us from unexpected directions and brings unexpected ramifications.

    We simply don’t know what to expect….but we can role play what to do, have a playbook (that we’ve thoroughly memorized) ready to tell us what to do, and then execute the appropriate play to give us the highest probability of harvesting the big bucks!

    Steve Bal replies:

    This would suggest that the news makes the markets. I would suggest that the news is in fact talking points - just as some individuals believed that Kerry’s mix up of words would hurt the democratic vote (which we now know did not happen).

    I do not trade every day but for some reason watch the business news regarding this number or that coming out. Further, it now appears that revisions happen more often than not (even if not true I believe it) and thus I may act upon it.

    Individuals have different trading time frames, along with different strategies. It is times when multiple time frames for individuals coincide that markets can move. This is not support for cycle trading but a recognition of different trading motives. As new news comes into the market, traders then attempt to mesh with older news to reinforce their views of future market direction.

    As Vic had previously pointed out when a big pharma increased their dividend (mostly dividend collectors noticed) a few days later they announced a big jump in earnings and the stock promptly moved. Everyone needs some form of extra comfort.

    The collective consequences of many traders (individuals) often defy intuition.



    With the recent success by Democrats in the House of Representatives and in the Senate, coupled with the recent rally in the US stock markets there are some thoughts that come to the surface.

    A quick review of Adam Smith’s comments:

    In 1776 he wrote “An Inquiry into the Nature and Causes of the Wealth of Nations” in which he promulgated his invisible hand theory, which stated that each individual, while striving for his own gain, of necessity advances the public interest by the free exchange of goods and services creating division of labor and a free market economy.

    Some natural questions:

    Gary Rogan replies:

    The market is obviously saying that major pharma, HMOs, and large defense contractors are likely to lose. It’s re-valuing non-dividend-paying stocks slightly higher relative to dividend-paying stocks and smaller stocks slightly higher than large-caps. It obviously thinks that gridlock is good, and it seems to have preferred the House and Senate to be controlled by different parties, at least as far as above-mentioned groups are concerned. Overall, it’s happy with the results.

    The only thing that’s likely to get done for sure is “immigration reform”. Whether that’s good or bad is in the eye of the beholder. I think it will be a long-term disaster, but the short-term economic impact just isn’t enough to worry the markets.

    The market got the big picture correct, the House situation and the Republican loss of control, because it was a relatively well-behaved stochastic event that could be pre-sampled and processed, but couldn’t deal with the Senate because it simply could not have known what fewer that ten thousand people who decided the election in Virginia and Montana would do. This illustrates perfectly both the power and limitation of markets: they deal with distributed information better than almost any individual, but fail with highly non-linear situations where small noise-like perturbations are amplified dramatically in a digital fashion to produce a significant outcome.

    Rick Foust adds:

    I just had a visit with a good friend and fellow engineer here in the risk-averse world of nuclear power. He is a devout Democrat and Bush-hater. He has been strongly bearish since 2001. I have pulsed him since 2003 when I first advised him to become bullish. He has consistently responded that everything is horrible and will stay that way. In return, I have teased that when he finally turns bullish, I am going to sell everything. This teasing has only strengthened his resolve. Today I asked him how he is feeling now that Washington power is shifting. He tells me that today he increased his 401K contributions and the increase is going to stocks. His choices are popular with risk adverse engineers: Fidelity Magellan, FMAGX, and Fidelity Equity Income, FEQIX. He believes that the market does better when the power in Washington is divided. He is eagerly anticipating trouble for Bush. If I am guessing correctly, he will be right (for a while) and one day he will come to my desk gloating over how the market has advanced coincident with Democrats’ taking vengeance on the Evil One. I will sell on that day.




    I am attempting to consider the analysis of jokes, e.g. James Lackey’s often stated “…get the joke…” as an aid to market analysis. The work of Arvo Krikman on Contemporary Linguistic Theories of Humour has been helpful. He divides this analysis into:

    1. Incongruence theories; the intersection of two different planes, incongruities, contrasts.
    2. Linguistic theories; those based on similar phonics or normal interpretations.
    3. Freudian theories; those based on the theory of the effect of humor on the recipient in allowing release.

