On a recent ski trip to Hokkaido Japan, we had 10 days of heavy snow on top of 3-4 meters on the ground. Deep fluffy light blower powder.

Food, lodging, recreation were very cheap. Nice airline Airport hotel for $65. Spaghetti dinner $9, wine $2. French Chateau bottled 2011 vintage $12, French regionals Medoc, Bordeau $9. Full room and board at rural onsen $60/day per person. Ski lift tix $40, $33 for senior, $10/single. Noodles $6. Big Mac, fries, coke…$7. Part of it is the recent 30% devaluation of the yen, but it still does not explain the values.

The Japanese were very polite and many more had some English than 25 years ago. Very noticeable demographic age bracket bulge in 60s and 20s.

Yishen Kuik writes:

Japan is cheap these days.

Hokkaido is a major tourist destination, famed for hot springs, sapporo beer, nikka whisky, the countryside, fruit from yubari, champagne powder skiing and a spectacular snow festival among other things. It is an island north of the mainland but chitose airport is beautiful and large and the shinkansen links it to Tokyo.

Pretty much the entire skiing population of Australia, New Zealand, Singapore, Hong Kong and South East Asia skis in Japan and Hirafu, Niseko in particular has emerged as the international ski capital of Australiasia with 1000 usd a night for a fashionable 2br apartment as the going rate in peak season. Malaysian, Australian and Hong Kong developers have filled the town with modern eateries and apartments.

But elsewhere, 100 usd a room with breakfast buffett and onsen is the norm at the many good bubble era hotels built all around the country. Cheaper alternatives go all the way down to 40 usd a night at ski pensions. Many Australian seasonaires are to be found in Niseko working the bar, cafe, ski hire and hotel.

In major cities outside Tokyo, food is excellent, crime non-existent, public infrastructure superb and the level of service is exemplary. In downtown Kyoto iirc you can get prime real estate for 400 usd psf and non-prime at 200 usd psf. You can lunch at a touristy place for 20 usd or pay 10 usd for an excellent bento box lunch. Kyoto is the cultural tourist destination for the Japanese and japanophiles with festivals throughout the year. A wonderful town where Steve Job's favourite hotel, the Tawaraya, is located.



 Often times I wonder If I am the only sane person in the world. For most of my career I have never understood why a corporate seller or I-banker should be praised because an IPO zoomed in the first few days of trading. By and large we praise people who buy low and sell high, but with IPO's the conventional wisdom is that we should praise those (and their agents) who sell low.

Imagine you hired a real estate agent to sell your house. He/She advises you to sell it for 300K. You do. The next day after you sell it sells for 500K. Are you happy? Of course not. Yet, when I-bankers do that very thing, they are praised, and so are the seller who sold at a low price.

The two decades of my career have seen only the following dynamic:

Stock goes up after IPO: Seller and Seller Agent good Stock goes down after IPO: Seller and Seller Agent bad.

Now, good and bad are subjective terms. If I were a buyer of an asset, I would want it to go up in price afterward. Of course, If I were a seller, I would want it to go down.

Conventional wisdom would probably say that it is in the interest of sellers and their agents as a whole if IPO's perform well, as that makes sure that buyers are around in the long term. However, shouldn't the seller's agent have a fiduciary responsibility to the seller, and not to the market as a whole?

The simple fact is this: This is the most successful IPO ever, and if I am ever in a position to IPO my company, I would want the stock price to plummet the day after I sold. That is how I would know that the investment banker(s) on the deal did a good job.

Yishen Kuik comments: 

I am sure there are other people who have been in and around the equity capital markets, but let me take a stab at Gordon's question.

1. An investment bank needs to have a stable of happy buyers and happy sellers to stay in business. All issuers like FB (the sellers) want to sell their equity for as high as possible - greed is universal among issuers. What investment banks will say in rebuttal is that you want to give the buyers a pop to make them happy, this way when you want to do a secondary down the road, your chances of successfully building a book is enhanced. Every businessman understands this — you have to leave a little on the table for the other guy, so that when you really need their cooperation, you can cash in those goodwill chips. This is why most IPOs are priced to pop a little. It's a goldilocks game - not too high and not too low is where both sides are happy.

Sometimes like Google, they thumb their noses up at Wall St and go their own way. But from what I understand the Google IPO was a mess.

2. At an investment bank during an IPO, the institutional sales coverage is the buyer's advocate and the ECM desk is the banks advocate. No salesguy who wants to stay in business wants to burn his client on a bad deal (although they are not adverse to inserting fat fees into a deal that won't burn the client - cue the selling of rich vol in creative re:opaque ways). The ECM desk however sometimes needs the buyers to take one for the team and support a weak deal. This is then repaid by participation in a good deals. Keeping track of favours owed and granted is the job of the respective heads of sales and capital markets, and this is what keeps the circus going, and how IPO books are built. The ability of an investment banks to raise stupendous amounts of capital very quickly is a non-substuitable service, and why they can charge substantial fees. A ECM desk that does not have the investment banking deal flow, does not have access to a top sales force, does not have skilled market makers, does not have the marketing power of a good research team and does not know how to manage favours with institutional investors will see it's ability to raise capital for clients degraded. And that ability is the engine room of an investment bank.

CFOs and CEOs usually have careers that span several companies, all of which will need to go to market now and then. Therefore it is in their long term interest to cultivate good relationships with investment bankers. They will give a little, not much though, in order to get a little when they really need it. So when the ECM guy says he wants to price in a 10% pop, they will acquiese.

Buyers want to align themselves with a bank that will feed them IPOs that have a high probability of popping. It's a sure strategy to pad their annual returns. But there is a dance here as well - buyers need to know that the investment bank is able to do a good job in pricing so that between the competing interests of the seller and the buyer, it is resolved slightly in favour of the buyer so that the health of the long term game is preserved. Buyers also want to know that their favours in swallowing bad deals are at least fairly noted and repaid. A good ECM professional therefore gets paid 7 figures, and the head can clear 8 figures.

This is why an IPO that goes up a little on opening day is viewed as a success by all parties. If it goes up too much it is viewed as a success by buyers & a mixed bag by investment banks ( the seller is pissed off, but then the industry is excited so more paper comes to market). If it tanks, it is viewed as a failure by buyers and the investment bank. The sellers have a mixed reaction.

This is also why I think it is very difficult to create an investment bank — there are many very expensive moving parts (teams of highly paid professionals) that need to come together. The Europeans and the Japanese have been trying for decades with very mixed track records and most recently Ken Griffith tried and failed.



 My friend is counseling his daughter who wants to pursue a career as a classical musician to double major. My daughter also is a music major and we have discussed this with her quite often. She is a freshman oboist in Chicago. You basically have to be a superstar in classical music, or close to it, to earn a good living and not be hugely dependent on income from teaching. If you love teaching, then its not so bad, but the competition for the larger orchestras is very intense. Plus, several symphony orchestras are cutting back, so the strained economics are more true now than ever. My daughter is on a double major track and it will be a year-by-year assessment process to determine what she does after graduation. Continue on with the oboe in a masters program, if the signs are reasonably positive that she can make it long term, or look for work (and probably a masters too) in her other field. Likely to be accounting or economics.

Laurel Kenner writes:

Studying music confers a multitude of qualities useful in business: discipline, an appreciation for timing, devotion to perfection, the ability to comprehend different voices, a readiness to "hear" change, competence in meeting deadlines, comfort in communicating with an audience. (And music can bring great personal joy.)

Not so long ago, classical musicians were mere servants in the households of the nobility or employees of the church. Even professional musicians today usually experience significant downward mobility from their parents' lifestyle. The pressure to be mobile — to accept jobs far and wide –makes it very difficult for them to maintain stable marriages and establish families. I recommend "Mozart in the Jungle" as a cautionary tale. The oboist in the story ended up becoming a journalist and wrote extensively about the economics of classic music today, as well as the pitfalls of the musician's personal life.)

I applaud the double major as a way to avoid starting at the bottom in an alternate career. But those kids are going to have to work twice as hard as anybody else.

Yishen Kuik writes: 

Certain doubles can be pulled off quite easily - many classes can be applied to several majors. Statistics, for example, is a common requirement for many fields. Skilful negotiation can obtain cross credit approval for a class not yet listed as such.

The most unusual double/triple majors however will be the left brain right brain ones, which tend to have very little overlap. I have yet to meet someone else with my combination : math, economics, history of art.

I have noticed also that just as many Asians of my generation who went to good schools started their careers in the West to obtain better opportunities and experience, post the 1997 recession in Asia, I bump into many young Europeans and Americans starting fresh from school out here in Asia.

These economic migrants as it were have little to lose, no family to hold them back and can be found in all parts of China and Asia in junior jobs. I would not be surprised if in ten years, these intrepid job seekers return to Europe and the US as the next important community of business people who can move seamlessly between Wichita and Wuhan.




 When we analyze data and find some sort of correlation either positive or negative what have we really found. Have we found cause and effect?

The simple answer is no. Proving correlation cannot demonstrate causation. The fallacy that is at the core of this is that even when two variables are correlated one does not necessarily cause the other. The real underlying cause could be a third unobserved variable that is moving both of observed variables.

An example of this might be that we observe that the stock market and bond market move together over a period of time. That does not mean that one is causing the other. In reality they may both be caused by the Fed's Permanent Open Market Operations (POMO). If that is a variable we have not considered then we are oblivious if it is removed from the economic landscape one day.

All of this begs the question as to whether or not we should be trading on past correlations. Is it just a fool's errand? I think it is not, especially of the correlation is strong enough. But it does expose us to the risk that the hidden real cause will evaporate someday without our being aware of it. That is the risk of speculation. We must be ready to give up a system or anomaly that has worked in the past if it suddenly stops working for us.

Yishen Kuik writes: 

I am far from qualified to speak with any authority on statistics, and my training in mathematics was only as an undergraduate focusing on number theory.

My only claim as to why my opinion on this matters is that I have been operating a statistical trading book for some years and have not yet been swallowed up by the market.

I find that I can get most of the answers I need with fairly basic statistical tools, as long as I ask the right questions with them. I have also found that most advanced tools have to used with care. I want to be able to rely on the results I get with tests, and advanced tools tend to have specifications and nuances that I find troublesome to be familiar enough with that I can use the tool with confidence.

I am surprised at how confident many people, especially those in academia, are in the results they get from using very involved statistical techniques. Even when using very simple tools, I find that I have to think very carefully about the range of explanations for results and how vulnerable they are to various quirky aspects of the data. The Chair's point about how fat tails can be the result of aggregated gaussians or how arc sine can lead to unexpected distributions of highs and lows are good examples of this. In practical usage, I find that such unexpected results are quite commonplace. With complex tools, I am concerned that I may be blindsided by unexpected results from the interaction of data attributes with the details of the implementation that renders my ability to interpret the results correctly. The non-stationary nature of financial time series, the single history, the memory, the regime based volatility and many other aspects of markets tends to really screw up many statistical tools. It is too hard for me to look through the details of the advanced tools and think about how the perversity of financial time series might affect the results in complex tools before I can even contemplate using them with any confidence.

I find that to get the right answers, it is more important to sit down and think and come up with the right list of questions to ask, the answers to which in total should reveal the bigger answer you want to find. For causality and correlation, I doubt if there is a "just add numbers" tool that will give you a worthwhile result.

My algorithm for answering such a question would be to draw a warm bath and sit in it for a while. Then in about 2 or 3 days, usually in the early morning for me, a list of questions will come to me, the combination of answers to which will address the correlation/causation issue, and then later at my office I can construct the tests necessary to express those questions in a few hours. 



 Not to be hostile or anything, but I have never had dealings with Chinese where they haven't cheated me. I am told that there is a Northern Chinese persona and a Southern Chinese persona, and that I believe in the South, everyone is dishonest with Westerners, and the more you have done business with such a one without a wrong being committed the more likely it is that it will happen the next time, a very strange kind of hazard rate by the way. I may be wrong about this, it cost me much of real time wrongness, many years ago which compounded, my goodness—I'd be a wealthy man— but I'd like to know if there's a kernel of truth to it. You, Mr. Jia seem like a very worthy and honest man, and nothing in this is personal, but the memory still stings, especially in these markets.

Yishen Kuik writes:

China today is often compared with America in the 19th century. What I find remarkable is how true this can be.
The Chinese in China will cut corners, bamboozle, harass, deceive and cheat you on par with any 19th century "wily yankee". They are energetic, entrepreneurial and as hungry as any red blooded capitalist can be.

The melanine milk poisoning scandal is often held up as the worst example of Chinese business men run amuck.

And it is an echo of New York City in 1858 where "swill milk" killed thousands.

The horrors of working conditions in Chinese sweatshops is an echo of Upton Sinclair's expose of the Chicago meat packers — which created such an uproar that Roosevelt sent a secret fact checking mission that largely corroborated Sinclair's novel.

If you have ever been on a boat or a plane in China and it is about to land, they will all surge towards the exit, pushing each other out of the way to save a few seconds on exiting. They are a nation that has industrialized late and are pushing and shoving to catch up.

Scott Brooks writes:

I believe Yishen is correct. China as a nation is where the US was back in the 1850's (of course, with modern technology and infrastructure mixed in). They are still transitioning from a 3rd to 2nd to 1st world country. If you stop and think about it, they are really all three mixed into one. To expect a country to act and behave like a mature adult when they are really more like an adolescent, raised by dysfunctional parents is simply not foolhardy.

It will take the Chinese several generations to move into full 1st world status, and several generations to after that to mature into a moral system that is akin to the US.

We all go through our growing pains, the key is recognizing where the other person, or country or trading partner is on the "national maturity continuum" and the relate to them accordingly.

However, it is also a mistake to underestimate or minimize someone or a group of people because you see them as "less sophisticated" than you. That's why there is such a divide in America between the coastal elite snobs and us backward country bumpkins out here in fly over country.

Jay Pasch writes:

One of my best friends had an IT business selling computer mainframes and services into overseas markets. He did fine everywhere he went until he wound up in China; he had the equipment shipped, put boots on the ground, bolted the mainframes together, bus & tag to the disk systems and tape drives, IPL'd the system and turned the project over to the Chinese with a perfectly turned-up MVS system complete with blinking cursor. To his dismay the Chinese all of a sudden wanted application support, which was not in the contract, nor part of the company's forte. The Chinese government detained the engineers for six months, holing them up in their hotel rooms, and withheld contract payment until the company was forced into bankruptcy after the big bank notes came due. That was a long time ago, but even today we can't get through a pitcher of beer without the inevitable cussing about dealing with the Chinese…

Rocky Humbert writes: 

My dealings with the Chinese are largely limited to my contact with the venerable General Tso. I should note that The General has treated me well over the years. However, one serious exception comes to mind: It was in a small, nondescript restaurant inaptly named, the Jasmine Rose, located on a hardly-traveled road in northwestern Massachusetts where my friend, who was seriously allergic to garlic, and I ordered dinner. We advised the waiter of his food sensitivity and were assured that our dishes would be prepared without any garlic. After my friend started to show preliminary signs of anaphylactic shock, we discovered some garlic in the dish and called over the manager. What amazed us was not that the kitchen had made a mistake (which happens), but rather that the manager when faced with irrefutable evidence simply kept repeating (in broken English), "NO GARLIC! NO GARLIC! NO GARLIC!" as if his protestations were proof that we were wrong and that he was right. It was a bizarre, but memorable experience, and left an indelible impression on my mind, and on my friend's medical chart.

More relevant to Specs is some below-the-radar-screen litigation currently underway against certain Chinese companies and their US underwriters. A lawyer friend, working on these cases has explained to me that vast numbers of listed Chinese companies are complete and total frauds — and that in fact, a variety of (private) Chinese firms exist solely for the purpose of providing seemingly-kosher accounting paper trails for the fraudulent Chinese companies– so legitimate US accountants will see their (completely bogus) payables, receivables and assets, and provide a clean bill of health. Every time I am tempted to buy a Chinese stock (or index), I think of this story and I stay away. It's not that US companies are immune to malfeasance (Worldcom, Enron, Adelphia, MF Global?), nor it is true that US companies don't massage their earnings (GE, etc.). But, rather, if you throw a dart at a list of US companies, the odds are good that you won't hit a complete fraud. It's my impression that the same cannot be said about Chinese companies, hence I will not invest there directly, but prefer to invest in world-class US companies that can complete their own on-the-ground due diligence in China. Lastly, the Chair has opined periodically on nature vs. nurture. At the risk of putting words into his mouth, he has usually come down on the side of nature. Without taking a position, I would suggest that corporate and personal behavior MIGHT BE more influenced by genetics than by culture. If this is so, certain countries and people will be inhospitable to passive investors for a very very very long time, while other countries and people will demonstrate very different characteristics. Again, I am NOT taking this position. I'm just putting it out there…



 Is the Singaporean enthusiasm for the death penalty just hard-nosed economics– it's cheaper to bump them off than keep them in jail? Hardly, the Singaporeans also have a very high imprisonment rate – 388 per 100,000 population according to current British Home Office figures. Australia's imprisonment rate is 115 per 100,000, Britain's is 141, the highest in the European Union. The USA has not only the world's largest prison population (now more than two million) but also the highest imprisonment rate (701 per 100,000). Russia comes second at 606.

The US imprisonment rate is so high it probably skews US unemployment figures, making them look better than they really are. Singapore leaves them all in the dust. The squeaky clean city state is not just secretive about its execution figures it's positively vague. When Prime Minister Goh Chok Tong was asked by the BBC in September 2003 why he didn't know the precise number of people executed (his guess was 70 or 80 when the actual figure that year was closer to 10) he replied that he had "more important things to worry about."

Yishen Kuik writes:

Singapore executes you for owning firearms, murder and drug trafficking, in that order of frequency. Drug trafficking is most of it (70%?), mostly couriers and dealers. We are not in the business of storing drug dealers, we are in the business of burying them so they dare not hawk their wares. Other nations make this a cause celebre because Singapore routinely executes their citizens (about 1/3 of all executions), especially the Australians. They never make the same fuss when Singapore executes Singaporeans (the remaining 2/3 of the time).

What they don't realize is that once upon a time, when Singapore was governed by the British, it was a free port with meager tax revenues. To pay for municipal administration, the colonial government promoted and taxed opium. 50 % of govt revenues was from opium before WW2.

As a result Singapore was a giant opium den with huge numbers of addicts. Having been there, there is an institutional memory among the older generation of the ruinous effect of drug addiction, and hence support to apply capital punishment to drug dealing.




 From the front lines as a soon to graduate grad student in the market for employment in the finance sector, the US can't hold a candle to China/Asia in terms of jobs and opportunity. The US has effectively become a place where a "trade" wins out over a degree. There are very specific skills and requirements to get in the door these days in America. Quants want C++ programmers and data scrubbers, fundamentalists want financial statement analyzers and channel checkers, macros want Econ PhDs who chaired a University Econ program or spent half a life with the IMF/Worldbank/Fed (I guess this one isn't so much a "trade"), sales teams want cold callers and entertainers who also understand the business. Once one enters one of these "silos" good luck moving to another unless you possess a multitude of different degrees, skills, and designations (Compu Sci, Econ, Stats, Math, Finance, MBA, Engineering, Hard Science PhD, 2 yrs Inv Banking, CFA, C++, MatLab, VB, CMT, etc.). And not many opportunities exist which don't fit into one of these categories.

The Asian markets on the other hand are so illiquid on a relative basis and so many rules apply that they generally want smart people who can figure out cross country nuances and a trader serves almost as an international lawyer figuring where to trade, how to trade, and how to settle (while learning a lot of markets and likely seeing vast opportunities). On top of this, the Asian trading desks are expanding headcount at a much higher rate. One desk, which will remain unnamed to protect the innocent, is hiring over 10 new people in their group alone in the next two years. I have not heard of a single US desk with a similar hiring plan. If anything I hear of jobs being cut in the USA and openings result from people leaving (one out, one in). Moreover, these jobs in Asia are very diverse. A person on a desk in Asia will get to deal with virtually all product types (equities, credit, FX, commodities, IPOs, etc.) and a ton of different countries. In the US it tends to be segmented by type further siloing (not sure this is a word) the silos (i.e. fundamental equity or macro FX). From what I am told the majority of job takers in Asia wind up with their choice of options (buyside/sellside, US/abroad, credit/macro/equity, etc.) after 9 to 12 months or they get promoted internally. If you pick up some Mandarin or Cantonese along the way, forget it you will be an eagle with razor talons competing for prey in a world where everyone else can't fly and is blind. A year in America in a silo within a silo will probably mean a relatively small bonus and the chance to keep climbing the ladder in your specific subsilo. So choose your silo wisely, to the extent you have a choice, as your first decision may be your last.

The American dream seems to now be manifesting itself in Asia. It is unfortunate that in order to have the best available options down the road in finance one will likely have to leave friends and family and venture to Asia. Unless said person chooses to be a "trade" professional or gets very lucky.

Yishen Kuik writes:

For decades, investment banking in Asia ex-Japan used to be a hire and fire business because of a very lumpy deal flow. China, and it's large growing capitalistic economy is a fundamental game changer.

However, the need to speak Mandarin fluently will become essential. There are few people at the top today who have the relationships, the experience and the language skills, hence the opening for Americans and Europeans to occupy the top spots. All junior people however, have the language skills, and in time they will acquire the experience and relationships. Within 8 years, all the associates working on Chinese deals today will be Managing Directors, and they will have the entire package.

40 years ago it was possible for a Frenchman to be the pre-eminent American investment banker. Today that notion is highly unlikely. Affinity is where the edge is.

Cantonese is not the language of business and has little value in the financial world even in Hong Kong. The people of Hong Kong, whose manufacturing was hollowed out by China long before Americans heard of the word outsourcing, are now undergoing the additional indignity of being culturally and linguistically hollowed out.



Didier SornetteA friend of mine sent this very interesting link. It's about the work of Didier Sornette.

Victor Niederhoffer comments:

He's an actor  always predicting the end of world, reporting one blade of scissors never expectations, like its 30% likely there will be catastrophic decline but never that it's also 40% likely that there will be an extraordinary rise. Similarities and retrospection galore and a doomsdayist.  

Allen Gillespie writes:

I can't speak to that, but his book does have an interesting section regarding the implications of a zero interest environments and he references Von Neumann and other who wrote in the late 1930s the last time t-bill went to negative yields. The math is such that both U and -U can be solutions and hence jumps (up or down) like the "flash crash" and 1999 become acceptable solutions. That's the problem with ZIRP and QE because what is the value of a continuous stream of rising dividends at near zero discount rates? And what happens when QE stops like it did March 31, and on the fiscal side where the government reached is max transfer payments on April 15? Where despite rates still being near zero there was a exponential relative tightening of monetary conditions. And where did PG and others print? Why just below the last free market lows in 2009 before QE.

