Those who follow the biotech world may have seen that Regeneron reported some fantastic results on its lipid-lowering drug. Much more efficacy than statins. Safety data was not reported but it seems safe to say that suggestions of hepatotoxicity that first appeared with the early statins and seem to be a fixture in use of statins for the first 6 months is a segment of the population, were not present; FDA wouldn't have hesitated to intervene if there had been such suggestion, since in FDA's eyes there are already "safe" lipid-lowering drugs on the market.

The same is true for rhabdomyolysis–essentially break down of muscle (some thing the muscle soreness often associated with statin use may be a pre-rhabdomyolysis state, but the data are anything but clear on that). It was rhabdomyolysis that was the reason Bayer's Baychol was withdrawn from the market.

There are some caveats:

1. There has long been the observation that if cholesterol levels are brought below 90-100, there is little gain in mortality (some studies suggest there may even be an increase) and that cancer risk in particular goes up. Of course, recovering from a heart attack has a higher probability than doing so from cancer. Unfortunately, I can't tell you which sites–I just don't remember.

2. There are some established drugs in the lipid-lowering space. Lipitor and Crestor come to mind. The former is generic, and it is probably finally making it onto many P&T committee lists. The latter is still patent protected and, not surprisingly, costs a bit more than the former. That's not to say that Crestor is more efficacious than Lipitor. In a given patient, one may prove to be less efficacious or better tolerated than the other. YMMV.

3. The thing that made the statin market what it is today was a series of studies by Bristol-Myers Squibb and Merck showing that use of statins was associated with lower mortality–quite a bit in fact. Since the effect of Pravachol from BMS in mortality reduction was greater than might be expected if only lipid-lowering were the explanation, there has been a persistent question over what exactly it is that statins are doing besides lowering lipids. There are suggestions that they reduce chronic inflammation (considered part of the pathophysiological process underlying atherosclerosis), reduce risk of osteoporosis (very controversial), reduce risk of gingivitis and periodontitis (Dr. Zussman is better positioned to opine on that one than I am), and some suggestions of reduced risk of Alzheimer's disease, among others. Will Regeneron's drug do any of these? We don't know. Will it even lower mortality? Again, we don't know. Such studies take some time to complete, and I'm not sure if they've even been started. There's also the comparative effectiveness matter. How much this drug will cost for each QALY (quality-adjusted life years) gained isn't yet know, and whether the drug is seen to be as good a value as the statins were when they first came to market isn't known. However, make no mistake, all of these factors will enter into the calculus of how successful, if at all, Regeneron's drug might be.

4. As one who has taken Lipitor for 13 years (horrible family history of heart disease–I keep my total cholesterol below a 100 and LDL below 75), I'm not particularly interested in switching drugs, never mind drug classes. There are many patients taking statins who, I think it's probable, think likewise. That most statins are now well off patent (and cheap generics) is another reason to stay with something of known efficacy in a particular patient. That presents a problem for Regeneron: How to convince physicians to put new patients on its drug and to convert those on statins to switch. The former may be straightforward, though the issue will be one of how much more growth can there/will there be in the lipid-lowering market. I'm agnostic-to-skeptical that there's a whole group of patients needing another lipid-lowering drug. That's not to say there aren't some, though. On the other hand, obtaining health insurance coverage may be problematic, as I'm sure that Regeneron will price the drug in the "near and dear" category (to use industry parlance), meaning high. Very high. I doubt that Regeneron will follow the Pfizer strategy of pricing the drug 10% below the leading statins (or in this case, perhaps, Crestor) for two years to gain some traction in the market, but I could be wrong. One thing to consider is that biotechs are not used to pricing competitively. Usually, they are the long entity in a market space, and they will price accordingly. As for switching patients off of statins, I guess if there are those not getting enough of a reduction, perhaps with LDLs over 140-150, there's a chance of a switch being made. There aren't that many of such people, though. All of this means that Regeneron will have some work cut out on the marketing end to get newly diagnosed hyperlipidemics onto its drug, as well as getting insurance reimbursement.

The long and short of it is the Regeneron's drug may be a game-changer in heart disease–but we just don't know enough as yet about it. The data released yesterday seem compelling, yet they are only in terms of reduction in lipid levels. Fine, except we know from the statins that something may be needed to get much benefit from a lipid-lowering drug.

For those of you liking growth stocks or story stocks, this is a company with a nice story to follow, perhaps to take a position in. For value investors (read: Mr. Melvin), enjoy using the drug (if it gets to market) but don't even thing about looking at this stock. It won't be a "value" one for a decade or two at least.

The President of the Old Speculator's Club writes: 

I wonder if any studies have been done on the increased cancer risk. A little while ago, a scientist did a study and claimed that a cancer cure could save something like $5 trillion a year. However, tagged on to the end of the study was a one sentence disclaimer to the effect that the suggested savings did not take into account that while a cancer cure could well cut down on costs, survivors might find that their longer life brought on equally (or more) expensive disabilities - like diabetes or, more likely various dementias. I've been in two post-operative cardiac exercise programs - both for several years. In that time, quite a few individuals come through - most stay for the minimum period; others, like myself continue on. One thing we long-timers watched for was the continued health of those who stayed and, if possible, those who left. The nurses at one hospital were especially diligent in keeping in touch with members of both groups. Over the years (18 to be exact), as one would expect, there have been numerous deaths. However, very, very few were due to cardiac problems - more often, cancer was the cause. So, here's the question: is the propensity for cancer among cardiac survivors an inevitable result of their survival, or can (and should) their deaths be attributed to statins. I know the latter is a popular one, but hell's bells, lawyers couldn't make a dime if it proved out that longevity was the real cause.

Kim Zussman writes: 

Life should be more expensive than death because it is more valuable, especially to survivors. The problem is that the disease lottery is zero sum: you will die of something. As medical / nutrition science advances, death rate due to some diseases has plummeted - and survivors go on to die of something else.
Hand (and voter) wringers over increasing medical expenses should start by blaming antibiotics:

"Historical Diseases Death Rates" (see first table)

The progress made with infectious and cardiovascular disease has been faster than cancer treatment (and cheaper). So don't smoke, eat fish, hit the gym, wash your hands, and prepare for the final fight with unregulated cell division.



A MillhoneEnd of the nightly news tonight had a segment about a fellow who used to own a NYC nightclub and realized there was more to his life. He now raises money to drill water wells in remote areas of the globe. It is estimated that 4,500 children die each day due to lack of safe drinking water.

Made me think back to my overseas duty in Korea in the Army. Every barracks on base had 'houseboys' and one day I visited Mr. Yee's hut in the village. Sanitation was about nil and the outside privy had next to it their water spigot protruding out of the ground right beside of the outhouse! The Land of the Morning Calm was a filthy third world country while I was stationed there. I am sure Seoul has progressed but oft wonder about other countries and the small villages that make up most of Asia.

Americans have much to be thankful for and clean drinking water is one of those things we are blessed with.

Legacy Daily writes:

Every morning when I drive against traffic on Route 128 in Massachusetts, I cannot help but notice the thousands of cars lined with thousands of people rushing to go to work and improve this country in their own meaningful ways. When I hear 10% unemployment, I remind myself that 90% of the workers get up every day and go to work hard, to do something useful, to create something, to maintain something, to help someone. In one or two weeks a major section of Rt. 2 was repaved for a very smooth ride with nice straight white lines and reflectors, at night. This gives me great hope about the future of this country. Thank you for the reminder to not take it all for granted.



ChessmenIt is interesting to speculate on which people in one's life have characteristics of chess pieces. We have only a limited number of people who are the significant players on our own "team." The design of chess (unlike Go or checkers) incorporates pieces which may symbolize psychological types, and as it works so well in the game, in life do we notice someone who:

The king can also represent spirit or essence which grows through the layers of personality which have long protected it. In this vein gestalt analysis can also be applied to a single personality. We have a part of all these types within us. As chess has evolved to a design that defies all attempts to improve it, its structures may have wider application.

GM Nigel Davies adds:

An interesting idea that is close to others I've considered. The most obvious extension is that the pieces all represent aspects of the personality (psyche, soul) and that our struggle to coordinate the pieces symbolises our attempts to be 'complete personalities'. The forces of the 'other side' are there to provide the necessary resistance that inspires us to grow.