    There are many events associated with markets that make one wish to roll on the floor with laughter. The selling out at the exact low, the attempt to make a profit without risk, the guarantees of profit, the attempt to make money the usual tested way that leads to oblivion because the cycles have changed, the assurance that the fund is in great shape the day before it fails, the loss of an estate built up over 60 years with one trade, the failure by one tick to make a good profit with a limit order, the trader that calls you with a seemingly good bid or offer that you trade on right before a number or news event or earnings report terribly against you that its 99% they knew about when making the quote, the change in position based on an economic number that’s completely random, ephemeral, and certain to be revised in your favor as soon as you get out, the market move that occurs way before the news, the constantly one sided analyst who explains every event, no matter how improbable as supporting his view, the forecasters who can’t forecast, the Chinese Wall that supposedly separates the buy and sell side and advisory role of Wall Street, the constant backdrop of explanations for the market moves and reasons to extricate from positions when buy and hold would be so much more appropriate, the shooting stars and falling comets, the attempt to couch a bearish sentiment in bullish terminology, the profits that can come from disaster and the losses from triumph, the inevitable fall from the top of yesterdays superstars, the inevitable results of overconfidence, the tweaking from the recommended 60% weighting in stocks to 58%, the flimsiness of the foundation for many runups or rundowns, the executive of the public company that chisels a hundred bucks on his expense account or dating of options when his salary is $100 million a year, the investments that’s made partly for reasons that make one unpopular in the hallways of the service that you lose your entire stake on, the commentator that’s always bearish who relies on the broken clock to be right once, the fundist who hits the top when his sector finally goes his way and receives great public acclaim for it.

    All this humour, and so much more, which I call upon readers to contribute, calls out for a general theory of market humour which is falsifiable and predictive, and helpful to the trading process.

    I am more partial to a mathematical theory which strangely I haven’t seen, i.e. most of humor seems to be based on two events in some sort of probabilistic relation to each other- contrasts, collisions, unusual couplings, ambiguities, startling events et al. usually of a pithy nature. That’s it. When an event A given B is highly likely, P(A|B) is near 1 and B occurs and not A occurs or P(A|B) is near 0 and B occurs and A occurs, that’s usually the foundation of humor. Alternately if P(A|B) is much higher then P(A|C) and A occurs, but even though it’s much more likely that B occurred, C really occured, then that’s another Bayesian revision sort of humor. A linguistic aspect of humor typified by the bronchial joke must also be considerd. That’s the joke where a very attractive young man with a bronchial condition knocks on the door of his Dr.’s house and whispers to his very attractive young wife, “Is the doctooor in?”. “No, come right in she says”. That would be typified by P(A|C) is much higher than P(B|C). C occurs and then B occurs but not A.

    J.T. Holley responds:

    The one that jumps out to me is the old formula that is not defined but given as:

    Tragedy + Time = Comedy/Joke

    The key being what is the definition of a tragedy and equally important what is the appropriate time elapsed?

    Looking at 1819, 1837, 1906, all the “Black Days” in ‘29 - ‘32, Oct. ‘87, 10/27 in ‘97, ‘98 Ruskie, the Internet Debacle ‘00-’02, one would say that we have had our tragedies. Throw in the Hunt Bro’s, Nick Leeson, and now Brian Hunter and you have more to poke at, but is it appropriate? Is the punch line the drift that the Mistress gives? It ain’t funny when you lose, especially money. The further we do get away, time has a wonderful way of healing due to our tenacity to come back. The bear camp doesn’t see the tragedies as lines in the joke; they don’t even get to laugh with giggles of resiliency?

    I am so glad that I have the Holley genes that makes me have a love of peanut butter on my pancakes, and a smile on my face. This has always been thrown back at me as a sign of not being serious about life, but I can’t act or see life any other way than as Nock stated “as it is” with that smile.

    Jimmy Buffet wrote the line “if we all couldn’t laugh we’d all go insane”.

    I was thinking that the opposite of the formula above is also a wonderful joke the market provides if you have a sick sense of humor:

    Comedy/Joke + Time = Tragedy

    How many think they can trade/speculate but really haven’t any clue and submit their money to the Mistress? They give and as Vic states “lose more than they have any right”. This is the sickest of sickest jokes involving the markets due to the plethora of examples many more times than that of Tragedies listed above. Maybe that’s a key to those that have been Body Snatched? They aren’t aware of the part they play in the joke?