So, in effect, he does mention the possibility of a large rise and decline because both U and -U are solutions in a speculative bubble regime driven by ZIRP, QE, and massive explicit moral hazard. In short, things can trade anywhere and the days around the timing of when the Fed finally removes its ridiculous rates low forever language will be interesting as it will represent a 3rd non-traditional tightening. The issue is the Fed will probably need to run QE2 in the background when the debt roll doubles next year and climbs more in 2012 before falling and stabilizing thereafter by which time FNM and FRE might have run through the max losses.

I am not a quant but just a fundamental guy who also has a decent eye for politics, and I think it is relatively simple– the Fed's said "oh sh_t" after Lehman so they have tried to put Humpty Dumpty back together again by running bonds back to par and stocks back to Lehman levels (1166). Prices above that they will not artificially support, far enough below that they will so long as they are allowed to print $$$. The big risk, which cannot be quantified, is that historically it is a POLITICAL event which removes this support mechanism from the markets and that can happen in a day and stocks must fall a lot to find true cash (not bank convergence trade) buyers - those old men with canes who do exist but are becoming fewer.

Also, for the curious given current events– there was a large rise when the U.S. declared neutrality in the third quarter of 1939 only to fall a year later as this laid the ground work for its friends being run over. Isn't GM supposed to be IPOed then - TM problems real? - AIG insured Goldman? BP - the green energy firm - Yukos for the industry anyone - except we can't create a faux back tax - so we will just grab it with environmental taxes that will be coming. As to gold, its takes tighter money to kill a real bubble as 1999 and 2004-2007 showed and while on a relative basis the Fed has tightened with no QE, Europe has eased and until the U.S. can roll its 3 year average maturity debt with large origination years of 2008 and 2009, I am staying long and I bet other are too.

Peter Grieve writes:

The word "econophysicist" alone should be a danger signal, that someone is hubristically applying a certain analytical discipline outside its sphere.

One might as well say "gamophysicist" for "marriage counselor", or "hippophysicist" for the author of a horse betting pamphlet.

I bow to no man in my love of physics, but it only has power in clear cut situations.

Ralph Vince Concurs:


Gimme a break!

"…bubble markets display the tell signs of the human behavior that drives them. In particular, people tend to follow each other and this result in a kind of herding behavior that causes prices to fluctuate in a periodic fashion."

Really? Who would have guessed that!

Ah, Switzerland! Yodeley hee hoo! These guys are always in Switzerland, aren't they? 

Yishen Kuik writes:

Victor may be right– some of Sornette's older (erroneous) predictions which I think appeared on his faculty UCLA website aren't around.

I don't know if someone has consolidated all his predictions to check the batting average, but he certainly may have left out his losers in recent press releases and papers. He seems to have channeled a lot of energy at bringing press attention to his work. I suppose his final objective is the lecture or consulting circuit a la the distinguished expert on derivatives and other professors.



Logo of American and Foreign Power CompanyHow does a company like DuPont have a book of 5 bucks a share when it's been earning 2.00 a share for 100 years? Part of it is that it pays dividends of 85% of earnings. The kind of stock my grandfather would have recommended for me along with American & Foreign Power. Couldn't go wrong with that 10% dividend — until they were nationalized. That corporation was another of his favorites besides Union.

Rocky Humbert comments:

DuPont has been a poster child for the Modigliani-Miller theorem. They've been increasing leverage and buying back stock for years, which — depending on the price paid — can cause a perverse and self-reinforcing decline in book value. And even with a low book value, about 61% of their shareholder equity is goodwill. But their ROE looks very sweet at 25+%.

Ironically, DuPont was originally a dynamite manufacturer. Dynamite funded the Nobel Prize. Modigliani-Miller won the Nobel prize in 1985. So the circle is unbroken. 

Yishen Kuik writes:

A more extreme example is Colgate Palmolive, which at one time had negative book value. The shareholder's equity portion is still a negative number, and the persistent accumulation of retained earnings has since brought book value back to positive. It still probably has some fantastic price to book ratio.

Rocky Humbert adds:

The following stocks all have market caps over $1 Billion and negative book values:


The significance of this phenomenon is left as an exercise for the reader.

Sushil Kedia comments:

Historical Accounting leaves disproportionate under-priced assets due to inflation on the books making book-value appear to be very small in comparison to earnings, for very old and profitable companies that distribute large dividends.

For younger companies in fortune businesses such as exploration, new molecule discovery etc. anticipations of a breakthrough can have large market caps and low hard assets.

Franchise businesses, including those that thrive on brands such as Colgate, customer loyalty concepts etc. will have a very large proportion of assets that are intangible and never appear on the books of accounts making book values very small.

Companies that have dominantly assets with large depreciation rates allowed too will have lower than average b/p price ratios.

Companies that have taken over larger companies would have a lot of ethereal assets termed as "goodwill" making low b/p ratios again.

Phil McDonnell writes:

I note that Colgate has a return on equity of 90% according to Yahoo data. Big Blue reported today. They currently have a respectable 77% ROE. They are paying an increased dividend and buying back stock. To me it is interesting that the large stable companies that are doing this also have fairly large goodwill entries, as Sushil noted. For example Colgate has about $2B in goodwill on the books. Usually this means they paid too much for an acquisition. Too much means they paid more than the book value of the assets acquired. But in the case of stock buyback if the company buys its own stock at market, which is higher than its book value per share then presumably that shortfall is recorded as goodwill. If the stock rises or has risen in the past then that may mean there is hidden asset value on the books in some sense.

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

Steve Ellison observes:

I am looking at Oracle's 10K. Oracle used $3960 million of cash in 2009 to repurchase shares. On the statement of stockholders' equity, Oracle reduced common stock by $550 million and reduced retained earnings by $3410 million. Thus the effect of share repurchases was to reduce stockholders' equity, but this effect was more than offset by the increase in stockholders' equity from net income of $5,593 million. 

Sushil Kedia comments:

If Inflation Accounting seminars held by so many august Accounting Bodies all over the world in the last two decades could not decipher how it could really be done, assume for a moment at some point it will be done correctly.

But then the book-keepers that produce the inflation estimates and keep revising them invariably all over the globe (I guess all gummints are at least alike on this parameter whether they be Capitalists or Communists) are also just book-keepers.

So, this one conundrum will never be solved.

In recent decades there have been some high-brow management consultancy firms that are peddling ideas of Brand Valuation. But then if a company could own a brand worth a Billion Dollars and make only continuous losses their ability and talent at producing so much red is eventually leaving a value on the table of that Brand at just a risk adjusted present value aggregate of these losses as a negative number only. Brand Valuation as an Accountancy tool has no place in the Accounting World, save for nice trips to Bermuda for such conferences.

Replacement Cost Theories have been used and rather mis-used to pamper the valuations of cash-loss generating companies on an idea that it would cost so much to build this same factory today at the extreme end of bull-runs.

Then they say Cash is King. But the King everywhere in this Universe has been only trashing cash ever since it was invented. So, we go back to the beginning of this note. All roads lead to Rome, in the world of Fundamentals.

So what Fundamentals are we talking about at any point and under any framework?

At least the price followers, even if prices are manipulable and get manipulated every now and then are having a far simpler illusion of suffering from knowledge and the best part is this manipulation keeps coming regularly, tick by tick. The follower of price action recognizes if there is an incentive to an economic activity, it is happening already. So, irrespective of whether prices are manipulated or they are not, the stimulus to any system of taking decisions is consistent.

The Fundamental Manipulations are erratic, supposed to be non-existent until an Enron comes by every now and then while they are happening throughout erratically and then with an endless battery of ideal world assumptions the whole Art of Fundamental Analysis has such elegant and consistent formulae for everything. The quantitative screens in each and every idea in the universe of fundamentals is so self-sufficing and yet this form of art never could get known to be any variation of Quantitative Finance.

I am not against Fundamentals at all, but just wish my elegantly consistent brothers and sisters in this art form acknowledge the fool's paradise they are keeping building.



a geomagnetic storm on earth due to solar activityThe NASA site has a prediction of 25% chance of geomagnetic storms at mid-latitudes in the next zero to 48 hours. The chance at higher latitudes is 30%. Recall that geo-magnetic storms have been linked in an Atlanta Fed study to stock market weakness in the nest few days following the event especially if accompanied by Coronal Mass Emissions.

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

Jeff Watson writes:

Years ago, I looked at the correlations between solar activity and markets using the solar flux, A index, J index, and K index, and Sunspot number, and couldn't find anything offering predictive value. The only correlation I could make was the total solar output with grain prices, and my conclusions were suspect, to say the least as many other factors were in play. A great solar storm,on the level of Sept 1-2 of 1859(which blew out the telegraph system world wide) might be bullish on chip makers and other electrical component providers, plus would be very bullish on metals. However, a solar storm of that magnitude could possibly wipe out our digital communications, computer system, and internet, for a long time.

Yishen Kuik comments:

I'd never heard of the 1859 storm before. A little more recently, the Toronto Stock Exchange was halted by a solar storm in 1989.



Mr. Galen Cawley kindly provided a link to a dated, but still interesting article entitled, "An analysis of the profiles and motivations of habitual commodity speculators". This comment was on William Weaver's post: "Study shows why it is so scary to lose money". I found this article provocative because when I was younger, some of my innate instincts were similar to the habitually losing commodity speculators'. I suspect everyone who reads this article will see some foibles he has overcome (or needs to overcome) for self-improvement. To summarize the article:

1) Most speculators use too much leverage.

2) Most speculators don't hold their positions for sufficient time.

3) Most speculators don't use stop loss orders. (However, the authors didn't differentiate between actual stop-loss orders and mental stops. The point was they don't cut their losses.)

4) Most speculators prefer a serious of "modest" short-term profits versus slowly accumulating long-term gains in a single position.

Bottom line: They found that the average speculator had a win/loss percentage of 51.3% and the best speculator in the study had a win/loss percentage of 80%. However, he still lost money because of his low profit factor. Despite great win/loss ratios, the average trader in the study is a career net loser. It's a Wall Street platitude that "no one ever went bankrupt taking a profit." This study shows that the platitude is false.

Kim Zussman comments:

"Most speculators don't hold their positions for sufficient time."

"Most speculators don't use stop loss orders… The point was they don't cut their losses."

Which is contradictory because many deep losses reverse eventually ("every price is hit twice")*, and often the correct trade is to wait for losses to reverse (and often it is not). Taken together, this means "ride your winners and ditch your losers." Isn't that trendfollowing, and if so, what if the (currently traded) market is not trendy?

*except Nasdaq 5000 in our lifetimes.

Victor Niederhoffer comments:

One has not read the article, but would wonder whether speculators would lose as much if they showed opposite traits. However, the characteristics noted all would lead to greater vigorish and this is where most of profits from the market makers occur. Everything that happens is guaranteed to increase the profitability of that vigorish to the house or top feeders.

Rocky Humbert responds:

If one attributes the speculator's losses entirely to transaction costs, then one's performance can be improved by simply having fewer transactions. One wonders whether there is an a priori relationship between all of w/l ratio, profit factor and quantity of transactions? Splitting hairs, I quarrel with your choice of the word "guaranteed." A much wiser man taught me that the only things guaranteed in life are "death and taxes."

Jordan Low comments:

Macro traders should be long gamma as markets can stay irrational, while value traders should be short gamma especially if they are positive carry and see no devaluation/fraud risks. I think it all depends on your style of trading.

Victor Niederhoffer writes:

One would say this is perfect as one trader should always be one way and the other trader should always be the other way. that is guaranteed to make the top feeders a perfect guaranteed profit. I say the above in all seriousness and respect to the high thinking Mr. Low.

Rocky Humbert comments:

Mr. Low articulately differentiates between arbitrage/positive carry, mean-reversion (providing liqudity) and trend-following (taking liquidity). Arguably every single trade or investment fits into one of these categories. But I'm confused and intrigued by Vic's comment about "top feeding".


1. Who exactly are the "top feeders" and should we buy their stock?

2. Are the top feeders always the same participants? If they always make a "perfect guaranteed profit" then how can they ever slip from their perch of being a top feeder? (Were EF Hutton, SW Strauss, Shearson, SmithBarney, Dillon, Kidder, Drexel, Revco, Bear, Lehman, Merrill once top-feeders?)

3. And if they do eventually slip off their perch of "top feeder" — then how does one argue that they ever had any advantage? As opposed to being just another opportunistic profit-seeking participant?

Theoretical questions of course — but they challenge the hypothesis.

Yishen Kuik comments:

Seems to me there is some kind of law of conservation going on. Usually if win-loss is very favorable, avg win > avg loss, then frequency of trades is low. If win-loss is very favorable, avg win < avg loss, then frequency of trades is moderate. If win-loss is only very slightly favorable, avg win > avg loss, then frequency of trades is high.

etc. etc. …. all solving for a reasonable profit factor.

But if you are doing something quite different or if you are early in a wave, you can have an unreasonably high profit factor. Then again, there is always the argument that low profit factor strategies with low capacity are the ones with the longest half lives.

Jordan  Low replies:

I appreciate the response.

My view is that the trades do not always net out. While the macro traders are attracted to events such as subprime, china, commodities or Greece, value traders avoid those trades rather than taking the opposite view. Buffet did not invest in dotcoms for example. Each has his own reasons, from only trading what he understands, to seeking or avoiding volume/volatility, to seeking catalysts.

Aside from trades, there might also be a timing mismatch. Traders with most skill in my view know when to sit on their hands. Others might be lucky or unlucky. Eg penny stock momentum strategies might only work in the dotcom era but not after. On the other hand, value did well in the great moderation of 2004-2006 but not during the quant meltdown of 2007. Given the tendancy to chase performance, the dollars in each camp may not net out exactly.

 I hope this clarifies my view, but I do think there are top feeders that make good returns off their franchise. ETF providers make money both by providing access to hot markets and by lending stock to short, for example.

Call me Jordan…



 Although I love to collect fine art, especially Impressionists, I also am an avid collector of Surf Movie Posters. These posters were made during the 1950s-70s and some were real works of art. Since I like to check out eBay for the offerings, I have noticed a few things.

Normally, in that eBay category, there will be 30 posters offered, mostly $4.99 reprints of terrible movies like "Blue Crush" or "Surf's Up." Lately, I've noticed that there are 100-150 posters being offered and sold for amounts that haven't been seen since Mat Warshaw came out with his excellent coffee table book on surf movie posters titled Surf Movie Tonite! Surf Movie Poster Art. His book caused a pronounced bubble in the market for posters, and I stopped collecting until the bubble popped.

Looking through the current offerings, I see works by John Severson going for as much as $109-$299. Bruce Brown's posters are going for $129, and even the faux surf movie "Ride the Wild Surf" original is going for $1200. 2007-2008 was the year to buy these same posters, as they were 60% less then the current market prices. Some posters like Yuri Farrant's "Hot Lips and Inner Tubes" command prices of $3,000 if you can find a copy. I got mine in 1976 for $6.00 from an ad in Surfer Magazine. Any work of art or original surf poster by the late Rick Griffin costs as much as a painting from a gallery in Soho. Somehow, I suspect that the market in original surf movie posters is going up and might test the 1986 highs. Still, in this market, it is caveat emptor, as there are a lot of fakes out there.

Jeff Watson, surfer, speculator, poker player and art connoisseur, blogs as MasterOfTheUniverse.

Yishen Kuik observes:

There is clearly a lifetime cycle effect for the collectible asset class.

People in their 50s who are at a stage in life where the most successful of their cohort have enough money and time to indulge in the things that most captured their fancy in their formative years between 15-20 bid up the best collectibles in that class. It is likely that that is the peak average asset valuation of that collectible — the best items might continue to mark higher and higher prices, but any random assortment of quality pieces would slowly become less and less liquid, and speculative sellers would have to choose between the theta of warehousing & unknown time of execution in order to obtain bid improvement, or pay up for the illiquidity disposal fee.

The kind of comic books I read as a kid (X-men) have enjoyed a resurgence in popularity in the movies that I assume must have translated into higher prices, just as old arcade game boxes have enjoyed a revival re-entry into many bachelor pads. Star Wars figurines by Kenner are another example of items that have enjoyed resurgences in the past 10 years after a 20 year lacuna since their introduction.

What are the things that fascinate the young today, which if stored cheaply and properly, might yield good appreciation 20 years hence?

Russ Sears writes:

Surely any women painted by Renoir and any girls by Degas, deserves a place on the list of art that "makes life worth living forever." 



 Dim Sum – it sounds so stern, and fiduciary. (Canada’s Auditor-General to the Royal Canadian Mint, who this year lost track of $10M worth of gold: “I take a very dim sum of this.”)

Yet, one finds oneself desiring an exceptional dim sum experience on one’s upcoming Christmas vacation to New York City, and was wondering if anyone here has had such exceptional experience recently, and would be forthcoming with some useful intelligence on the matter. (Translation: does anyone know where to get good dim sum in New York?).

Yishen Kuik comments:

There isn't any good dim sum in New York City. The nearest place to get good dim sum would be in Vancouver or London.*

However, Chinatown Brasserie by Great Jones Way & Lafayette is a decent choice. While it is apparently Westernized on the outside, the chef inside, Joe Ng, is quite competent.

* Why is this, you might ask. Dim sum is found all over China but reaches its apogee with the Cantonese in Hong Kong. Like all other art, the best examples flourish with proximity to wealthy patronage. Prior to 1997, many wealthy Cantonese secured second passports and homes in Canada and Great Britain as insurance. Thus they brought the discerning patronage necessary to sustain top flight dim sum to Vancouver and Toronto.



 I used to do a lot of business in Japan and I think very highly of Japanese businessmen (unfortunately they rarely include women at high levels). They have an industrious, highly intelligent population, are very interested in business, and a good base as the second largest economy in the world.

It is a great mystery to me why they (and their stock market) have not done better in recent years and I have never seen any good explanation of it. Okay, they had a bubble that burst, government policies that were not great, and they have an aging population. But so what? They had plenty of opportunity to recover on their own in spite of whatever the government has been doing. (BTW their government policies could not be any worse than our current ones, so if government policies are the test, we're in big trouble.)

Has anyone seen or can anyone give a decent explanation of why Japan has lagged?

Ken Drees writes:

1. LDP party out of power after 55 years.

2. Exports and profits slumping via USA trade like others Asian exporters.

3. Big(gest) holder of USD denominated debt.

4. Aging populaton (nothing new), but 81 billion spending package just announced, more internal stimulus to follow?

5. Need to diversify their surplus holdings like others (China, Brazil, Russia, et. al.)?

6. New party administration playing a little differently with USA — recent Obama trip no real results, prior to that some grumblings about USA debt, etc.

7. Japan equities — bottoms in 1998, 2003, 2009 — skewed symetric reverse head & shoulders – or just bumping along the bottom?

8. Will need to strengthen export markets everywhere and keep USA markets open and profitable. Japan's growth lies with its neighbors if USA doesn't fix itself.

9. Yen carry trade over, yen rising — conflicts with strategic direction that exports and export profits need to be robust.

10. Zugszwang-lite Japan — any small move doesn't change game for the better. Are there any good moves available?

How will the new party lead? If they cannot rope in the yen to improve exports can they stimulate spending via QE and weaken yen at same time? Or is this approach too slow and meandering? There seems no real strong moves available unless global imbalances happen first and allow Japan countermove possibilties. Japan seems still to be unable to escape via its own power.

Is Japan getting tired of being tired?

Charles Pennington adds:

A broad-brush explanation is that the Nikkei got way out of line with other world markets and has spent the past 20 years returning to normalcy.

The Japanese price to earnings ratio was "well over 100" in the late 80s, and now it's 33 (reported by today's Financial Times), still higher than the US at 22. Earnings for the S&P are up about 2-3 times over their level in 1989, and perhaps the Nikkei's are as well, but if the P/E fell from, say, 200 down to more normal value of 33, a value much more in-line with other world markets, well, that explains a lot.

The Chair will rightly point out that this is retrospective, descriptive, and not predictive, that Japan's interest rates are (or at least were) lower, that the accounting may be different. Also, Mr. Grossman doubtless already knows all these figures, so he is looking for a better explanation, which I don't have.

Kim Zussman adds:

Country-stock could be like "best company" studies, showing admired firms under-performing the rest. Presumably established/successful companies/economies have less upside than currently dire situations. And more downside? 

Vince Fulco replies:

To the list I would add traditional factors such as:

1. Shareholders — very far down the societal list of all stakeholders in the corporate world. The stock market is generally considered more for gambling (no jokes Dr. Z!)

2. Much heavier reliance on debt financing (too much) due to roots in maibatsu/keiretsu structure whereby a conglomerate's banking branch handles all the financing needs

3. No Carl Icahn or Guy Wyser Pratte influence to shake up entrenched mgmts and unlock under-utilized assets. The quote is 'the nail which sticks up gets pounded down'. A few have tried over the years but are usually labeled degenerates or cowboys and run out of town one way or another.

4. Years of very low ROI, white elephant projects by the government, to keep happy important constituents of the LDP (the old group in power) such as construction and the mob — i.e. the bridge to an island with 50 people on it, which we almost got in Alaska a few years back.

5. Legacy obligations which haven't been addressed but simply kicked down the road as we've emulated so well in the last 12 months.

Ken Drees responds:

Mt FujiVince, Kevin, Kim and Charles have all provided excellent observations as to Japan's inbred entrenched-ness, inabilities to move, and relative over valuations. Also, the idea that is was the once high flyer status albatross, so all these past behaviors are in the rear view mirror, yet they continue to taint the view of Japan as an old has-been power country. But change agents may now be inside this yesterday/today paradigm. So far Palindrome's reflexive reinforcement of trend is still in force. The malaise continues. Will some new change agent surface? Will the reflexive reinforcement finally be breached.

The early elements for a change exist. To bet on a new bullish Japan is a long shot. But how much money can be made betting the field? Tax policy can be repealed, monopoly/hands in hands can be abolished, small investors can be made more ownership level. All the levers to lift the old dead stump and turn it over are at the ready. Or is this a dead end due to lack of will? Is Japan a stunted growth, never ever to leave off-broadway? If a global imbalance rises up, will Japan change tack and ride out on a new wind? I am watching Japan, if only since they since they are shackled to the USD. Maybe the impetus for change is at hand. This new administration in Japan — what do they owe the US? 

Stefan Jovanovich replies:

The Japanese are certainly not hidebound where their Navy is concerned. They are the dominant sea power in their part of the world. From the folks at

"Japan is currently the second largest naval power in the Pacific (after the United States), with a total of 32 destroyers, nine guided-missile destroyers, and nine frigates. The older Tachikaze-class guided-missile destroyers are being replaced by the new Atago-class destroyers. Japan also has 16 modern diesel-electric submarines. The Chinese navy is larger in terms of ships. They have 25 destroyers and 45 frigates. However, of these 25 destroyers, 16 are the much older (than Japanese equivalent) Luda class. Most of the frigates are the obsolete Jianghu class ships. China has 60 diesel-electric submarines, but most of them are elderly Romeo and Ming class boats. China's Han class SSNs (nuclear attack subs) are old and noisy. In terms of modern vessels, China is not only outnumbered, but the Japanese ships spend more time at sea and the crews are better trained. The Chinese are also at a disadvantage when it comes to naval air power. Most of China's naval fighters are old. They have a growing number of modern J-11s (a copy of the Russian Su-27) and the Su-30MKK. Japan is almost at parity in terms of numbers (187 F-15J/DJs and 140 F-2s to 400 Chinese J-11/Su-30MKKs). Japan has better trained pilots, although China is trying to close that gap as well."

