Letters Prize

Daily Speculations is a benevolent forum to encourage good thinking about the market. Material is provided free by us and our readers. Because incentives work, and to augment the mutual benefits of participating in the forum, we offer awards each month for top contributions. Our most recent winners are Stefan Jovanovich, Nigel Davies, Tom Ryan, Jack Tierney, and Kim Zussman (for two posts), who will each be getting $500 in the mail. Brett Steenbarger, who also won a prize for his post "Second Handers" has kindly donated it to another contender in honor of his son and futures spec., Macrae Steenbarger. All the winning posts can be found below:

More on the Signs of Subprime, from Stefan Jonanovich

March 27, 2007 | 1 Comment

 My partner and I recently listed the names of every entrepreneur we had worked with in three decades of doing business in California and then tried to decide whether or not any had provided income documentation for a business, auto, or home loan with "stated income" that varied significantly from what we knew their actual income was. The answer was that less than a quarter of our law clients and business associates had been "completely honest" when it came to filling out lenders' paperwork. That may be a damning commentary on our choice of associates, but there is an alternate explanation.

Credit scoring and credit documentation, at least as we have directly experienced it here in California, is based on the assumption that people work for government, the educational-industrial complex (by far the State's largest employer group), or a large corporation. Failures such as losing a job, having a business go under, or surrendering assets in a divorce can be excused, but only if one has reformed, i.e., worked for at least five years as a W-2 employee for a bureaucracy or company that cannot possibly go out of business. Having substantial assets but no current income, the common fate of entrepreneurs, is not seen not as the natural result of making one's living from deals. On the contrary, it is taken as a clear sign of having a questionable character.

People who work for themselves repeatedly go through these inquisitions. Being nothing if not resourceful, they soon learn how to "pass" as upstanding citizens. They form corporations that can "verify" their own personal incomes as employees. They learn how to provide copies of tax returns that "restated" their income appropriately. We do not know but strongly suspect that the decision of the Sandlers and CFC and WM (each of which we bought last week) to offer "no income verification" loans in California was a sensible response to the fact that income verification had become a bigger genre of show business than either CSI spinoffs or reality shows.

It has been a number of years since we have been involved with a start-up, and the entrepreneurs on our list and we are now all respectably successful. A few people we know have done time - one for drug dealing, another for securities fraud, but none has defaulted on their mortgages. We know nothing about the credit market other than the little we have gleaned from George Zachar's considerable wisdom. But the recent "discovery" of dishonesty on the part of sub-prime borrowers and their mortgage brokers seems to have at least some echoes of Claude Raines' expression of "shock" at discovering that there was gambling going on at Rick's.

Principle of Proportion, from Nigel Davies

March 18, 2007 | 2 Comments

 In explaining the theory of Steinitz, Lasker tells us that the strength of an attack must be in proportion to the amount of advantage held at a particular time. A player can be 'right' about who holds the advantage in a chess position, but they will lose anyway if they gauge the extent of their advantage poorly.

How should someone gauge his or her advantage? Lev Alburt proposed the idea that advantages could be stated in terms of expected results between equal opponents, and thus a 55% position would mean that White should slightly outscore his opponent (e.g., 5.5 points from 10 games). But if someone thinks his advantage is much bigger (e.g., 85%) he'll probably lose to someone who is essentially 'wrong' on the judgment but who is closer to the correct proportion (e.g., 50% or 45%). The point is that a large overestimation will lead to someone over committing to the attack and paying too little regard for the weak underbelly of his position.

The applicability to trading is very clear, but usually these issues seem to be dealt with as just a binary signal (e.g., 'bullish', 'bearish', 'entry,' or 'exit') and with money management being approached as a separate issue, again with rather artificial discrete inputs (what is the maximum adverse excursion, what can I risk, where's my entry/exit, etc.).

It strikes me that a more proportional approach is much better, e.g., committing or reducing forces according to the amount of advantage. But how should one model such an approach and test it statistically? The problem would seem to be that highly variable commitment dramatically increases the complexity of any test.