    Sushil Kedia adds:

    1. Newspapers : All newspapers that cannot refrain from offering explanations of market moves post-facto. Particularly the electronic screen famous for its dark- back ground-orange text, despite its outstanding analytical tools.
    2. Experts: Columnists, newsletterists, bar-waitresses, friendly cabbies all espouse opinions worth only the size of their exposure to the markets. The world doesn’t want to get the joke because the formal from such ones are the experts who are selling ideas which as though would otherwise still be getting rich on their own.
    3. Margin of Safety : So bad that one holy grail is believed to be truly existent since the wealthiest of the the investors seems to have actually implemented this but nothing else.
    4. Insider trading regulation: the assumption probably supporting such expenditure of effort is that one day they will be able to or willing to put to end from where information on each thing begins! End the beginning? What’d be leftover then?
    5. Free markets: well to put the idea getting my mind for a while on this core issue finally a joke: girl fights up with her boy saying he is being much of an easy flirt. Boy laughs back saying, “Well, you are quite a believer in free sex. Aren’t you?” Girl yells red-eyed, “free sex! My foot” Boy says with a deep cold sigh, “well just tell me then what have you started charging ?”

    James Sogi responds:

    Humor has the element of surprise, the unexpected. That’s what the market gives, the unexpected. Its never what you might think it is, its always something else, something counterintuitive, not what you expect. And it knows ahead of time what you are going to do and sees you coming. Like the thread on the group mean, the group knows everyone’s secrets, for it is theirs. The market trains you to go the wrong way, feints, always gets you off balance. You need to be a step ahead, look over the horizon, over your shoulder. You can’t be a step behind, reactive, you have to lead and take the initiative. Following is too late. The reflexes are not fast enough to defend in the market, you have to punch first, and let the others in the market defend, and have that split second initiative advantage. On longer terms get that strategic edge moving the troops first,. Like lack says, don’t let the joke be on you. You have to beat it to the punch line. Why do you think its called the “punch” line? Just like a punch, the reaction is always slower. Got to beat the market to the punch, bob and weave, come in low. Keep your distance. Always protect yourself. It really not all that funny except in a self deprecating sort of way.

    Tom Larsen replies:

    While I was working as a no-advice broker, a Texan who had added several spreads to his option position, told me: “I got myself so I don’t know what I want the stock to do”. Maybe it’s funnier when I say it out loud with a drawl. In any case, it shows how people think they have a simple financial product figured out and then realize that they are in over their head. Some people who hear this are laughing at the guy who seems inferior, but thinking, “this could be me!” Or it could be reminding us to not get too cute with our positions. Don’t take on more complexity than necessary. This is probably just a variant of a common form of joke where we laugh at somebody who gets confused. Superiority humor?

    While working as an option market maker in the pit, it was common for traders to deconstruct the trading day in the brokers lounge after the close. During one such conversation another market maker told me that during the day he had been so desperate that he “would have paid anything for those puts. Fortunately no one would sell them to me.” This is very deep for me, and reminds me that sometimes you can be unaware flying full speed toward disaster, and the only thing that saves you is grace. and it reminds me not to panic. This joke is probably funny because of the reversal implied as the speaker is clearly aware of his good luck. It’s like the feeling you get when you tell someone about the near collision you avoided on the freeway. There is a release, relief and relaxation at the end.

    James Lackey responds:

    Why did god make chartists? To make weather men look good. The mistress of the markets can make traders look so foolish at times, it is much better to laugh than to cry. Your only as good as your last trade. However, your next trade might be your last, make it a good one.

    The worst market jokes are those that everyone has known for years. The market makes “you feel” like a child. You start your joke to friends: a priest, Jesse Jackson and Clinton are all on an airplane that is about to crash. Your Dad, the old man immediately chimes in and crushes your joke “only two parachutes get back to work!” They have heard them all before.

    The joke is “housing is a disaster, the consumer is all tapped out” the news tape blinks Bulletin: “US Housing lowest level in 30 years.” The market immediately goes to the punch line. The old codgers come in, at the market “take it and bid it.” The time and sales boys say “my limits never get filled all size trades the offer all day, who knew?”