Yishen Kuik adds:

 The attention to detail and sense of duty of their workforce is amazing, and the public infrastructure in Tokyo is of a very high quality — certainly better than Boston, DC, New York or the Bay Area. Tokyo is much bigger than all these four areas. It makes New York seem small.

It's not entirely clear to me why their equity markets haven't done better, but the "obvious" explanations of long term multiple contraction and shrinking internal aggregate demand seem to be correct.

I believe GDP per capita in Japan has been rising all along at the same pace as in the US since 1989, so it isn't as if quality of living in Japan has been frozen at 1989 levels. From what I can tell walking around the streets, they still enjoy a comparable standard of living to anywhere in the OECD, and have an unemployment rate (whatever that means in Japan) of 5.0%

Henrik Andersson replies:

Some investors are expressing great fear about the debt given the large amount maturing in the coming 12 months that is held by citizens, as Yishen writes, and given it has "no foreign demand, no domestic savings, structurally declining tax receipts and savings due to demographics, etc." Any views on this?

The top line numbers for the country are stagnant, but the per capita numbers don't look so bad. Japan might have a ton of public debt, but most of it is yen denominated and some 3/4 of it is held domestically by its own citizens.

Dan Grossman writes:

 Two thoughts perhaps follow from the helpful comments of Prof. Pennington and Mr. Kuik:

1. Based on the two-decade decline in average Japanese stock PEs from 200 to 33, why shouldn't average US stock PEs decline further from the current 22 if government policies following bursting of the bubble are equally ineffective in the US as they have been in Japan?

2. If since 1990 the U.S had avoided illegal and legal immigration anywhere near the extent to which Japan has, the US unemployment rate would probably also be 5%.

Vitaliy Katsenelson adds:

Please look at slide 14. Japanese valuations at the of 1989 were incredibly high, add to that a lengthy deleveraging process on the corporate side and leveraging (debt to GDP has tripled) on the government side and you also have anemic economic growth.

Vince Fulco writes:

Here is fascinating article in the WSJ re: a foreigner helping a small japanese village manage the downside of the demographic slowdown. One wonders how much more pervasive this sclerotic 'no change' attitude really is…

Charles Pennington adds:

There's a nice column by Lisa W. Hess in the Dec. 28 Forbes about investing in Japan.

She claims that small cap companies are even more undervalued than large cap, and recommends buying the Topix rather than the Nikkei.



LeverThe levered ETFs tend to underperform. Take SSO, which is double the S&P 500 compared to SPY. SSO was listed in 2006. On 7/7/2008 the SPY was back to even while SSO was down 12% since inception. YTD the SPY is down 0.15% (as of yesterday's close) while the SSO is down 4.83%. Levered ETFs are re-weighted each day to match the double daily performance of the S&P. A simple example: if the market stands at 100 and increases to 110 and falls back to 100, the double ETF will be worth 98. So levered ETFs will tend to underperform in sideways markets and naturally (for long ETFs) in declining markets. Also there must be some transaction costs and vig to be paid with the daily re-balancing, especially in volatile markets.

Yishen Kuik replies:

I've thought that owning a double up ETF and a double down ETF at the same time is really like owning a straddle. While the index drifts sideways, you keep losing value, somewhat analogous to theta, but when it takes off in one direction, you start to really get in the money.

Alex Forshaw adds:

The ultra ETFs just hedge themselves with options; a 2x long ETF buys you a basket of calls with some management overhead. A 2x short ETF buys you a basket of puts. So if you are short the ultra long and the ultra short, you are short a bunch of calls and a bunch of puts. So you're short the VIX. And you get hit if vol and vol-squared both go up at the same time.



CurveHow can we avoid curve fitting when designing a trading strategy? Are there any solid parameters one can use as guide? It seems very easy to adjust the trading signals to the data. This leads to a perfect backtested system - and a tomorrow's crash. What is the line that tells apart perfect trading strategy optimization from curve fitting? The worry is to arrive to a model that explains everything and predicts nothing. (And a further question: What is the NATURE of the predictive value of a system? What - philosophically speaking - confer to a model it's ability to predict future market behavior?)

James Sogi writes:

KISS. Keep parameters simple and robust.

Newton Linchen replies:

You have to agree that it's easier said than done. There is always the desire to "improve" results, to avoid drawdown, to boost profitability…

Is there a "wise speculator's" to-do list on, for example, how many parameters does a system requires/accepts (can handle)?

Nigel Davies offers:

Here's an offbeat view:

Curve fitting isn't the only problem, there's also the issue of whether one takes into account contrary evidence. And there will usually be some kind of contrary evidence, unless and until a feeding frenzy occurs (i.e a segment of market participants start to lose their heads).

So for me the whole thing boils down to inner mental balance and harmony - when someone is under stress or has certain personality issues, they're going to find a way to fit some curves somehow. On the other those who are relaxed (even when the external situation is very difficult) and have stable characters will tend towards objectivity even in the most trying circumstances.

I think this way of seeing things provides a couple of important insights: a) True non randomness will tend to occur when most market participants are highly emotional. b) A good way to avoid curve fitting is to work on someone's ability to withstand stress - if they want to improve they should try green vegetables, good water and maybe some form of yoga, meditation or martial art (tai chi and yiquan are certainly good).

Newton Linchen replies:

The word that I found most important in your e-mail was "objectivity".

I kind of agree with the rest, but, I'm referring most to the curve fitting while developing trading ideas, not when trading them. That's why a scale to measure curve fitting (if it was possible at all) is in order: from what point curve fitting enters the modeling data process?

And, what would be the chess player point of view in this issue?

Nigel Davies replies:

Well what we chess players do is essentially try to destroy our own ideas because if we don't then our opponents will. In the midst of this process 'hope' is the enemy, and unless you're on top of your game he can appear in all sorts of situations. And this despite our best intentions.

Markets don't function in the same way as chess opponents; they act more as a mirror for our own flaws (mainly hope) rather than a malevolent force that's there to do you in. So the requirement to falsify doesn't seem quite so urgent, especially when one is winning game with a particular 'system'.

Out of sample testing can help simulate the process of falsification but not with the same level of paranoia, and also what's built into it is an assumption that the effect is stable.

This brings me to the other difference between chess and markets; the former offers a stable platform on which to experiment and test ones ideas, the latter only has moments of stability. How long will they last? Who knows. But I suspect that subliminal knowledge about the out of sample data may play a part in system construction, not to mention the fact that other people may be doing the same kind of thing and thus competing for the entrees.

An interesting experiment might be to see how the real time application of a system compares to the out of sample test. I hypothesize that it will be worse, much worse.

Kim Zussman adds:

Markets demonstrate repeating patterns over irregularly spaced intervals. It's one thing to find those patterns in the current regime, but how to determine when your precious pattern has failed vs. simply statistical noise?

The answers given here before include money-management and control analysis.

But if you manage your money so carefully as to not go bust when the patterns do, on the whole can you make money (beyond, say, B/H, net of vig, opportunity cost, day job)?

If control analysis and similar quantitative methods work, why aren't engineers rich? (OK some are, but more lawyers are and they don't understand this stuff)

The point will be made that systematic approaches fail, because all patterns get uncovered and you need to be alert to this, and adapt faster and bolder than other agents competing for mating rights. Which should result in certain runners at the top of the distribution (of smarts, guts, determination, etc) far out-distancing the pack.

And it seems there are such, in the infinitesimally small proportion predicted by the curve.

That is curve fitting.

Legacy Daily observes:

"I hypothesize that it will be worse, much worse." If it was so easy, I doubt this discussion would be taking place.

I think human judgment (+ the emotional balance Nigel mentions) are the elements that make multiple regression statistical analysis work. I am skeptical that past price history of a security can predict its future price action but not as skeptical that past relationships between multiple correlated markets (variables) can hold true in the future. The number of independent variables that you use to explain your dependent variable, which variables to choose, how to lag them, and interpretation of the result (why are the numbers saying what they are saying and the historical version of the same) among other decisions are based on so many human decisions that I doubt any system can accurately perpetually predict anything. Even if it could, the force (impact) of the system itself would skew the results rendering the original analysis, premises, and decisions invalid. I have heard of "learning" systems but I haven't had an opportunity to experiment with a model that is able to choose independent variables as the cycles change.

The system has two advantages over us the humans. It takes emotion out of the picture and it can perform many computations quickly. If one gives it any more credit than that, one learns some painful lessons sooner or later. The solution many people implement is "money management" techniques to cut losses short and let the winners take care of themselves (which again are based on judgment). I am sure there are studies out there that try to determine the impact of quantitative models on the markets. Perhaps fading those models by a contra model may yield more positive (dare I say predictable) results…

One last comment, check out how a system generates random numbers (if haven't already looked into this). While the number appears random to us, it is anything but random, unless the generator is based on external random phenomena.

Bill Rafter adds:

Research to identify a universal truth to be used going either forward or backward (out of sample or in-sample) is not curvefitting. An example of that might be the implications of higher levels of implied volatility to future asset price levels.

Research of past data to identify a specific value to be used going forward (out of sample) is not curvefitting, but used backward (in-sample) is curvefitting. If you think of the latter as look-ahead bias it becomes a little more clear. Optimization would clearly count as curvefitting.

Sometimes (usually because of insufficient history) you have no ability to divide your data into two tranches – one for identifying values and the second for testing. In such a case you had best limit your research to identifying universal truths rather than specific values.

Scott Brooks comments:

If the past is not a good measure of today and we only use the present data, then isn't that really just short term trend following? As has been said on this list many times, trend following works great until it doesn't. Therefore, using today's data doesn't really work either.

Phil McDonnell comments:

Curve fitting is one of those things market researchers try NOT to do. But as Mr. Linchen suggests, it is difficult to know when we are approaching the slippery slope of curve fitting. What is curve fitting and what is wrong with it?

A simple example of curve fitting may help. Suppose we had two variables that could not possibly have any predictive value. Call them x1 and x2. They are random numbers. Then let's use them to 'predict' two days worth of market changes m. We have the following table:

m x1 x2
+4 2 1
+20 8 6

Can our random numbers predict the market with a model like this? In fact they can. We know this because we can set up 2 simultaneous equations in two unknowns and solve it. The basic equation is:

m = a * x1 + b * x2

The solution is a = 1 and b = 2. You can check this by back substituting. Multiply x1 by 1 and add two times x2 and each time it appears to give you a correct answer for m. The reason is that it is almost always possible (*) to solve two equations in two unknowns.

So this gives us one rule to consider when we are fitting. The rule is: Never fit n data points with n parameters.

The reason is because you will generally get a 'too good to be true' fit as Larry Williams suggests. This rule generalizes. For example best practices include getting much more data than the number of parameters you are trying to fit. There is a statistical concept called degrees of freedom involved here.

Degrees of freedom is how much wiggle room there is in your model. Each variable you add is a chance for your model to wiggle to better fit the data. The rule of thumb is that you take the number of data points you have and subtract the number of variables. Another way to say this is the number of data points should be MUCH more than the number of fitted parameters.

It is also good to mention that the number of parameters can be tricky to understand. Looking at intraday patterns a parameter could be something like today's high was lower than yesterday's high. Even though it is a true false criteria it is still an independent variable. Choice of the length of a moving average is a parameter. Whether one is above or below is another parameter. Some people use thresholds in moving average systems. Each is a parameter. Adding a second moving average may add four more parameters and the comparison between the two
averages yet another. In a system involving a 200 day and 50 day
average that showed 10 buy sell signals it might have as many as 10 parameters and thus be nearly useless.

Steve Ellison mentioned the two sample data technique. Basically you can fit your model on one data set and then use the same parameters to test out of sample. What you cannot do is refit the model or system parameters to the new data.

Another caveat here is the data mining slippery slope. This means you need to keep track of how many other variables you tried and rejected. This is also called the multiple comparison problem. It can be as insidious as trying to know how many variables someone else tried before coming up with their idea. For example how many parameters did Welles Wilder try before coming up with his 14 day RSI index? There is no way 14 was his first and only guess.

Another bad practice is when you have a system that has picked say 20 profitable trades and you look for rules to weed out those pesky few bad trades to get the perfect system. If you find yourself adding a rule or variable to rule out one or two trades you are well into data mining territory.

Bruno's suggestion to use the BIC or AIC is a good one. If one is doing a multiple regression one should look at the individual t stats for the coefficients AND look at the F test for the overall quality of the fit. Any variables with t-stats that are not above 2 should be tossed. Also an variables which are highly correlated with each other, the weaker one should be tossed.

George Parkanyi reminds us:

Yeah but you guys are forgetting that without curve-fitting we never would have invented the bra.

Say, has anybody got any experience with vertical drop fitting? I just back-tested some oil data and …

Larry Williams writes:

If it looks like it works real well it is curve fitting.

Newton Linchen reiterates:

 my point is: what is the degree of system optimization that turns into curve fitting? In other words, how one is able to recognize curve fitting while modeling data? Perhaps returns too good to believe?

What I mean is to get a general rule that would tell: "Hey, man, from THIS point on you are curve fitting, so step back!"

Steve Ellison proffers:

I learned from Dr. McDonnell to divide the data into two halves and do the curve fitting on only the first half of the data, then test a strategy that looks good on the second half of the data.

Yishen Kuik writes:

The usual out of sample testing says, take price series data, break it into 2, optimize on the 1st piece, test on the 2nd piece, see if you still get a good result.

If you get a bad result you know you've curve fitted. If you get a good result, you know you have something that works.

But what if you get a mildly good result? Then what do you "know" ?

Jim Sogi adds:

This reminds me of the three blind men each touching one part of the elephant and describing what the elephant was like. Quants are often like the blind men, each touching say the 90's bull run tranche, others sampling recent data, others sample the whole. Each has their own description of the market, which like the blind men, are all wrong.

The most important data tranche is the most recent as that is what the current cycle is. You want your trades to work there. Don't try make the reality fit the model.

Also, why not break it into 3 pieces and have 2 out of sample pieces to test it on.

We can go further. If each discreet trade is of limited length, then why not slice up the price series into 100 pieces, reassemble all the odd numbered time slices chronologically into sample A, the even ones into sample B.

Then optimize on sample A and test on sample B. This can address to some degree concerns about regime shifts that might differently characterize your two samples in a simple break of the data.




 In the 90s, there was a company called Wizards of the Coast who put out the playable fantasy trading card game Magic the Gathering. The designer of the game was a mathematician by the name of Richard Garfield.

The basic premise was that you were a wizard and your deck of cards was a book of spells and artifacts. An enemy player would challenge you to a duel and you would both shuffle your respective decks and draw cards off the top for your hand. You could cast spells from your hand to damage your opponent, or summon creatures to attack opponent or enhance your creatures or do a myriad of things. You could take 20 points of damage and whoever reached zero first would be the loser.

The remarkable thing about the game, other than its incredible popularity, was its flexibility. All kinds of odd strategies evolved as players used cards in combination to achieve results the original designers of the cards probably did not forsee. Deck construction became a fine art of selecting cards. Because the cards are shuffled, you have to take into account the probability of the certain cards turning up. If you try and cover too many contingencies, you would have a very thick deck of cards, and the wait time for a particular card could be long. If you have a very focused and thin deck, your expected wait time would be short, but so would your list of options.

For example, if you have a deck geared towards summoning trolls, giants and other creatures to pummel your opponent to death, but your opponent has a deck full of spells to paralyze or disable creatures in addition to a few bolts of lightning to directly zap you, you are going to be slowly zapped to death. Your hand will likely be filled with creatures to summon and his hand will likely be filled with paralysis spells. As you summon creatures he paralyzes them and waits for a lightning bolt spell to be drawn to zap you. If you slipped in 2 healing cards in a 80 card deck otherwise devoted to monsters, and your opponent had 8 lightning bolts and fireballs in a 60 card deck otherwise devoted to paralyzing monsters, you would likely be the eventual loser in this war of attrition.

An entire tournament structure blossomed regionally and nationally around MTG.

The cards were sold in sealed random packs like other collectible cards and had different print frequencies (ie rarity) for each card. The rare and particularly useful cards become extremely valuable, both for winning at tournaments.

It has been 15 or more years since I've played MTG, but I see on ebay that the most valuable cards have held their value of a few hundreds of dollars. The fantasy playing card market is far less lucrative than the collectible sports card market.  



Being too lazy to find out on my own and, therefore, that much more curious about the answers, I repost this past exchange by Yishen and Kim in the hope that they may have further thoughts on the subject. How much, I wonder, has the cost of lodging changed over the centuries and in the recent slump for an unskilled laborer? I can provide one factoid: for the unskilled laborer without papers here in the SF Bay Area the price of housing - i.e. sharing a bedroom with 3 other laborers in a ranch house in the non-posh suburbs - has gone down by 30-40%. House rents have slumped badly as the supply of tenants has fallen even faster than housing prices (the decline in remittances from the U.S. to Mexico is a lagging indicator of this trend.)

Yishen wrote:

I recently took a look at cost of living in 1700s London versus 2000s New York City.

I took the approach of figuring out how much of each item could an unskilled worker consume a year based on his salary and the price of goods then.

For instance, an unskilled laborer could purchase 511 lb of bacon in 1700s London with his annual paycheck versus 4122 lb of bacon in NYC today.

There's a lot of detail one can get rigourous about (like correcting for various taxes) and a lot of assumptions about prices, so I don't think the numbers I cite contain much (or any) precision, however the magnitudes of improvement should tell the right story:

Item              1700s 2000s

Postage 80 miles  1872  83324

Coarse Soap, 1lb  3744  5833

Beer, 1qt         1404  3888

Barber visit      936   1167

Butter, 1lb       624   5833

Bacon, 1lb        511   4122

Mail, London-NY   468   41662

Steakhouse dinner 468   583

Candles, 1lb      165   1458

Coffee, 1lb       94    1326

Tea, 1lb          62    1750

Simple dinner     899   1167

Ticket            45    93 (Handel's messiah vs Madonna's latest tour) 

Our average Joe benefited the most in communication anywhere from 40 fold to 90 fold greater consumption.

Agricultural goods came next, some 10 to 30 fold for tea and coffee, 8 to 9 fold for processed goods like candles, butter and bacon.

Finally, a trip to the barber didn't change all that much in terms of affordability for the average Joe.


Kim Zussman replied:

By any measures standard of living (i.e., real wages/real cost of living) has improved dramatically since the 1930s. Just check any data source (government conspirators), and you will see that with improved productivity and agriculture, this is true over time in most periods.

However it is still possible, with 2006 dollars, to eat for less than $20/week:




Dr PhilAll moving averages have to be based on a backward looking window of time. So a 10 day average is the average of the last 10 days and so on. But the center in time for that average is really about five days ago. To be more precise it is (n+1) / 2 days ago or 5.5 days ago.

So comparing two moving averages of different lengths is really comparing apples and oranges. If we compare a 10 day to a 30 day average, for example, then we are comparing the average of 5.5 days ago to 15.5 days. In other words they are not the same point in time. Mr. Glazier's enlightening 3D representation of moving averages of various lengths shows that the longer windows respond more slowly to ripples in price than do the shorter moving averages because of this lag effect.

Another feature visible in the chart is the apparently cyclical undulations. The problem with that is that it may simply be a manifestation of the Slutzky - Yule effect. Essentially Slutksy-Yule says that any series, when averaged, will show sinusoidal oscillations as a result of the averaging process. This is true even if the original series was composed of random numbers which could not possibly be sinusoidal in nature.

Another common pitfall when using moving averages is to think that all one has to do is to find the magic combination such as a 19, 27 and 79 day triple crossover with a minimum threshold of 1%. The problem with any such system is that there are an infinite number of these combinations. We quickly fall into the data mining trap where we will appear to find something even if it is merely a product of chance.

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

Yishen Kuik adds:

Another interesting point about moving averages is that the daily change in an N period moving average is caused by the difference between the values of the Nth day and the current day:

MA(t) = (1/N) * ( p(t) + p(t-1) + … + p(t-N+1) )

MA(t) - MA(t-1) = (1/N) * ( p(t) - p(t-N) )

So in cases where N is small, and where the p(t-N) value that fell out of the calculation is large, the moving average can experience sudden drops. This causes that cognitive dissonance when one sees a moving average fall even as the values are climbing between yesterday and today.This also provides the intuition to Slutzky Yule - for any given set of observations, there exists a cluster of points that has the highest average of all similar sized clusters, so while that cluster is passing through the calculation period of the moving average, there will be a peakedness, with two troughs surrounding it.

Alice Allen remarks:

While we’re talking about moving averages, a practical caution from my own experience with a popular commercial trading platform: If you are in a fast trading situation, monitoring a price graph with less than a 1-day display unit (e.g., 60-min, 30-min, 15-min), a line labeled “200-Day Moving Average Study” may not be the true 200-Day MA but perhaps the MA of the last 200 ticks. Under these circumstances, you may visually note that the price has crossed your MA line, but it will not necessarily be a true MA crossover as calculated by programs. Maybe this is obvious, but it took me a while to figure out and perhaps is unique to the platform I use.

Anatoly Veltman writes:

The best use of MAs that I know has nothing to do with crossovers. And it happens to be essential to one’s daily/weekly chart perspective. Extremely useful! I first saw it described by Stan Weinstein; then the periods and trading signals were optimized by a few proprietary shops. I believe it to be one of the better tools; if not for all markets, then at least for stocks.



Came across a long (18 min) podcast with Jeremy Siegel. Towards the end he talks about his proprietary sentiment indicator, bottoms, newsletters and sounds much like any other technical market timer.



I'm not an American citizen, but I go to the Chinatowns in Manhattan and Flushing, Queens often enough to know some of the stories of those communities.

It always amazes me to see the American Dream in action there — men and women from mainland China who can't speak English and live six to a room doing very menial work, but scrimping and saving to send their kids to Stuyvesant and then to the Ivy League.

The only connections these kids have are uncles who cook take-out on Mott St or drive the $15 bus to Boston.

The number of Asian Wall Street professionals who go back to Chinatown on weekends to visit their parents is a testament the American system of meritocratic reward to striving and hard work is intact and alive.



  To look at the issue of margin from a different angle, imagine there are two similar companies who have very different balance sheets: Company A is 100% equity financed while Company B has taken on tonnes of debt and is highly geared. Can the investor roughly replicate the higher risk-return profile of the highly geared company simply by borrowing on margin and investing in the 100% equity financed company?

Yishen Kuik replies:

IMHO, the one has nothing to do with the other.