Tom Ryan on Pythagorean Scales & Markets

I find this Pythagorean scale discussion fascinating and have thought about various applications of musical scales and notes to market prices often over the years. Pythagoras believed the universe was an immense monochord and many of the Pythagorean teachings at Crotona are remarkable insights, especially with respect to what we now call string theory.

Pythagoras believed that by studying music mathematically, one could develop an understanding of structures in nature. One of the more interesting aspects that I have found in this is the lambdoma table, which is a 16×16 dimensional matrix of ratios starting with 1/1 and ending with 16/16,

1/1 1/2 1/3 1/4 1/5 1/6 1/7…….1/16
2/1 2/2 2/3 2/4 2/5 2/6 2/7…….2/16
3/1 3/2 ………..
16/1 16/2 16/3……………….16/16

The lambdoma is composed of two series. The first represents the divisions of a string which represent frequencies or tones. The second level represents harmonics. For example the first 16 harmonics of C are 256 hz (C), 512 hz (C), 768 hz(G) 1024 hz(C) 1280 (E) 1536 (G) 1792(B-) 2048(C) 2304(D) 2560(E) 2816(F#) 3072(G) 3328(A-) 3584(Bb-) 3840(B) and finally 4096 hz (C again since 4096/256 =16/1). This series represents the overtones or partial and whole harmonics of C and are represented by ratios in the table

Through the ratios one can study other types of natural structures as well. Botanists in particular have studied geometrical structure and many plant structures (leaves, flowers) have been noted to be geometrically developed in consistent ways where the key geometric ratios fall into a contiguous grouping or overtones of a fundamental, i.e. a pattern of squares within the lambdoma matrix. Leaves for instance often have simultaneous ratios of thirds (5:4) and fifths (3:2). The Renaissance studies including Da Vinci's notebooks note that the human body develops along particular lines as well, namely an abundance of major sixths (3:5) and minor sixths (5:8).

These whole number ratios or pattern of harmonics, as Laurel noted, form the basis for musical scales,

Octave 1:2
Fifth  2:3
Fourth  3:4
Major sixth     3:5
Major third     4:5
Minor sixth     5:8
Minor seventh   5:9
Major second    8:9
Major seventh   8:15
Minor second    15:16
Tritone 32:45

The question is whether specific harmonic patterns occur at times in the market and whether these can be quantified in some way. Victor discusses market prices as music in his book EdSpec.

One way would be to classify movements as ratios, and see the patterns of ratios as they unfold, classifying movements in price as patterns on a scale or within the lambdoma. From that one might be able to find a few meager predictable patterns. But there is a problem with this: to calculate ratios in a contiguous strip of real time prices one must arbitrarily choose reference points in order to calculate the ratios.

This means that there is a substantial level of subjectivity in developing the ratios from which the patterns can be studied. But one could arbitrarily divide the day into segments and look at ranges or deltas within those segments (say 30 minutes) and then calculate ratios of adjacent periods. There are probably an infinite variety of ways to segment and calculate ratios and therein lies the dilemma.

Some Insights into the Water and Coal Industries, by the President of the Old Speculator’s Club

January 31, 2007 | Leave a Comment

A Note from the President:

The Chair proposes that I stick my neck out. I'm accepting only because the august company that comprises the List prevents many of us from letting it "all hang out." That's unfortunate since I believe the List has members whose forecasts might prove very insightful. However, I'm not one of them. In fact, I've been so wrong so often that one of my forecasts, if viewed as the babblings of a hoodoo, might provide a fortune to those who fade my conjectures. With that in mind, I offer an early apology for any prediction that may prove accurate.

First, in a recent post I revealed that I was over weighted in natural resources. This is an affliction that dates back many years and must be accepted with the same understanding one extends to his fellows for their inexplicable preference for blondes or redheads. So with one exception, which I'll get to a little later, we'll skip that category.

My favorite "chemical" is extremely abundant, slightly acidic, and is as essential as oxygen. It is water. I don't like it for just next year, but for the next thirty. Investor owned water stocks are few in number. Herewith are nine: AWR, WTR, CWT, CWCO, SBS, MSEX, SWWC, SZE, and UU. From here, it's a game of pick-and-choose; however, over the past year, three foreign companies (SBS, SZE, UU) have cumulatively crushed their American counterparts. However, until last year, American water companies carried the highest valuations as measured by P/E or P/B. Although the group gets little mention, American water utility stocks have outperformed other asset classes for the past 12 years. (Actually, it's been longer, but I can't find my reference.)

