and closes of the daily prices that gointo the charts.The approach we take is based on a test-taking method pioneered by ourfriend Adam Robinson, cofounder of the Princeton Review. It involves puttingyourself in the mind of the people who write questions for the EducationalTesting Service’s college entrance exams. The tests always begin with easyquestions where the obvious answers are correct and proceed to tricky ones,where the obvious answers are wrong (but close to the right answer).The way to handle those tricky questions is to avoid the obvious response. The way to make money in stocks is to do the opposite of what seemsobvious—and recently profitable. (For example, if selling the rallies worksthree days in a row, then it probably won’t work the fourth day. And if a testedsystem fails to work one day, it probably will the next day.)It is at least as hard to make money in the markets as it is to score high onthe SAT or the GMAT. But instead of throwing you hard questions toward theend of an exam, the market likes to throw you tricky moves when you are offguard, in hopes that you will give the wrong answer and thereby contributetoward your broker’s Porsches, profit-sharing plans, and well-appointed dining rooms.On a long-term basis, the market loves to throw in a nice 10 percent rallywhen the gloom is greatest. That a rally was coming always seems obviousafter the fact.On a day-to-day basis, the market likes to throw out trick questions that willmake monkeys out of people who rely on visual impressions of charts. Take, forexample, the 80 times during the six-year period ending December 31, 2000,that S&P 500 futures have gone up 20 or more points, or about a 2 percent rise.(We use futures in all our calculations because they represent prices that youcan actually trade at and make or lose money, while the slow-moving indexoften lags behind the real price moves.)On days after big rallies, wise-guy traders like to set up for a decline because the market has a slight tendency to retreat on those days. What the market likes to do on such occasions is to give those traders an easy profit the firsttime. Next time, they will go short and the market will stick it to them.The Princeton Review technique that we use in our own trading involvesthe quantification of some 1,700 separate answers to questions posed by themarket. Before making a trade, we like to measure the accuracy or profitability of each of these 1,700 answers to the questions that are most similar towhat the market is asking today. We take account of the uncertainty of the
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results in each case and the ideal position relative to today’s range to placeentry and exit orders.This approach uses standard technical data only. Thus, in essence, wehave devoured the Hydra.Doubtless many other practitioners of technical analysis are using similarmethods. We hope that others will modify their visual and nonquantitativetechniques, to come into line with scientific procedure.
Testing the VIX IndicatorNow that we have described an approach to technical analysis in linewith the scientific method that has been so effective in advancing knowledgein every other field, we can apply it to our own favorite indicator, theChicago Board Options Exchange’s Volatility Index, commonly referred toas the VIX.People forget that the market can go up when it has been declining for awhile, just as they forget it can fall after a prolonged rise. These swings in optimism are among the most notable regularities in the market. Sentiment indicators—the degree of bullishness and risk in options, the percentage of bullishadvisors, the percentage of advancing stocks, and the percentage of cash held bymutual funds—swing back and forth from high to low like pendulums. The bigquestion is whether these changes in sentiment have any predictive power visà-vis future moves in the general market.As everyone knows, it is always darkest before the dawn. There is no measure for “darkest,” but the signals provided by the VIX are among the best wehave found. The index provides a measure of the expected level of volatility inthe market.The normal level for the VIX is about 25. A good working hypothesis isthat when volatility is high—above 30 percent or so—investors tend to befrightened, and it is a good time to buy. When volatility is low—below 25 percent or so—investors tend to be complacent, and it is a good time to sell.“When fortune means to men most good, she looks upon them with a threatening eye,” as William Shakespeare wrote in King John, Act 3, Scene 4.The VIX is calculated based on the coming month. As a practical matter,however, expected volatility for periods up to a year correlates almost 100 percent with the changes in one-month VIX.We tested the VIX hypothesis by calculating the return on buying S&P500 futures the first time the VIX closed above 30 and selling them the firsttime the VIX closed below 25. Similar results could be obtained by buying an