A company that takes on leverage to conduct its business is exposed to business risks that cause it to be momentarily short of operating cash and therefore unable to make an interest payment. The equity holders are now at the mercy of the bondholders.

If it did not take on leverage, none of this would happen.

The issues that cause a leveraged equity holder to have to sell out of his position are completely different from those that cause a levered company to go into default, and the consequences are completely different as well.




"…Left off the balance sheet is the value of the asset that Gary Becker, Nobel Laureate in Economics, calls human capital. Professor Becker says that the skills and experience of our people are worth more than half a million dollars per person. By this calculation, traditional assets comprise less than 25 percent of the national balance sheet, which means that true U.S. assets exceed $180 trillion…" Mike Milken

I haven't had my morning coffee yet but here's an attempt at arithmetic along Beckerian lines:

A recent FT article put Japanese assets at 75% of its GDP. Pulling a totally random number out of nowhere, if the return on assets is 5%,

GDP = 5%*(total assets)

GDP = 5%*75%*GDP+5%*humancapital

19.25*GDP = humancapital

Looking at World Bank statistics

World GDP 2006 = 48.2 trillion

World financial assets = 170 trillion

Return on assets = 5% (can someone give me a better number?)

Return on financial assets = 8.5 trillion

Return on human capital = 39.7 trillion

Human capital = 794 trillion

population = 6.6 billion

Average human capital per capita (hheh..) = 120303.3

Anyway, very rough calculations with numbers plucked from the ether, but the order of magnitude at least is in line with Prof. Becker.

(Also, I left out something important - GDP is not just a return on capital (even human capital) because human ingenuity produces excess profits and increases the value of the capital. So you'd have to adjust the calculation of human capital to account for growing return. And risk adjustments. Etc. etc.)

Any real macro economists care to point me in the direction of more accuracy?

Phil McDonnell replies:

Rather than pulling an imaginary growth rate out of our … armpit, perhaps a better approach can be found. GDP is the goods and services produced by a society. However much of that is consumed as well. The number we are really seeking is the net 'profit' figure that can be carried forward into the next year. It is good to remember that any 'profit' carried over must be held in the form of an asset. Thus a reasonable measure of the rate of return would be the net increase in total assets year over year.

Yishen Kuik counters:

Maybe I'm too classical, but I've always thought that GDP is a flow measure of all the goods and services we produce, of which one portion is consumed to give us present utility and the remaining portion is invested to enhance our ability to increase GDP in the next period.

Presumably all goods have some aspect of both utility and investment ("school is fun and you learn something" or "bridges are beautiful and enable transportation"), but we can think of the investment portion of GDP as flowing into a stock of accumulated capital.

The stock of capital deteriorates over time, so some of that flow is just running to keep still. Part of the stock is human, part of it is physical plant, and part of it is institutional arrangement of society (courts, laws etc). The dollar figure we attach to capital stock is just a very rough attempt at measurement, and doesn't take into account the importance of having the right arrangement of the 3 kinds of capital stock. The right arrangement catalyzes a $100mm investment to return 15%, while the wrong arrangement will have no such catalyzing effect. That is why $100mm produces such different results when invested in America versus Africa.

I think it is this accumulated capital stock (human/physical/institutional) which is the right place to discuss big picture returns on investment. Unfortunately much of it is unquantified and unquantifiable.

Adi Schnytzer brings up the stock market aspect:

Surely the real issue here is that, however, we define GDP, it's notoriously unpredictable? After all, why has the market been shooting up and down so furiously lately? In part it's because every one has been wondering whether or not the US economy is moving into a recession. Well, if we could agree on a way to to measure and predict GDP, we'd have solved that issue for the market pretty quickly, wouldn't we? 

Derek Gard dissents:

This assumes the market moves based on GDP at all.

From 1950 to 1960 GDP went from 1696.765 to 2517.365 (48%) and the DJIA went from 198.89 to 679.06 (241%)

From 1960 to 1970 GDP went from 2517.365 to 3759.997 (49%) and the DJIA went from 679.06 to 809.2 (19%)

From 1970 to 1980 GDP went from 3759.997 to 5221.253 (39%) and the DJIA went from 809.2 to 824.57 (2%)

From 1980 to 1990 GDP went from 5221.253 to 7112.100 (36%) and the DJIA went from 824.57 to 2810.15 (240%)

From 1990 to 2000 GDP went from 7112.100 to 9695.631 (36%) and the DJIA went from 2810.15 to 11357.01 (304%)

GDP during the 60s was higher than the 50s and yet the market barely budged. And GDP during the 60s and 70s surpassed the growth rates of the 80s and 90s, yet what decades saw the greatest gains in stocks? Stock market moves do not correlate well with actual GDP data over decades or even years, let alone the daily thoughts and musings of financial pundits.

To say stocks move on GDP data, or confusion thereof, is not supported by raw data. This is the same logic that says, "Stocks rose on a drop in oil prices" one day and then the very next day says, "Stocks fall despite a decline in oil prices." It is a fallacy promulgated by the same people who earned 3.5% per year in stocks during the 80s and 90s when the market was earning more than triple that.

Adi Schnytzer replies:

My argument was not that the market moves in line with GDP, rather that lately the market has been reacting to news suggesting either an imminent recession or not. To measure the relevance of this assertion you need to check whether or not the market falls some months before a recession (thus anticipating it) and not whether over a long period the market tracks GDP.

Nigel Davies opines:

As a simple chess player I must admit to being confused by the apparent
implication (seen everywhere right now) that positive GDP is good and
negative GDP is bad. In my own admitedly primitive pursuit one rarely
gets the opportunity to play expansive moves on a continuous basis,
there are periods when one must regroup in order to increase the
potential energy of a position.

So if I were an economist I would not be looking for answers in simple
linear relationships. Instead I'd try to study the interplay between
'potential energy' (one might try to define this in many ways, for
example by defining debt in 'real' terms) and GDP. And I'd hypothesise
that one of the most bullish economic times would be during a recession
in which personal debt was being reduced.

Vinh Tu tries to sum up and conclude:

Whether more GDP is "good" or "bad" is a normative judgment. To an
economist, however, since GDP by definition refers to the production of
"goods", it has to be good. (It is generally assumed that utility is
monotonically increasing with goods.) Whether the increase in goods
produced corresponds to an increase in share prices is an entirely
different matter. A share represents a claim on assets which, in turn,
yield a stream of goods (or money which can be exchanged for goods.)
Whether an increase in GDP is beneficial for share prices has
everything to do with where that increase comes from. An increase in
efficiency, whereby the return on existing assets increases, would
probably increase share prices, all else being equal. On the other
hand, the creation of new capital assets would not increase the value
of pre-existing assets if it resulted in the assets being less



LemurBurton Fabricand wrote two interesting books: The Science of Winning and Non-Brownian Movement in the Stock Market. One of the major principles of the books, highly recommended as a supplement to Bacon, is that when a horse goes off at odds that are unusually unappealing, it's good to bet on it. He applies the method to a small sample of horse races, and finds that for specific applications of the principle, a slightly winning system can be developed.

I was reminded of this principle by the very unusual action of the stock market the last two overnights. Thursday evening and Friday morning, New York time, the market moved up about 1% overnight after yet another 40 day low on Monday. The optimism was broken by the Merrill announcement and the disappointing Fed testimony, as well as the credit downgrades. One of the worst declines in history occurred, 47 points from the open to close, exceeded only by the 66 point decline on 4/17/2000.

You would think that after such a decline, especially after an up opening, with fear in the air as never before, there would be a terrible fear about opening the market up again overnight. But no, it's up 2/3% overnight and Japan during the last two days, when the US market has been down 4%, is up some 1% from 13505 at Wednesday's close to 13650 as I write at 11:00 pm EST.

The insight of Fabricand is relevant, that this seeming underlay, this amazing courage in the light of the pessimism is not quite as amateurish , "boy, don't try too hard in the stretch unless you really are going to take it because I want the odds to be up next time" as it might seem.


I have been studying the intake of clay by lemurs and parrots so as to neutralize the alkaloids and other poisons in seeds that they eat and disperse. What are the comparable foods that the market must eat to neutralize bad events? What does the speculator have to do to neutralize the many uses of specialized information and unlimited capital that the trading houses can apply when they are not acting over and above the various Chinese Walls that they can climb whenever there is a merger or downgrade?

I found 38,000 articles on "underestimation of change" on Google and have not read them all yet. Victor Zarnowitz found that underestimation of change was a persistent aspect of his data on GNP forecasts although the rarity of predictions of declines made his data consistent with algebraic underestimates as well. I thought a realistic way to test this was to look at all the moves from close to 2:00 am EST to see if the big ones are underestimates. I found there were 18 big ups of more than 10 points as of 2:00 am, and 18 big declines of more than 10 points. Of these 36 big moves, 18 had reversed by 10:00 am and 18 had continued. Thus, there was no evidence in a real data set without revisions or biases or contrivances, that there was an underestimate of change. 

Martin Lindkvist adds:

Fabricand also wrote the books "Horse Sense" and "Beating the Street".
In both he explains the principle behind his systems: The principle of
maximum confusion. Writes Fabricand in "Horse Sense":

"The betting public is most likely to err in determining the winning
probability of the favorite in those races where the past performance
record of the favorite is very similar to that of one or more horses
in the race."

in "Beating the Street" he continues on the topic:

"For the races, the intuitive idea behind the principle is that
although the favorite appears very much like the other horses in
ability, there must be some reason or reasons not immediately obvious
for the betting public to make that horse favored. Yet, because the
two horses seem alike on the surface, the public may be confused
enough to bet too heavily on the other horse, making the favorite

In "Beating the Street" Fabricand also lays out a stock trading system
based on the principle. 

Yishen Kuik reports:

A new word for today, Geophagy.  Wikipedia says:

Geophagy is the human practice of eating earthy or soil-like substances such as clay, and chalk, in order to obtain essential nutrients such as sulfur and phosphorus from the soil. It is closely related to pica, a classified eating disorder in the DSM-IV characterized by abnormal cravings for nonfood items.

Geophagy is most often seen in rural or preindustrial societies among pregnant women and children. However, it is practiced by members of all races, social classes, ages, and sexes. In other parts of the world the practice is less stigmatized, and geophagy is not studied as a pathology but rather as an "adaptive behavior" that supplements the diet with essential nutrients or treats a disorder such as diarrhea.

In some parts of the world, geophagia is a culturally sanctioned practice. In many parts of the developing world, earth intended for consumption is available for purchase.

Bill Craft relates:

In the rural Southeastern US there exist deposits of Kaolin along the Oconee Group (formerly called the Tuscaloosa Formation). The locals and miners call it 'chalk' because of the white look and ability to stick when wet and permeate when dry any supposedly closed space.

Some of the residents have consumed the 'chalk' for centuries as it was a cure-all. Even the Creek Indians used it with Yaupon Holly (Ilex Vomitoria) for ritual 'cleansing.'

Mix some Washington State Apples with it and you get:


Ahh! Ritual Cleansing! Just what the mistress ordered!

Phil McDonnell explains:

Ketchup/MustardMost toxins are alkaloids, which in turn are bases. These toxins can usually be neutralized by ingesting acids. This is a practice which is not unique to backward civilizations. Check common condiment ingredient lists for vinegar. It is in ketchup, mustard and many other items. Chemically it is an acid. Oil and vinegar salad dressing is another example. When an acid and a base combine they neutralize each other and form a salt. Many salts are water soluble and can be readily flushed from the body.Even in modern society we have many minerals that are important to nutrition and are routinely used as remedies. Antacids such as Tums and Rolaids are simply calcium carbonate — chalk. Products such as Milk of Magnesia and Pepto Bismol are long-time mineral based remedies as well. Most so-called vitamin pills also contain a long list of minerals that are essential to our daily well being.

In the markets the toxins are the bad stocks at any given time. Recently the toxic stocks have been the big banks, most are down something like 50% over the last year. They continue to feel the worst effects of the current financial meltdown. Money usually goes somewhere. So when the banks are sold the good stocks are the beneficiaries. Google is a prime example. The high growth of earnings continue on track. So for a while GOOG continued to surge ahead. But toward the end of a panic the market acts more like the police when they raid a house of ill repute. They take the good girls with the bad. So even the formerly strong GOOG has seen a come down from well above 700 to a touch below 600. But there is nothing wrong with Google as a company. It is only that the big G has to act as an acid to neutralize the toxic base which is the subprime dependent stocks. So that salty taste in your mouth may not be just blood. It may be the act of a market neutralizing its toxins in order to return to good health.

George Parkanyi writes: 

To answer Victor's question about ingesting antidotes to poisonous markets, I eat 2x leveraged short ETFs, and I'll tell you why.

I live in Canada. Our family assets are tied up in tax-deferred registered retirement savings plans and registered education plans denominated in Canadian dollars. Although we can buy U.S. equities (and have to convert currency back and forth every trade), we can't buy options (we can write covered calls), we can't use margin, and we can't use futures. So there was a time when you had two choices in these conditions, sell or hold.

One morning last year I'm making my kids' school lunches, watching the Business News Network, when a commercial comes on proudly trumpeting three new pairs of long/short 2x leveraged ETFs. I remember thinking "Finally, something useful!". Later that day I researched those same Canadian ones, and found the U.S. ones. There was a wide range of available pairings, not only by indices, but by industry sectors as well. Some even paid dividends.

I use a specific strategy that requires full investment. By embedding (OK, eating) just a few of these ETFs on Jan 2, I was able to maintain my holdings, and keep my drawdown to only 3% as of today's close (despite all those NASDAQ stocks — ahem). It didn't take many; at most, 1/6 of the portfolio was in short ETFs, and I even scaled these back as the down-leg progressed.

Bottom line — your garage mechanic or plumber now has the ability to turn his retirement savings into a hedge fund.

If you can now so easily buy what is essentially market-catastrophe or profit-protection insurance, could this be changing the fearscape when markets fall? It makes being a contrarian more complicated. Reminds me of the Monty Python sketch where the people's bandit Dennis Moore is so successful stealing from the rich and giving to the poor that the poor become rich and lazy, leaving him confused and conflicted. Eventually he ends up holding up stage coaches and just re-distributing the wealth amongst the passengers.



A casual glance at the commodities charts for agricultural and metals suggests the volatility expansion in credit and equities has not infected the world of "real" produce.



 With the inevitable firings that will take place at quant firms, a deluge of stat arb talent will get recycled into other related fields. And let's not forget those formerly employed as quants in mortgage land.

In a previous era, when Banker's Trust ruled Wall Street derivatives, desks were able to get away with egregious pricing against dumb-as-rocks clients. The old saw "risk flows to the dumbest guy in the room" was perfectly illustrated. When the scandals at Orange County and P&G broke, banks collapsed and desks were dismantled. Wall Streeters were scattered to insurance companies, corporate treasury desks, pension managers and other banks. With the infusion of intellectual property, clients got smarter and were finally able to figure out the vig. That correction to the imbalance of knowledge raised the "ethical" conduct bar in derivatives.

The vigor of capitalism will ensure these quants find a home, and I wonder where those homes will be and how that will reshape the industry and the game.



Today's Wall Street Journal had the US auto sales report for June. Of the four categories for cars, all sizes posted negative YoY YTD sales except for "small", which defied the trend with +3.2%. Of the four categories for SUV, again "small" was the only category with positive YoY YTD sales at +36.7%.

Nice to see textbook substitution effect at work.



 In the animal world, ground hogs will make a certain noise to signal that a hawk is overhead. Other animals have similar patterns such as bees doing a dance to signal the source of food. It would thus reason that investments that share characteristics would behave in patterns familiar to people using a value or style method.

Animals left to themselves find a natural stable point between predator and prey but this becomes unstable with people as there is a need to get ahead in the short term at the expense of others. In business this issue is often resolved with methods of price-fixing.

Finally, groups may behave unlike the random investor who will attempt to profit from trial and error in this sector or another. It would appear that a stable group of (long term) investors has come to conclusions about the future of the sector and random (some such as small caps are larger) fluctuations just come with the investment.

Scott Brooks writes: 

Studies have shown that white-tailed deer that are left to themselves, or orphaned (assuming this is after they are weaned) actually do just as well as their counterparts with a mother.

Another interesting aspect to this phenomena is that if you want to keep the buck fawns on your property, it is best to shoot the momma deer and leave the fawns alone. Once the momma goes into estrus, she will run off the button buck (buck fawn). It is believed that this is an instinctual action to that lessens inbreeding. The buttons are left to fend for themselves and find a new home range. They usually travel for several miles, and are disproportionately killed in the hunts. If the mother dies or is killed, there is no one there to run off the button buck, and he will almost certainly stay in his familiar home range. This actually has been shown to increase his chances of survival.

There is a definite cyclical instability in wild in predator prey models. One of the easiest ways to observe this is by watching the rabbit population vs. the coyote population. They definitely ebb and flow opposite each other, never seeming to reach an equilibrium.

The problem is not so pronounced in a well managed whitetail herd. Man is the whitetails biggest predator and man does a pretty good job of keeping the whitetail in check. Due to our ability to use reason and logic, we do a pretty good job of holding the whitetail population in check and stable.

What I find interesting is that in the area's where the whitetail population is out of control, such as cities, it's usually because people are not using logic and reason to solve the problem they're using emotions. I'm reminded of when John Galt said to Dagny, that when you're confronted with a choice and your head and heart are conflicted, always go with your head. ) The point being that in cities, people let their emotions get in the way of doing what is best for maintaining the healthiest most well balanced deer herd possible.

I always find it interesting when city people complain about the deer, but then are all aghast at the idea of harvesting the renewal resource. They always seem to want to try the same tried and failed methods.

This is similar to investing. Most people that invest in the markets really don't have a fixed system that is researched and tested and proven to work. They invest in the emotion of the markets and end up buying the investment that they wish they'd bought last year. As a result, they never reach a consistent equilibrium in the markets and as a result, greatly under perform the 10% long-term positive drift.

The Market Mistress loves to swoop in and devour the portfolio of the unexpecting. But her older sister, Mother Nature, is a vicious task mistress and makes the Mistress look tame by comparison.

Yishen Kuik comments:

I think it has been mentioned here before that classic predator-prey models show cyclical instability instead of steady equilibrium. 

James Sogi writes:

Fish cluster in schools. The edges of the clusters are quite defined. None of the fish want to stray far beyond the pack. Same with traders. Look at how the closing price over the last six days, except Tuesday, clustered together despite wild swings.

Panicking is the worst thing to do around sharks. They don't bother humans or fish, only things that are injured or dead, easy prey. They never bother a strong confident swimmer or surfer, only things that look injured or panicked which is a good market lesson as well.



Fed economist examines "bounce" frequencies around support and resistance in FX.



 The local Singapore business paper had an article breaking down performance of local equities in various sectors. There is triple-digit performance in the construction sector, 40 to 50 percent performance in the finance sector and healthy rises across the board.

Swanky new nightspots are mushrooming and expensive cars are seen in greater numbers. Property sells for record prices with each new development. Recently there was a story of professional speculators who purchased condos to get on their boards in order to urge residents to agree to flip the entire building to a developer, essentially merger arbitrage in real estate.

From Ryan Carlson:

Yesterday, I just returned from a week in Singapore and am wildly bullish on it as well. So bullish that I'm planning on moving there in about six months and this trip was to help lay the groundwork for it.

Apparently, I'm one of many. The current cover of Time's Asia edition is on Singapore and the lead story is Singapore Soars.

In regards to construction stocks, besides riding along for the sharp upturn in local real estate values, I think it's a great way to play region growth as many have projects in China, Vietnam, Indonesia, and other countries where I wouldn't/couldn't invest directly.

The mention of expensive cars really is a great wealth indicator judging on how expensive it is to have a car in Singapore. I certainly won't have one once I move. An easy estimate is that whatever a car costs in the US, double it for there.

I strongly believe Singapore is the most dynamic place to live in the world today, and if I had to choose what investment I would buy and hold for the distant future, Singaporean equities, real estate, and the currency would be my choice.

Geographically, it's at the hub of three of the four most populous countries in the world (Indonesia is the 4th), which makes it an excellent place to watch developments in those other countries. No other place in the region can even remotely offer the quality of life or cleanliness and I firmly believe that wealthy citizens of India, China, Vietnam, Indonesia, etc, will all aspire to live in Singapore's cleaner, safer and more orderly society. If not full-time, then perhaps a pied-a-terre as a hedge against trouble in their homeland.

Regardless, the most important thing that will find a home in Singapore is capital. Private banking in the country has been a particular highlight as bank secrecy laws are in some instances stricter than in Switzerland. As the saying goes, "when it comes to large amounts of money, it's advisable to trust no one." And I certainly wouldn't trust the banks in other regional countries to hold a large amount of my money.

To help with inviting capital, Singapore offers favorable low tax rates, doesn't tax capital gains, and also provides numerous incentive programs including one aimed at attracting derivatives traders. I agree with the method of taxing consumption rather than income, which is generally how the system allows for a lower direct tax.

A reason why so many policies are correct in my view is that almost every Singaporean I've ever met was educated at a university overseas in the UK, US, Canada, or Australia. In turn, they take back home the best policies but also get a firsthand view of damaging policies elsewhere to avoid.

Those civil servants who enact and draw up policies in Singapore are some of the highest paid in the world. Although there is understandably some backlash to government officials paid so highly, I like how it retains those who would be bid away to the private sector. It's hard to take care of others if you can't take care of yourself first and the policy discourages corruption.

Quite often the mentality of Singapore is summed up simply with the word 'kaisu' which translates from Chinese into 'afraid to lose.' The small island has to compete globally in almost every facet and most notably with Malaysia in terms of many regional competitions. Because of the mindset and no shortage of competitors, Singapore will always have to continue the pace of development to drive the economy. Those in Singapore have built a tremendous global city through their ingenuity, and I hope that I can make my contribution by moving there myself soon.

Nigel Davies asks: 

Why is Singapore considered to be a good place to live? Is it really freedom, or is there an unspoken 'biggy-like' respect for property rights? Here are some sample laws in Singapore:

  1. Bungee jumping is illegal.
  2. The sale of gum is prohibited.
  3. Homosexuals are not allowed to live in the country.
  4. Pornography is illegal.
  5. As it is considered pornographic, you may not walk around your home nude.
  6. Failure to flush a public toilet after use may result in very hefty fines.
  7. It is considered an offense to enter the country with cigarettes.
  8. Cigarettes are illegal at all public places.
  9. It is illegal to come within 50 meters of a pedestrian crossing marker on any street.
  10. If you are convicted of littering three times, you will have to clean the streets on Sundays with a bib on saying, "I am a litterer."



 I attended a presentation by Andrew Lo on 'The Psychology of Trading,' on May 21 2007. Here is a brief summary of his remarks:

On the one hand the Efficient Markets Hypothesis is at the foundation of Finance (for example all the work by Black-Scholes assumes that the market for options is efficient) on the other hand many people nowadays find it hard to believe that EMH is literally true. This has led to the development of Behavioral Finance, which studies biases that may hinder financial decision making. BF has acceptance problems of its own: it brings up so many possible biases that it is hard to believe (if all these biases are true) that anyone is ever able to make a correct decision. Many economists ask if the behavioral biases even exist.