    Perma bear brain teaser: Bond prices fall as traders sell bonds to buy relatively cheap US stocks.. .interest rates rise, consumer sentiment falls, bonds rise on slowdown fears, stocks rise due to lower interest rates and future uptick in consumer spending, bonds fall as traders sell bonds to buy stocks. Market rallies 6 weeks in a row on short covering.

    We watched Yes Men last night. The movie is a Sundance comedy. A couple of jokers start a website to mock the WTO. To their delight no one actually reads the website and offers them speaking engagements. They mock “free trade” and the “government of, by and for the corporation.” Their last speech they had to regrettably cancel their presentation to Australian accountants. Their reason for a program change was the WTO was to be disbanded. The post interviews with the seminar participants was hilarious. “its great to see an organization admit their faults, scrap the program and restart from scratch.” I was laughing so hard my wife called upstairs to see if I was okay! I said yea this skit is hilarious. Now the sad joke. She says, “that is good Jimmie, that is the first time Ive heard you laugh in 6 weeks” yes Jennifer as you have heard, the markets were strait up for 6 weeks.

    About two weeks into the fall rally, the headlines read Ford Motor company might go private. All the talk of how bearish and difficult SBOX is for public companies we thought, wow a double bullish whammy for the indexes. IPOs are far more difficult, the cash flow rich, no growth, dead money stocks are going private, a simple reduction in supply. All that index money must be reinvested in the market. Ill buy the next pull back. What if there is no pullback? Joke is first down move was after a huge “made in China,” bank IPO.

    Speaking of Chinese stocks…Is it possible to make an ETF of Chinese stocks that are unregisterable on the NYSE, yet float the ETF as a “Chinese investment”. Oh the joke is an ETF on private equity.

    The daytraders joke they are never right, why bother? The funniest joke is everyone can be right if they wait long enough. You might go broke waiting, but eventually you can be right. Funny debate between admitting your wrong or the market is right vs. your right, just too early. Of course we strive to be rich rather than right, until your rich, right?

    The worst market joke. Get even post from Mr. Clive. From the Yra Harris interview….Inside the house of Money:

    The worst thing you can do in a trade is try to get back to even. I call that the “prayer trade.” I can spot guys on the floor who have it on because they shake back and forth, basically in prayer, mumbling, “oh, please God, just let it come back to me. Let me break even.” What is that? Break even? That’s a loser. I’m not in this business to break even. There’s always opportunity in the markets, so forget breaking even. If breaking even is your goal, you’re not trading anymore.

    Rick Foust on traders:

    Here is a short one that reminds me of some trades/traders.

    Question: What is an Ohno bird?

    Answer: A bird with 5 inch balls and 3 inch legs. When he comes in for a landing…

    Quick followup.

    I have this placard on the instrument panel of my Cessna.


    Craig M. shares a market truism:

    The best joke of all is that the market allows you to think you actually know what you’re doing at times, and while you may profit during these times you never ‘make enough’ and when you lose it seems even worse. The actuality is that you never really knew anything in the first place.



    The average is something that we all would like to know so that we can learn what makes the world go round. Since more people are near the average than anywhere else, knowing about them is a key to success in business whether considering who you're going to sell to, buy from or employ. I like to study average people by reading the magazines they read the most, such as the National Enquirer, or seeing them in representative settings such as ballgames, church, car dealerships, or homes. It's an article of faith to me that the more I know about the average, the better an investor I'll be.

    Thus, it was with great eagerness that I read The Average American by Kevin O’ Keefe, a successful married intellectual Democrat fund raising executive, championship runner, and friend of Jimmy Rogers. The book describes his quest to find the one “most average” American through a series of interviews with people whose eponym or business is average or normal.