GM Davies is the author of Play the Catalan, Everyman, 2009

Legacy Daily asks:

The people/personality spectrum is perhaps far richer than the chess glasses allow but the situations in which we find ourselves are indeed as diverse as the possible combinations of pieces on a board. But how do the three outcomes (win, lose, draw) mirror life? Also, in life the “queen” or some other piece decides to sacrifice another piece or move in a direction. While in chess the player rules and dictates all of the moves. Who’s the “player” in life?



CycleI may well be wrong, but my belief is that we are at the end of a big cycle. The end of the "easy debt" cycle?

1/ 2008-2009 shows clearly that nothing will be done by borrowers to stop their dependence. Nothing will be even tried. On the contrary. Because of our debt levels, this triggers the question of solvency. At least, this makes the question of solvency exceed a significant psychological level for the lenders. Confidence lenders/borrowers is definitely affected (gone). (Even if little is publicly said about that).

2/ This situation of confidence loss is new. The exhibition of our attitude at such a level is new. The awareness/knowledge/understanding of this situation is new. Presently, neither the lenders, nor the borrowers, have exact plans to deal with this novelty.

3/ … but, under the calm and apparent status quo, they are of course actively searching. At least the lenders. With the intent to do something. (Something will be done, even due to randomness. At least some small domino pieces will fall.)

4/ so my belief is we arrive at a delicate/complex crossroads/nexus/crux/bifurcation point (à la Prigogine). We're now inside a huge, real-life, game theory exercise. Many many things can happen. (But I believe many probable scenarios will share common steps). (I believe even dramatic events are now made possible.) But the status quo seems me rather improbable (even if it would be the case, this would just postpone things).

The above sequence lacks numbers (and may look abstract), incomplete, too coarse and biased with a sort of "pessimism", (but it's not how I feel about it). I'll thank you for any help to remove the flaws/omissions/clumsiness of this reasoning.

Phil McDonnell replies:

Debt is an important part of the big picture.  But I believe that a better perspective on current economics is that private consumer debt will no longer be easy.  In fact current figures show that consumers are 'saving' in greater amounts.  To be sure this savings does not show up in savings accounts or other tangible assets.  Rather it shows up as consumers pay down credit cards and mortgages.

The key thing to understand is that the powers that be do not want a reduction in total debt.  The size of the world economy is directly related to the size of the world money supply and all of its assets.  Given the destruction of wealth in mortgages, real estate, stocks and commodities the only source of money creation to reflate the world balloon is government borrowing.  So in effect the consumer debt is being replaced by increased government debt and conscious efforts to print money out of thin air.

J. Rollert predicts:

The present environment will make people treat debt like our grandparents did… and not trust financial types in particular. This is a social change beyond the cycle.

Paolo Pezzutti recalls:

People will not change behavior and attitude unless they are forced to do it.  When I arrived in the US from Europe two years ago I went to a dealer to buy a car.  There were signs on the cars on sale indicating $400, $350 and so forth that I could not understand at first.  When I started to talk with the guy it became clear to me that the signs were the monthly payments you had to make.  When I buy a car I want to know first how much it costs, not how much I have to pay each month.  But in the US people are apparently either encouraged to buy on debt, or they like to buy on debt, or they must buy on debt because that is the only way they can afford a car.  Only if the behavior of the lenders changes, we will see a different attitude of consumers.  And this is what could happen. Even with 0% interest rates.  Unless lenders find "new" ways to lend "easy" money.

Russ Humbert writes:

It is not just Govt. debt in the traditional sense, that the Govt. is increasing, it is putting more risk on the Govt. balance sheet on the asset side as well.

The Bernanke plan is to keep it coming, from what I can tell, to those that are willing to beg from the government.  Securitization is not dead, for the government quasi guaranteed it… This includes education and housing loans for most people, up to the point of being "rich".  It would seem that those that have no real prospects of paying off the principal, those that won't better themselves will be frozen out. At the other extreme those that better themselves to the point that it's clear Government is impeding personal progress, will not get this "risk free" money.  There won't be another AIG to scoop up all the risks, without any real capital backing it, for a long time.

This may seem momentarily like we are headed back to the sixties, before even credit cards, because of the sharpness of the down turn.  But this still leaves the US with much more debt capability than existed 10 years ago, before things got out of hand.  And money will flow down to consumption, it just won't be direct and if direct not as cheap.

Legacy Daily is skeptical about big changes:

I perceive debt to be the current fuel in the engine of growth. Unless an "alternative energy" is discovered, I believe debt is here to stay. The donut maker got it wrong, "America runs on debt." One reason for the efforts to improve the geopolitical landscapes in emerging economies is to also help raise their asset bases against which further debt can be created to satisfy the unending need for growth that our markets, our 401(k), and our lifestyles require. Since there's nothing new under the sun, just as soon as this cycle of diet and slightly better behavior has run its course, the patient will be right back to the liquor store for more of the same and a new cycle will be born. When and in what shape? That's the really difficult question.

We received a contribution from thin air (or is it Thin Air?):

Let me introduce myself: my name is Thin Air. Yes, THE Thin Air. I've been around for eons upon eons and have enjoyed a fairly tranquil existence. Who or what am I? A Princeton web site defines me thusly: "thin air (nowhere to be found in a giant void) "it vanished into thin air." That's OK with me, I can even live with the example which characterizes me as the passive element in an inexplicable event. Over the centuries millions of people, things, explanations, excuses, villains, heroes, and life savings have "vanished" or "disappeared" into me.

No problem. If you humans lack the will or imagination to discover just whatever it was that was lost, misplaced, filched, or embezzled, that's fine with me. But trust me on this, I don't have any of those people or things….never even was aware they were gone until I looked me up on Google - imagine, almost 3 million references. Rosie O'Donnell's number is just slightly higher, Bill Clinton's is 7 times greater, Barack Obama's 25 times greater, and Michael Jackson's 70 times greater- a telling measure of your society's priorities.

Those individuals weren't chosen capriciously; as a member of the "thin" contingent I chose two thin representatives and, by contrast, two fat ones - although it appears I'm being dissed in relation to other "thins", I love it and want to keep it that way. But Philip McDonnell served as the straw that broke the camel's back when he penned: "So in effect the loss of consumer debt is being replaced by increased government debt and conscious efforts to print money out of thin air."

I'm getting so, so tired of hearing that. You can't get through an hour of CNBC or Bloomberg without hearing that phrase or a riff on it. But those people are pretty lame and I expected Dailyspec contributors to provide a creative twist to a tired theme. Additionally, when phrased as shown above, it appears that I had an active part in the event; that I somehow swooped down and dumped billions and billions of dollars upon a group of bankers. First off, I'm broke; I neither have nor need money (gasp). Secondly, if I did have money, do you really suppose I'd drop it on that group of dummies? Not a chance.

Being a disembodied element and not a human, I can still make value judgments, tell the truth, discriminate, and speak out without fear of being condemned, jailed, boycotted, or shunned. Among those things that are unquestionably bad is excessive debt. It would seem this is self-evident, and Mr. Andres ought to be commended for bringing it to the fore. Similarly, Mr. Conrad (on another thread) reveals that the WEEKLY treasury begging bowl calls for low-interest-loving optimists to pony up almost one quarter of a trillion dollars. If this occurred every week, Treasury's annual issuance would approach the nation's annual GDP.

One can hardly blame debt buyers, though, as it's a given that the system will get better (or as the Sage, a student of Pangloss, stated this a.m. "better than ever") and that American Exceptionalism will prevail where, in similar circumstances, similar efforts failed. On the contrary, we witnessed major adjustments following the Tulip Bulb mania, the South Sea Bubble, Teapot Dome, the Great Depression, the Salad Oil scandal, the S&L fiasco, Russia's Default, LTCM, Y2K and Tech Mania, Enron, and the Real Estate Bubble.

History has demonstrated that none of these came out of Thin Air, nor did their eventual solutions. You can check it.

Thanks for your consideration and

Please leave me alone,

Thin Air



 The bid/ask spread is another one of those hurdles that speculators must jump over in the quest for profitable trades. The spread is the instantaneous inside market, reflecting current market conditions, but it also is a product of unbridled free market forces. The bid/ask spread is a profit engine, for those in the right place at the right time, make no doubt about that. Many of the great fortunes on Wall Street were the result of always being able to buy at the bid, and sell at the offer.