To try to advance beyond the EMH/BF debate, Andrew Lo has been working on his own framework, which he calls the Adaptive Market Hypothesis, and has been investigating the role of emotion in trading by reading the neuropsycholgy literature and conducting experiments, some of which will be described below.

Do perceptual biases really exist

The first experiment involved the audience. They were invited to watch a video showing college students, some in white T shirts and some in black T-shirts throwing basketballs to each other. Lo told the audience to concentrate on the white T-shirt players and count the number of times they passed the ball to each other. The exercise was made more difficult by the fact that the black-T shirt players intermingle with the white shirt players and that Lo kept talking throughout the video to try to confuse the audience.
After the video was over Lo asked "how many people saw the gorilla?". More than half the people in the audience had not seen any gorilla. [I personally did not see the gorilla, even though I knew that Andy Lo is famous at MIT for showing a video in which a gorilla appears !]. Lo replayed the tape, and sure enough a man dressed as a black gorilla walks through the scene halfway into the tape. Lo explained that people who are concentrating on white figures will often miss black objects; in some sense the human perceptual system is filtering out the black objects.

In conclusion, said Lo, in any debate between economists and psychologists as to whether perceptual biases really exist is going to be won by the psychologists, who have demonstrated these phenomena beyond doubt through careful experiments.

The neuropsychology literature

The book "Descartes Error" by A. Damasio has changed how we view rationality. The classical philosophers believed emotion and rationality were polar opposites. Damasio investigated people who have suffered serious brain injuries and found that people who do not perceive emotions correctly will act irrationally. Emotion is necessary for rational behavior, Damasio says. Emotions allow you to choose quickly and easily among the many choices constantly available to you, saving you time and allowing you to zero in on correct solutions to problems.

The Triune Model of the Brain was proposed by Paul McLean. The human brain is made up of three parts: -the brain stem, which controls basic functions such as breathing and wakefulness is the oldest part of the brain, philogenically speaking. It exists in reptiles as well as in higher life forms. -the midbrain is involved in emotions (such as fear and greed, sexual preference and so on). It exists in mammals. -the neocortex controls higher functions, is the seat of thinking, language, etc. and exists only in hominids. There is a definite order of priority among these three subsystems; a painful stimulus for example will disrupt the processing functions of the neocortex for several hours according to experiments in which blood flow to the brain is measured via MRI scans. When a lower level is activated it disrupts (or takes priority over) the higher level mental functions.

From a financial point of view it is clear that risk-preferences and decisions under risk arise from interactions between the midbrain and the neocortex. Rational decision involves a balance and/or cooperation between the emotional and calculating parts of the brain.

Experiments in neuropsychology and finance

(1) Studying professional traders as they go about their job. Lo attached sensors to traders to measure emotional responses. (2) Lo also interviewed 80 neophyte traders who were learning to trade in a class given by LBR and reviewed their trading


a. emotion is definitely involved in trading decision making, even in the case of experienced decision makers (i.e. it is not solely the beginners who experience these emotions). However, the emotions are somewhat more controlled among the more experienced or more able decision makers. b. traders who experience little emotion during trading have a lower P&L, however traders who experience a great deal of emotion during trading also have a lower P&L. It appears that there is an optimum level of emotion somewhere in the middle. c. people who excessively internalize the outcomes (i.e. attribute everything that happens to their own doing) have a lower P&L, however people who attribute everything to luck also have a lower P&L. Again there appears to be a proper balance, i.e an attitude that events are partly due to ability and partly to luck.

The Adaptive Markets Hypothesis

The AMH takes a biological/evolutionary view of markets, whereas the EMH took a physical/engineering view.

The AMH postulates that financial decision makers:
1. act in their own self-interest
2. make mistakes
3. learn and adapt (through heuristics, not through optimization)
4. competition drives adaptation and innovation
5. natural selection drives the ecology of the markets
6. evolution drives market dynamics

With regard to point 3. Lo has a high regard for Herbert Simon and his idea of "safisficing" (not optimizing), and of making decisions through simplified (and non-optimal) heuristics (since an optimal decision is computationally infeasible). A question that Simon could never answer is "where do heuristics come from", but Lo thinks the answer is that "evolution determines heuristics" (point 5). He did have not elaborate on this. Lo expressed the view that Simon's work is even more important than the Theory of Rational Expectations, even though it has received less attention in economics.

The AMH implies that anomalies can appear, disappear and then reappear again as the market ecology changes. For example the profits to Statarb have waxed and waned over the last 15 years. It is true that the profits have dropped sharply after the Summer of 2002, but this does not mean that hey have been permanently arbitraged away. Statarb profits may not be gone forever, they may come back at some time under different market conditions than what we have now.

So far the AMH is incomplete. Lo is working on extending it and convincing others.


We need emotions to be rational. We need both, it is not either/or. In trading there is a right level of emotion. There is a "right zone". The Zen of Trading.

Jean Paul Schmetz writes:

It is almost impossible to see the gorilla [see video] if you concentrate on the players. I have tried this video with 100+ people in the room and very rarely did more than 10% see it. It usually helps to mention beforehand that males or females are better than the other at keeping score (you do not tell which and so people concentrate even more). 

Chris Hammond adds: 

There is an article in Scientific American this month that discusses a game called the "Trader's Dilemma," which is a variant of an older game called "Prisoner's Dilemma." Experiments involving this game address some of the issues mentioned earlier. There is, of course, some extraneous background story, but essentially, the game works as follows: two people pick a dollar amount between 2 and 100. The smaller of these two amounts will be awarded to both players, except the person who chooses the smaller amount will receive an additional $2 and the person who chooses the larger amount will receive $2 less than the lower of the two amounts.

If the players pick the same amount, then there is no penalty or reward. If you assume that both players are working solely for their own self-interest and make rational decisions, then both will pick $2. However, in an experiment where the range was between 80 and 200 cents, and the penalty/reward varied between 5 and 80 cents, the player's average choice was never the Nash equilibrium of 80 cents. For the 5-cent penalty, it was 180, and when the penalty was 20 cents, it was 120. This particular study used economics students. A similar study used game theorists, and the results were similar.

More interesting is what happens when people play the game repeatedly. Apparently, for "large" rewards, the amount that is picked as people play many times tends towards the low number, 80. For "small" rewards, the amount moved towards the high, 200. The article is not more specific than that.

Here, a system evolves as participants learn. It's also interesting that there is a bifurcation at some particular reward amount, and that the system evolves completely differently on either side of that value. Also worth noting is that not even game theorists think like game theorists.

Yishen Kuik writes:

I have been reading E.O. Wilson's Consilience, which has a nice chapter on what we know about the brain.

He also has a good chapter on what it takes to be a productive scientist engaged in the business of discovery, some of which seemed to me to be uncannily applicable to describing the business of uncovering statistical edges to trading. 



 FX trading has become huge and very popular with the public, system sellers, and brokers. This report is from a dear friend.

I recently spoke to one of the largest Forex FCM's in the country, who has thousands of clients. He made a statement to me that is very telling. Out of the thousands of clients who have accounts with them, only about 60 - 80 are profitable this year so far. A majority are down significantly.

From Riz Din: 

Welcome to my world. FX does not afford sufficient protection to the public, and unscrupulous brokers abound. I hear complaints of trading platforms freezing up around the big numbers (payrolls etc), of orders being slipped, and of stops not being honored. I will not question the validity of these complaints but I do not believe they lie at the heart of the problem. Instead, I attribute most retail level blow-ups to inadequate capital and excessive leverage — with just 10k the inexperienced retail investor can command up to 4m of underlying.

There is also a high level of price uncertainty due to the lack of an underlying marketplace (this is being addressed). Also, while the manipulative marketing by brokers and system sellers is worrying, I have faith in the development of the market over the long-term. Spreads have tightened considerably over the past five years, and banks are moving into the retail space, offering trading platforms with more credibility than the off-shore broker who sends marketing e-mails offering 'price guarantees,' 'no slippage,' etc.

Also, while this may be less relevant to the day trader, another factor that makes FX trading a tricky proposition is the absence of a clear upward drift. Individual exchange rates may appear to exhibit long-term trends. But at their core, we are just dealing in relative prices and there is no such thing as a built-in reward for the entrepreneur such as is found in the equity market. Banks are now launching various ETF-type products that claim to capture the exchange rate beta — incorporating strategies that have proved rewarding over the longer-term, such as the carry trade. But I believe this is far more questionable than equity beta.

I find the dynamics of this marketplace fascinating, but there is no doubt that it's a tough racket. Still, I am surprised by those numbers.

From Chris Cooper: 

I, too, have been trading a lot of forex recently. I don't find it too hard to believe that there are very few profitable retail traders. Most retail brokers run operations designed to milk money from their customers. That, plus the leverage available, pretty much guarantees that few will profit. My commissions are not high, but since I trade fairly frequently (not scalping) I know that commissions alone cost me 50% of my equity annually. Slippage is even more costly. That's a pretty big nut to overcome.

There are retail brokers who are built with ECN technology, and these tend to give their customers a better deal. I would recommend either Interactive Brokers or EFX Group.

Once you move past the retail stage, I have noticed that another serious issue is liquidity. Because of the lack of a central exchange, you end up having to execute in multiple locations to find liquidity and that complicates the trading. Claims about forex being the biggest market in the world (trillions!) are so much hogwash. I can see that my trades have a brief but visible effect on the market occasionally, more than I see by trading index futures. It doesn't take much to buy the entire amount offered at the best ask.

I am optimistic about the industry, and one of the reasons is the big increase in numbers of small retail traders. They are certainly losing more than they have a right to lose, but the competition engendered for their accounts will ultimately better the experience for all customers.

Alan Millhone writes:

You all talk of 'slippage', lack of liquidity, costly commissions, retail brokers who milk their customers. Do all of you stay in the market as a challenge, make a living, just something to do to pass time?

In construction we also have 'fly by nights' who prey on the elderly and the unsuspecting and give the good builders a bad rap. Perhaps it is the same in any business. I have had plenty of experiences in the construction business where on the other end some people run out of money and simply will not pay you. Because the court always assumes the builder is making a fortune, 99% of the time it rules against the builder.

Chris Cooper replies:

To be fair, one must distinguish between the costs of doing business, which are simply features of the marketplace, and those which are borderline fraudulent.

Commissions, slippage, and lack of liquidity are all costs of trading which are fair in principle, and the magnitude is determined ultimately by competition among providers. Also, brokers in the forex markets artificially widen the spreads and take the difference for themselves, and trade against their customers. While perhaps not unethical, such practices don't enhance the perception of fairness that will ultimately lead to increased participation. Traders can educate themselves to avoid these brokers, but for now plenty do not. 

From Yishen Kuik: 

This brings to mind epidemic models. If account fatality rates are so high, should one assume that marketing is a key driver in this business (to renew the population of accounts)? 

Vincent Andres adds: 

My experience in the market is short. For what I understand from this retail market, I don't see that brokers need to do great marketing. In fact FX customers are too optimistic. They see what they want to see, e.g., "Mr. X won the FX contest with 1000%." They don't see what they should see, that 99% of participants loose their account.

I posit that some of the overconfidence may be due to the presumed knowledge each of us has about currencies, which seems simply better than what we have about stocks, etc. I believe I understand the Euro better than Merck & Co./Soybeans etc, simply because I practice/use/own them everyday.

The FX market is a closed finite market, with ten main currencies, 10×10 main vehicles. This may calm people, the liquidity meme, forgetting to look at the granularity of this liquidity. FX is de facto an oligopoly archetype, the guru. I understand nothing. But I rely on somebody who understands. In fact, the simili-pro is like one of Mr. Rafter's nice examples. The only thing the simili-pro understands is how to dupe his customers.

The reading of FX forums is a 4th dimension experience. The customer's innocence/ignorance/unwillingness to try to understand/learn/look seems without limits. At the retail level, there are few attempts to know the market, the brokers, who are the players, what is the leverage, the spread, etc. It seems like people want deliberately to play blindly. When they buy a piece of fish at the fish market, they will carefully compare, weigh, smell, touch, remember, etc. When they buy 10,000 euros with leverage 10, they will base it on two crossing lines from a surrealist Picasso like painting.

It is not so hard to quantitatively verify that a great part of the losses is not due to the market, but to the broker. People focus on the market (even completely wrongly), while the real play is not there. A great percent of trades/plays don't happen at the market level, but stay intra broker. (Hence, if you want to make money, you'll strongly have to make it from your broker, and not from the market. That's a rather different game.)

Despite all the above remarks, I found the FX a very nice teaching and training field. Since the broker's big obstacle, an oligopoly, etc, searching edges is quite hard. It's thus quite formidable. I do not pretend other markets are marshmallows, but the FX is specific. 



Gong, Guojin; Louis, Henock; and Sun, Amy X., Earnings Management and Firm Performance Following Open-Market Repurchases (November 2006).

Abstract: We provide evidence suggesting that both the post-repurchase long-term abnormal returns and the reported improvement in operating performance documented in prior studies are driven, at least partly, by pre-repurchase downward earnings management, rather than genuine growth in profitability. The average firm reports significantly negative abnormal accruals prior to open-market repurchases. The extent of the downward earnings management increases with the percentage of the company that managers repurchase and CEO ownership. The pre-repurchase abnormal accruals are also significantly negatively associated with both future operating performance and future stock performance, and the negative associations are driven almost exclusively by those firms that report the largest income-decreasing abnormal accruals prior to the repurchases. The study suggests that one reason firms experience post-repurchase abnormal returns is that the post-repurchase realized earnings growth exceeds expectations formed on the basis of the pre-repurchase deflated earnings numbers.



It occurred to me the other day (and probably years ago to those more astute than I) that the broad shift of assets into ETFs has the second-order effect of raising demand for stocks. An investor thinks $1 in a mutual fund is "the same" as $1 in an ETF. But in fact the ETF is (by definition) fully invested, whereas the fund might be 5% in cash (because of liquidity needs, or just because the spirit so moved the fund manager).

Something like $300-400b of new money has flowed into EFTs since the 2002 market bottom; 5% of that is $15-20billion of marginal extra buying, equivalent to buying all of SUNW.

From Yishen Kuik:

As a tangential point, daily shares traded on the NYSE Group have doubled from about 1E9 in the 1st week of 2000 to about 2E9 today. During this period, the SPX has been largely unchanged, the NYSE Comp (new method) has gone from 7000 to 9400.

As an aside, I assume all trades on crossing networks show up as prints on T&S and thus are captured by metrics such as NYSE Daily Shares Traded. If someone knows better, I would love to be educated.



 A seeker of knowledge inquires:

Q: Can you give me a good layman's term "working" definition of R squared? Questions that pop up are why is it important? What does it reflect? Is it predictive?

A: R Squared is simply the square of the correlation coefficient. As most will recall the correlation coefficient can range from +1 for a strong positive correlation to -1 for a strongly negative relationship between two variables. Two variables which are unrelated will usually have a correlation around zero.

So when we square the correlation coefficient we get a number between 0 and +1. Remember that the negative correlations become positive so there are no more negative numbers. We also almost always get a smaller absolute number because multiplying two numbers less than 1 always gives a small number (except for zero and 1).

There is another interpretation. The R^2 also generally associated with a regression model (but need not be). The R^2 can be thought of as representing the percent of variance which is explained by the model. Mathematically things are linear in the variance but not in the square roots such as the standard deviation and correlation. So we can decompose the total variance of a regression into the part that is explained by the model and the part that is unexplained (the error or residual variance). The three relationships are:

Total variance  =  Explained Variance  +  Unexplained variance
    100%       =        R^2           +       (1 - R^2)
Total SSq       =  Explained SSq       +  Unexplained SSq

In the last line the term SSq means the Sum of Squares. The sum of squares relationship simply comes about because the variance is simply the average sum of squares. The bottom line is that if you have an R^2 of 25% you know that it explains 25% of the variance in the variable you wish to predict. You also know that the correlation coefficient is +/-50% because .5 * .5 = .25. Conversely if you know that a correlation coefficient is 90% then you know the R Squared will be 81%.

From just the R Squared you do not know if the correlation is positive or negative however. For that you have to look at the beta coefficient of the regression which tells you which sign to choose for the correlation coefficient. 

Yishen Kuik adds:

I've found an intuitive interpretation of correlation coefficient (R) to be a measure of how in phase two datastreams are.

For two dataseries X and Y:

R = (sum of Zx * Zy)/(N-1), where Zx is the z-normalized series X and Zy is same for Y

Hence, the more the below-mean datapoints in X and Y coincide, the greater the value in the numerator, since the product of two negative Z scores is positive. The corollary is that above-mean datapoints will also coincide, and since the sumproduct of two positive numbers is also positive, also contributes to a larger numerator.

Hence I think of this coincidence of above/below mean datapoints as in phase.



 When we do a study based on historical data and find a statistically significant result at the 5% level, we really are saying that there is less than a 5% chance that this study is completely attributable to chance. But if we observe some pattern in recent market action and then study it, that can be a problem: the multiple hypotheses problem.

One might think that if only one test is done that only one hypothesis was tested. Sometimes this is true. Other times traders will be intense students of the markets and notice a recurrent pattern. The trader then forms a hypothesis based on this pattern. It is properly tested on the most recent data and shows itself to be statistically significant.

There are two problems with this approach. First, if "the most recent data" include the same patterns that were observed and used to form the hypothesis then we are subject to the multiple hypothesis issue. This is true because that exquisite pattern-matching machine called the human mind continually looks for non-randomness and meaning in everything it sees. The mind tries out incredibly many hypotheses all the time. Most of us cannot even guess how many hypotheses our mind tries out before we identify one as interesting. So including the data, which formed the hypothesis, implicitly includes an element of multiple hypothesis testing.

The other problem is that we already know that the data will validate our study because it was used to help form the hypothesis. So it is not independent data but inherently biased. Thus our significance tests will be biased toward acceptance.

The best way to do these kinds of studies is to form the hypothesis on one data set and to test it on another completely different data set from another period.

Bruno Ombreux adds:

Or consider the same period but another market. For instance, if some phenomenon shows up in US stocks, test it on French and German stocks, too. There must be a reason for the putative phenomenon, either microstructural, behavioral, or economic. If so, it should show up in several markets. This extends the amount of testable data. One must be cautious with microstructure however, because it can differ. 

Philip J. McDonnell responds:

I do not agree with the idea of testing on data from different markets during the same time period, because many markets are highly correlated on a coterminal basis, sometimes as much as 90%. So it is really not an independent test on independent data.

But when one uses different time periods the correlations drop to near zero. So we can conclude that the data are truly out of sample.

Bruno Ombreux replies:

Dr. McDonnell is 100% right, but I still think it is not completely worthless to extend the sample to other markets. If you test a hypothesis on the US market, you'll be interested in the cases when you reject the null. Now, you test the German market and you still reject the null. You're right — not very useful. But if you fail to reject it on the German market, you need to come up with a very good explanation why it would work in the USA and not in Germany.

This is not nearly as good as different time periods, but it can be useful and increase understanding. 

Yishen Kuik adds:

I like to take an idea that has demonstrated its worthiness in actual trading in the US, then port it to other countries to see whether it works or not. If one has a group of countries for which the idea works and another for which it does not, it becomes interesting to try to figure out what members of each group have in common.

Nigel Davies remarks:

Presumably you're also taking account of time zones here. I've noticed that other markets tend to be led by the US during the day session (and even a couple of hours before its open) and have their measure of independence at other times. China is probably leading the overnight action now and Europe dominates during its morning. So perhaps it's not so much cultural as different time snapshots showing a certain similarity.

Martin Lindkvist extends:

Like the human flus that originate in Asia, many market ones seem to come from there too. Now, last night's Chinese flu seems to be of the same strain as that of late February. And as such, the market's immune system should be better prepared now. Perhaps a bit of coughing, and some sneezing for a little while, but not much of a fever this time? 

Henry Carstens adduces:

From a book recently recommended to me: "Routine design involves solving familiar problems, reusing large portions of prior solutions. Innovative design, on the other hand, involves finding novel solutions to unfamiliar problems." To borrow a quote from a friend, "Better necessarily means different." 



 The best coffee is Arabica. You guys drink the worst coffee. I'll bring some good Kona stuff out when I come next.

I got a sampler of eight different international coffees with the new iRoast 2, in green bean from Mexico, Peru, Timor, Sumatra, Congo, Panama, Nicaragua, Guatemala, and a few others. I'm not sure if it's what they're trying to sell or just trying to get rid of, but none held a candle to fresh roasted homegrown hand-picked sun dried Kona Coffee. Most were bland. Peruvian was about the best of the bunch, but still rather bland. Some were close to undrinkable. Sumatra tasted like dirt, Panama very bland, Nicaragua very bitter, and Peru mellow, good to mix 10% with 90% Kona.

Sam Humbert asks:

Why does anyone voluntarily drink "flavored" coffee? I'm having a cup just now, because "hazelnut flavored" beans were all we had on hand in the office today. But I feel like the high-school stoner who's so desperate he'll smoke roaches. The stuff tastes like something the EPA would send HazMat-suited guys out to Jersey to detoxify.

Who buys it? Is it a ladies' drink? Would appreciate insight.

Yishen Kuik adds:

A coffee importer once told me that the flavoured coffee industry grew out of a desire to use cheaper robusta beans and yet avoid the inferior aftertaste that caused manufacturers to prefer arabica. But then flavoured coffee took off. 

J T Holley writes: 

Having earned and financed my college education working at various coffee shops such as Mill Mountain Coffee and Tea in the Roanoke Valley, and Food For Thought in Missoula, MT, I can tell you very few [buy flavored coffee]! Most coffeehouses have pots of coffee lined up on the counter of some sort for self pouring. The ratio to the best of my knowledge on refilling those was around 5 to 1 compared to regular coffees of many varieties.

Not that what you drank was good but there are two ways to flavor coffee. I have utilized both ways. One is with a horrible flavored oil and the other is via bottled syrup. The oiled way is to roast a rather cheap Columbian bean and then mix the oil and coat the beans (like applying chemicals to kill weeds). The other is much better and that is having an individual cup of coffee and adding a shot of flavored syrup. This seemed less toxic to me even though both are probably the same.

I witnessed very few people other than women that would order flavored coffee. Espresso drinks would be the exception to that. I would classify flavored coffee along the lines of 100 cigarettes. We used to joke that those extra long 100's were for people that like to ash not smoke. They don't smoke the cigarette they simply puff to be able to "ask" so they look sleek and sexy or something. Same with flavored coffee drinkers I've witnessed. They don't drink coffee like you and me, they sip and end up throwing half of it away in those plastic lined trash cans that weren't made to hold liquids!