108 Practical Speculationindex-tracking mutual fund such as the Vanguard 500 Trust, or by purchasing SPDRs Trust shares (spiders).Figure 3.5 shows that using a 25–30 VIX system to swing from buy to sellyields an average profit of 3.4 percent on 12 trades since October 1997. Therewere two small losses.David Simon and Roy A. Wiggins III came to similar conclusions separately in a rigorous study, “S&P Futures Returns and Contrary Sentiment Indicators.”26The professors looked at the effect on S&P 500 futures of each percentage point change in the VIX. They concluded that for each point increaseabove the norm, the S&P goes up an extra 0.1 percent in the next 10 tradingdays. Thus, given a normal VIX reading of 25, if VIX goes up to 35—10 percentage points above the norm—the S&P can be expected to rise 1 percentextra in the next 10 days. Conversely, when the VIX falls to 15 percent, theS&P can be expected to perform 1 percent worse than its normal move.Simon and Wiggins also show what happens when the VIX is at high levels and at low levels. Most impressive of all, they run what is called an “out-ofsample test.” They demonstrate that with information available at thebeginning of each year, a forecaster could make a useful prediction. For example, based on VIX levels, they came up with 39 forecasts that S&P futureswould go up in the next 10 days. In actuality, 22 of them went up and the average change was exactly as predicted: up 1 percent. Similar results occurredfor the occasions when the market was predicted to go up by 3 percent.Professors Simon and Wiggins are not the usual run of academics whoobscure their results with impenetrable mathematics and statistics so that theresults are meaningful only to a handful of finance PhDs. Perhaps the reasonis that Simon, who teaches at Bentley College in Waltham, Massachusetts,has an unusual background for a professor. He actually worked for a hedgefund before going to academia, rather than the much more common reversesituation. The professor is not averse to a bit of trading of his own, and he isactive in individual stock options. Furthermore, Bentley College has a tradingfloor equipped with dozens of workstations and live feeds from all the majordata providers that most traders would envy. The students use these machinesto answer realistic trading questions that they are assigned in class.An indicator like VIX might have validity because expected volatilities arerelated to the returns that investors demand. When VIX registers high anxietyand uncertainty in the market, investors naturally demand a higher rate of return to compensate them for the extra risk they perceive. Put another way,they will only buy if the price is low enough.
VIX Swing System
DateOct. 27, 1997Dec. 1, 1997Dec. 24, 1997Dec. 30, 1997Jan. 9, 1998Jan. 14, 1998Aug. 4, 1998Nov. 5, 1998Dec. 14, 1998Dec. 18, 1998Jan. 13, 1999Mar. 8, 1999Sept. 23, 1999Oct. 6, 1999Oct. 15, 1999Oct. 21, 1999April 5, 2000June 1, 2000Oct. 11, 2000Jan. 23, 2001Feb. 28, 2001May 18, 2001Sept. 6, 2001Nov. 23, 2001June 20, 2002
VIX39.9624.8830.4724.9334.4624.2133.124.832.4724.6631.2624.9830.2823.5331.4824.7730.5924.7430.9523.863124.2632.4824.7832.5
Buy S&P500876.99
Sell S&P500
Chg.
Duration ofTrade(Days)
974.77
11.10%
35
970.84
4.10%
6
927.94
0.00%
5
1,133.85
5.80%
93
1,188.03
4.10%
4
1,282.73
3.90%
54
1,325.40
3.50%
13
1,283.61
2.90%
6
1,448.81
-2.60%
57
1,360.00
-0.30%
104
1,291.96
4.30%
79
932.7927.691,072.121,141.201,234.401,280.411,247.411,487.371,364.5912391,103.501,153.004.50%1,007.10 N/A*N/A*N/A*
78
*At time of writing, VIX was still above 25.
Swing System Results10 wins in 12 tradesAverageReturn/TradeStandardDeviationAverageDuration ofTrade (Days)
3.40%3.40%
44.5
Figure 3.5
Swing System
109
110 Practical SpeculationThis link between risk and expected return is central to the modern theory of finance. The lower the expected risk, the lower the return required byinvestors; and the higher the expected risk, the higher the required return.All portfolio analysis, all Nobel Prizes given in the field, all students in business school, all analysts taking exams, are taught and understand and acceptthis relation. Corporations use it to determine which investments to accept,and regulators use it to determine how much to let regulated companiescharge. Underwriters use it to determine the pricing of new and secondarysecurities.It is therefore not surprising that when market risk is perceived to be high,subsequent returns are indeed high. That is exactly what a high level of VIX indicates: a higher-than-average expected volatility for stocks during comingmonths. Similarly, it is not surprising that when the level of VIX is low—that is,the expected future risk of the market is perceived to be low—subsequent returns from holding the stock market would turn out to be low.While a 3.4 percent-per-trade return may not seem much, bear in mindthat it’s a multiple of the money market rates currently being paid for an entire year.