In earlier times, people would pay for the privilege of an exchange membership in order to capture this spread. It must have been a worthwhile investment, as exchange membership prices have gone up on average for the last century. Now, in these more democratic, electronic times, it is harder to collect the spread on an all day, everyday basis. Much more confusion at the bid/ask point of the market reigns in this digital age. The mistress of deception likes to have her way with this spread. In today's supposedly open electronic age, where tyros see transparency in the markets, the same ages-old bluffing, misdirection, feints, probes, and stabs rule the inside market, as always. The same deceptive games played in the open outcry market have seamlessly morphed into the electronic markets, but with much more ruthless efficiency. Big players can see the open book, get the little ducks all lined up in a row, then slaughter them mercilessly. The inside market, the bid/ask spread, is tough to trade from anywhere on the outside, especially if you're a small player. Limit orders attempt to avoid the bid/ask spread, but one is really not avoiding the spread with a limit order when you think about it. Market orders give the other side of the trade an instantaneous profit, or return on their investment. No matter what you do, you're going to bump up against the spread, as it's unavoidable.

The bid/ask spread can represent the minimum amount of risk a player is going to assume, or it can cause a maximum amount of pain, it's your choice. Liquidity seems to rule the day in the bid/ask spread, with the more liquid instruments having narrow spreads, and some illiquid instruments (like pink sheet stocks) having up to a 10% spread. The spread can still change in liquid instruments, depending on the free market forces, fear, greed, deception, or any other emotion in nature's handbasket.

Emotions come into play when you are trying to get a trade down and don't get filled because the bid/ask spread won't allow it. Emotions can cause you to chase a market while the bid/ask spread seductively dangles a carrot in front of you. Emotions can cause you to avoid a good trade because of a perceived increase in risk when the spread is wider and you don't want to pay the cost, or assume any extra risk. I like to keep an eye on the spread, as I find that it gives many, many valuable market indicators, especially in thin markets and after-hours. However, like commission, vig, slippage, and mistakes, I accept the bid/ask spread as part of the cost of doing business.

Legacy Daily comments:

Some of the volatility seems to be created to soak up more money from the participants in the form of the spread but even with this money printing-press the houses got slammed in the past year. With their collective voice, maybe they would say that is their cost of doing business but I am yet to fully comprehend the societal impact of a bid/ask spread between a 1% deposit and a 5% loan. 

Phil McDonnell writes:

The bid/ask spread, volatility and liquidity are very much related concepts. When the spread is wide there is usually greater volatility. When volatility is greater the spreads widen. It is difficult to say which causes the other, rather it is safer to reason that they are manifestations of the same underlying phenomenon. In both cases that phenomenon may be liquidity or lack thereof.

The bid/ask spread and volatility are directly observable. But underlying liquidity is a hidden variable which cannot be directly observed. The St. Louis Fed has done some limited research looking for the underlying cause of volatility. In that work they found that consumer liquidity was highly correlated with market volatility. That offers a strong hint that liquidity, spreads and volatility may all be manifestations of the same thing.

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

George Parkanyi responds:

The spread is a market price in its own right –- the price of liquidity, and also of laying off risk. If you want to establish a full position immediately, or liquidate one, you pay the price for that convenience. If your small orders can piggyback the action of the big lines in a liquid market, then you don’t have to pay very much at all. If you’re the only guy walking up to the table, it can be pretty-much take it or leave it when things are thin. Market makers maintain a position in the security indefinitely. They can wait you out. Your interest is typically transitory, and you often want to get in quickly to act on an idea, or get out and move on to something else. You don’t have as intimate a relationship with that market. So the bid-ask is in effect a service, for which you pay a price.

I’ve stopped trading certain ETFs because they are too thin. The spread on the thinner ones was sometimes 10%, and even when I was getting a signal I couldn't always execute. This was disruptive, so now I’ve spent some additional effort weeding out thin markets where the spread is too costly, or makes me miss signals that would otherwise be profitable if I were trading a similar, more liquid security.

I’ve thought about and played with spreads a lot, and believe that with adequate capital, you can effectively simulate being a market-maker yourself by maintaining a “virtual” bid-offer. You simply put in limit orders to buy and sell at certain increments. The profitability of your “market-making” depends on how wide you make your “spread”, and how volatile the security. Too wide the spread and you might not get enough action to warrant the risk, too narrow and you may pick up a whole lot of inventory going the wrong way that you don’t want. Looking at the profitability of the specialist system, I believe you can make good money with a strategy like this in a market in which you have a reasonable grasp of the dynamics, although you won’t have the visibility of other limit orders — you’ll have to do it statistically.



 Reading the lines and everything between the lines recently, I could hardly wait for a small break. It is almost the same feeling when one is waiting for a price to hit the target but only for a split second, coming very close but not hitting it for hours and then finally hitting the mark for that split second and then taking off. When my beautiful wife said that she went to an interesting place called the Restaurant Depot where she bought a "healthy" portion of baby back ribs, I could hardly wait. Using my sister-in-law's birthday as the perfect occasion, I put the ribs in the oven to parboil (the easiest way to make these things) at 225 for 4 hours (some call this cheating). This was the waiting time. After they were almost ready, I cleared the backs with a knife, and put them on the grill for another hour of slow cooking. The southern BBQ sauce made by my American mother came next. Five or six applications of the magic sauce on the magic ribs ready to fall off the bone and I was in the zone where politics, markets, money, NKVD disappear into the noise and the background. Who would have thought that an Armenian would come to enjoy the sweet taste of that special southern BBQ baby back ribs. That was a moment to be shared and to be remembered. Enjoying the meal with the family, I thought may God continue to bless this country and all its people.



 In a recent discussion with my father, an astrophysicist, I was trying to learn about the scientific discovery process or more precisely the mind of the researcher, the thinking, and the feelings that are a part of the journey. Later a friend, also an astrophysicist, suggested this list of fallacies.

It is interesting how the mind sometimes falls prey to fallacies and at other times creates them. It is also interesting how the market (or the various participants) sometimes build stories based on one or more of these. Even the numbers that stand for themselves sometimes play these games.

As a mental exercise, I thought it might be fun to try to determine which are particularly applicable on a given day.



One of hardest things to do is nothing. To rest. It goes against everything. The urge to do something can result in disaster. Especially the urge to catch up say when price passes you by or you miss a fill.

Victor Niederhoffer writes:

In reading Deep Survival ( which one has eschewed for many reasons), one comes across the chapter on panics. The conflict between trying to achieve a goal, of food shelter and a mate, (always there) , and being lost causes great discombobulation. Great foolish activities leads to people refusing to survive when it was so close. One finds the same conflict between lost and goal in markets. For example, one has a target. You put your limit in. The algorithm boys move in front of you. The price moves away. You are lost. You have a goal. There is a tendency to panic, to die when it would have been so easy to go down the previous path, or use your tools. A terribly poignant and applicable sensation.

Chris Cooper responds:

Those lessons about paying attention are reiterated in depth in a book I recently finished, "Traffic: Why We Drive the Way We Do" . It is full of counter-intuitive evidence regarding driving and safety. Especially noted is that seemingly unsafe situations can be safe simply because people pay attention.

Dan Grossman replies:

I agree with Chris, Traffic is a great book. Both for understanding driving/road safety and for other aspects of life.

Book was the only advice in my life that changed the way I drive. For example, now realizing statistically how dangerous changing lanes is (what a high percentage of accidents are caused by it), I change lanes far less frequently.

Also makes one appreciate how less safe red light cameras (now common in NYC) are: More accidents caused by stopping short at red lights to avoid camera tickets, than by finishing scooting through.

Alan Millhone writes:

Hello Mr. Sogi. I had an old friend that told me , " if you miss one deal there is usually another around the corner somewhere ". Regards, Alan

Legacy Daily comments:

So true… I don't know which is a bigger regret: the buyer's/seller's remorse or the regret of chasing a price to get a fill then seeing the market go back to the original order level. The price frequency distribution helps (not always) against my wrong instincts so the new routine is to remember the eye exercise program in those moments. :)

1. Blink ten times by closing the eyes as if falling asleep (very slowly). This help re-wet the eyes.

2. Look away from the computer and gaze at a distant object outside or down the hallway. Looking far away relaxes the focusing muscles inside the eye to reduce fatigue.

3. Look far away at an object for 10-15 seconds, then gaze at something up close for 10-15 seconds. Then look back at the distant object repeating the cycle 10 times.

4. Take a break, stand up, move about and stretch the arms, legs, back, neck and shoulders.

Kevin Eilian writes:

Wisewellian - that which effects your move the least effects your opponents the most (courtesy of chair).