My experience in the Navy taught me something about coffee as well. Cream and sugar were rarely added to a cup on my ship. Your sexual orientation back in the early 90s when I served was questioned if you had a stir stick in the cup. It was taunting or hazing thing on my ship. Words were slung at you in humiliating ways and made a man either quit drinking coffee altogether or go with the straight black cup of coffee to avoid the hassle.

It's amazing how psychological warfare works. I drank my coffee straight anyways so it wasn't a bother to me, but literally saw fights break out. Can't even imagine what would've come about if someone would have brought their own International Flavored Coffee onboard.

On a lighter note, I spent 6 to 8 years of my life roasting and serving coffee in all of its varieties. I have to confess that it is amazing how much caffeine is abused and that literal addicts consume the beverage. The mark-up on a cup of coffee from raw bean, to roasting, to brewing and serving is utterly amazing to me as well. The shops that I worked in did absolutely zero advertising as well, another fascinating fact of the coffee business.

Pitt Maner adds: 

I hate to think of the abuse one might get for using the following, but based on a crude experiment it does seem that cold brewing makes for a smoother (some say lack of) taste.

With respect to Nicaragua there seems to be a fair amount of variability in the taste of the coffee. The best coffee growing region is up around Matagalpa and Jinotega in northern Nicaragua.

The Nicas seem to like to drink it black with a fair amount of sugar.

Problem with all coffee though seems to be how long it has been sitting on the shelf. You don't always get a "born on date" on the package. Of course you can pay $9 a pound for some of the brands that are sealed with nitrogen gas.

I know of someone who actually was marketing small discs that you put in your coffee maker to flavor the coffee of your choice. Better living through chemistry indeed. 

Pamela Van Giessen writes: 

The Irish coffee flavored stuff is the worst. My mother served it to me once when I was visiting. Being sleepy I didn't focus on the malodorous nature but the second it hit my taste buds I literally spit it out. Thankfully we were outside. I think that stuff was made for older ladies. 

Scott Brooks writes: 

Chicory is a plant that I use in my food plots to feed and attract deer and turkey. It is highly desirable, palatable, and nutritious to deer and turkey as well as many species of birds, and other assorted animals.

Gordon Haave adds:

I am a big chicory fan. The only kind to get is Cafe Du Monde. Every other kind I have tried is terrible. That being said, I don't know that it mellows the flavor, unless the underlying coffee is much more harsh than regular. I drink it with sugar and cream. 



 This past weekend, the NYT reported that bids had come in to replace the aging Willis Avenue Bridge, which spans 304 ft between Manhattan and the Bronx. It was built in three years and nine months, completed in 1901 at the cost of $2.5 mil. Adjusted for CPI, this is $59 mil in 2005 dollars.

By comparison, the Brooklyn Bridge spans 1600 ft, cost $15 mil to build in 1883 or $300 mil in 2005 dollars. Today, 106 years later, with the advent of modern technology, we can replace the puny Willis bridge in an estimated five years at $600 mil, assuming no cost or time over-runs, based on bid submissions.

If we oversimplify things by assuming material and all labor costs have increased with CPI - giving no credit to a century of progress in building technology and advancements in material extraction and fabrication, then, $600 - $59 = $541 mil is the burden created by the choices we have made as a society in adopting regulations, studies, legal requirements, constituency approvals, bureaucratic overhead, etc.

It seems remarkable that these costs should be almost 10 times that of purchasing the skilled and unskilled man hours and the materials to fabricate the bridge, and that we should take 33% more time to get the job done. And these are best-case figures assuming no overruns.

The moral of the fable seems clear — by embracing a model which allows many different constituents to have a say in investment into public infrastructure, New York City and possibly the rest of the country have greatly retarded its ability to create and renew physical infrastructure. This is very clear in NYC where we contend with decrepit and aging infrastructure while cities in Asia maintain constant renewal of public works.

In a previously disastrous experiment, liberals thought they could achieve affordable housing at no cost by legislating rent control, only to watch landlords allow buildings to fall into neglect from lack of economic incentive. Perhaps a similarly misguided belief today that we can save the trees, the fish, and the environment at no cost by legislating all projects to obtain numerous constituent approvals will have similar consequences - leaving us with a stock of aging infrastructure by excessively raising the costs of getting them replaced. 

Stefan Jovanovich writes:

I reviewed the Census Bureau's calculations of the changes over the time periods 2000 to 2006, in the number of people who report themselves as non-immigrant residents in a metropolitan area. To my amateur view it is a change in the demographic patterns from the "white flight" of the last decades of the 20th century. The "flight" now is by all groups of "native" Americans. San Francisco, for example, has seen its black population drop from nearly 20% 2 decades ago to 8%. Riverside, which has been one of the fastest growing exurban counties in Southern California over the same period, has seen much of its growth come from African-American emigrants from Compton and Watts.

Bridge addendum from Yishen Kuik:

Vietnam $42mm Thuan Phuoc Bridge is a cable-stayed bridge that crosses the lower Han River at Da Nang, Vietnam. The four-lane bridge, completed in 2005 has a main span is
405 meters. The four-lane bridge is 1.85 km long and
18 meters wide.

Sweden & Norway $185mm The 704m Svinesund Bridge is a compression arch suspended-deck bridge crossing Ide fjord at Svinesund, and joining Sweden and Norway. 4 lanes, longest span 247 m (810 ft).

China $700mm The Runyang Bridge is a large bridge complex that crosses the Yangtze River. It is part of the Beijing-Shanghai Expressway. South bridge main span of 1,490 metres (4,888 ft). Upon its completion in 2005 it became the third largest suspension bridge in the world and the largest in China. The width of the deck is 39.2 metres (129 ft), accommodating 6 traffic lanes and a narrow walkway at each outside edge for maintenance.

Slovakia $172mm The 854 m Apollo Bridge spans the Danube at 231 m. The Apollo Bridge became the only European project named one of five finalists for the 2006 Outstanding Civil Engineering Achievement Award (OPAL Award) by the American Society of Civil Engineers.

Scotland $40mm The Clyde Arc is a road bridge spanning the River Clyde. Dual two-lane carriageway, two cycle/footpaths (total width 140 m) in west central Scotland, 96m span.

Thailand $70mm The Second ThaiLao Friendship Bridge over the Mekong connects Mukdahan Province in Thailand with Savannakhet in Laos. The Friendship Bridge is 1600 meters long and 12 meters wide, with two traffic lanes.

If anyone can explain what exactly is in the 90m span Willis Bridge that makes it good value at $600mm+, I would be all ears. At that price, I would expect the bridge attendants to serve us coffee as we approach the ramparts.



 It is the season for looking at tax statistics. 

In the year 2004 and 4,488,654 filers reported short term capital gains ("ST gain") and 5,506,046 reported short term capital losses ("ST loss"). The IRS has thoughtfully binned all filers into 19 income categories ranging from AGIs of zero to $10mm plus

Every bin showed more filers reporting an ST loss than an ST gain except the last two bins of $5mm-$10mm and $10mm plus. Every bin also showed the total dollar amount of ST losses suffered by filers exceeded same for ST gains, save for the last two bins.

If we take the total dollar amount of ST losses divided by the same for ST gains in each bin, naturally we get a ratio greater than one for all bins except the last two. If we then plot this, we get a nice slightly kinked line starting from an incredible high of 20 [AGI $5,000 to $10,000] to 7.76 [AGI $25,000 to $30,000] before rising again to 9.21 at [AGI $40,000 to $50,000] and falling gently thereafter to hit 1.25 at [AGI $2mm to $5mm], before going into sub-1 territory.

The aggregate ratio for all returns is 3.65, i.e., ST losses for all US filers were 3.65 times ST gains in 2004.



 I was recently alerted to the bull market in dried seahorses. A value-oriented friend on vacation in Hong Kong told me merchants in traditional Chinese medicines have found their inventory of dried seahorses enjoyed rates of return in the teens.Since this is not exactly a market with a well-reported price time series, a bit of Googling shows:

Ten years ago, the kilo-price for dried Sea horse in Hong Kong ranged between 250 U.S. dollars for "inferior" small, brown species and 850 U.S. dollars for large, bleached species.

Punching the numbers into my 17B, I get 10.94% return over 10 years.



 Daniel Dennett on YouTube trots out several examples of parasites that turn their hosts suicidal: lancet flukes that turn ants into zombie ants climbing plant stalks for no reason; toxoplasma that turn mice into Mighty Mouse, fearless of cats; and flukes that make fish jump into bird's beaks. His motivation in citing parasites that modify host behaviour is to cast doubt on religion.

Memes seem like a similar kind of parasite, modifying their hosts' behaviour, such as causing people who normally wouldn't presume to have anything useful to say on an esoteric topic to suddenly behave like experts, forcefully arguing the few talking points learned from last night's CNBC show as if they were the conclusions from a lifetime of investigation.

Abe Dunkelheit writes:

Every year I tend to fall for a new meme. Last year a friend of mine called me from Monte Carlo and sucked me into an oil exploration 'insider' deal which lost me 1% of my overall performance in less than five days. This time it was this article on Feb 28, which quoted Thomas Brown, that made me brainlessly buy lend shares two days before they tanked — a tiny position which lost me another 1% in a couple of days. The monetary loss is not even the worst thing. What makes it so bad is the mental turmoil and emotional disequilibrium such a memetic infection can have upon one's psyche, which substantially increases the likelihood of additional misjudgments. It is hellish!

What sucks me in?

I think it may be the following:

First, there is the appearance or mystique of knowledge: "Tiger Management alumnus and former top bank analyst Thomas Brown."

Second, there is a prediction: "Investors with at least a one year investment horizon will be very happy they bought the stock at current price."

Third, this so-called knowledge is conveyed with an unshakable conviction, which turns the prediction into a prophecy: "This is one of those times in investing, I believe, when it will pay to be very, very aggressive."

And forth, there must be a heightened level of emotion, excitability, vulnerability, and/or distraction so as to inhibit the analytical mind from properly functioning and to increase suggestibility.

[I had experienced an unusual amount of emotionally unbalancing news before my memetic infection: (1) I just had made and immediately lost an unusually large amount of money in the previous five days. (2) Before Feb 27th I had the best month ever and outperformed the market by 12 points. (3) I just gained the mandate for a large private investment account. (4) I had won a lawsuit that had haunted me for more that a year and a half. (5) I got very unexpected news of former bank colleagues who had been doing extremely well financially since I had left banking some five years ago, which made me weak and doubtful in a very subtle way. Basically, from what I had heard I concluded that I had missed out on millions, a thought that sort of traumatized me and introduced a sense of urgency into my life for a day or two. This contributed to the reduction of my mental immune system and made me ready for the memetic infection!]

In religion, we have a similar structure. First, there is the appearance of knowledge [the priest caste]. Second there is a prediction regarding the future. Third is the prediction revealed in a do-or-die urgency ["Believe me or die"]. And forth, emotional excitability, vulnerability, and distraction are strongly triggered by all sorts of techniques like induction of mass hysteria, forced confessions, dehydration, sleep deprivation, induced fear and guilt, peer-pressure, induced imaginations and phantasmagorias [the promises of hurries in Paradise and the vivid depiction of the pains of Hell], predictions, awe, synchronicities, interpretation madness [everything appears to be significant in some higher sense], etc. Often the victim has already suffered from an emotional destabilization in their life like a divorce, job loss, a rejection, etc.

What makes the meme so dangerous is that when the prediction turns out to be wrong [and they tend to be wrong all the time] the meme-infected mind has the tendency to 'explain' the failure away and that has the effect of sucking the person in even more! [See: Leon Festinger, When Prophecy Fails (1956), and also the recent documentary "Waiting for Nesara" ].

In, The Psychology of Human Misjudgment, Warren Buffet's life long friend and partner Charles Munger writes:

"Pure curiosity made me wonder how and why destructive cults were often able, over a single weekend, to turn many tolerably normal people into brainwashed zombies and thereafter keep them in that state indefinitely. I resolved that I would eventually find a good answer to this cult question if I could do so by general reading and much musing."

Abe Dunkelheit continues:

Not only does information help the public very little, but instead it helps predators! (This is a very rough calculus; I know that even between predators Pareto law applies).

Information has no implicit value. The value of any information is relative to the person's experience structure, which in turn depends on the person's relative position inside of the social fabric, and on hereditary factors.

There are no winners because it ends with death. But there are relative winners [predators] and losers [prey] in relation to each other. And that relation is relatively rigid. It doesn't change in one's lifetime. Ninety-five percent are food. Only five percent can be helped, which in turn seals the fate of the other ninety-five percent.

Free dissemination seems not to reduce the paretian effect, but on the contrary seems to help make things still worse. So what to do?

The question is rhetorical, because one cannot be interested in any serious solution. If one really wants to reduce harm simply stop educating stupidity! Don't do anything and don't go anywhere. It is almost certain that this way one would outperform any other solutions. But nobody can be seriously interested in such a solution.

So one will come up with lots of justifications why it is good to do something, anything, and thereby seal one's and everybody else's fate. Here is mine: I have no conflict with reality. (Implicit assumption: I will be saved from the cruel fate of the ninety-five percent. In fact, everybody will be saved.)

Hope and wishful thinking can be wonderful things. They can make things happen!

Alston Mabry adds:

In nature, predators are not "winners," nor are prey "losers." Being preyed upon by lions does not make zebras into losers. The lion, too, will eventually be food for another creature. The zebra does not compete with the lion, but with his fellow zebras and other herbivores. Likewise, the lion competes with the neighboring pride, the leopard, or the pack of hyenas. And when the watering holes dry up, they all die.



A gem, noticed by Brett Steenbarger:

Henry Carstens's latest article, Introduction To Testing Trading Ideas, is a gem. It walks traders through the process of historical testing, significance testing, and portfolio allocation.

From  Yishen Kuik:

I've found this other "how-to" guide to testing informative as well.

The market is jai alai.



 There has been entirely too little thought given to the mechanism, pathways and reasons that negative feedback works in markets. Perhaps the main reason is that the feeding web is based on a reasonable stability in what and how much is being eaten and recycled.

The people who consume and redistribute must maintain a ready and stable supply of those who produce. They develop mechanisms to keep everything going. One of them is the specialization and great efficiency in their activities. If markets deviate too much from the areas and levels within which the specialization has developed, then much waste and new effort and mechanisms will be necessary.

Aside from the grind that trend following causes (i.e. the losses in execution), and the negative feedback system of movements in the supply and demand schedules that equilibrate, which Marshall pioneered and are now standard in economics, and the numerous other reasons I've set forth (e.g. the fixed nature of the system and the flexibility to profit from it), this appears to me to be the main reason that trend following doesn't work.

Here are a few interesting articles on the subject:

How Great Traders Make Millions in Up or Down Markets 

Does Trend Following Work On Stocks?

Interviews At RealWorld Trading

Why I Don't Believe in Trends

Briefly Speaking . . . 

Bill Rafter writes: 

Dr. Bruno had posed the idea of beating an index by deleting the worst performers. This is an area in which we have done considerable work. Please note that we do not consider this trend-following. The assets are not charted, just ranked.

Let us imagine an investor who is savvy enough to identify what is strong about an economy and invest in sectors representative of those areas, while avoiding sectors representing the weaker areas of the economy. Note that we are not requiring our investor to be prescient. He does not need to see what will be strong tomorrow, just what is strong and weak now, measured by performance over a recent period.

What is a market sector? The S&P does that work for us, and breaks down the overall market (that is, the S&P 500) into 10 Sectors. They further break it down into 24 Industry Groups, and further still into 60-plus Industries and 140-plus Sub-Industries. The number of the various groups and their constituents changes from time to time as the economy evolves, but essentially the 500 stocks can be grouped in a variety of ways, depending on the degree of focus desired. Some of the groupings are so narrow that only one company represents that group.

Our investor starts out looking at the 10 Sectors and ranks them according to their performance (such as their quarterly rate of change). He then invests in those ranked first through fourth (25 percent in each), and maintains those holdings until the rankings change. How does he do? Not bad, it turns out.

From 1990 through 2006, which encompasses several types of market conditions, the overall market managed an 8 percent compound annual rate of return. Our savvy investor achieved 10.77%. A less savvy investor who had the bad fortune to pick the worst six groups would have earned 7.23%. Those results are below. (Note, for comparison purposes, all results excluded dividends.)

How can our savvy investor do better? By simply sharpening one's focus, major improvements can be achieved. If instead of ranking the top 4 of10 Sectors, our savvy investor invests in a similar number (say the top 4, 5 or 6) of the 24 Industry Groups, he achieves a 13.12% compoundedannual rate of return over the same period. Note that the same stocks are represented in the 10 Sectors and the 24 Industry Groups. At no time did he have to be prescient.

One thing you will notice from the graphs above is that the equity curves of our savvy and unlucky investors mimic the rises and declines of the market index itself. Being savvy makes money but it does not insulate one from overall bad markets because the Sectors and even the Industry Groups are not significantly diversified from the overall market.

Why not keep going further out and rank all stocks individually? That clearly results in superior returns, but the volume of trading is such that it can only be accomplished effectively in a fund structure - not by the individual. And even ranking thousands of stocks will not insulate an investor from an overall market decline, if he is only invested in equities. The answer of course is diversification.

It is possible to rank debt and alternative investment sectors alongside equities, in the hope of letting their performances dictate what the investor should own. However the debt and commodities markets have different volatilities than the equities markets. Anyone ranking them must make adjustments for their inherent differences. That is, when ranking really diverse assets, one must rank them on a risk-adjusted basis for it to be a true comparison. However if we make those adjustments and rank treasury bonds (debt) against our 24 Industry Groups (equity) we can avoid some of the overall equity declines. We refer to this as a Strategic Overlay:

Adding this Strategic Overlay increases the returns slightly, but more important, diversifies the investor away from some periods of total equity market decline. We are not talking of a policy of running for cover every time the equities markets stall. In the long run, the investor must be in equities.

Invariably in ranking diverse assets such as equities, debt and commodities, our investor will be faced with a decision that he should be completely out of equities. It is likely that will occur during a period of high volatility for equities, but one that has also experienced great returns. Thus, our investor would be abandoning equities when his recent experience would suggest otherwise. And since timing can never be perfect, it is further likely that the equities he abandons will continue to outperform for some period. On an absolute basis, equities may rank best, but on a risk-adjusted basis, they may not. It is not uncommon for investors to ignore risk in such a situation, to their subsequent regret.

Ranking is not without its problems. For example, if you are selecting the top 4 groups of whatever category, there is a fair chance that at some time the assets ranked 4 and 5 will change places back and forth on a daily basis. This "flutter" can be easily solved by providing those who make the cut with a subsequent incumbency advantage. For a newcomer to replace a list member, it then must outrank the current assets on the selected list by the incumbency advantage. This is very similar to the manner in which thermostats work. We have found adding an incumbency advantage to be a profitable improvement without considering transactions costs. When one also considers the reduced transaction costs, the benefits increase even more.

Another important consideration is the "lookback" period. Above we used the example of our savvy investor ranking assets on the basis of their quarterly growth. Not surprisingly, the choice of a lookback period can have an effect on profitability. Since markets tend to fall more abruptly than they rise, lookback periods that perform best during rising markets are markedly different from those that perform best during falling markets. Determining whether a market is rising or falling can be problematic, as it can only be done with certainty in retrospect. However, another key factor influencing the choice of a lookback period is volatility, which can be determined concurrently. Thus an optimal lookback period can be automatically determined based on volatility.

There is certainly no question that a diligent investor can outperform the market. By outperforming the market we mean that he will achieve a greater average rate of return than the market, while limiting the maximum drawdown (or percentage equity decline) to less than that experienced by the market. But the average investor is generally not up to the diligence or persistence required.

In the research work illustrated above, all transactions were executed on the close of the day following a decision being made. Thus the strategy illustrated is certainly executable. Nothing required a forecast; all that was required was for the investor to recognize concurrently which assets have performed well over a recent period. It is not difficult, but requires daily monitoring.

Charles Pennington writes:

Referring to the MathInvestor's plot: :

At first glance it appears that the "Best" have been beating the "Worst" consistently.

In fact, however, all of the outperformance was from 1990 through 1995. From 1996 to present, it was approximately a tie.

Reading from the plot, I see that the "Best" portfolio was at about 2.1 at the start of 1996. It grew to about 5.5 at the end of the chart for a gain of about 160%. Over the same period, the "Worst" grew from 1.3 to 3.2, a gain of about 150%, essentially the same.

So for the past 11 years, this system had negligible outperformance.

One should also consider that the "Best" portfolio benefits in the study from stale pricing, which one could not capture in real trading. Furthermore, dividends were not included in the study. My guess is that the "Worst" portfolio would have had a higher dividend yield.

In order to improve this kind of study, I would recommend:

1.) Use instruments that can actually be traded, rather than S&P sectors, in order to eliminate the stale pricing concern.

2.) Plot the results on a semilog graph. That would have made it clear that all the outperformance happened before 1996.

3.) Finally, include dividends. The reported difference in compound annual returns (10.8% vs 8.0%) would be completely negated if the "Worst" portfolio had a yield 2.8% higher than the "Best".

Bill Rafter replies:

Gentlemen, please! The previously sent illustration of asset ranking is not a proposed "system," but simply an illustration that tilting one's portfolio away from dogs and toward previous performers can have a beneficial effect on the portfolio. The comparison between the 10 Sectors and the 24 Industry Groups illustrates the benefits of focus. That is, (1) don't buy previous dogs, and (2) sharpen your investment focus. Ignore these points and you will be leaving money on the table.

We have done this work with many different assets such as ETFs and even Fidelity funds (which require a 30-day holding period), both of which can be realistically traded. They are successful, but not overwhelmingly so. Strangely, one of the best asset groups to trade in this manner would be proprietarily-traded small-cap funds.

Unfortunately if you try trading those, your broker will disown you. I mention that example only to suggest that some assets truly do have "legs," or "tails" if you prefer. I think their success is attributed to the fact that some prop traders are better than others, and ranking them works. An asset group with which we have had no success is high-yield debt funds. I have no idea why.

A comment from Jerry Parker:

 I wrote an initial comment to you via your website [can be found under the comments link by the title of this post], disputing your point of view, which a friend of mine read, and sent me the following:

I read your comment on Niederhoffer's Daily Spec in response to his arguments against trend following. Personally, I don't think it boils down to intelligence, but rather to ego. Giving up control to an ego-less computer is not an easy task for someone who believes so strongly in the ability of the human mind. I have great respect for his work and his passion for self study, but of course disagree with his thoughts on trend following. On each trade, he is only able to profit if it "trends" in a favorable direction, whether the holding period is 1 minute or 1 year. Call it what you will, but he trades trends all day.

He's right. I was wrong. Trend following is THE enemy of the 'genius'. You and your friends can't even see how stupid your website is. You are blinded by your superior intelligence and arrogance.

Victor Niederhoffer responds:

Thanks much for your contributions to the debate. I will try to improve my understanding of this subject and my performance in the future so as not to be such an easy target for your critiques.