ConclusionWe are under no illusion that our suggested recasting of technical analysis tobring it into conformity with the scientific method will convince many technical analysts to change their ways. Nor do we think our workout showing thetheoretical and empirical utility of our own favorite indicator, the VIX, hasmuch chance of setting the world of technical analysts on fire. That is fine withus. Not only does it make the game more interesting, but it will lengthen thetime that it takes for our approach and favorite indicator to become worthless.No doubt certain technical indicators, under certain vague interpretations, work for certain selective periods. That is, in fact, guaranteed to happen.But overall, the outcome has not been fruitful to the technical analysts. Forjust when they are ready to throw the greatest amount ofmoney at a system they believe has worked the best in the past,the system will lose the most in subsequent periods.A good indirect indicator of the ever-changing cycles in technical analysis is the marketing of technical trading systems. Such tools and techniquestypically are marketed as being the very ones used by the greatest technicaltraders of all time. Such systems start off being offered to a handful of
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specially picked wealthy investors for tens of thousands of dollars. Next, theyare offered to those wealthy enough to spend their time attending a seminar,where the developer or a disciple explains the method. In the final stage ofthe life cycle, these systems are offered in the back pages of technical analysis magazines and books at prices ranging from $2 to $200. Only in America do firms exist that specialize in wholesaling beaten-down tradingsystems.All of which tends to support another rule included in that massive compendium, Investing Rules:• See what the trend followers are doing, and do the opposite.Need we add that this one was from us?
Epilogue: Ode to the Hydra of TrinDr. Brett Steenbarger, the behavioral finance expert we introduced in Chapter2, was an ardent devotee of many of the techniques of technical analysis before he met us. The mutual experimenting and reporting that he and Vic haveeach undertaken since then have increased Steenbarger’s skepticism abouttechnical analysis to a large extent. He has memorialized the conversion process and his current thinking with particular reference to material in thischapter as follows:Of Heroes and HydrasGather ‘round, ye Speculators, and I shall tell you a tale of heroes and hydras, andthat fiercest Hydra of all: the Hydra of TRIN. She was said to possess nine headsof poison, the middle one immortal. A single bite from a single head was enoughto fell any hero.I was but a young lad, filled with the enthusiasm of battle, when I set forth tovanquish the monsters. Many complex strategies had I devised to party with thelikes of Cerberus, Medusa and, of course, the Hydra of TRIN. Indeed, my strategies were so complex that I believed myself to be beyond defeat.On my sojourn, however, I came across a teacher who questioned my ways.He was a wise but strange man, speaking portentously of music and games ofskill. He warned me that my intricate battle plans would come to naught againstthese fierce monsters. “Always take the direct approach,” he counseled. “Indirection is the quickest path to ruin.”