 What a difference in the complexion of the world markets from last year where at the end almost every market was down 50% with no exceptions. This year as of March month-end the world markets are down a mere 10% and there are exceptions galore, notably Israel up 15% and Russia up 31%. All over, anomalies exist. Norway up 10%. Pakistan and Taiwan up 17%. Indonesia up 10%. All over South America markets up from 10 to 30 % in Peru and Venezuela. Venezuela up 40% from 1999. Recapping the wisdom of Maturin during the French Revolution advising Sophie to buy stocks, a stridency relevant to today shortly.

George Parkanyi writes:

Many a financial network talking head these days pronounces that "buy-and-hold" is dead. Here, or somewhere around here, is the perfect time to initiate a buy-and-hold strategy. This is from where the $3 AMDs and Motorolas of the world go back to $30 or $40 in the next bull market. And what of it if it takes 10 years, not that it's likely to take that long. That's still 100% per year non-compounded. My ex-high-school teacher and stock market mentor Omar Sheriffe Vernon-el-Halawani in the last two decades of his life (he passed away in 2005) did just that for most of his portfolio — buy good companies on the incredible cheap when the opportunities arose, and just put them away. He introduced me to "Reminiscences of a Stock Operator" long long ago, and in his last few years kept admonishing "George, why bother to sell?" (Though he wasn't inflexible either — he did sell Sun Microsystems once it got to $200. A couple of his closer friends rode Nortel back down to nothing.)

Paolo Pezzutti replies:

What if in ten years from now Motorola and AMD do not exist any more because a Chinese or Taiwanese corporation has wiped out these companies in an already mature market of telecoms and semiconductors? Sort of a General Motors and auto industry fate in 2015? In the meantime we have to see if the Western countries will manage to lead the next wave of innovation. It is not a given.

Stefan Jovanovich adds:

Motorola may survive as a defense/government contractor like Studebaker did; but its days as a competitor in the mobile dial-tone device market are long over. It has a legacy business in walkie-talkies, but those devices are now commercial products for — oh, happy day! — the construction and events trades. The "next bull market" will be in businesses that do not need the help or money of the academic/finance/regulatory complex. Some pissed off genius who is dropping out of graduate school right now because he can't stand another day listening to a discussion about hockey sticks will be the guy who creates a viable alternative to the internal combustion engine. The fact that the next Henry Ford did it because his uncle died and left him enough money to allow him to pursue his dream of racing an electric motorcycle will definitely NOT make the history books. Instead, some not-so-bright but perfect resume student of "economic trend analysis" at Berkeley will write a seminal paper explaining how it was all due to the "convexity of the forces of ecological history" (assuming, of course, that CalPERS has not blown all the money and put the University of California into receivership — which may the wildest of all my surmises). On a happier note, the Cal Men won the national swimming championships this week. Go Bears!

Pitt T. Maner III writes:

"Hardened silo" companies, with strong management, that have survived through and handled multiple, steep cycles over the past decades by mothballing equipment as needed, sending seasoned hands "back to the house" when necessary, and which have high barriers to entry (and negative government support) into the particular business would appear value candidates now. High quality drilling and drilling service companies, over the longer term, are appealing at present prices unless solar, windmill, nuclear, and alternate energy supplant the need for hydrocarbons. There are many other groups and companies that probably fit this undervalued, "tough-times survivor" model that odds would favor moving forward.

Jim Sogi adds:

After such a rally, and now when more and more people and pundits are calling a bottom, and I hear news proclaiming a thaw, and I hear talk of people starting to buy, these are the type of things that put my radar up. It's funny that the news media is somewhat stultified in that despite their steady barrage of bad news, the markets are all up. They actually have to change their copy of bit as it's hard to proclaim, markets up 15% on steady barrage of bad news. Obama did make a good call to buy, the day before the low and gave everyone a chance to buy. He knew what was in the govvy cards of course. That was the time to make the big commitment, not now. There should be more chances before they proclaim the next bull market as the market tops.

Legacy Daily writes:

Given things stay roughly the same, I cannot disagree with any of these comments. The challenge right now is that nothing is given.

For people who trade via systems, I have a question.

At which point does one decide to a) modify the system (and to what degree and based on what), b) discard the system (and why), c) continue relying on the system (and for how long); if such a system is producing losing trades more recently but has worked fine for a long time (definition of time scales not relevant)?

Perhaps the answer contains clues regarding our recent government actions (and market reactions) where the scale of the system and the magnitude of its impact is great. The problem is further complicated by control over one's actions but lack of control over [negative] consequences of those actions in a human system.

The second question that does not leave me alone is whether a game of chess (or any other game) can be won if every few moves, the game rules are modified. Does the player quickly adjust and remain focused on winning the game according to the new rules ("queen can only move three squares at a time" for example) or does the focus shift on guessing what the next set of rule changes may be? After a few set of changes and corresponding adjustments, does the player begin to suspect the rule maker in taking one side or the other?



 Given the current mortgage rates and the fall of the housing market, I want to purchase my first home. Since I am stationed at Fort Hood in Texas, I have been doing heavy research in the Killeen / Harker Heights area. I thought I would ask for some advice. I spoke with Tim Melvin about this earlier, and he mentioned that I should never pay more than 10 times the annual rental rate of comparable houses. Does anyone else have any other good valuation metrics like this or have any knowledge / advice that would help me out as a first time homebuyer?

Legacy Daily replies:

I have found 10x to be used in two cases:

1. High house prices relative to rent — get one to cool off and think more clearly about an investment and do additional homework 2. Low house prices relative to rent - get one to jump in without thinking clearly on a "bargain" investment without doing any additional homework 

Some initial questions worth clarifying:

1. Is this a home or a leveraged investment? a. home — ignore rules like this and find the best place to live, raise a family, pursue happiness… b. leveraged investment — do enough homework to be confident enough about the decision to ignore all general rules.

Assuming investment:

2. What is the holding horizon? What future plans could interfere with that holding horizon? 3. What is the appreciation potential for the country, state, county, city, town, neighborhood, subdivision, this property…? I have not yet been able to come up with sufficient justification to buy for income alone when it comes to residential real estate. 4. What segment of rental market would the property (subdivision, neighborhood, town, etc.) attract? Is that the segment one wants to serve? Real estate agent needed to rent? 5. How predictable is the income stream? How would economic booms/busts affect it?
6. What are the worst case scenarios? What could go wrong?
7. Financial analysis — P&L, tax impact, financing options, downpayment flexibility (very illiquid), initial estimated repairs, etc. 8. Legal analysis — zoning issues, easements, property title issues, locality department issues, neighbor issues, etc. etc.

Couple additional points:

1. Decent real estate attorney representing one's interests can save from numerous headaches (especially true in foreclosure/short sale cases). 2. Avoiding a buyer's broker saves one money, gives additional negotiating room, makes the seller's broker more willing to work extra hard for the deal. 3. Inspections are money well spent, even if one does not end up buying the property. 4. The market is generally very efficient (yes even during this recession). Why has the property one's considering not sold yet? etc.

I hope you find this useful.

Jim Rogers writes:

The rule of thumb I've heard used is 1% of sales price should be equal to or less than comparable monthly rent (that's a little more aggressive than Tim Melvin's measure, especially when you factor in the mortgage tax shield). I'd say, use either and stick to your guns.

Sam Marx replies:

Don't trust what the real estate broker says about a house's value or price. Do your own research.

Try to find prices of recent sales of similar houses in same neighborhood.

Check with the local banks to see what houses they now own and what are their asking prices.

If you can go to foreclosure sales, do it, not to buy a house but to get an idea of what the market in houses is and remember those prices when negotiating with a broker.

I don't recommend buying at a foreclosure unless you're experienced at it.

Don't be shy about making offers 25-30% below asking price when dealing with a broker.

Watch for estate sales, the heirs are motivated sellers.

I don't know your area, maybe it's reached a bottom, but in FL, housing prices are still too high. The stock of St. Joe Land (JOE), FL's largest landowner, was 69 a few years ago — now it's 15.

Phil McDonnell advises:

 Buying a first home can be a frightening prospect. It should start with a realistic look at your needs. How many bedrooms and baths do you need now and in the future? If your life involves one or more women strongly consider the extra bath. If you have the skills a fixer upper my be of interest.