Ronald Weber writes: 

 When you think about it, most players in the financial industry are nothing but trend followers (or momentum-players). This includes analysts, advisors, relationship managers, and most fund or money managers. If there is any doubt, check the EE I function on Bloomberg, or the money flow/price functions of mutual funds.

The main reason may have more to do with career risk and the clients themselves. If you're on the right side while everyone is wrong, you will be rewarded; if you're on the wrong side like most of your peers you will be ok; and if you're wrong while everyone is right then you're in trouble!

In addition, most normal human beings (daily specs not included!) don't like ideas that deviate too much from the consensus. You are considered a total heretic if you try to explain why, for example, there is no link between the weak USD and the twin deficits. This is true, too, if you would have told anyone in 2002 that the Japanese banks will experience a dramatic rebound like the Scandinavian banks in the early '90s, and so on, or if you currently express any doubt on any commodity.

So go with the flow, and give them what they want! It makes life easier for everyone! If you can deal with your conscience of course!

The worse is that you tend to get marginalized when you express doubt on contagious thoughts. You force most people to think. You're the boring party spoiler! It's probably one reason why the most successful money managers or most creative research houses happen to be small organizations.

Jeremy Smith offers:

 Not arguing one way or the other here, but for any market or any stock that is making all time highs (measured for sake of argument in years) do we properly say about such markets and stocks that there is no trend?

Vincent Andres contributes: 

I would distinguish/disambiguate drift and trend.

"Drift": Plentifully discussed here. "Trend": See arcsine, law of series, etc.

In 2D, the French author Jean-Paul Delahaye speaks about "effet rateau" (rake effect), here and here .

Basically, our tendency is to believe that random equals equiprobability everywhere (2D) or random equals equiprobability everytime (1D), and thus that nonequiprobability everywhere/everytime equals non random

In 1D, non equiprobability everytime means that the sequence -1 +1 -1 +1 -1 +1 -1 +1 is in fact the rare and a very non random sequence, while the sequences -1 +1 +1 +1 +1 +1 -1 +1 with a "trend" are in fact the truly random ones. By the way, this arcsine effect does certainly not explain 100% of all the observed trends. There may also be true ones. Mistress would be too simple. True drift may certainly produce some true trends, but certainly far less than believed by many.

Dylan Distasio adds:

 For those who don't believe trend following can be a successful strategy, how would you explain the long-term performance of the No Load Fund X newsletter? Their system consists of a fairly simple relative strength mutual fund (and increasingly ETF) model where funds are held until they weaken enough in relative strength to swap out with new ones.

The results have been audited by Hulbert and consistently outperform the S&P 500 over a relatively long time frame (1980 onwards). I think their results make a trend following approach worth investigating…

Jerry Parker comments again: 

All you are saying is that you're not smart enough to develop a trend following system that works. What do you say about the billions of dollars traded by trend following CTAs and their long term track records?

Steve Leslie writes:

 If the Chair is not smart enough to figure out trend following, what does that bode for the rest of us?

There is a very old yet wise statement: Do not confuse brains with a bull market.

Case in point: prior to 2000 the great tech market run was being fueled by the hysteria surrounding Y2K. Remember that term? It is not around today but it was the cause for the greatest bull market seen in stocks ever. stocks and new issues were being bought with reckless abandon.

New issues were priced overnight and would open 40-50 points higher the next trading day. Money managers had standing orders to buy any new issues. There was no need for dog-and-pony or road shows. It was an absolute classic and chaotic case of extraordinary delusion and crowd madness.
Due diligence was put on hold, or perhaps abandoned. A colleague of mine once owned enough stock in a that had he sold it at a propitious time, he would have had enough money to purchase a small Hatteras yacht. Today, like many contemporary dot.coms, that stock is essentially worthless. It would not buy a Mad magazine.

Corporations once had a virtual open-ended budget to upgrade their hardware and software to prepare for the upcoming potential disaster. This liquidity allowed service companies to cash in by charging exorbitant fees. Quarter to quarter earnings comparisons were beyond belief and companies did not just meet the numbers, they blew by them like rocket ships. What made it so easy to make money was that when one sold a stock, all they had to do was purchase another similar stock that also was accelerating. The thought processes where so limited. Forget value investing; nobody on the planet wanted to talk to those guys. The value managers had to scrape by for years while they saw their redemptions flow into tech, momentum, and micro cap funds. It became a Ponzi scheme, a game of musical chairs. The problem was timing.

The music stopped in March of 2000 when CIO's need for new technology dried up coincident with the free money, and the stock market went into the greatest decline since the great depression. The NASDAQ peaked around 5000. Today it hovers around 2500, roughly half what it was 7 years ago.

It was not as if there were no warning signs. Beginning in late 1999, the tech market began to thin out and leadership became concentrated in a few issues. Chief among the group were Cisco, Oracle, Qwest, and a handful of others. Every tech, momentum, and growth fund had those stocks in their portfolio. This was coincident with the smart money selling into the sectors. The money managers were showing their hands if only one could read between the lines. Their remarks were "these stocks are being priced to perfection." They could not find compelling reasons not to own any of these stocks. And so on and on it went.

After 9/11 markets and industries began to collapse. The travel industry became almost nonexistent. Even Las Vegas went on life support. People absolutely refused to fly. Furthermore, business in and around New York City was in deep peril. This forced the Fed to begin dramatically reducing interest rates to reignite the economy. It worked, as corporations began to refinance their debt and restructure loans, etc.

The coincident effect began to show up in the housing industry. Homeowners refinanced their mortgages (yours truly included) and took equity out of their homes. Home-buyers were thirsty for real estate and bought homes as if they would disappear off the earth. For $2000 one could buy an option on a new construction home that would not be finished for a year. "Flipping" became the term du jour. Buy a home in a hot market such as Florida for nothing down and sell it six months later at a much higher price. Real estate was white hot. Closing on real estate was set back weeks and weeks. Sellers had multiple offers on their homes many times in the same day. This came to a screeching halt recently with the gradual rise in interest rates and the mass overbuilding of homes, and the housing industry has slowed dramatically.

Houses for sale now sit on the blocks for nine months or more. Builders such as Toll, KB, and Centex have commented that this is the worst real estate market they have seen in decades. Expansion plans have all but stopped and individuals are walking away from their deposits rather than be upside down in their new home.

Now we have an ebullient stock market that has gone nearly 1000 days without so much as a 2% correction in a day. The longest such stretch in history. What does this portend? Time will tell. Margin debt is now at near all-time highs and confidence indicators are skewed. Yet we hear about trend followers and momentum traders and their success. I find this more than curious. One thing that they ever fail to mention is that momentum trading and trend following does not work very well in a trendless market. I never heard much about trend followers from June 2000 to October 2002. I am certain that this game of musical chairs will end, or at least be temporarily interrupted.

As always, it is the diligent speculator who will be prepared for the inevitable and capitalize upon this event. Santayana once said, "Those who cannot remember the past are condemned to repeat it."

From "A Student:"

 Capitalism is the most successful economic system in the history of the world. Too often we put technology up as the main driving force behind capitalism. Although it is true that it has much to offer, there is another overlooked hero of capitalism. The cornerstone of capitalism is good marketing.

The trend following (TF) group of fund managers is a perfect example of good marketing. As most know, the group as a whole has managed to amass billions of investor money. The fund operators have managed to become wealthy through high fees. The key to this success is good marketing not performance. It is a tribute to capitalism.

The sports loving fund manger is a perfect example. All of his funds were negative for 2006 and all but one was negative over the last 3 years! So whether one looks at it from a short-term one year stand point or a three year perspective his investors have not made money. Despite this the manager still made money by the truckload during this period. Chalk it up to good marketing, it certainly was not performance.

The secret to this marketing success is intriguing. Normally hedge funds and CTAs cannot solicit investors nor even publicly tout their wares on an Internet site. The TF funds have found a way around this. There may be a web site which openly markets the 'concept' of TF but ostensibly not the funds. On this site the names of the high priests of TF are repeatedly uttered with near religious reverence. Thus this concept site surreptitiously drives the investors to the TF funds.

One of the brilliant marketing tactics used on the site is the continuous repetition of the open question, "Why are they (TF managers) so rich?" The question is offered as a sophist's response to the real world question as to whether TF makes money. The marketing brilliance lies in the fact that there is never a need to provide factual support or performance records. Thus the inconvenient poor performance of the TF funds over the last few years is swept under the carpet.

Also swept under the rug are the performance figures for once-great trend followers who no longer are among the great, i.e., those who didn't survive. Ditto for the non-surviving funds in this or that market from the surviving trend followers.

Another smart technique is how the group drives investor traffic to its concept site. Every few years a hagiographic book is written which idolizes the TF high priests. It ostensibly offers to reveal the hidden secrets of TF.

Yet after reading the book the investor is left with no usable information, merely a constant repetition of the marketing slogan: How come these guys are so rich? Obviously the answer is good marketing but the the book is moot on the subject. Presumably, the books are meant to be helpful and the authors are true believers without a tie-in in mind. But the invisible hand of self-interest often works in mysterious ways.

In the latest incarnation of the TF book the author is presented as an independent researcher and observer. Yet a few days after publication he assumes the role of Director of Marketing for the concept site. Even the least savvy observer must admit that it is extraordinary marketing when one can persuade the prospect to pay $30 to buy a copy of the marketing literature.

Jason Ruspini adds:

 "I attribute much of the success of the selected bigs to being net long leveraged in fixed income and stocks during the relevant periods."

I humbly corroborate this point. If one eliminates long equity, long fixed income (and fx carry) positions, most trend-following returns evaporate.

Metals and energies have helped recently, after years of paying floor traders.

Victor replies:

 I don't agree with all the points above. For example, the beauty of capitalism is not its puffery, but the efficiency of its marketing and distribution system as well as the information and incentives that the prices provide so as to fulfill the pitiless desires of the consumers. Also beautiful is in the mechanism that it provides for those with savings making low returns to invest in the projects of entrepreneurs with much higher returns in fields that are urgently desired by customers.

I have been the butt of abuse and scorn from the trend followers for many years. One such abusive letter apparently sparked the writer's note. Aside from my other limitations, the trend following followers apparently find my refusal to believe in the value of any fixed systems a negative. They also apparently don't like the serial correlation coefficients I periodically report that test the basic tenets of the trend following canon.

I believe that if there are trends, then the standard statistical methods for detecting same, i.e., correlograms, regressions, runs and turning point tests, arima estimates, variance ratio tests, and non-linear extensions of same will show them.

Such tests as I have run do not reveal any systematic departures from randomness. Nor if they did would I believe they were predictive, especially in the light of the principle of ever changing cycles about which I have written extensively.

Doubtless there is a drift in the overall level of stock prices. And certain fund managers who are biased in that direction should certainly be able to capture some of that drift to the extent that the times they are short or out of the market don't override it. However, this is not supportive of trend following in my book.

Similarly, there certainly has been over the last 30 years a strong upward movement in fixed income prices. To the extent that a person was long during this period, especially if on leverage, there is very good reason to believe that they would have made money, especially if they limited their shorts to a moiete.

Many of the criticisms of my views on trend following point to the great big boys who say they follow trends. To the extent that those big boys are not counterbalanced by others bigs who have lost, I attribute much of the success of the selected bigs to being net long leveraged in fixed income and stocks during the relevant periods.

I have no firm belief as to whether such things as trends in individual stocks exist. The statistical problem is too complex for me because of a paucity of independent data points, and the difficulties of maintaining an operational prospective file.

Neither do I have much conviction as to whether trends exist in commodities or foreign exchange. The overall negative returns to the public in such fields seem to be of so vast a magnitude that it would not be a fruitful line of inquiry.

If I found such trends through the normal statistical methods, I would suspect them as a lure of the invisible evil hand to bring in big money to follow trends after a little money has been made by following them, the same way human imposters work in other fields. I believe that such a tendency for trend followers to lose with relatively big money after making with smaller amounts is a feature of all fixed systems. And it's guaranteed to happen by the law of ever-changing cycles.

The main substantive objection to my views that I have found in the past, other than that trend followers know many people who make money following trends (a view which is self-reported and selective and non-systematic, and thus open to some of the objections of those of the letter-writer), is that they themselves follow trends and charts and make much money doing it. What is not seen by these in my views is what they would have made with their natural instincts if they did not use trend following as one of their planks. This is a difficult argument for them to understand or to confirm or deny.

My views on trend following are always open to new evidence, and new ways of looking at the subject. I solicit and will publish all views on this subject in the spirit of free inquiry and mutual education.

 Jeff Sasmor writes:

 Would you really call what FUNDX does trend following? Well, whatever they do works.

I used their system successfully in my retirement accounts and my kids' college UTMA's and am happy enough with it that I dumped about 25% of that money in their company's Mutual Funds which do the same process as the newsletter. The MFs are like an FOF approach. The added expense charges are worth it. IMO, anyway. Their fund universe is quite small compared to the totality of funds that exist, and they create classes of funds based on their measure of risk.

This is what they say is their process. When friends ask me what to buy I tell them to buy the FUNDX mutual fund if their time scale is long. No one has complained yet!

It ain't perfect (And what is? unless your aim is to prove that you're right) but it's better than me fumfering around trying to pick MFs from recommendations in Money Magazine, Forbes, or Morningstar.

I'm really not convinced that what they do is trend following though.

Dylan Distasio Adds:

 For those who don't believe trend following can be a successful strategy, how would you explain the long-term performance of the No Load Fund X newsletter?

Michael Marchese writes: 

In a recent post, Mr. Leslie finished his essay with, "I never heard much about trend followers from June 2000 to October 2002." This link shows the month-to-month performance of 13 trend followers during that period of time. It seems they did OK.

Hanny Saad writes:

 Not only is trend following invalid statistically but, looking at the bigger picture, it has to be invalid logically without even running your unusual tests.

If wealth distribution is to remain in the range of 20 to 80, trend following cannot exist. In other words, if the majority followed the trend (hence the concept of trends), and if trend following is in fact profitable, the majority will become rich and the 20-80 distribution will collapse. This defeats logic and history. That said, there is the well-covered (by the Chair) general market upward drift that should also come as no surprise to the macro thinkers. The increase in the general population, wealth, and the entrepreneurial spirit over the long term will inevitably contribute to the upward drift of the general market indices as is very well demonstrated by the triumphal trio.

While all world markets did well over the last 100 yrs, you notice upon closer examination that the markets that outperformed were the US, Canada, Australia, and New Zealand. The one common denominator that these countries have is that they are all immigration countries. They attract people.

Contrary to what one hears about the negative effects of immigration, and how immigrants cause recessions, the people who leave their homelands looking for a better life generally have quite developed entrepreneurial spirits. As a result, they contribute to the steeper upward curve of the markets of these countries. When immigrants are allowed into these countries, with their life savings, home purchases, land development, saving and borrowing, immigration becomes a rudder against recession, or at least helps with soft landings. Immigration countries have that extra weapon called LAND.

So in brief, no - trends do not exists and can not exist either statistically or logically, with the exception of the forever upward drift of population and general markets with some curves steeper than others, those of the countries with the extra weapon called land and immigration.

A rereading of The Wealth And Poverty Of Nations, by Landes, and the triumph of the optimist may be in order.

Steve Ellison adds:

 So Mr. Parker's real objective was simply to insult the Chair, not to provide any evidence of the merits of trend following that would enlighten us (anecdotes and tautologies that all traders can only profit from favorable trends prove nothing). I too lack the intelligence to develop a trend following system that works. When I test conditions that I naively believe to be indicative of trends, such as crossovers of moving averages, X-day highs and lows, and the direction of the most recent Y percent move, I usually find negative returns going forward.

Bacon summarized his entire book in a single sentence: "Always copper the public play!" My more detailed summary was, "When the public embraces a particular betting strategy, payoffs fall, and incentives (for favored horsemen) to win are diminished."

Trend Following — Cause, from James Sogi: 

Generate a Brownian motion time series with drift in R

WN <-rnorm(1024);RW<-cumsum(WN);DELTAT<-1/252;

MU<-.15*DELTAT;SIG<-.2*sqrt(DELTAT);TIME<-(1:1024)/252 stock<-exp(SIG*RW+MU*TIME) ts.plot(stock)

Run it a few times. Shows lots of trends. Pick one. You might get lucky.

Trend Following v. Buy and Hold, from Yishen Kuik 

The real price of pork bellies and wheat should fall over time as innovation drives down costs of production. Theoretically, however, the nominal price might still show drift if the inflation is high enough to overcome the falling real costs of production.

I've looked at the number of oranges, bacon, and tea a blue collar worker's weekly wages could have purchased in New York in 2000 versus London in the 1700s. All quantities showed a significant increase (i.e., become relatively cheaper), lending support to the idea that real costs of production for most basic foodstuffs fall over time.

Then again, according to Keynes, one should be able to earn a risk premium from speculating in commodity futures by normal backwardation, since one is providing an insurance service to commercial hedgers. So one doesn't necessarily need rising spot prices to earn this premium, according to Keynes.

Not All Deer are Five-Pointers, from Larry Williams

 What's frustrating to me about trading is having a view, as I sometimes do, that a market should be close to a short term sell, yet I have no entry. This betwixt and between is frustrating, wanting to sell but not seeing the precise entry point, and knowing I may miss the entry and then see the market decline.

So I wait. It's hard to learn not to pull the trigger at every deer you see. Not all are five-pointers… and some will be bagged by better hunters than I.

From Gregory van Kipnis:

 Back in the 70s a long-term study was done by the economic consulting firm of Townsend Greenspan (yes, Alan's firm) on a variety of raw material price indexes. It included the Journal of Commerce index, a government index of the geometric mean of raw materials and a few others. The study concluded that despite population growth and rapid industrialization since the Revolutionary War era, that supply, with a lag, kept up with demand, or substitutions (kerosene for whale blubber) would emerge, which net-net led to raw material prices being a zero sum game. Periods of specific commodity price rises were followed by periods of offsetting declining prices. That is, raw materials were not a systematic source of inflation independent of monetary phenomena.

It was important to the study to construct the indexes correctly and broadly, because there were always some commodities that had longer-term rising trends and would bias an index that gave them too much weight. Other commodities went into long-term decline and would get dropped by the commodity exchanges or the popular press. Just as in indexes of fund performance there can be survivor bias, so too with government measures of economic activity and inflation.

However, this is not to say there are no trends at the individual commodity level of detail. Trends are set up by changes in the supply/demand balance. If the supply/demand balance changes for a stock or a commodity, its price will break out. If it is a highly efficient market, the breakout will be swift and leave little opportunity for mechanical methods of exploitation. If it is not an efficient market (for example, you have a lock on information, the new reality is not fully understood, the spread of awareness is slow, or there is heavy disagreement, someone big has to protect a position against an adverse move) the adjustment may be slower to unfold and look like a classic trend. This more often is the case in commodities.

Conversely, if you find a breakout, look for supporting reasons in the supply/demand data before jumping in. But, you need to be fast. In today's more highly efficient markets the problem is best summarized by the paradox: "look before you leap; but he who hesitates is lost!"

Larry Williams adds:

I would posit there is no long-term drift to commodities and thus we have a huge difference in these vehicles.

The commodity index basket guys have a mantra that commodities will go higher - drift - but I can find no evidence that this is anything but a dream, piquant words of promotion that ring true but are not.

I anxiously stand to be corrected.

Marlowe Cassetti writes:

 "Along a similar vein, why would anybody pay Powershares to do this kind of work when the tools to do it yourself are so readily available?"

The simple answer is if someone wishes to prescribe to P&F methodology investing, then an ETF is a convenient investment vehicle.

With that said, this would be an interesting experiment. Will the DWA ETF be another Value Line Mutual Fund that routinely fails to beat the market while their newsletter routinely scores high marks? There are other such examples, such as IBD's William O'Neal's aborted mutual fund that was suppose to beat the market with the fabulous CANSLIM system. We have talked about the great track record of No-Load Fund-X newsletter, and their mutual fund, FUNDX, has done quite well in both up and down markets (an exception to the above mentioned cases).

For full disclosure I have recently added three of their mutual funds to my portfolio FUNDX, HOTFX, and RELAX. Hey, I'm retired and have better things to do than do-it-yourself mutual fund building. With 35 acres, I have a lot of dead wood to convert into firewood. Did you know that on old, dead juniper tree turns into cast iron that dulls a chain saw in minutes? But it will splinter like glass when whacked with a sledgehammer.

Kim Zussman writes:

…about the great track record of No-Load Fund-X newsletter and their mutual fund FUNDX has done quite well in both up and down markets… (MC)

Curious about FUNDX, checked its daily returns against ETF SPY (essentially large stock benchmark).

Regression Analysis of FUNDX versus SPY since inception, 6/02 (the regression equation is FUNDX = 0.00039 + 0.158 SPY):

Predictor    Coef         SE Coef           T             P
Constant    0.00039    0.000264        1.48        0.14
SPY            0.15780    0.026720        5.91        0.00

S = 0.00901468    R-Sq = 2.9%   R-Sq (adj) = 2.8%

The constant (alpha) is not quite significant, but it is positive, so FUNDX did out-perform SPY. Slope is significant and the coefficient is about 0.16, which means FUNDX was less volatile than SPY.

This is also shown by F-test for variance:

Test for Equal Variances: SPY, FUNDX

F-Test (normal distribution) Test statistic = 1.17, p-value = 0.009 (FUNDX<SPY)

But t-test for difference between daily returns shows no difference:

Two-sample T for SPY vs FUNDX

            N          Mean      St Dev       SE Mean
SPY      1169     0.00041  0.0099       0.00029
FUNDX 1169     0.00045  0.0091       0.00027   T=0.12        

So it looks like FUNDX has been giving slight/insignificant out-performance with significantly less volatility; which makes sense since it is a fund of mutual funds and ETFs.

Even better is Dr Bruno's idea of beating the index by deleting the worst (or few worst) stocks (new additions?).

How about an equal-weighted SP500 (which out-performs when small stocks do), without the worst 50 and double-weighting the best 50.

Call it FUN-EX, in honor of the fun you had with your X that was all mooted in the end.

Alex Castaldo writes:

The results provided by Dr. Zussman are fascinating:

The fund has a Beta of only 0.157, incredibly low for a stock fund (unless they hold a lot of cash). Yet the standard deviation of 0.91468% per day is broadly consistent with stock investing (S&P has a standard deviation of 1%). How can we reconcile this? What would Scholes-Williams, Dimson, and Andy Lo think when they see such a low beta? Must be some kind of bias.

I regressed the FUNDX returns on current and lagged S&P returns a la Dimson (1979) with the following results:

Regression Statistics
Multiple R                0.6816
R Square                 0.4646
Adjusted R Square   0.4627
Standard Error        0.0066
Observations           0.1166

                    df         SS          MS         F            Significance F
Regression       4      0.0444    0.0111   251.89    8.2E-156
Residual      1161      0.0511    4.4E-05
Total           1165      0.0955

                Coefficients  Standard Error  t-Stat        P-value
Intercept  8.17E-05     0.000194           0.4194        0.6749
SPX          0.18122      0.019696           9.2007        1.6E-19
SPX[-1]    0.60257      0.019719         30.5566        6E-151 SPX[-2]    0.08519      0.019692           4.3260        1.648E-05 SPX[-3]    0.04524      0.019656           2.3017        0.0215

Note the following:

(1) All four S&P coefficients are highly significant.

