KiraEquation is applied to markets, the movements in bonds, stocks, Germanbonds, and the dollar in a period sum to zero. For those who follow the marketon a day-by-day basis, the idea is somewhat intuitive: Time and time again, astrong move in the bonds is counterbalanced by an equal and opposite movein stocks.Next, we separate out two elements in the equation: daily moves in bondsand stocks over the last five years. The correlation between the two is shownin Figure 13.1. There is a slight positive correlation between the two.The counterbalancing holds true from week to week. As illustrated in Figure 13.2, when U.S. bonds are up more than two points in one week, then theS&P 500 tends to go up 3.5 points in the next week.The predictive connection between stocks and bonds illustrated by thescatter diagrams in Figures 13.1 and 13.2 is one of the most useful regularitiesthat we have discovered in many hundreds of thousands of hours in studyingsuch interrelations. For traders, a few points a week in the S&P 500 adds upto pretty big money over time. After all, 11 percent a year, compounded continuously over 20 years, amounts to an eightfold increase.
50
0
–50
–100–3
–2–101Current Daily Change in Bond Points
2
y = 1.7% + 1⁄2 (x)R2 = 0.1%
Figure 13.1 Correlation of Daily Moves in U.S. Bonds and U.S. Stocks,July 1994–May 2001. Source: Niederhoffer Investments.
Point Change in Next Week’s S&P 500
270 Practical Speculation
100
0
–100
–50Point Change in Current Week’s Bond Futures
5
y = 0.7% + 1.4 (x)R2 = 0.5%
Figure 13.2 Correlation of Weekly Moves in U.S. Bonds and Stocks, July1994–May 2001. Source: Niederhoffer Investments.
Moreover, the results are highly significant from a statistical standpoint;mean changes this far from zero are less likely than 1 in 1,000 to have beenobtained by chance variations alone.The total amount of energy in the market is constant vis-à-vis the closedsystem of bonds and stocks. It is possible to exchange between time periods,borrowing, if you will, from the total energy, with a certain lag for repayment.Einstein’s special theory of relativity casts further light on these borrowingsand repayments. The special theory explains that mass and energy are equivalent and that energy is forever being converted to mass and then back again.When you wind a watch, the spring’s mass increases ever so slightly as energyis stored in it. As the spring unwinds, this barely perceptible amount of massis converted back to energy. The market, too, can “store” energy. The energy,however, must always be repaid, just as Kira must make up a missed pianopractice session in subsequent weeks.Conservation of Energy, Variation 2: Disappearing MoneyHope springs eternal for humans. Well it should, given the human capacityto improve well-being and happiness, as evidenced by the contributions tocivilization of such giants as Leonardo da Vinci, Isaac Newton, and Thomas
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Edison. The everlasting, renewable nature of hope seems to be a necessary ingredient to our ability to deal with the hardships and disappointments of life.And nowhere do we see hope better exemplified than when we turn on ourtelevision after a dismal period for stocks and find an attractive reporter removing her glasses and saying, “Tech is back!”Perhaps Intel just reported better-than-forecast earnings, prompting abuying rush among investors. The resulting price rise in Intel makes otherstocks in the tech sector relatively cheap, and money comes in to buy theseas well. The process continues, sometimes for years, as it did in the 1990s,when a tremendous river of money flowed into the field from savings accounts, money-market funds, and foreign investors, and the Nasdaq rosefrom 374 to 4069.More important than any particular company’s earnings report in thisprocess is an underlying perception that technology is good, that profitsare available, and that entrepreneurship leads to a beneficial horn of plentythat is constantly being replenished for investors, suppliers, customers, andemployees.Ah, but always the seed of discontent. Enthusiasm has a tendency to waxand wane. Ultimately, potential energy in the world of savings, alternative investments, or even credit card borrowings will be drawn down to the pointthat there won’t be enough to continue the rise or even to sustain the rise thathas taken place. At that point, confidence is shaken and doubts that had longseemed unrealistic suddenly assume an alarming aspect.The events of 2000, discussed in the introduction to Part One, illustratethis well. When the point of maximum drawdown of potential energy wasreached in early 2000, the chairman of the Federal Reserve, who had beenconcerned with irrational exuberance for more than three years, chose that inopportune time to ratchet