I frequently advise my Realtor wife on the statistical aspects of our local real estate market. Pricing in this market is especially tricky. It is a declining market but that also means buyers have much more negotiating leverage. To measure your local market ask a local Realtor for the latest stats on number of homes on the market and number of sales in the last few months in your area of interest. For a normal market this is about a four month supply of homes at the current monthly sales rate. In this market it is running about 10 months of inventory per home sold. Hence the declining prices as sellers compete. One should consider staying out of the market until the inventory show signs of declining. However do not be fooled by a one month decline in local inventory. Buyers in the Seattle area are negotiating prices an average of 4% below asking. Get the similar number in your area.

As a buyer in this market it is best to view the prices as a price distribution. Suppose we have ten houses in your area. But only 1 will sell in the area in the next month. Clearly it is most likely to be the one that offers the best value on a relative basis. The other nine are over priced for these market conditions. By staying on the market for another month they will probably lose something like 1% in value per month.

There is an old saying in real estate. One should buy the least expensive house in the neighborhood. Generally this is true. After numerous regressions on homes it can be said that among comparables the most important single factor is square foot of the house. For the best resale find out which area has the best schools. Even if you do not have kids the people who ultimately buy your home may have them and it will help resale in the long run.

Check out all the government mortgage deals and tax subsidies. They are offering a tax credit of up to $8,000 for first time buyers. 30 year fixed rates are below 5%. The military may offer even better deals. Remember the $8,000 credit is only paid the following year via a refund so you do not have it to use as a down payment. It is more beneficial the smaller the house you buy. I saw a recent home sold for something like $80,000 in Killeen. The $8k represents 10% on that home, but only 5% on a $160k home.

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

Henry Gifford adds:

Home prices, in general, are still falling in the US, therefore waiting will probably bring lower prices.

As property prices fluctuate, one sign of high prices is easy loans. Times when prices are better tend to be times when loans are hard to get, with of course reasons for this relationship. But, as an affiliate of the military, there are sometimes special deals available to you that are not available to other people, which means you can be one of the few buyers out there at a good time to buy. Some of these loan deals only exist on paper now, as the price limits and interest rates make them impractical, therefore nobody talks about them, but because they are government programs which get updated slowly, and usually out of sync with the market, they can be really good deals at times. Therefore there may come a time when you can get both a good price and a good loan.

Buying near a military base involves risk of base closure (I owned a whole bunch of houses near a base that closed) or downsizing, and since you're in Texas where there is lots of land, upsizing the base won't put much pressure on prices - people will simply build more houses. Perhaps you can ask around inside the gates to get a feel for this.

Buying and selling property involves large costs for brokers, taxes, title insurance, etc., which penalize short term ownership, meanwhile you can get transferred to another base at a moment's notice, which puts you in the position of being in a hurry to sell. If, instead, you buy a commercial property, you can own it as long as you live, with far less management headache, which makes owning it while living elsewhere more realistic than renting a house to someone.

Phil McDonnell responds:

I think the truth in this statement is based on a defect in the way people perceive value. Suppose the average home in a neighborhood sells for $500k but yours is worth $400k. Then if the average goes up to $600k the innumerate masses will think that all homes have gone up $100k not the 20% they really should have. When they do this the $400k home appreciates by 25% not 20%. In other words people add when they should multiply by a percent increase factor.

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

David Hillman writes:

Another part of that defect is focusing on the value of the improvements v. the value of the land.

Some years back, a close friend bought a lousy house on a great piece of property in the best neighborhood. Even though it was a prestigious address in a 'branded' area, he got a deal on the property because the house was so undesirable. The plan all along was to demo the house and built a new one to suit, which is exactly what he did. He had realized the land was worth perhaps 90% of the true total value of the property before the new construction.

Many county auditors, etc. have searchable tax records online with the assessed values of land/ improvements parsed out. One might use that to figure a reasonable estimate of market value of land v. improvements. Don't forget the old saws apply….'land, they're not making any more of it'….and….'location, location, location.'

Bill Egan writes:

In the last 10 years, I have bought three homes and sold two. Did not plan to, but that's the way it worked out due to job changes. Sold both houses in < 1 week for a profit despite forced timing. We were not in subprimeville, either, and the last sale was 2001 before the real estate madness.

My wife and I kept resale value in mind because you never know what can happen to you. We made sure we bought homes that were average to excellent on the following criteria:

  1. School quality
  2. Exterior appearance and interior layout — good and normal
  3. Quiet, safe neighborhood that looks good
  4. Reasonable size (3/2 or larger)
  5. Likely demand due to commuting routes/distance to jobs

For example, I was working at a biotech in NJ from 1999-2001. We bought a 3/2.5 in a newer development, nice neighborhood in Burlington County, right next to an average-quality elementary school. However, the area was less horridly expensive than the homes closer to Princeton, where I commuted to. There was strong demand from people priced out of the homes closer to NYC/Princeton.

Rich Bubb replies:

1.  look at the neighbors. C-L-O-S-E-L-Y… look at the state of their domiciles (even getting "invited-in" for a look see if at all possible), and the state of the upkeeping… especially the immediate next door folk. You might end up living next door to your own personal nightmare. Believe me, it is Not Enjoyable. Even after almost 20 years. Thankfully everyone else on the entire block is somewhat more sane and respectful of their neighbors than my nextdoor nightmare. Or to put it another way: you might get the best deal that no one else could stand…

2. if you really know somebody in the real estate biz (my sister is an agent), have them look around for you. she got her daughter's family a fabulous deal in a great neighborhood. Or to put it another way: sometimes real professionals Do Know what they're doing.

3. look long at the deal, bid low for the deal (Game Theory might help a little here, here is a cool intro), then be prepared to walk away… even if not doing the deal means you'll have to go back and start the whole search-etc process all over again, and don't put pressure on yourself or let anyone pressure you into buying. My wife was not prepared to walk away from her last car purchase. She still got a good vehicle, but she could've strengthened her bargaining position by uttering the words, "Let me think about it." And then purposefully heading for the door. We went outside and argued between ourselves about leaving. She *wanted the vehicle*. It cost her almost $5k more than I wanted her to pay.

4. Consider the cost of long term ownership. I mean, Really figure it out… what's the cost of x, and y, and z, and can you afford it if those costs all hit at once.

5. Tangentially to #1 above, if there'll be kids living next door… would you:

(a) invite them in?, or

(b) chase them away?, or

(c) start scouting for really out-of-the-way burial sites?, or

(d) let them borrow your most deadly power tools?

Just mentioning this as my siblings and I were the 'b-c-d' and almost always the Never-more-than-once 'a'. And the neighborhood's less-than-model parents would often let their barbarians-in-training train at our place… Or to put it another way: your neighbors' kids might have fiends, er friends, worse than they already are…

Hmmm, karma might really exist…

Russ Herrold adds:

A anonymous blogger, 'Benjamin.Publicus' on Thomas Paine's blog  had this this observation:

… The author lives in a community that is (or was) at the epicenter of the mortgage crisis. The developer aggressively marketed the homes to young, first time home buyers, many of whom renters. No money down, own instead of rent, mortgage payments the same as the rent, etc, etc. The development was started in 2001, so the first wave of 5 year ARM's hit in 2006.

…and it goes on from there.

I have spoken to that author (and a couple others) about contributing to DailySpec, but he has been busy.

Dr. Herrold is Principal of Owl River Company, a high-end Unix consultancy

Rich Bubb adds:

As mentioned previously, my sister is a real estate agent. following are her comments on home shopping & buying.

Get a Real Estate Agent to represent YOU as a BUYER. Sign a contract as such. Tell them what YOU want.

There are surely things important to you that you would like to have in one of the biggest investment decisions you will make.

TAKE NOTES of likes/dis-likes of each home you view. re: Basement, Garage, Four Bedroom, Square Footage, LOCATION. I stress location because it can make or break the satifaction of your purchase.

Drive through the neighborhoods you are considering at different times of the day to see what the atmosphere is.Pay attention to the neighbors up keeping of their property. Schools?, established neighborhood?, new additions? child / adult ratio?
Comparison shop, don't just jump at the first home you look at just because you can afford it. Ask your agent to provide you with a CMA (a market analisis of a surrounding area - 5 mile radius ).

Get pre-approval from your lender, look at homes a bit higher than your range and offer LESS - the worst that can happen is, they will say NO or counter-offer and you may wind up with a nicer quality home.

BE Strong in making the decisions of your offers. Be prepared to give and take.

Then BE PATIENT thru the purchase process which seems like it takes forever because we are a see it, buy it, want it now, kind of people. It is a process that is in place to protect you. re: CLEAR TITLE

Again, don't just settle for a home, get as close to what you want as possible.