112 Practical SpeculationI would have none of it. “Is it not written,” I asked, “that Medusa cannot beapproached directly, lest the hero be turned to stone?”“Ah, yes,” the teacher smiled. “It is so. But did not Theseus take a direct pathnonetheless? He could not go after a different monster to conquer Medusa. Hehad to go to her lair and seek her out with no intermediary.”The teacher’s words made sense to me, and I vowed to make direct warfareupon the Hydra of TRIN.She was gruesome in appearance, filling me with fright and awe. Her headsbobbed and weaved, dropping poison on the ground around her. Nothing couldgrow in that ground. I found myself in a true wasteland. Around her serpentinebody lay the skeletons of heroes before me, who had proven inadequate to theirtask. I prayed that I not meet their ignominious fate.With my heart steeled, I approached the Hydra of TRIN with my mighty cluband gave a ferocious swing. So vicious was my blow that one of the heads—thefive-day TRIN—was severed from the body. Before I could rejoice, however, another head sprang in its place: the 55-day TRIN. Furiously, I struck another blow.This head, too, fell from the neck only to be replaced by the Open TRIN.In the interim, the other heads swooped closer and closer to my body, snapping their jaws and dripping their venom. I realized that I had to act fast or face apainful death.With a wide arc, I swung my club and severed two heads. But, alas, the Eliades TRIN and the Bretz new TRIN replaced these.The venomous heads swung lower, nipping the edge of my robes. I realizedin that moment that Death was upon me.In anguish, I called out to the spirit of my teacher. To my amazement, hiswords filled my ears, as surely as if he were standing barefoot beside me. “Takethe direct approach,” he intoned. “There is power in simplicity.”“But what will vanquish the Hydra of TRIN?” I cried in desperation.“Remember, my pupil,” the words came to me. “Volume is a proxy forvolatility. The TRIN measures volatility as a function of price rises and declines.There is nothing in the ratio that cannot be derived from a direct investigation ofprice change and volatility.”With that, a brilliant torch appeared in my hands. My confidence renewedand my resolve strengthened, I held the eight heads at bay with the torch, searingthem before they could grow back. The center head thus exposed, I chopped it atthe root with my sword, burying it forever in the ground where it could menaceheroes no more.I am an old man now, and have fought many a battle. But no lesson shines sobrightly as the one I learned from my teacher that day. I say to you now, valiantspeculators and heroes: “Listen to the words of my teacher. In the midst of darkness, always take the straight, illumined path. The torch of wisdom is mightierthan any warrior’s club.”
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All in all, our battle with the market momentum Hydra shows her to be amyth. We hope that this chapter will help illuminate the murky caverns of themind where the Hydra dwells. Furthermore, we hope our approach will allowreaders to reflect on and build beliefs about market momentum that arecloser to science than superstition. There is an infinite poetry and beauty tomarket moves, with inexhaustible wealth awaiting those who can unravel thefuture course of movement.
4
T H E C U LT O FTHE BEAR
This will all end badly, we’ve not the slightest doubt,and the only question is when. Probably not tomorrow, as wesay. But that’s as far out as we’ll go.—Alan Abelson, “Up and Down Wall Street,” Barron’s, May 24, 1993(Dow Jones Industrial Average at 3492)
W
hen we see a man who persists in wearing galoshes on his feet, mittens on his hands, a heavy wool jacket on his back, and a ski cap onhis head on a warm summer day, we know that we are witnessing someonewho has succumbed to false beliefs. The man must have believed that it wasgoing to be very cold and wet outside, and he was wrong. If we were trained psychologists, we might attribute the behavior to a dysfunction in separating reality from belief. Very young children have a similar problem in differentiatingbetween the two. By the age of 10 or 11, they usually can identify fantasy, and except for autistic children, they behave in a manner consistent with reality.It is amazing to see an adult who has not only maintained a false belieffor his entire working life, but has also consistently ridiculed others who do115
116 Practical Speculationnot share his beliefs. Such an adult still sits in the catbird seat at one of theworld’s most prestigious financial publications—a news magazine that, according to its marketing materials, circulates among hundreds of thousandsof the world’s wealthiest and most influential decision makers.The man is Alan Abelson, author of the weekly Barron’s column, “Upand Down Wall Street,” for the past 36 years. Abelson’s irreverence towardthe most powerful figures in politics and finance, his facility with words,and his puns have earned him a reputation as the wittiest writer about WallStreet. No one, be he the chairman of the Federal Reserve or a U.S. president of either party, is safe from his sardonic pen. Circulation doubled in hisfirst year of writing the column, and kept growing. Today, the paid circulation of Barron’s is 300,000, and the average household net worth of its readers is $1.2 million.From the start, Abelson played a dual role as editor-columnist at the publication that gave him far more than the usual power for a columnist. In 1998,he received a Lifetime Achievement Award from the Loeb Foundation, arguably the most important organization in financial journalism. While he nolonger serves as editor, he commands speaking fees of $10,000.