As most are aware, only a small percentage of the earth's water is drinkable (potable). And unlike other commodities, there is no substitute, nor is it likely more will be discovered. I have followed the desalination industry since 1974, and though much has been promised, little has been delivered (although CWCO seems to be doing very well). I believe more successes will eventually be achieved, but timing is iffy. (There's a lesson here for those who believe our energy problems will be solved shortly.)

Water infrastructure worldwide is pathetic. And it will take hundreds of billions (probably trillions) of dollars to set it right. Those who provide pipes, pumps, membranes, meters, etc. can benefit substantially. Because water is so essential to those who pump, process, and/or sell, it would seem inevitably profitable, although not necessarily. A number of years ago, I invested in one of the foreign companies listed above. They specialized in taking over municipal water works and rebuilding the systems. As required, they went in and began repairs to the system, improved efficiency, and cut down on costs (partially by eliminating public employees).

However, their investments were substantial and as agreed in the initial contracts, they sought to recover their expenses through increased charges. Every city and hamlet in this nation has a Utility Watchdog Group - their main job is to bitch about every utility increase ever put forward, regardless of its legitimacy. But, with water, the problem is especially acute. We can drive less, dress warmer indoors in winter, put up with higher indoor temperatures during the summer, shut off the gas to the decorative lighting fixtures, or move in with our in-laws. We cannot cut back much on our water consumption. So, when that price goes up, there is more than the usual complaining. If the price goes up several years in a row, the outcry cannot be ignored. As a result, the same city councils that brought in the outside company now attempt to control, freeze, or roll-back prices - even though they had no contractual power to do so.

But governments, as was just demonstrated when congress successfully demanded that legitimate contracts with the oil companies be rewritten, can do almost anything they choose. As a result, this company backed out of deals with several American cities because they could not and would not operate in the red. Running a for-profit water system in an American city should be a no-brainer money-maker - and in many cases, it is. But when the real crunch comes, when water prices, of necessity, skyrocket, it is imperative to be aware of the Cowardly American Politician who will abrogate any contract if it assures his or her continuation in office.

The group with the most to offer and with the least vulnerability to political duplicity are those companies that supply pipes, valves, pumps, meters, etc. that will become essential purchases in the immediate future. Although there are several large caps that have become involved in these areas, their exposure remains relatively small in relation to the size of their overall operation. However, there are a number of companies which could perform nicely: LAYN, NWPX, TS, GRC, LNN, HYFXF, WTS, TTI, and KELGF.

(An approach to supplying water that to date hasn't been too successful but hasn't received much attention, is the use of machines that pull potable water out of air. These machines, depending on size, can produce anywhere from two liters up per day. If the area's climate meets certain humidity minimums, the systems will work. However, I've been reluctant to even attempt a speculation as it seems something this important would have received much more coverage by this time. I'm not sure if this is a performance or a marketing issue.)

A second area that appears fruitful (but which revolts just about everyone) is coal. I doubt, despite current talk, that America will ever again go nuclear. (And even if I'm proven wrong tomorrow, the first new plant wouldn't be up and running until 2015). And the movers and shakers (that phrase, by the way, is from a very nice poem, We Are the Music Makers) have determined that we will cut back on gasoline (i.e, oil) consumption. The cuts envisioned are Lilliputian and one of the proposed substitutes, corn-based ethanol, is an excellent example of why a government should never be allowed to determine efficiency.

The recent news stories on the escalating price of tacos and the Mexican government's reaction to it, is the first bell in the death knell of corn-based ethanol. The next bell will be an American one when prices of pork and chicken begin to rise because we've determined it's more important to feed our cars than the livestock our consumers count on for protein.

Yes, perhaps we can expand corn growing acreage (at the expense of soy beans, but only with the use of more fertilizers, pesticides, and herbicides) and satisfy both demands - at least until the weather, a capricious demon, decides otherwise. Additionally, the very best estimate I've seen to date on daily ethanol production (assuming the current 116 plants and the 79 under construction are all up and running) totals 718,000 barrels. That's 3.5% of our daily requirement. If we all decided to never exceed 60 mph, we would save that much. (Interesting fact: the amount of grain it takes to produce 25 gallons of gas could feed one person for an entire year.)