Is there a form for the typical market? Does it have a shape, a proper way of conducting itself? Is the form for a week regular enough to defy randomness or better yet to be predictive in any way? Is there a form corresponding to the a b a form of music in markets? How does rhythm and volume of sound enter into the picture? Those are the questions I'm pondering this after reading a great book on the walking bass by Jon Burr.

Thomas Miller writes:

I have always believed the markets are similar to musical pieces. A rhythmic sideways market lulls many into relaxed state only to burst higher or lower in mighty sudden crescendos, and a rallying or declining market moves in musical waves with mini crescendos noting momentary tops or bottoms. I wonder how many successful traders have musical backgrounds? Music and mathematics are universal languages and convey the messages of markets. I regret not having more formal training in either.

Newton Linchen replies:

I always thought "Metamorphosis IV" by Philip Glass to be the perfect "market music", not only by its crescendos and decrescendos, but by its impression of regularity (Philip Glass is known as the father of "repetitive music"). Nevertheless, its changes in tempo and volume (strength) gives a rhythm almost fluid. And there's a part of "explosion" (volatility) where the fast-pace is in order — without loss in harmony or structure. I always thought of moments of "trading range" of market going aimlessly followed by a explosion in price upwards or downwards. And it's kind of sad melody remembers us of the majority who only find losses in the markets.

James Lackey comments:

Yeah it's been brutal awful market music. Reminds me of all the VIP mumbo parades, changes of command formations, and dress blue parties I was forced to attend in the Army.

0300 with the Dax open its reveille. Then we all form up into one huge cluster in the parade grounds stand for an hour then "the stars and stripes forever" plays with a government official on the mic saying how far we have come our history and how they are committed to Change "us" with too many last hour's "retreat."

Then with so many brutal last hours "to the colors" reminds me of Flag detail after the close then the discussions with old Colonels passed over, that didn't want to go home to family asking "the kids" new soldiers over a 5pm coffee what we wanted to do with our lives "when I was your age and if I could do it all over" then every few nights after Chow we get "Washington post march" the tune used most in movies to sound off patriotism and how if we all work together, after the next bailout everything will be back to the normal American way… Then back at 7pm "Auld Lang song" to the Nikkei open.

I have noticed over the years my music tastes intra day trading go with the market flows, Baroque, Jazz, Fusion, and when the market is rockin', new alternative rock.

I am in a bad way when all music sounds awful, like Army band music. I would rather listen to the hum of the ceiling fan and as of late the birds singing to the open windows..and to my surprise, spring has sprung and a lawnmower engine sounds more inviting than the music of the markets. ha.

The U.S. Army Band Ceremonial Music Guide

Legacy Daily responds:

 When the Soviet Union collapsed, I witnessed the creation of foreign exchange markets and also of stock and other types of markets in Armenia. These images are very vivid in my mind. When I read about people trading on Wall Street (I mean before the exchange building was even a consideration), I can see how that trade took place, because I participated in similar trades in a few of the streets of Yerevan (different places of gathering for different markets). That experience always overrules the charts, the derived statistics, the counts, and all the jargon that I hear daily.

Does the market have a form, a proper way of conducting itself? This question brings up the picture of the crowd dealing in foreign exchange (with the usual guys leaning against their usual trees) against the typical crowd dealing in real estate or stocks or stamps or coins. Of course each market has its form, its unique characteristics, its shape, its place, its rules. Each market has its rhythm, its language. I have not had the opportunity (and never really wanted) to participate in the floor trade at the NYSE or in the outcry system. But having seen the seedlings in their early stages of germination, I only see supply and demand and the various factors that affect these.

In this digital age, it is easy for one to go long bonds and short stocks or long XOM short CVX without ever realizing that the market for every single security represents a unique gathering of those who run the market and those come to the market. If I had to put this picture into something related to music, I'd imagine a choir of professional singers that sing a particular song we recognize. At some point, we join in singing in our heads and then at one point begin to sing out loud thereby changing the overall experience of everyone around us until we move on to the next choir singing a different song. Could one be successful in singing with multiple choirs all at the same time? Can we really understand the market for the SDS and SPY which are derived from hundreds of unique markets with their tunes in addition to their own market creating noise at the same time? What about the noise from the "gold" room affecting the singing going on in the "dollar" room or the other way around?

When it comes to commodity markets, I remember the fruit and vegetable market where some of the sellers would sell what they had grown and the others would sell what they had bought from those who couldn't or didn't want to travel to the market. Does that have a music? If you have ever been in a similar market, you'd recognize the buzz, the "singing" of the man selling his delicious watermelon, and the aroma coming from the area where peaches are sold.

The big question - is all this random or is it predictable? There is nothing random to it, yet it is completely unpredictable. The market makers operate in a very normal expected way, yet those who come to the market act in ways I cannot anticipate or predict. The only elements visible are my own instincts, wishes and desires which happen to approximate those of the people who go to the market very well. Imagine you have a phone to your ear that is connected to a line on a speakerphone where hundreds of people are talking at the same time. What do you hear? Noise! Can you find patterns and conversations in the noise, in some cases yes. Are the conversations and patterns going to repeat? In some cases, absolutely ("How are you today?" is typically followed by "I'm well thank you." or some variation of that) I'd like to be convinced that they could be consistently reliable but then again if that was feasible someone would have already found a way and would have proudly advertised that "past performance does not guarantee future results" does not apply to them.

Jim Sogi writes:

One constant regularity of form in music is the return to the root or home base. I think the market tends to have a root or home for each of its pieces. Recent root seems to be 800. Prior jump on Fed had to return Treasury plan to resolve. 800 was a big theme earlier in the year as well. Now we are in the contrapuntal mode, as Bach would play it doing it from the reverse. In a larger sense, it all satisfies the craving for symmetry and resolution.

Often the craving is frustrated creating a tension. Music is all about emotions on different levels, as is the market. Musical gaps are one of the greatest sources of tension. We still have this Monday gap right below created by maestro Timmy G and the trillion dollar blues. Too much tension and disruption of rhythm to make good music.



 Here's an investment theory. Rather than buy when the expectation is greatest, buy when the risk is the least. The question is whether or not they are the same times. I define risk as the lowest probability of account drawdown from entry, rather than common definitions of volatility. A corollary of this is that buying at what appears to the public as the greatest risk is actually the time of least risk. A recent discussion here looked at expectation of range vs expectation of change. The theory of the least risk would be to buy at the expected maximum extension of range, at the time of greatest expectation. The other issue is the holding period and expectation of gain. Some argue that the maximum expectation period over time will reap the highest returns. The problem is that the deviation goes up as fast if not faster, increasing risk. The second problem is the issue of changing cycles and prior history may not match future performance. Dr. Phil has pointed out that profit stops reduce deviation but not necessarily rate of return. Yet account deviation is the bottom line. He has proposed formulas to optimize risk/loss vs return. But realtime trading demands some sort of realtime system. This is hard to implement. The underlying idea is that management of risk is more important than maximizing return. This has been the basic systemic flaw in the recent boom and bust. The idea is distinct from the idea of leverage as risk. The answer will differ from individuals to institutions and funds with differing goals.

Martin Lindkvist comments:

Try creeping commitment, that is, start with a small line and increase if market goes in one's favour. But this has a built in assumption of some kind of trending behavior of prices, which might or might not be true depending on other circumstances.

A twist to the creeping commitment of a single position is to start out a period (year, or other of your choice) and increase risk taking after profits have been made, and decrease if losses are incurred to the capital at beginning of time period; that is play harder with "market money". I believe that both this method and the first one might have some psychological benefits if nothing else.

Risk in the usual deviation sense has sometimes been disguised, through e.g asymmetrical strategies ("picking up nickels in front of a bulldozer") where the risk might seem far away only come back hard when least expected. Moral - one should always be suspect when one thinks one have found a good way of managing risk - "what am I missing". Liquidity issues comes to mind too.

Using leverage as the risk manager, still seems to me the most clean way to manage risk. Cutting off risk with stops or options also is a way but run of the mill costs for these should be higher over time. That doesn't matter though if you meet black swan on day one….

Phil McDonnell writes:

A knotty part of this question is to define risk. To academics it is probably something like standard deviation of returns. To traders it may be only the losing trades, in other words only the downside deviations need to be considered. Another metric might be draw down or maximum loss.