    The book starts with a visit to the Census Bureau, where he interviews statistician Greg Robinson and finds source material for the communities that he will canvas to find his average American. He then interviews a magician named Myklar the Ordinary, a track steward of a Land Rover club who awards a prize for an average finish, smoke-gun owners in Elko, Nevada, a director of noxious weeds in Dickinson County, Kansas, a postman in Maui, Hawaii, a presidential candidate for the Average Joe Party in Pennsylvania, an alderman running for office on the Average American ticket, the pollster George Gallup pollster, the president of the Little League in Williamette, Oregon, a golfing husband and wife in Florida whose business is selling products to the average golfer, and a person whose last name is Average. Eventually he finds the average American based on a checklist of 140 of their characteristics such as age, charity, community, education, employment, faith, family, geography, health, income, hobbies, home, physical characteristics and political convictions. The average person has all 140 of the positive attributes of averageness and it's Bob Burns in Windham, Connecticut . In the only beautiful part of the book, O’Keefe tells Burns that the average American is unique and glorious, not mediocre, and that he's the Average American. Burns says "What an honor!" and invites Keefe to go fishing next year. "What an honor!", O’Keefe says and he means it.

    The list of average American qualities is instructive and includes:

    Regrettably, the book is marred by the author's complete ignorance of statistics. He uses community criteria to exclude individuals, then tries to find the average by including each of 140 criteria that he randomly picks up from interviews with people whose businesses or names have something to do with averageness, or sparked by reading of popular magazines, movies, and books about average things. It's interesting to see how many average things he discovers and how many matches different people might have to them. But there is no validity or even justification for the goal of the book, which is to find the most average person. Instead what he comes up with is a person unique in fulfilling each of 140 criteria that each have, say, a one-third probability of failure. That indeed is a unique person, not an average person. In addition the author's persona is displeasing. He's the typical intellectual who is unsure of his position and status in life, and tries to find himself through exposure to common people.

    In an effort to find the average stock, I am brainstorming about different approaches. One such approach comes from ecology where they consider such things as plant hardiness zones where in each zone conditions are more similar than growing conditions across two zones; this  reminds me of the industry classifications that one usually uses to divide up an average. A nice approach to this is contained here.  What is the average stock? the most representative stock? The problem is that it is different based on which of the multiple variables that can be used. Should it be classified by market value, price, profit margins, kind of business, kind of CEO, or a distance measure based on combining all of these. Here are some names of companies that Mike Pomada and I came up with in preliminary efforts to find the representative stock:


    The above stocks are in the middle of the average rank (i.e., rank each category, then average the ranking — on an equal weighted basis — and then rank the average rank) of the following 4 categories:

     Stefan Jovanovich adds:

    "The typical intellectual who is unsure of his position and status in life, and tries to find himself through exposure to common people" is a beautiful expression of an important truth. It reminds me of what happened to Milovan Djilas had after was released from prison by Marshal Tito and allowed to came to the United States.

    Dad had my brother Peter drive Djilas around the Northeast so he could meet American intellectuals. One excursion was to Princeton. Peter remembers overhearing a member of the faculty asking Djilas what the other prisoners were like. "Ordinary criminals," Djilas replied. "Not political prisoners." "But, they were good guys, right?" asked the intellectual. "No," replied Djilas, "ordinary criminals — murderers and rapists and thieves."

    Rick Foust offers:

    I too enjoy watching the average man. And living in a state with no great claim to fame other than being in the center of the US gives me plenty of opportunities to do just that. And when I travel, I insist on passing through the poor areas (to my wife's discomfort). When others might go to the tourist traps, I go to a county fair, or an auction, or even a flea market. My favorite way to travel is to spend months away from home as part of a job. That gives me time to become immersed in and gain an appreciation for the locals.

    As I revealed previously, my best stock market indicators are the average 401K feeding guys at work. When I take time off from work, it is like going blindfolded with regard to the stock market.

    The average man is of value as an indicator because he is an outlier from the Wall Street community. He knows nothing of how the stock market works. He thinks the Dow represents all stocks except those in the Nasdaq. His only involvement with the stock market is what he puts in his 401K and what he hears on the news. Both of these activities are on automatic and largely ignored because his focus is in on his family and his hobbies. He puts money in his 401K because his company matches his contribution. He puts his 401K in stocks because he has been told that stocks are the best investment over the long term. The average man does not trade, but instead buys stocks because he has faith in the system. His environment that has taught him that it is easier to work within the system than without it. He stays with the herd.

    So how could watching the average man be of any use in trading? He is a filter. He ignores the noise and alerts at the extremes. If you have ever watched a herd of animals you may have noticed that they are oblivious to random and regular noises about them. But try sneaking up on them. They will pick you out of the noise every time. It is an instinctive skill honed since the dawn of time.