up the federal funds rate from 5.50 percent to 6.50percent. The increase was accomplished in three steps. The first two increases,of one quarter-point each, took place February 2 and March 21. The final, halfpoint increase was made May 16—after the Nasdaq had already fallen 26 percent from the high of 10 weeks earlier. Confronted by the powerful force of theFed, large investors who had recently converted to tech began selling their inflated holdings. New tech firms had only lately been besieged by investmentbankers seeking the privilege of underwriting their initial public offerings.Suddenly they found it impossible to sell stock. Without capital, they couldnot order equipment. Manufacturers of the equipment saw a precipitousdrop-off in orders. Tech shares fell, so the public withdrew money fromtech and put it into growth stocks. When growth stocks began to succumb,the public bought value stocks. When the revered value investor of Omaha
272 Practical Speculationallowed in his annual letter to shareholders on February 28, 2002, that he had“decidedly lukewarm feelings about the prospects for stocks in general overthe next decade or so,” the public began to convert any remaining shareholdings into cash—and waited for the attractive TV reporter to stop furrowing herbrow and start removing her eyeglasses again.The same sort of transfers happens constantly in the natural world. Thesun generates energy, a plant uses the energy to make sugar, a jackrabbit eatsthe plant, a coyote eats the rabbit, the coyote dies, and nutrients from the carcass leach into the soil to become fertilizer for plants.The important thing to know is that at any point in such stories, the quantity of mass and energy is exactly what it was at the start. Any amount thatseems to have gone missing can be found somewhere.The conservation of energy law is helpful, for example, in deflating fallacious news reports about the trillions of dollars that “disappeared,” “evaporated,” or “vanished” in stock market declines. Money, like energy, does notdisappear; it always goes somewhere. From its peak in March 2000 to the lowsof October 2002, the U.S. stock market, as measured by the inclusive Wilshire5000 index, lost 50 percent of its value, or $8.15 trillion, based on Wilshire Associates’ formula of $1.1 billion per point. But the money did not disappear.For every investor who bought at the top, a seller on the other side of the tradegot out at the top.Our story about the attractive TV reporter is a qualitative tale about a single move in a single market. Other explanations could be developed. The stories regarding the markets of other countries and other periods of U.S. historywould doubtless be different. Our model is not an exact depiction of all theforces that affect markets. All models are necessarily simplifications of reality.The key question for any particular model is whether it leads to fruitful predictions and insights, and then based on tests of these, whether it is possibleto develop a better model.The amazing thing about the model that we have posited is that many ofthe specific regularities embodied in it appear to be consistent with actual relations that have appeared during the past 20 years.Conservation of Energy, Variation 3: Where DoesMoney for IPOs Come From?Assume that money available to buy stocks is fixed, and that it depends to asignificant degree on the money taken up by initial public offerings. Money tobuy new stocks must come from somewhere. A good working model is that it
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comes from the money that would otherwise be available to buy stocks that already exist. And that leads to a working hypothesis:• When IPOs are numerous, little money is available to buy existing stock.• When IPOs are few, much money is available to buy existing stock.In fact, declines in IPOs are highly bullish. Figure 13.3 shows the totalnumber of IPOs in each of the past 20 years contrasted with the S&P’sperformance.Statistically speaking, the correlation between the change in the numberof IPOs in one year and the percentage change in the market the next year is−36 percent—a strong negative association that reminds us of the transfersof energy we see in the bounce of a ball or the movements of a roller coaster,something that market participants are all too familiar with these days.We next looked at the correlation between the total dollar value of IPOsand market results in the next year, and found similar results going back to1991, the earliest year for which data were available. The correlation was−33 percent.
S&P 500 Return Next Year
30
20
10
0
–10–1001020Percent Change in Number of IPOs This Year1
y = 14% – ⁄25 (x)R2 = 12.7%
Figure 13.3 Fewer IPOs Lead to Better Market Performance. Source:Niederhoffer Investments.