Skepticism, Science, and Self-Esteem: A Multitrillion-DollarCase StudyThough he is a clever and talented writer, by any objective standard Abelsonhas the distinction of being one of the worst market forecasters in history. Hehas been skeptical, if not outright bearish, on the stock market for his entiretenure as a Barron’s columnist. Yet during this period, the Dow Jones Industrial Average and S&P 500 gained some 3600 percent, with reinvested dividends, perhaps the greatest accumulation of wealth in history. On January21, 1966, the Friday before Abelson’s first column appeared, the Dow closedat 988.14. Thirty-four years later, on January 14, 2000, the average reached ahigh of 11,722.98.The key to a happy, successful life is to be humble about one’s knowledgeand open enough to admit the possibility of change and to adjust our thinkingwhen facts contradict our beliefs. In the market, it means a determination tokeep up with new ideas and academic theories that influence the practitionersand to have a procedure for judging and testing the work of others before touting it to us.
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We all know people who do not rely on logic, who cling defiantly to biasesand errors in thinking in the face of incontrovertible evidence to the contrary.The tendency to hold onto manifestly illogical beliefs is the subject of an entire line of study in psychology. One of the great contributions of the psychologist Leon Festinger was the theory of cognitive dissonance. Festingercataloged rationalization techniques that people use to preserve their selfesteem when facts run afoul of their beliefs. The theory was developed as a result of Festinger’s famous study of a doomsday cult, recounted in his 1956book, When Prophecy Fails.1With two colleagues, Festinger infiltrated a small group of believers ledby Marian Keech, a Midwest woman who claimed to be hearing messagesfrom outer space. Keech believed that a flood would destroy the world, butthat flying saucers would take her and her followers safely to the planet Clarion before the devastation began.Keech’s adherents quit their jobs and shed their money, houses, possessions, and, in some cases, their spouses to await the day of rescue. One evening,Keech heard from Clarion that the saucers would come at the stroke of midnighton December 21. On the evening of December 20, her followers gathered inKeech’s living room. The moment passed in utter silence. No one knew what todo. At last, at 4:45 A.M., Keech’s face lit up. She said she had just heard fromClarion that the world had been saved by the faith of the little band of believers.Until then, the group had shunned publicity and not sought new recruits.Now, they called up the media and handed out leaflets on street corners thatdescribed how they had saved the world through their purity, prayers, andsteadfast faith.When facts and belief come into obvious dissonance, the logical responseis to adjust the beliefs. Whether the dissonance occurs in a doomsday cult orin a corporate boardroom or a trading room, self-esteem often gets in the way,and the adjustment does not always occur. For Marian Keech and her followers, the unresolved inner conflict was so great that mere rationalization couldnot ease the discomfort; affirmation from others was required to allay theshame of having acted foolishly.Undercover research is frowned on today, and since Festinger’s study, research into cognitive dissonance, groupthink, and similar irrational phenomena has consisted mainly of Monday-morning quarterbacking of past eventsand contrived experiments involving college students. The remarkable thingabout Abelson’s columns is that they provide a real-world case study of cognitive dissonance involving trillions of dollars of lost wealth and the reputationsof powerful securities firms.
118 Practical SpeculationAs Festinger noted, the attempt to maintain consistency in one’s beliefsand self-esteem gives rise to maladaptive behavior. When you have gone farout on a limb and so many people have followed you, and there is much “sunkcost,” as economists would say, it is difficult to admit you have been wrong.That is exactly why the scientific method was developed: so that people, bethey scientists, traders, doomsday cult leaders, or leading financial columnists, could adjust their beliefs based on constant feedback between hypotheses and evidence.The scientific method involves experiment and observation.Its essence is a humble attitude toward one’s state of knowledge.There are as many ways of doing science as there are scientists,but everybody agrees that it involves four elements:Induction: Forming a hypothesis—a testable statement.Deduction: Making specific predictions based on the hypothesis.Observation: Gathering data.Verification: Testing the predictions against the data.Throughout the 1990s, while the Dow and S&P 500 quintupled and theNasdaq enjoyed a ninefold gain, Abelson predicted an imminent crash basedon one or more of the following: overextended prices; high price/earningsratios; weak pessimism; weak bullishness; strong bullishness; high interestrates; inflation resulting from low interest rates; a weak dollar; fiscal extravagance; low dividend yields; the weakness of the Fed; Clinton’s fiscal extravagance; the narrowness of the market’s advance; the percentage of stocksbelow their 52-week highs; market capitalization as a percentage of GDP;the growing number of chartered financial analysts; the oversupply of newequity; a shortage of stocks to meet the demand of mutual funds; the presence of the “little guy” in the market; the generous salaries paid to nanniesin Greenwich, Connecticut; an indoor skating rink in a Hamptons home;similarities to conditions prevailing before past crashes; trouble overseas;the imminence of recession; the imminence of recovery; debt reduction;the inability of companies to raise prices; and Abelson’s favorite, speculative excess.The adjustment of beliefs afforded by the scientific methodsurely was not taking place.The market’s major decline in the new century made Abelson’sideas finally appear relevant. This does not chasten us in the least. Investorswho followed the columnist’s advice during the many years he was wrongwould have long ago lost all their chips.