The risk measure one chooses makes a big difference. For example suppose we look at the standard deviation of the market after it has been rising for a while. Assume our criteria of rising is that the market is above its 200 day moving average. We would find that the risk measured by the standard deviation is less for all such periods than it would be for those periods which are below the 200d moving average.

When markets approach major bottoms they are often quite volatile. Currently we often have daily moves of 3 to 5%. If one were to study the subsequent behavior the probability of large down moves the next day are quite high as are the chances of large up moves at such times. This is true even though one can often argue that after such large declines the market is close to good value levels and has not much more to fall.

Note that one can get two different answers to the question depending on time frame. At a low area such as now, the long term risk outlook might be that it cannot go much lower. But because of volatility the short term outlook is for continued riskiness.

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

Legacy Daily replies:

As for this statement, "Rather than buy when the expectation is greatest, buy when the risk is the least," the risk of not being in the market is the least (assuming cash is constant). Perhaps you mean "buy the highest expected return for the lowest risk." Theoretically, "maximize return but minimize risk" may be suitable for a linear programming model where one would need to define the various constraints and let the machine solve for the best alternative to maximize return given the constraints. The challenge: the right definition of the constraints. Also, the optimal solution may change tick by tick.

And as for this statement, "a corollary of this is that buying at what appears to the public as the greatest risk is actually the time of least risk," I think many market participants buy and hold. Therefore, the main reason a market appears a great risk to them is because their money disappears. The more money disappears, the greater the fear (hence perception of risk). It also seems that these "emotions" are only visible during intermediate-term/long-term market turning points which may not be suitable for a day trader.Furthermore, "time in the market" and "percent invested" are also ways to increase/decrease risk when account balance rather than security price volatility is the key criteria. Account balance is an extremely useful risk manager. AUM does not have the same effect.I cannot remember where but I came across the concept of a very successful trader at one point or another getting completely wiped out and some being so good that they could build a fortune multiple times and get wiped out more than once in a lifetime. If true, is that possibly a manifestation of "buy when the expectation is greatest" with not enough focus on "when the risk is the least?"



 These days all one hears is hundreds of billions here, trillions of dollars there. It almost seems like the B and T keys must be getting worn out. At the very least any politician who doesn't think in terms of billions is clearly not a visionary. Since we do counting here perhaps a little back of the envelope counting is in order. Suppose the government were to guarantee every sub prime mortgage out there. What would happen and how much would it cost? Clearly every sub prime mortgage would dramatically rise in value perhaps even higher than the value when they were issued. Their value on the bank balance sheets would rise dramatically. In many cases 3 fold to as much as 10 fold. Suddenly the banks would be wonderfully solid and flush with money. This massive infusion of capital into all the banks would come without a dime of Federal capital injection.

Just because the government guarantees a loan does not mean that the homeowners would or could keep making all his payments. Some will certainly default. Suppose also that the Government took over all such homes and kept them off the market for the duration of the current unpleasantness. Real estate would turn around much faster without the burden of more new homes being sold in foreclosure. Foreclosures would actually decline because a rising real estate market would give homeowners more skin in the game. But what would the cost be? There are 109 million full time homes in the US with $8T in mortgage outstanding. Supposing that the average mortgage is about 6% then the average payment is about 0.5% per month. This amounts to $40B per month. But in the 4th quarter Bloomberg reports that 0.83% of all mortgages defaulted. So the government would only have to $332M in new monthly payments every quarter. It is somewhat embarrassing to write a number as small as millions these days. Millions are so Twentieth Century! But the reality is we could save real estate, the mortgage market and banks by just making relatively small payments over the next few months.

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

Stefan Jovanovich comments:

Our Dr. Phil's definition of "the banks" is interesting. It includes (1) the borrowers and implicitly (2) the counter-parties to Citi and the other Tennessee Williams banks' outstanding swaps, asset-backed paper and other promises and (3) the bond-holders for these wonders of financial construction. The one group that has been left out of the discussion so far have been those terrible villains of the present economy - the people who insist on saving instead of borrowing and spending money - aka (4) the depositors.

The FDIC has made a belated move to acknowledge that their reserve fund and the contributions of the healthy country banks will not be enough to save the money center bank depositors. As recently as November they were still pretending that everything was OK; now they are realizing they better get in line at the Treasury window if they expect to be able to avoid a bank run. The current increased guarantees for the people who put money into the banks expire at year end. The Treasury barely has enough credit left to make good on its indirect promise to the depositors. If, as Dr. Phil suggests, the "banks" and their mortgagees are going to be allowed to have priority, everyone who can will swap their checking account balances for T-bills and cash. (No doubt Paul Krugman will then decide that it is declining velocity that is the problem.) Having already seen the rerun of 1930, we will see 1933 all over again.

The "crisis" is one that businesses face every day but that most academics literally have trouble understanding (it must be that they can endlessly recycle those same old lecture notes) - namely, the market had changed and a lot of inventory has gone bad. You can changing the price tags on the shelf all you want; no one is going to buy them for cash.

George Parkanyi writes:

I agree with Dr. McDonnell. Western governments should guarantee MOST of the paper (not the worst of the pure sub-prime stuff that's basically uncollectable - something needs to be written down) - at maturity, and not buy it outright now. In fact I would make the interest tax-free in the US, and get the Europeans to do the same in Europe. Make them government muni-bond equivalents.

I would even re-securitize them (make them collateral) for essentially new standardized government Treasury mortgage and asset-backed securities - that would then be traded openly on exchanges - with associated derivates like futures and options created (think the T-Bond or T-Note markets) so the owners can risk-manage them. Banks and financials could then move them off their books over to investors, who would have collateralized government securities - ironically now more safe than unsecured Treasuries.

For all the billions being thrown at the problem, surely a billion or two out of that could buy a lot of accounting and book-keeping horse-power to document, track, and value the "collateral" - the income streams from the mortgage and loan payments, and the value of any re-possessed assets. Create a single clearing house for all these securities that come into the program, managed with a war-time urgency as a matter of national security. The current income, and recoveries from property sales, would fund the first waves of re-payments as they come due. This would serve to defer the un-secured at-risk portion of the total package well out into the future, buying time to resolve all this leverage in a more orderly fashion.

Then move toward solving the structural problems. Still allow financial engineering, securitized products and derivatives, but never again unregulated, off-exchange, or off-balance sheet.

Legacy Daily replies:

I just cannot figure out how the numbers work.

According to this, mortgage debt outstanding is about 15T.

Based on this article around 11% are delinquent.

If government guarantees 1.65T, at 6% average that's 8B per month? Ignoring moral hazard (since already ignored anyway), we still have the issue of 11% increasing as a result of unemployment.

Giving a government ability to hold real estate at a large scale is only a leap or two away from certain factions pushing to "increase" the living standards of the proletariat (similar to what created the sub-prime fiasco in the first place) at the expense of others. With all its issues, the current system of private real estate ownership is a key factor in protecting freedoms. I am sorry but I see many negative "unintended consequences" in the proposals mentioned.



 This paper makes one think of the effect of actually having money in the trade, vs just sitting analyzing data on a Sunday. And the real question is still, how to be free of it? Or control for it?

"The tree of experience in the forest of information: Overweighing experienced relative to observed information." Uri Simonsohn, Niklas Karlsson, George Loewenstein, Dan Ariely


Standard economic models assume that the weight given to information from different sources depends exclusively on its diagnosticity. In this paper we study whether the same piece of information is weighted more heavily simply because it arose from direct experience rather than from observation. We investigate this possibility by conducting repeated game experiments in which groups of players are randomly rematched on every round and receive feedback about the actions and outcomes of all players. We find that participants’ actions are influenced more strongly by the behavior of players they directly interact with than by those they only observe.

[ … ]

One important distinction, when it comes to the process leading to acquisition of information, is whether the information was obtained through personal experience—i.e., in a process that had or could have had direct consequences for oneself—or only by observing the experience of others. We refer to the former as “experienced information” and the latter as "observed information."

Legacy Daily adds:

In Battle for Investment Survival Loeb says: "Knowledge born from actual experience is the answer to why one profits; lack of it is the reason one loses. Knowledge means information and the ability to interpret it marketwise. But, in addition, making money in the market demands a lot of "genius" or "flair." No amount of study or practice can make one successful in the handling of capital if one really is not cut out for it." I think that the education of one's own $1000 put to work in the market cannot be substituted by reading, theoretical analysis, or observation. My questions are: "Do you feel that making money in the market is a natural gift or a learned skill? To which one or two key factors would you attribute your success?"