274 Practical SpeculationConservation of Energy, Variation 4: Transformations of EnergyIn considering energy in nature or markets, it is helpful to think of potentialenergy, on the one hand, and “working” transformations of energy, on theother. Active forms of energy include kinetic, chemical, electric, electromagnetic, elastic (as in a bouncing ball), nuclear, heat, and sound.Money available to buy stocks may be thought of as a form of potential energy. When cash piles up in money-market accounts and investment in stocksdwindles, as it did in 2001 and 2002, the situation is similar to a pendulumpausing at the top of its arc. At that moment, the energy seems to have disappeared. In reality, it is there in potential form and quite likely to be convertedinto movement.When movement begins, one possible route is into equity funds. At thebeginning of 2002, the ratio of assets in equity funds relative to money market funds was 1.5, close to a four-year low of 1.4. A high of 2.6 occurred in thespring of 2000 just as the market was embarking on its terrible 18-monthdescent.Our study of the equity/money-market ratio indicates that the best prediction for the return the next month as determined by regression analysis is 5.8percent less 2.4 percent multiplied by the level of the ratio (see Figure 13.4).
10
S&P 500 Return
50
–5–10–151.5
2.0Equity/Money Market
2.5
y = 5.8% – 2.4 (x)R2 = 2%
Figure 13.4 Equity/Money-Money Ratio as a Predictor of Next Month’sS&P 500 Return. Source: Niederhoffer Investments.
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The Second Law of Thermodynamics: EntropyIn the middle of the nineteenth century, Rudolf Clausius and William Thomson (Lord Kelvin) formulated the second law of thermodynamics—entropy. Inessence, the law says that whenever an energy distribution is out of equilibrium, a potential force exists that the world spontaneously dissipates or minimizes. Clausius coined the term “entropy” to refer to the dissipated potential.Whereas the first law explains that the total amount of energy remains constant, the second law observes that the world is inherently active, always acting to minimize potential (or, to say the same thing in a different way, tomaximize entropy).The second law is easy to demonstrate empirically. Place a glass of hotwater in a cold room. Heat from the water will spontaneously dissipate intothe room until the temperatures of water and room are the same. Thus, thepotential energy of the water’s heat is minimized, and entropy is maximized.Entropy, Variation 1: Maximization of TransfersThe stock market, too, has a way of maximizing entropy: It transfers wealth.The percentage of NYSE stocks traded that close unchanged on an averageday is about 2 percent, much higher than would be predicted by chance. Thestock price moves in such a way that it maximizes entropy while goingnowhere. This holds true for longer periods as well. When a stock has a bigmove in the beginning of a week, the best guess for the second half is exactlythe opposite.The types of orders used by traders are comparable to different forms ofenergy. Market orders can be compared to kinetic energy, while limit ordersand stops correspond to potential energy. A sharp up move triggers stop lossorders. After the usual retracement, the market encounters less resistance onits next rise, and is able to move up with greater ease. That is why double andtriple tops tend not to hold. The removal of limit orders maximizes the entropy in the system.To illustrate, take any ordinary piece of paper and crumple it in yourhand. As the paper crumples, energy is stored in all the creases. These resistthe force you are exerting. If you can overcome this resistance, the crumpledball of paper must collapse, forming more and more creases and points.Eventually, the energy stored in the crumpled ball will be so great that youwould need to exert a huge force just to make it even slightly smaller. Thanksto research being carried out on this phenomenon, scientists may better be
276 Practical Speculationable to understand how a blood cell’s membrane contorts to pass through thesmallest capillaries, how a car’s bumper absorbs the energy of a crash, andhow the earth’s tectonic plates collide and buckle to form a mountain range.This phenomenon also appears in markets. Sharp downward moves in pricesrequire a lot of energy. When these sharp movements occur, the energy required to take the price lower is so great that prices tend to take the path ofleast resistance and move up.Entropy, Variation 2: Friction and Heat DissipationFriction is an obvious example of entropy in everyday life. As with any realworld system, some of the energy in the market is not captured by the trader,but is dissipated in the form of friction. In the market world, perhaps $15 billion a year is extracted by the infrastructure in the form of bid-asked spreads,brokers’ commissions, and National Futures Association fees.The profitability of the market infrastructure may be gauged by the value ofseats on major trading exchanges. The number of seats on the New York StockExchange, American Stock Exchange, Chicago Mercantile Exchange, ChicagoBoard Options Exchange, Chicago Board of Trade, and New York MercantileExchange totals more than 8,000, with a combined value in early 2002, basedon the most recent seat sales, of $6.4 billion (see Table 13.2).Average people who do average things are the ones who make seat ownership a lucrative business. If you conform to all the customs in the markets,you will be a valued contributor.Different traders must deal with different amounts of friction, dependingon their place in the infrastructure. Friction is minimal for a trader on the
Table 13.2
Value of Seats on Selected U.S. Exchanges
Exchange
Number ofSeats
Last SalePrice ($)
Date
NYSEAMEXAMEXCBOTCMECME-Index and options market divisionCME-International monetary market divisionCBOENYMEX
1,366203 (options)661 (regular)1,402 (full )625 (full voting)1,287 (voting)813 (voting)930816
2.5 million300,000270,000400,000800,000550,000380,000365,000875,000
Feb. 2002Feb. 2002March 2002March 2002Jan. 2002March 2002Feb. 2002Jan. 2002Jan. 2002
Source: NYSE, National Association of Securities Dealers, Chicago Mercantile Exchange,Chicago Board of Trade, Bloomberg News.