(2) The Dimson Beta is 0.914 (the sum of the 4 SPX coefficients). The mystery of the low beta has been solved.

(3) The evidence of price staleness, price smoothing, non-trading, whatever you want to call it is clear. Prof. Pennington touched on this the other day; an "efficiently priced" asset should not respond to past S&P price moves. Apparently though, FUNDX holds plenty of such assets (or else the prices of FUNDX itself, which I got from Yahoo, are stale).

S. Les writes:

Have to investigate the Fund X phenomenon. And look to see how it has done in last several years since it was post selected as good. Someone has to win a contest, but the beaten favorites are always my a priori choice except when so many others use that as a system the way they do in sports eye at the harness races, in which case waiting for two races or two days seems more apt a priori. VN 

 I went to the Fund X website to read up, and the information is quite sparse. It is a very attenuated website. I called the toll free number and chatted with the person on the other line. Information was OK, but, in my view, I had to ask the proper questions. One has several options here. One is to purchase the service and do the fund switching themselves based on the advice of their experts. The advisory service tracks funds that have the best relative strength performance and makes their recommendations from there,

Another is to purchase one of four funds available. They have varying levels of aggressiveness. Fund 3 appears to be the recommended one.

If one purchases the style 3 one will get a very broad based fund of funds. I went to yahoo to look up the holdings at

Top ten holdings are 47.5% of the portfolio, apparently concentrated in emerging markets and international funds at this time.

In summary, if money were to be placed into the Fund X 3 portfolio, I believe it would be so broad based and diversified that returns would be very watered down. Along with risk you would certainly be getting a lot of funds. You won't set the world on fire with this concept, but you won't get blown up, either.

Larry Williams adds:

My 2002 book, Right Stock at the Right Time, explains such an approach in the Dow 30. The losers were the overvalued stocks in the Dow.It is a simple and elegant idea…forget looking for winners…just don't buy overvalued stocks and you beat the idex.

This notion was developed in 1997, when i began actually doing it, and written about in the book. This approach has continued to outperform the Dow, it is fully revealed.

Craig Cuyler writes:

Larry's comment on right stock right time is correct and can be used to shed a little bit of light on trend following. This argument is at the heart of fundamental indexation, which amongst other points argues that cap weighting systematically over-weights overvalued stocks and under-weights undervalued stocks in a portfolio.

Only 29% of the top 10 stocks outperformed the market average over a 10yr period (1964-2004) according to Research Affiliates (this is another subject). The concept of "right stock right time" might be expressed another way, as "right market right time." The point is that constant analysis needs to take place for insuring investment in the products that are most likely to give one a return.

The big error that the trend followers make, in my mind, is they apply a homogeneous methodology to a number of markets and these are usually the ones that are "hot" at the time that the funds are applied. The system is then left to its own devices and inevitably breaks down. Most funds will be invested at exactly the time when the commodity, currencies, etc., are at their most overvalued.

Some worthwhile questions are: How does one identify a trend? Why is it important that one identifies a trend? How is it that security trends allow me to make money? In what time frame must the trend take place and why? What exactly is a trend and how long must it last to be so labeled?

I think it is important to differentiate between speculation using leverage and investing in equities because, as Vic (and most specs on the list) point out, there is a drift factor in equities which, when using sound valuation principles, can make it easier to identify equities that have a high probability of trending. Trend followers don't wait for a security to be overvalued before taking profits. They wait for the trend to change before then trying to profit from the reversal.

Jeff Sasmor adds:

As a user of both the newsletter and the FUNDX mutual fund I'd like to comment that using the mutual fund removes the emotional component of me reading the newsletter and having to make the buys and sells. Perhaps not an issue for others, but I found myself not really able to follow the recommendations exactly - I tend to have an itchy trigger finger to sell things. This is not surprising since I do mostly short-term and day trades. That's my bias; I'm risk averse. So the mutual fund puts that all on autopilot. It more closely matches the performance of their model portfolio.

I don't know how to comment on the comparisons to Value Line Arithmetic Index (VAY). Does anyone follow that exactly as a portfolio?

My aim is to achieve reasonable returns and not perfection. I assume I don't know what's going to happen and that most likely any market opinion that I have is going to be wrong. Like Mentor of Arisia, I know that complete knowledge requires infinite time. That and beta blockers helps to remove the shame aspect of being wrong. But there's always an emotional component.

As someone who is not a financial professional, but who is asked what to buy by friends and acquaintances who know I trade daily (in my small and parasitical fashion), I have found that this whole subject of investing is opaque to most people. Sort of like how in the early days of computing almost no one knew anything about computers. Those who did were the gatekeepers, the high priests of the temple in a way. Most people nowadays still don't know what goes on inside the computer that they use every day. It's a black box - opaque. They rely on the Geek Squad and other professionals to help them out. It makes sense. Can't really expect most people to take the time to learn the subject or even want to. Should they care whether their SW runs on C++ or Python, or what the internal object-oriented class structure of Microsoft Excel is, or whether the website they are looking at is XHTML compliant? Heck no!

Similarly, most people don't know anything about markets; don't want to learn, don't want to take the time, don't have the interest. And maybe they shouldn't. But they are told they need to invest for retirement. As so-called retail investors they depend on financial consultants, fee-based planners, and such to tell them what to do. Often they get self-serving or become too loaded with fees (spec-listers who provide these services excepted).

So I think that the simple advice that I give, of buying broad-based index ETFs like SPY and IWM and something like FUNDX, while certainly less than perfect, and certainly less profitable than managing your own investments full-time, is really suitable for many people who don't really have the inclination, time, or ability to investigate the significant issues for themselves or sort out the multitudes of conflicting opinions put forth by the financial media.

You may not achieve the theoretical maximum returns (no one does), but you will benefit from the upward drift in prices and your blended costs will be reasonable. And it's better than the cash and CDs that a lot of people still have in their retirement accounts.

BTW: FOMA = Foma are harmless untruths, intended to comfort simple souls.
An example : "Prosperity is just around the corner."

I'm not out to defend FUNDX, I have nothing to do with them. I'm just happy with it. 

Steve Ellison writes: 

One might ask what the purpose of trends is in the market ecosystem. In the old days, trends occurred because information disseminated slowly from insiders to Wall Streeters to the general public, thus ensuring that the public lost more than it had a right to. Memes that capture the public imagination, such as Nasdaq in the 1990s, take years to work through the population, and introduce many opportunities for selling new investment products to the public.

Perhaps some amount of trending is needed from time to time in every market to keep the public interested and tossing chips into the market. I saw this statement at the FX Money Trends website on September 21, 2005: "[T]he head of institutional sales at one of the largest FX dealing rooms in the US … lamented that for the past 2 months trading volume had dried up for his firm dramatically because of the 'lack of trend' and that many 'system traders' had simply shut down to preserve capital."

I saw a similar dynamic recently at a craps table when shooters lost four or five consecutive points, triggering my stop loss so that I quit playing. About half the other players left the table at the same time. "The table's cold," said one.

To test whether a market might trend out of necessity to attract money, I used point and figure methodology with 1% boxes and one-box reversals on the S&P 500 futures. I found five instances in the past 18 months in which four consecutive reversals had occurred and tabulated the next four points after each of these instances (the last of which has only had three subsequent points so far). The results were highly non-predictive.

Starting        Next 4 points
Date      Continuations  Reversals
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Anthony Tadlock writes:

I had intended to write a post or two on my recent two week trip to Cairo, Aswan, and Alexandria. There is nothing salient to trading but Egypt seems to have more Tourist Police and other guards armed with machine guns than tourists. It is a service economy with very few tourists or middle/upper classes to service. Virtually no westerners walk on the streets of Cairo or Alexandria. I did my best to ignore my investments and had closed all my highly speculative short-term trades before leaving for the trip.

While preparing for taxes I was looking over some of my trades for last year. Absolute worst trade was going long CVS and WAG too soon after WalMart announced $2 generic pricing. I had friends in town and wasn't able to spend my usual time watching and studying the market. I just watched them fall for two days and without looking at a chart, studying historical prices and determining how far they might fall, decided the market was being stupid and went long. Couldn't wait to tell my visitors how "smart" a trader I was and my expected profit. It was fun, until announcement after announcement by WalMart kept causing the stocks to keep falling. The result was panic selling near the bottom, even though I had told myself before the trade that I could happily buy and hold both. Basically, I followed all of Vic's rules on "How to Lose."

Trends: If only following a trend meant being able to draw a straight line or buy a system and buy green and sell red. The trend I wrote about several months ago about more babies being born of affluent parents still seems to be intact. I have recently seen pregnant moms pushing strollers again. Planes to Europe have been at capacity my last two trips and on both trips several crying toddlers made sleep difficult, in both directions. Are people with young children using their home as an ATM to fund a European trip? Are they racking up credit card debt that they can't afford? Depleting their savings? (Oh wait - Americans don't save anything.) If they are, then something fundamental has changed about how humans behave.

From James Sogi:

My daughter the PhD candidate at Berkeley in bio-chem is involved in some mind-boggling work. It's all very confidential, but she tried to explain to me some of her undergrad research in words less than 29 letters long. Molecules have shapes and fit together like keys. The right shape needs to fit in for a lock. Double helices of the DNA strand are a popular example, but it works with different shapes. There is competition to fit the missing piece. They talk to each other somehow. One of her favorite stories as a child was Shel Silverstein's Missing Piece. Maybe that's where her chemical background arose. Silverstein's imagery is how I picture it at my low level. 

Looking at this past few months chart patterns it is impossible not to see the similarity in how the strands might try fit together missing pieces in Wykoffian functionality. The math and methods must be complicated, but might supply some ideas for how the ranges and strands in the market might fit together, and provide some predictive methods along the lines of biochemical probability theory. I'll need some assistance from the bio-chem section of the Spec-list to articulate this better.

From Kim Zussman: 

Doing same as Alex Castaldo, using SPY daily change (cl-cl) as independent and FUNDX as dependent gave different resluts:

Regression Analysis: FUNDX versus SPY ret, SPY-1, SPY-2

The regression equation is FUNDX = 0.000383 + 0.188 SPY ret - 0.0502 SPY-1 - 0.0313 SPY-2

Predictor     Coef           SE Coef       T        P
Constant     0.000383    0.00029      1.35    0.179
SPY ret       0.187620    0.03120      6.01    0.000*            SPY-1        -0.050180    0.03136     -1.60   0.110           SPY-2        -0.031250    0.03121     -1.00   0.317 *(contemporaneous)

S = 0.00970927   R-Sq = 3.2%   R-Sq (adj) = 3.0%

Perhaps FUNDX vs a tradeable index is the explanation.




Esteem. What are the reasons that business people act as they do? One reason is the desire for profits. The second most studied reason is the sanction and guide of regulation and the law. A third reason, which is not considered enough, is the desire for esteem and the avoidance of disesteem. This topic is covered very well in The Economics of Esteem by Geoffrey Brennan and Philip Pettit. They consider how esteem is allocated and how it can be improved in the economy. Chapters include why we want esteem, the demand and supply of esteem, the economics of equilibrium of esteem, publicity, the intangible hand, and voluntary associations. It's mainly a diagrammatic and psychological framework within which the principles and non-mathematical tools of economics are applied. It should have great application to the endeavor of finding good companies and good managers.

VIX. With VIX at 9.7, its lowest level in 12 years, the jury is out. Will the new year, or the new expirations to be traded, lead to a change in regime? Usually decision-makers are not apt to change horses near the holiday season, especially in view of the bonuses gravitating down to the middle classes.

Torts. It's hard to do anything these days without thinking that fear of litigation is a driver of the customs and procedures. In hospitals, people in critical care are subjected to an endless barrage of red tape while in shock so that doctors can protect themselves from subsequent claims, including giving X-rays while life hangs by a thread. And of course autopsies are a thing of the past because they often are not paid for, and because of what they might reveal.

Happiness. The happiness that people forego to protect themselves from liability is often not accounted for in the cost benefit-analysis of third party payment schemes. For example, in squash, certainly the rule that one must wear goggles causes more accidents than it saves. And people can't remember the time when you could actually enjoy a game of squash and see the whole court. And many people have not taken the game up because of the wearing of goggles. Of course, the invisible hand explanation for such rules is the fees associations get from the manufacturers. More importantly, many have had their happiness quotient decreased. The same is true of car seat laws for babies. How much wasted time, how many cancelled trips? There are hundreds of other examples.

Antipodes. I spoke at Yale yesterday, a week after Professor Taleb had been there. And we have both adopted George Zachar's device of "your own man says it's so" to discuss the merits of what the other does, even though it is more than 99% likely that on any given trade in the pit we are on opposite sides.

Anthropology. The customs of various trading pits, and the movement from simple to complex rules, a subject anthropologists study, would also be good for speculators to consider. I am reading the Encyclopedia of Anthropological Theory and find in every chapter insights into the way people perform tasks in different cultures and times, and the way that markets work. The anthropology of markets should be studied in detail and not just in terms of the customs and norms that develop on the floor and how they affect the public.

George Zachar replies:

One of the peculiarities of the big dealer shops I frequented was their intensely tribal nature. The sales/trader types loathed the slick investment bankers, who in turn treated "the floor" with contempt. The bond guys thought the stock guys were idiots, and the stock guys thought the bond guys were dweebs. The salesmen thought the traders were calculating lying thieves, and the traders thought the salesmen were glib lying thieves.

Many of the failures I observed at these firms could be traced directly to these tensions, and management's inability to get all the horses to pull the twin carts of customer satisfaction and firm profitability.

I've always assumed the key to 85 Broad Street's stupendous success lay in creating and sustaining a culture/management/incentive structure that solved the tribalism problem.

Vance Falco adds:

I'll reinforce George's observations. In the late 1990s I ran a research desk on the trading floor of a small boutique investment bank. Our primary responsibility was to very quickly make assessments about news flow regarding the companies under the firm's coverage, synergize that with the industry analysts' existing research stance and get the perspective out to block traders and the institutional salesforce. It was very amusing to see the quickly shifting manner in which we were treated. When queried about the meaning of something, we were treated (generally) respectfully. The moment we weren't on stage providing the value added insight (we hoped), we slid back to being treated as simply consumers of others' potential compensation upside and our part in the larger process was lost. To the traders, we weren't rough and tumble enough. To the salesforce, we knew the research well but weren't glam enough to put out the firm's sales call. Second class citizens from every angle.

Yishen Kuik comments:

I just wanted to add that I've long shared the same observations.

My experience is that some institutions can be very balkanized and surprisingly ineffective at coordinating efforts. Additionally, not especially well organized to move talent within the organization, allowing it to find its best fit.

Having said that, the Grand Sichuan Bank does seem to have created a good structure/culture to deal with these issues.

Vincent Andres contributes:

This reminds me of a very very good book called The Naked Ape by Desmond Morris.

Considering we're just apes with costumes has often helped me to put things into perspective. I believe it's also useful to understand crowd behavior, because most new types of behavior emerge at common denominator points, and thus many such behaviors are of a very primitive sort.

Andrew Godwin extends:

Having played squash for over 25 years, I give the thumbs up to Victor's analysis of goggles. Rather than point out profitable liability management portfolio ideas to the public, shouldn't you instead go long the athletic cup manufacturers? The sport authorities don't make you wear those yet. The loss of family jewels in a squash match would count much more significant than injury to goggle-protected portions to males without children. Indeed, parents and grandparents would support such an initiative. Only current spouses or kids in divorce situations would object. The descriptive terminology of "family jewels" makes the point to savvy marketers. Self-evident points need expression in your form, apparently.



Private military contractors are war zone speculators and the new book from Robert Young Pelton gives an enjoyable glimpse into the history, formation and daily activities of these contractor companies.

Licensed to Kill does not go too deep and bore the reader but rather makes the most of Pelton's vast contacts and personal stories from operating in various war zones. His balanced writings give him access to the major players in the industry which allows him coverage that other writers cannot match.

The book opens up with an email which was circulated amongst contractors that summarizes their outlook and reasoning for such a job.

One investment theme that I continue to pursue is the government contracting out of infrastructure to private companies, and I felt the book was a great insight into the beneficiaries in global security infrastructure. Countless examples are given of the military being replaced for non offensive duties by fewer and more highly skilled contractors in a trend that gains momentum.

An important theme throughout the book is the difference between a mercenary operation and security contractors. The line is occasionally blurred but the greatest distinction is that mercenaries conduct offensive duties and security contractors only act defensively. Discussed in this regard are the Sandline affair and the failed coup attempt in Equatorial Guinea by former Executive Outcomes personnel

A few of the contractor companies mentioned in the book are Blackwater USA, Triple Canopy, and SCG International. Some offer interesting emails which update and assess the security situation around the globe as well. I am a big fan of anything Pelton puts out and if anyone has further interest in his works you can check his webpage.

Peacekeeping is a growth area for the contractors, and the President of Blackwater states in the book that, "We are going to field a brigade-sized peacekeeping force. You can quote me on that."

For instance in regards to Darfur, Blackwater's President elaborates that, "We are turning a CASA 212 into a gunship that would cruise around at thirty-eight degrees…and when we find the bad guys, we would lay into them." The Director of Business Development then followed up to say, "Yeah, Janjaweed be gone!"

One effect of market forces upon the contractors is the cost of an armored drive from Baghdad's Airport to the Green Zone along Route Irish. Pelton reported in July that the price of an airport run is as low as $1500, down from upwards of $20,000….but this is one expense not to skimp on! Perhaps the run is simply getting safer but I imagine that competition plays the largest part in the price drop.

In regard to everchanging cycles, it is also noted that suicide bombers would approach the convoy initially from the rear until the convoy gunners learned and would shoot anything that came close. To adjust, the bombers would slow down from the front and when that failed to consistently work, they began to drive from the opposite direction and over the median into the convoy. All that in addition to roadside IEDs makes for a lot of uncertainty.

Also, a useful technique that Pelton observed during training for new contractors at Blackwater was the role reversal where the trainees would act as terrorists assaulting a convoy and the instructors would act as the convoy. This enabled the trainees to get into the mind of their enemy and probe for weak spots which were fully exploited. In the markets, how many price takers fully understand how price makers operate? Very few in my opinion.

Yishen Kuik adds:

Oddly enough, all of the points in Mr. Carlson's post are directly applicable to aficionados of team based first person shooting PC games like Day of Defeat. Someone who has played the Axis team on a given map becomes much more effective when playing the Allied team. Hiding spots, ambush points become clearer.

On changing cycles — an Axis sniper in a church tower can rack up kills, but will also eventually draw enemy fire. A skilled player knows when to move on to the next spot, for soon the tower will be strafed with machine gun fire and rockets. This also has parallels to fixed systems. The market will adapt and take you out.

When such an ambush point becomes 'hot', enemy forces will continue to deliver precautionary fire on it, regardless of whether anyone is there or not. It then becomes a very dangerous spot to be near - this is the trough of the cycle.

However, again very much like markets, if the church tower is left unoccupied for a long enough time, the enemy's wariness of it slowly diminishes, and the skilled sniper knows when the time is right to re-occupy it.

In fact, very good players make it a point to cycle between ambush points, leaving just before the previous point draws fire, moving onto a new point and then returning to the old point once it "cools" down.

First person team shooters are a wonderful laboratory of group dynamics. I've seen the above cycles again and again over hundreds of games.



Most people assume that a daytrader is a guy losing his $10,000 account in CMGI, who will have to go back to moving refrigerators for a living. Sadly, that is not too far from the truth for a guy running his own money, given time, using any investment approach.Another reason for the negative reaction is jealousy. It makes people green with envy to imagine a guy taking down mid six figures while working four hours a day in his pajamas from home.

But the reaction that I respect, is the more experienced traders who recognize that there are size limits to daytrading and that if one wants to play in the big leagues one has to develop a higher level of sophistication, no matter how successful one may be as a daytrader. These same experienced souls recognize how easy it is for a guy running his own money to destabilize when the market changes and crash and burn.

My professor, who was at Solly when it was Solly and was the fourth guy at LTCM, looked at my resume and my sheets and told me that I had the worst resume he had ever seen (after 10 years of daytrading) and that I needed to get beyond daytrading because if I was not careful I would be 40 when cash equities went away and then I would be a greeter at Wal-Mart.

Of course the flip side is that for many of the investment/trading guys out there who are not doing something as 'easy' as daytrading to make a living, their 'sophistication' is just a crutch to hide behind as they will under perform indexing year after year.

The bottom line is that dollars are green and if you have got the nerve to do it on your own and can do it, then you can write your own ticket and live the way you want to live. As has been well discussed on the list, money doesn't buy happiness once one can pay the bills, so it is mostly the intellectual challenge that should push any successful daytrader into the 'big leagues.'

Nat Stewart comments:

In the 1990s and 2000s some on the sidelines missed opportunities and were afraid to take a chance. They often now manifest their impotence in hatred for those who shoot for a dream and are willing to assume risk. The day trader phenomenon of the late nineties created a mass mob of little Abelsons, waiting for the fall and relishing the reports of young upstarts getting their comeuppance.

Yishen Kuik adds:

In the late 1990s thousands of otherwise unremarkable young people were making a great deal of money as day traders. Public knowledge of this was fairly widespread — perhaps you recall the television ad where stock trading Junior lands his helicopter on the front lawn of the family home, as Dad looks on bewildered.

It was about upsetting the perceived status quo, young upstarts making fortunes doing apparently nothing too strenuous while 'the rest of us' were left behind, looking stodgy and foolish. When the NASDAQ collapse came and a lot of these mo-mo fortunes were destroyed, the moment of schadenfreude was too delicious for the general public to resist. The public's smug satisfaction that "we were right after all" led to the comforting notion that those who day trade are indeed fools who will soon lose all their money.

I think therefore that the public's enmity towards daytrading is partially explained by the need to protect its own fragile ego — it hurts too much to believe that someone sitting at home in his pajamas can draw down 7 or 8 times the median wage while Joe Public sits in his cubicle cursing out the boss.

Craig Cuyler mentions:

I came across some guys that had a fund in Switzerland about a year ago they were posting plus ten percent returns per month scalping the Dax and Dax options. They developed some software for the Deutsche bourse and had a data pipe line that was a few seconds faster than the rest of the market. The were buying or selling bullets and making five to ten ticks all day on many many trades. It lasted about six months until their method was discovered. Articles on the Flipper have also appeared over the past year, and it is the same story, they have a very short lifespan. There are some other very short term strategies that I have seen for trading futures based on NYSE tick, that work quite well. I just think that, for the reasons I have given, the equities are very risky, and perhaps you bleed to death slowly until rampant markets like pre 2000 come along again.


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