    Dr. William Rafter responds:

    One of our strategies ranks about 1000 stocks and selects 40 at a given time for further review. We then apply some different ranking methods to build a portfolio with the sort of qualities most investors would choose, like lower volatility. But for the most part, the 40 are our "stars", and most investors would be relatively indifferent as to holding one over the other. When we run the statistics we find that over long periods of time (say 10 years), out of the 1000 stocks we wind up owning 950 of them. That is, almost every one is a star at some point. Or put another way, it's quite average to be a star.

    The smaller you make the list, the more it occurs. We also rank and rotate 20 International Indices and the 24 S&P Industry Groups. We have even researched this on markets we cannot yet trade, like the 14 DJ Blue Chip China Sectors. And over long periods of time we find that we were at some point long every one of the above.

    The ranking process is a fairly complicated combination of linear and non-linear methods, so there are a few "hoops" the assets have to jump through. That is, we have deliberately made it difficult for these assets to be the stars, but yet they manage to do so.

    Wouldn't the law of ever changing cycles dictate this very outcome?

    Steve Ellison replies:

    This idea is congruent with my intuitive reaction to this discussion. There is no such thing as an average person. In our advanced economy in which specialization is the norm, just about everybody has some unique talents. A person is only average when viewed through somebody else's filter–usually based on one measure, or at most a few.

    Russell Sears replies:

    One of my first jobs was helping building an extension onto Fairview Hatchery in Remington, Indiana. At the hatchery,  millions of chicks are hatched on trays stacked on top of trays. These are wheeled around on rack after rack in incubators to processing and then to shipping.

    For the most part, the thousands of chicks looked exactly the same. If a chick looked different or showed weakness, the others would gang-up on it and peck it to death. The processors would then take the damaged defective chick and pitch into a bucket. There these damaged tortured chicks would continue to peck at each other. They were left in a hopeless, oppressed condition, where rage was the only thing left to give them hope. They would attack each other until they all died.

    You look at the violence going on today, and you find the political oppressor, feeding the rage, rather than the benevolence. They do this by making the "average guy" see wealth and betterment as a closed system. The only way to get ahead is "steal theirs". It is "us" against "them".

    Its not just that the average is good or benevolent. The average is powerful.

    Here are some ways in which this power is turned to benevolence or the greatest good:

    1. Freedom and Liberty.

    2. Legal system that encourages competition.

    3. Transfer of wealth not limited. (property rights)

    4. Democracy (giving power to the "average") and checks and balances limits power.

    Some thoughts (most need testing) on how to apply this to stocks and investing:

    1. Invest in countries where freedom is high and is growing.

    2. Invest in companies where union votes against striking or to end a strike without concessions.

    3. Invest in companies where options grants are widespread, not just privileged few.

    4. I believe the Olympic marathon is a event open to everyone, the average guy. Invest in countries that have become more competitive in the Olympic marathon or other "average guy" sports.

    5. Other sports such as equestrian, are more political, more elitist, rather than personal merit. Invest in countries that have the most "average guy" in the elitist sports.

    6. Invest in countries whose athletes become wealthiest through other endeavors, after winning the Olympics.

    7. Invest in companies with an open door policy: that is access to the top is encouraged.

    8. Invest in companies with highest bonus pay to the "average guy".

    9. Invest in companies who "oust" the option back daters after they settle.



    A good measure of stability, or uncertainty, is the distribution of S&P futures opens relative to closes. Right now, I note five down opens in a row, each succeeded by a up open to close — the average open about -1 point, and four levels of close to close within a 2.5 point range, with the average absolute variation among them 1.7, and nary a big decline since September 6. If only these signals could be unraveled predictively, like those 2000 per game in baseball described in The Hidden Language of Baseball. There are certain coaches in baseball who are expert at reading signs, and are hired mainly for that purpose, and I would like to know of such personages in the markets.