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floor of an exchange and is highest for retail customers who enter tradesthrough a traditional brokerage firm. A trade that is profitable for floor tradersor institutional traders may be a losing proposition for retail investors. Aneasy way to improve your returns in the market is to reduce trading expenses.There are many ways to do this. Start by negotiating lower commissions, or byfinding a discount broker. High-volume day traders, who typically pay verylow commissions but nevertheless pay out 50 percent of their profits as commissions, should consider adjusting their trading style. High-cost investments such as load-bearing mutual funds, foreign securities that requirehigher commissions, penny stocks, and structured notes are best avoided infavor of less expensive alternatives.Entropy, Variation 3: Sector Rotation and MaximumEntropy ProductionThe reader may wonder why, if the law of entropy rules the market, some sectors manage to stay “hot” for long periods. A similar apparent conflict existsin science, where physics says energy dissipates, while biology observes thatlife tends to become more ordered.The answer is that an ordered flow—a flame, for example—can be moreefficient at dissipating energy potential than a disordered flow. In the market,hot sectors exist because they feed off potential energy in their environments.Once the sector matures and becomes predictable, quick profits disappearlike a candle burning out.A further everyday illustration of this principle, known as maximum entropy production, is provided by a pot of boiling water. Given the law of entropy, we might expect the movement of the water to be random andunpredictable. Instead, the movement is quite orderly. When the burner isturned on, the heated water at the bottom moves up the center of the pot to thesurface. Some water escapes as steam, and the rest cools and moves back downto replace the hotter water rising to the surface. This orderly process efficientlytransfers the heat from the gas burner into the atmosphere, thereby maximizing entropy.The same principle allows the persistence of heat in certain sectors of thestock market, with happy consequences for some investors. Some mutualfunds tend to invest in industries that are showing relatively strong performance and ride them until they lose steam. Mark Hulbert, dean of fund evaluation, concluded that these “sector rotation” funds outperformed the averagemutual fund in the five years ending in 2001. We see no evidence as towhether the superior performance of sector-switchers will continue in the
278 Practical Speculationfuture, or whether their success was a by-product of the market conditions peculiar to the 1997–2001 period. At the end of November 2001, some $173 billion was invested in such funds, up from $92 billion in November 1997.Assets in industry-specific funds totaled less than $100 billion in late 1997;they peaked at $301 billion in August 2000.We performed our own studies of sector rotation andfound that the relative rankings of at least some classificationsshow negative correlation between years. From 1987 through1998, the average annual move for a Nasdaq industry groupafter a year in which it suffered a 10 percent decline was +25 percent.In 2000, and 2001, the reversals of fortunes in the performance of theS&P 500 Economic Groups were almost complete. The two best- and twoworst-performing groups of 2000 switched places the following year, with therank correlation between them −0.8 (with −1 being a perfect inversion).This is consistent with the idea that a limited amount of energy is available for the purchase of stocks (the first law of thermodynamics), and with thekey insight of the second law of thermodynamics, or the law of entropy, thatthe world acts spontaneously to release potential energy.Entropy, Variation 4: The Law of Ever-Changing CyclesAn options-trading associate of ours, Leonard Kreicas, made someobservations on the second law—entropy—in a January 3, 2002, postto the Spec List:It seems generally when the investment community has figured out a surefire way to make money, the system collapses due to the law of entropy. Mostcommentators blame it on a random event, a 100-year flood. The market conditions now are all in a consensus for a 2002 stock market recovery, which meansthe bets have already been placed. What I’m expecting is a random event that setsthe balloon to go off in a entirely different direction. When a balloon full of air islet go, it’s impossible to predict which direction it will go as the air escapes. We doknow that the process is very fast, follows a random path and increases entropy.The same could be said for markets as they lose air.Entropy and diversification can be considered kin. In the late 1990s, the public had a mania with stocks. Figures showed record numbers of shareholders.This meant people were not putting money in bonds, savings accounts, gold, etc.They were concentrating their money in one asset class: Nasdaq stocks. The lasttwo years showed the consequences. Perhaps now investors will diversify theirportfolios. Put another way, entropy will increase. Mutual funds and brokers willkeep on talking up stocks, but increasing entropy predicts money will randomizeand spread out more. Maybe the euro, real estate and money markets will receive
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some funds as investors reduce risk. I can’t predict the eventual distribution.However, when money rushes into one spot as it does during a bubble, eventuallyit bursts in a dramatic show of entropy.