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.




 Much of the creation of money over the last 15 years was induced by low Japanese interest rates on the order of 1% per annum. However since March of 2008 the Japanese money stock (M1) has fallen year over year in every single month.

In the US, part of the problem is the inherent contraction in money supply caused by people repaying their loans. When a loan is repaid money disappears from circulation.

There is another more insidious problem in the economy these days. It is really a form of fear. Everyone is afraid to make a decision, to invest, to spend or otherwise do something with their money. Thus the money that does exist has largely frozen up. This is best measured by the velocity of money also called the money multiplier. We recall that the multiplier is not an observable number but is simply given by the formula:

G = V * M or V = G / M

where G is the Gross Domestic Product, V the velocity and M is the Money Supply, in this case M1. The latest data shows that velocity has fallen from about 1.6 a year ago to .88 in the most recent numbers. A number below 1 means that the average dollar of M1 is turning over less than 1 time per year. A chart can be viewed at the St. Louis Fed site.

To compensate the Fed is aggressively easing M1, the monetary measure they can influence directly. In just a few months they increased M1 from 1.4 trillion to 1.6 trillion, an increase of $200 billion.

Part of the question of how we got here can be seen in the history of M1. On April 3, 2006 M1 peaked at $1402.5B. For the most part this peak was not exceeded and as late as Sept. 1, 2008 M1 was still at $1391.9B. That means there was essentially no growth in M1 for 17 months!

2006-04-03 1402.5
2008-09-01 1391.9 No growth for 17 months

Somebody at the Fed must have awakened from his snooze and noticed that TARP, TAF and alphabet soup was not quite working. So he started aggressively adding more than a trillion in garbage (the polite term) to the Fed balance sheet. This had the happy result of pushing more than a trillion in cash into the economy. So M1 money supply grew from 1391.9 in September to 1638.1 on Jan. 5th, 2009. The $1T bought us an increase of $200B or about 20 cents on the dollar. Don't ask where the other $800B went. After all they are still trying to figure out where the TARP money went.

2009-01-05 1638.1
2009-01-26 1548.2 -5.5% decline in January

More ominously during January M1 began to tank again. It was down 5.5% in January.

Looking at the broader measure of MZM, money supply with zero maturity we see that it has grown from about $8 T to about $9.3 T during the last year.

Thus M1 represents about 16% of the broader MZM metric. The current unpleasantness began with the decline in real estate and will not end until the real estate market stabilizes. There is more to be done.

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

Bud Conrad replies:

Bud CThe topic is one of great importance as to whether we return to inflation from the deflation we are experiencing, and when if it happens.

One of the problems in our fiat money system is that we have lost the definition of money. It used to be what we could turn into gold. M1 was distorted by the money market funds that replaced much of demand deposits at banks so under reported what was available for transactions. M2 included small savings. M3 had large savings. The Fed stopped reporting M3 which also included some strange measure of Eurodollar accounts and repos that they said they didn't want to spend the money to collect.

MZM seems the most sensible for the measure of money as it is accounts where money can be immediately used to buy things (Money of Zero Maturity).

When the M1 Money supply (Currency plus demand deposits including Reserves at the Fed) changes dramatically higher as it did from September because banks now have gargantuan ($700B) of excess reserves, which is higher than ever before even as a measure of GDP), it is logical to expect Velocity to decrease just from the increase in money supply. GDP is much less fast to respond, but was declining adding to the slowing of velocity. All we have done is let the banks hold a big bunch of money on deposit at the Fed, where they got the deposit invented out of thin air. The low velocity is not a reflection of consumer and business behavior, as much as it is a measure of money expansion. GDP movement was relatively, in % term small. The velocity concept is not wrong, it just shouldn't be a reflection of consumers, but a reaction of Central bank money creation that is stuck at the banks not yet flowing loans to the economy.

The measure to watch should be the Excess Reserves, which is declining some. As to whether this Fed buying assets is inflationary is crucial, and it is the lack of bank lending that eviscerates the Fed, as it is just pushing on a string. My own expectation is that foreigners may come back with their dollars accumulated form our trade deficits to buy real assets instead of financial assets to cause inflation. Such action would also increase Money supply measure sand be inflationary. But foreigners are reluctant to tell us that is what they are doing so we will only know after the fact. We would also see that action in the velocity measure.

Dr. Conrad is chief economist for Casey Research and teaches graduate courses at Golden Gate University.

Stefan Jovanovich comments:

These speculations assume that money is still somehow a "supply". Not now. It has become only a residual - the amount of stuff available to buy things and pay debts, including what can be instantly converted to legal tender. It is what is actually left over after businesses make or lose money, people borrow or save, governments borrow more than they spend. In an age of Bill Rafter and George Zachar and all the other smart people and smartly-programmed computers, central banks no longer enjoy the privileges of seignorage, nor can they conjure up "new" loans by using a magic wand to create reserves. Neither can the Congress and the Treasury "create" jobs using the magic wand of the multiplier. That is why Timmy looks so utterly helpless and Ben so tired. If you are looking for a physical metaphor for the monetary present, try water out here in the West. No one has yet to figured out how to make it rain; and when the ground supplies are depleted or the reservoirs not built and filled, you have a drought. Evaporation is not the source of your scarcity; it is simply the constant. Desalination, like "stimulation" (truly the appropriate metaphor for academic economics in the age of porn), offers the illusion of an answer but only if you ignore the fact that creating fresh from salt water is 2-3 times the cost of simply buying it from the people who have some to spare.

Bud Conrad responds:

Bud CI agree that there is no good definition of money, but the Fed can contribute to expanding the measures that are almost always included in the narrow measures of money, and then also therefore in the bigger measures. It seen best in conjunction with the real source of new credit (money), the deficit of the Federal government. The Treasury prints up new Treasuries. The Fed (usually through middle parties but leave them out for simplicity) creates a new demand deposit at the Federal Reserve Bank in the name of the Treasury out of thin air, in payment for the Treasuries. The Fed's books are balanced with more Treasuries as an asset, and a deposit as a liability that the Treasury can write checks on to buy bombers or pay Social Security. When the Social Security recipient deposits their check in their bank, the deposits of the whole banking system are increased. The usual narrow money measure is M1 that is basically currency plus demand deposits (checking accounts).

To be clear, If a foreigner with dollars from a trade surplus (our buying their products like computers) bought the Treasury, that would not add to the traditional money measures. That would then be considered that the Treasury borrowed the money for the deficit, rather than have it Monetized by the Fed. The distinction is probably over emphasized in money and banking texts, but the reason I bring it up is to be clear that the Fed can create what is generally called money.

You then need to know that the most of the money (demand deposits) is not created by the Fed. It is created by the banks making loans. The banks must set aside a little as a reserve against any new deposit but can loan out the rest. The borrower buys something like a house or car, the seller then deposits the proceeds, and that new deposit minus the reserve requirement can be loaned out again. In that fashion, banks make something like 6 times more money than the Fed does in total. The problem now of the Fed "printing" (= creating demand deposits out of thin air), doesn't work (have much effect), when banks don't lend. The Fed addition is not very big if the loans aren't made. That is called "pushing on a string", as we have now. And that is why we have deflation in the face of the most extreme Fed expansion and the Treasury $2 trillion deficit this year.

Dr. Conrad is chief economist for Casey Research and teaches graduate courses at Golden Gate University.

Legacy Daily comments:

It seems to me that a rosy outlook is in order. When the government and key "experts" say the worst is yet to come, I (and everyone else with me) fear to take on additional loans not knowing if 1) we can pay back 2) we'll make money from the loan. While the Fed/Treasury can create reserves (and pressure the bankers to state how much they're lending), unless there's increasing demand for loans, money will not be created to the degree it was created when every American thought they could buy a house and sell in a year with at least 20% profit.

Unfortunately, this type of shift in outlook will probably roughly coincide with the proverbial "capitulation" when I (and everyone else with me) can no longer imagine the situation getting worse. Until greed comes into the picture, money will not be multiplied to the degree it was multiplied in the past bubbles. The problem is that when greed becomes the key driver, we'll have incredible amounts of reserves - causing "sales" of money and the officials will be late to throttle back the system to prevent inflationary bubbles.

The "assets" are "toxic" because the outlook of getting the promised cash flows is negative. When that outlook changes (the poor guy who borrowed more than he should have sees the possibility of his house appreciating), the "toxic" will actually become like gold that never tarnishes.

What is the flaw in my logic?


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