It doesn't appear that either the Congress or the states are in the mood to approve drilling in the Rockies, in Alaska, or offshore in any of our sanctified coastlines. Russia and China are moving quickly and decisively in striking long-term deals with foreign oil producers. India is beginning to search for deals. Europe appears content to whine over Putin's insensitivity while hoping his tenure is followed by a kinder, gentler former KGB operative. Our oil companies aren't doing much more than being kicked out of Russia and Venezuela.

But we still will need a fuel and we will need it in abundance and we will need it from a dependable source. Coal is the only alternative. And it need not be the dirty, filthy stuff that used to be poured down the basement shoot when I was a kid. Germany developed the Fischer-Tropsch method for synthesizing a hydrocarbon like coal into a much cleaner burning liquid. We have several companies (mostly small ones, but I understand GE is testing the waters) who are currently using the process with our largest coal producers.

The process works. The question to be answered is at what level (of acceptable carbon output) will the bar be set. There exist influential groups who feel no level (of coal emissions) is acceptable. I doubt that they'll prevail. But should they, you can be sure that when Americans begin shivering too much in winter and sweating too much in summer, they'll be rolled flatter than a nickel beer. As with the Fischer-Tropsch companies, I'm not going to name any candidates as they're not that numerous and my omissions would be indicative of my holdings. (By the way, I do not own any of those stocks whose symbols I have listed.)

Those are my two primary targets. Water shouldn't be a surprise; it's been a great idea for a long time. Coal is something else; to some it may seem like buying into pornography. For those, I suggest searching the geothermal field, though initially expensive, the systems work (in both summer and winter), and can be installed almost anyplace where several deep holes can be drilled.

I became president of the old duck hunters courtesy of Gordon MacQuarie's great stories. It's appropriate then that I end with a Macquarie story (notice the difference in spelling.) My son will be 42 next month and has been a confirmed bachelor. Just two weekends ago I received an email from him (he's lived in Japan for six years) announcing his marriage this coming July in Honolulu. Now I felt I was pretty well set in making whatever minor financial arrangements I could for my children and theirs. (Lord knows we're leaving them with enough debts.) This adds a new dimension and one that requires real long-term thinking.

For those in the same boat, check out MIC, The Macquarie Infrastructure Fund (there are a group of Macquarie Funds and you may find one more appropriate). This fund has been buying up (or getting long-term - 75 year - leases) on tollroads, airport parking lots, commercial heating and cooling outfits, and energy service providers. If it's something that's an absolute public necessity, Macquarie owns or holds a long term lease on it. It pays a great dividend, but I'm told, reading their financial statement, it will give you the yips.

I now yield the field for at least a year.

If You Think This Market Is Boring…, from Kim Zussman

February 24, 2007 | Leave a Comment

…and taxes too low, just wait:

Compared SP500 monthly returns since 1950 under Democratic and Republican presidents (from inaugurations in January). Turns out under Dems stocks do a little better, but not significantly:

Two-sample T for Dem ret vs Rep ret

                N       Mean      St Dev      SE Mean
Dem ret   685    0.0073    0.0408      0.0016 T=0.51
Rep ret    410    0.0060    0.0429      0.0021

Notice the standard deviation is a little lower for the party of redistribution, so maybe their appeal is less volatility?

Test for Equal Variances: Dem ret, Rep ret

95% Bonferroni confidence intervals for standard deviations

               N      Lower    St Dev      Upper
Dem ret  685   0.038     0.041        0.043
Rep ret   410   0.040     0.043        0.047

F-Test (normal distribution) Test statistic = 0.90, p-value = 0.252

Depending on your definition of what "is" is (as well as significance of DNA on children's clothing), Dems do have slightly lower market volatility (N.S.) as well as possibly better skills subduing the mistress.  