ConclusionThe first two laws of thermodynamics are not the Holy Grail. They do not explain how a system operates or what causes it to change, either in physics or infinance. They do not account for psychic energy or productive energy—key elements in markets. They apply only to closed systems. They cannot address allthe unpredictable ways in which potential energy can be converted to kineticenergy (or waste heat). There is a basic problem in measuring potential energy.As our friend Jack Tierney, a plainspoken Tennessee philosopher, says, “In therealms of biology and physics, it might be possible, but in a realm with AlanGreenspans and printing presses, you can’t.”The laws of conservation and entropy are amazingly helpful, however, inmaking predictions in a world of seemingly constant change. The usefulnessof any model is measured by the verifiability and falsifiability of its predictions.We believe that our applications of the laws of thermodynamics will be fruitful,although they certainly have many holes and many areas forimprovement. As always, knowledge is acquired through continuing observations, experiments, and theoretical reasoning.The application of physics to investment has great potential.
14
PRACTICAL MARKETLESSONS FROM THETENNIS COURT
In order to gain a win against me, you have to beatme in the opening, the middle game, and the endgame.—Alexander Alekhine, Chess World Champion 1927–1935, 1937–1946
T
he roads to victory and defeat cross the same ground in games and financial markets. The fundamental goal in each pursuit is to win, giventhe resources brought to the table, expected edge, potential variability, duration of the game, and the point at which the game ends in victory or ruin.It is no accident that games and trading are so similar. Games were createdto mirror the crucial risk-reward decisions that we face in life, whether they relate to finance, marriage, jobs, education, or sports. As Paul Heyne points outin The Economic Way of Thinking, in a quote we cannot repeat too often, “Everyone who makes a decision in the absence of complete information about the281
282 Practical Speculationfuture consequences of all available opportunities is a speculator. So everyoneis a speculator.”Throughout my trading career, my experiences in competitive squash, tennis, and other racquet sports have provided me with a rich source of insights. Iwas undefeated for 10 years as U.S. squash champion, won a few national titlesin paddleball, and was winner or finalist in a handful of state tennis and pingpong tournaments. Steve “Hobo” Keeley, the holder of numerous national titlesin paddleball and racquetball, kindly refers to me as the greatest all-round racquets player of all time, which may be stretching it some. I did defeat MartyHogan, the greatest racquetball champion, in a world series of racquet sports afew years ago when I couldn’t move more than a few steps because of a bad hip.True, Marty let up a bit. But here is Lesson 1: A player should never let up, insports or in markets.In this chapter, we point out what investors can learn from how champions prepare for and play their game.