       DATE       O         H         L         C
    10/9/2006   1357.3    1361.8    1355.1    1359.2
    10/6/2006   1358.4    1360.0    1352.7    1358.8
    10/5/2006   1357.8    1363.2    1356.5    1360.8
    10/4/2006   1341.2    1359.0    1339.8    1358.3
    10/3/2006   1338.6    1347.8    1336.0    1343.2
    10/2/2006   1345.7    1348.1    1339.3    1340.4
    9/29/2006   1348.2    1349.5    1345.0    1345.4
    9/28/2006   1347.5    1350.3    1343.1    1347.3
    9/27/2006   1345.3    1350.2    1343.2    1347.7
    9/26/2006   1336.0    1347.1    1335.0    1346.7
    9/25/2006   1328.3    1340.0    1321.6    1335.7

    Rick Foust responds:

    I have no related credentials to hang on the wall, but I have studied this very question at length and I have a definite opinion. I have not seen this question answered elsewhere and no one seemed willing to touch it here. So, I will offer my opinion, for whatever it may be worth.

    Examples of such talent exist in every walk of life. I notice this talent most often in athletes, coaches, children, mothers, animals and animal trainers. An off the wall example that never fails to amuse me is the ease with which some taxi drivers negotiate city traffic. I have found the talent to be independent of intelligence or education. The best market reader I have encountered was a grandmother in Texas that day traded options as she worked around the house (folding clothes, etc). For other examples, think of some of the great quarterbacks that were known for being able to read defenses while being cool under pressure (e.g., Joe Montana). I recently received a video of a guy that I think is outstanding. Here is a link. The file is large, so please be patient if you have a slow connection. Just in case you wonder if you got the wrong file, it really is about a guy and a dog.

    In my opinion, the essential ingredients are; a willingness to accept life as it comes, perseverance and attentiveness. Experience is a great help.

    The ability to accept life as it comes is the most rare of the three ingredients. I generally have difficulty explaining this concept because it is so easily confused with being Pollyannaish or lackadaisical or reckless. It is none of those things. A wise woman once told me that love is unconditional acceptance. So, unconditional acceptance of life means loving life. Accepting life removes the filters that cloud perception and also relieves the tensions that inhibit decisions. And of course, if you love life, it will love you back. (I know that sounds corny and sappy.)

    Perseverance is common. But a strong combination of acceptance and perseverance is very rare. All too often, those with high levels of perseverance are just stubborn, doggedly refusing to accept reality. I mean perseverance in the sense of having the courage to do one's best even though down 12 points. (No, I am not a football nut.)

    Attentiveness seems common, but I am talking about a special kind. I apologize, but I don't know how to explain it other than by using myself as an example. Although I have always been able to get good grades without much effort, I have never liked school. So I rarely scored the best in any class. Early in my career, I was in some fairly intense training to qualify as a Shift Technical Advisor to reactor operating crews. And true to form, I scored third highest in the class without much effort. What disturbed me was that the top scorer exerted even less effort than I did. I was used to being outscored by the studious. But not this. I watched him in class, trying to figure it out. All I can say is that he just sat there, relaxed, soaking it up like a sponge. Years later I became involved in martial arts. At first, I had difficulty learning the movements and techniques, but it got easier with time. After a couple of years of martial arts training I had more job related training. To my amazement, I found I was able to sit and effortlessly soak in the information. And I was able to turn it on and off. And I got 100% on the tests and was typically first finished. I don't know what happened. My guess is that the martial arts training opened the resistance in some learning pathway.

    On related topics: Attempting to profit on readings adds a degree of difficulty because it involves risk and timely decision making. The element of risk has the potential to emotionally disrupt the ability to read the signs. The element of timely decision-making is a problem in that by the time sufficient data has accumulated to enable statistic verification (if that is the correct terminology), the pattern is likely near the end of its useful life. (The exception would be patterns that are so obscure that they are not likely to be seen by many.) Therefore, in order to profit, the trader must be able to act in the face of uncertainty.

    Another difficulty is that a black swan inevitably appears when things are otherwise going well. As patterns become evident to too many players, the patterns can no longer be sustained (similar to the cycles of rabbits and foxes). This has the advantage of perpetuating a game where one person cannot end up with all the marbles. If the trader is complacent and/or has not prepared a defense, the end result can be disastrous. In the markets it has cost me money. As a small plane pilot, it almost cost me my life. The misfortune that occurred to Siegfried and Roy is a well-known example.


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