First A Riddle, by Kim Zussman

February 17, 2007 | Leave a Comment

 "What an evil day when the market down just 1/2 point, and the shorts can only make commissions on their holdings. But what a grand plan unfolding." VN

What grandiosity awaits us, with new highs weekly and persistent near-record low volatility? Considering high contemporaneous negative correlation between market returns and volatility, a great trick would be a huge advance from here.

What about all the calls for an overdue 2% decline? Well, the answer is: Big moves come during volatile periods. Since we are not in one, we have none.

Here is the evidence: SP500 index daily returns since 1980 were partitioned into non-overlapping 20 day periods. At the end of each period, counted moves <-1% and >+1%, as well as st dev of daily returns for each period.

Then regressed big move counts vs. st dev: The regression equation is if >1% = - 0.421 + 566 stdev 20.

Predictor     Coef                  SE Coef           T            P
Constant         -0.4214           0.2171          - 1.94      0.053   
stdev 20       566.1300         21.1200           26.80      0.000

S = 1.84381 R-Sq = 67.9% R-Sq(adj) = 67.8% 

Clearly the count of big moves is highly correlated with concurrent volatility.

And volatility regimes are persistent. For example (more detailed in literature), here is regression of current 20d big move count vs the prior one:

Regression Analysis: if >1%_2 versus if >1%_1

The regression equation is if >1%_2 = 1.65 + 0.653 if >1%_1

Predictor     Coef      SE Coef      T              P
Constant     1.6506   0.2374        6.9500    0.0                      
if >1%_1    0.6526   0.0412       15.8300    0.0

S = 2.46771 R-Sq = 42.5% R-Sq(adj) = 42.3%

And here compare count of big moves in 20d following those in bottom and top quartiles (<=2 and >=7):

Two-sample T for nxt if <=2 vs nxt if>=7

                          N        Mean    St Dev     SE Mean
nxt if <=2 99     2.59    2.24      0.23        T=-12
nxt if>=7 95      7.51    3.10      0.32

Second Handers, from Brett Steenbarger

May 17, 2007 | 1 Comment

 I wanted to comment on how some old men grow old gracefully whilst others grow old grotesquely, and to look at how this effects their take on the markets. I believe that those who age worse often exhibit worse trading symptoms!

Ayn Rand used to talk of second-handers: those who derive their self esteem from the perceptions of others, not from objective achievements.One virulent form of second-handedness masquerades as virtue: the need to be needed. I suspect it's behind the overly chivalrous and boastful demeanor, but also behind the pessimism.

The doomsayer needs followers who feel endangered and vulnerable. The forecasts of doom make the prophet needed to get through the pending calamity. No one needs a savior if the forecast is for sunny times ahead. By undercutting the sense of security of others, the doomsayer carves out a niche for himself: I will get you through the market panic, the economic collapse, etc. The same dynamic is at work with the seemingly solicitous and chivalrous man who wants his woman dependent upon him.

I'm thinking of a couple I once saw in counseling. He refused to let her work outside the home, insisting that he must be the breadwinner. She was bright and talented and, now that the children were older, wanted to work. She took up a hobby (quilting) and became quite expert at it. Eventually her quilts became collector items and she was a hot item on the art festival circuit. He was increasingly threatened by her success and tried to derail it by belittling its importance — all the while maintaining his love for her and his willingness to provide for her.

He needed to be needed: his greatest threat was an independent woman. The doomsayer similarly needs to be needed. The confident, optimistic investor is his greatest threat. To become needed, they must make others needy. Such is their benevolence.

She divorced him, by the way, and went on to become a successful instructor of quilting and crafts, owning her own business.

And 20 years after 1987, we stand at new highs and the doomsayers continue to beat their drum. Odd how we excoriate those who encouraged people to buy stock in 2000, but say nothing about those who counseled against equity ownership for the last 10,000 Dow points. If a physician sickened his patients in order to have a steady stream of revenues, no one would hesitate to call it malpractice. But what of investment advisors who fill their clients with fear in order to sell them services and seminars?

"You need not examine a folly", Rand once wrote; "you merely need to identify what it accomplishes". Pessimism and negativity create dependency and a psychological crippling. The need to be needed is a need to undercut the certainty and security of others. That's why it's a "symptom of something worse".


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