Before the GamePick Your SpotsOn the court: The beauty of both sports and markets is that you can choosewhen and where you want to play. If you are a tennis player, you might chooseto stay away from the relatively uncontrolled conditions of grassy courts, thesurface on which Goran Ivanisevic, who was not even seeded in the top 100,won Wimbledon.In the market: According to the academics, the market enjoys a 10 percentannual upward drift, with random movements from all previous paths ofprice change. For those with satisfactory long-term staying power, buy-andhold is therefore a winning strategy. Most people find it difficult to maketwo timing decisions that both carry above-average expectations. Additionally, a stake can be substantially reduced by capital gains taxes; ask any veteran day trader.Even an old dog sometimes learns new tricks, though. If I have learnedanything over the past several years, it is that opportunities resulting fromsubstantial event-driven declines are occurring with increasing frequency—and conversely, there are certain times when it is best not to enter the market tournament. Certain indicators have proved reliable in identifying suchtimes:
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• An increase in the stock-bond ratio (the number of 30-year Treasurybonds it requires to “buy” the level of the current S&P 500 futurescontract).• A decline in the Chicago Board Options Exchange Volatility Indexbelow 25.• A 20-day high in stock futures.Decide How Much Risk You Will TakeOn the court: All great players will tell you that the thing they hate most iswhen an inferior opponent plays a risky game—creating confrontation, goingfor broke, going for the lines on every shot. That is the only way the betterplayer can lose.In one of my early squash tournaments, I played against Sam Howe, thenU.S. champion. Sam called “one point set” at 14–14 in each of three consecutive games to fray my nerves. (Sam had the option of extending the game bythree points, or letting the game be settled in the next point, “one point set.”)I was not overly averse to risk, and won each game 15–14. What Sam did notappreciate fully is that younger players frequently react much better to handling risk. Older players are more fearful of not making it back should theyfall behind the eight ball.Art Bisguier, a chess grandmaster who has won every conceivable U.S.championship, tells the story of how he once made a sharp move in a gameagainst then-world champion Tigran Petrosian, and Petrosian asked for a draw.Bisguier, who believed Petrosian had an edge, accepted, and then asked himwhy he offered a draw. Petrosian said rivals Mikhail Tal and Paul Keres werewalking by and he was afraid that if did not accept Bisguier’s challenge, theywould consider him a coward—but if he did, he might get beaten. So he tookthe middle road. That was the right thing for a world champion to do. The bottom line is that when you have an edge, you should play a conservative game.When you do not have an edge, you need to take risks.In the market: In speculation, the house almost always has the edge. The“house,” of course, is the operator of the casino—the Nasdaq market maker, theNYSE specialist, the broker. That is why the speculator should go for big profits.Only the house can grind small profits day in and day out. If your gains are limited relative to your capital, then the only constant will be the vigorish extracted from you in commissions and bid-asked spreads: asure formula for losing. That said, I do not advise crazy gambles.My own approach to risk taking is based on statistical analysis.
284 Practical SpeculationHave a Game PlanOn the court: Prepare before the game; there is no time once the play starts. Iloved it when my opponent had to take an extra few minutes in the warm-upto practice a shot. I was always at the court two hours before I played. All goodplayers know that the action during a game is too fast-paced to rely on improvisations. Practice and plan for all possible scenarios in advance; expectyour opponent to have done the same.In the market: Do all your studies at least two hours before the open. Run thevarious scenarios that can occur unexpectedly during the trading day. Preparefor the myriad situations that may result from a government or corporate announcement. Once a major contingency happens, there will be little time tothink before you react. While you should always be aware that plans are subject to the law of ever-changing cycles, it is important to have a certain stick-toit-iveness if your plan gives you an edge.Have Sufficient StaminaOn the court: There are very few things you have complete control over insports, but stamina is one element that is completely in your hands. After amatch, it is also the one element you would hate to kick yourself for having letslide. Make your opponent beat you . . . do not beat yourself.In the market: The larger your asset base relative to the fluctuations in yourholdings, the better able you will be to take advantage of the situations whenyour studies tell you that you have the edge.Have Backup EquipmentOn the court: No matter what, if you do not have the proper equipment, you area sure loser. Good tennis players can be observed carrying six identical racquetsto their matches, each one strung to the same tension. Strings and racquetshave a way of breaking down, and if they do, the change to unfamiliar equipment can be calamitous.One of my favorite squash victories occurred against Mike Desaulniersduring the Canadian Open in Toronto in 1975. After the game, I struck up aconversation with Mike’s mother:Vic: Mrs. Desaulniers, your son did very well. One little point would havemade the whole difference in the match.
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Mrs. D: Yes, I was very proud of him. I thought he did pretty well considering he lost his racquets yesterday and was playing with borrowedshafts.Vic: In that case, Mrs. D, we’ll give your boy a “but-for” victory on that one.In the market: How many traders do you know who have confided to you thatthey lost a fortune when their Internet connection went down, their broker’