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The Critic’s StoryIn a July 25, 2001, interview, Abelson told Laurel that he approached the market as a skeptic. “That’s the contribution I think I’ve made to financial journalism,” he said. “You’re supposed to bring a critical presence to the field.”Without in any way minimizing the importance of skepticism to the field of financial journalism, or Abelson’s own laudable contributions to the field, wewould draw a line between skepticism and unrelenting gloom in the sunshine.Laurel interviewed Abelson at Barron’s offices in the World FinancialCenter in lower Manhattan. Barely two months later, terrorist attacks destroyed the neighboring World Trade Center, forcing Barron’s and its parentcompany, Dow Jones & Company, to abandon 200 Liberty Street for NewJersey. On the day of the interview, lower Manhattan really did look like thecenter of the financial world. The harbor was full of private yachts, and themirrored buildings reflected the July sun.Abelson was waiting at the elevator doors to lead the way to his office. Ashort, trim man, he wore tan slacks and a blue-and-white shirt with a brightplaid tie. His office was not particularly large, but it was private and it had ariver view. A four-shelf bookcase lined one wall. Two computer terminals sat onthe desk. A few cactus plants provided the only greenery. Laurel and Abelsonsat at a small table.Abelson had not contemplated a career as a financial journalist, he said.Born October 12, 1925, in New York City, he graduated from Townsend Harris High School, then earned a dual degree in English and chemistry fromNew York City College. He earned a master’s degree in creative writing at therenowned University of Iowa Writers’ Workshop.Back in New York, he took a job as copy boy at Hearst’s New York JournalAmerican, one of the city’s several now-extinct afternoon papers. He became areporter in the business section, and in 1956 went to work as a jack-of-alltrades at Barron’s.His first job at Barron’s was editing investment stories, “which was interesting because I didn’t know anything about investing.” To learn, he read amanual on markets from cover to cover. The rest of his market knowledgecame through interviewing sources and from perusing Securities and Exchange Commission filings in the fray of reporting.He began developing a style of reporting—tough-minded, skeptical—modeled on nonfinancial journalism. “Until the 1960s, nobody ever wroteanything critical of the stock market,” he recalled. Press releases and thespeeches of corporate chairman were summarized unquestioningly. The best
120 Practical Speculationwriting—Ida Tarbell’s exposé of John D. Rockefeller’s Standard Oil Trust, forexample—had been done by generalists, not financial journalists.“There’s so much bullishness in Wall Street,” he said. “Brokerage housesturn out tons of material, companies issue press releases—that’s all bullish. Idon’t think sounding a skeptical note is threatening the life of the republic;I think that’s what journalists are supposed to do.”In 1966, then-editor Robert Bleiberg asked Abelson to write a column.Speculation was rampant. The market was filled with colorful characters. Itseemed to Abelson that the period had been created especially for him towrite about.Nevertheless, he said he took the job reluctantly. “The column was alwaysa sideline,” he said. “I was assistant managing editor, I was running severaldepartments. Those were my priorities. We always had a very thin staff.”Laurel noticed two copies of Peter Bernstein’s Against the Gods: The Remarkable Story of Risk, one of the finest histories of statistics available, onAbelson’s shelf.2 She remarked on them to Abelson, and asked if he had studied statistics. The answer was no. “Statistics can really be the undoing of ajournalist,” he said. “They’re too fascinating, like crossword puzzles. Peopleare always making statistical comparisons—in the end, they don’t add up toanything.” He does