Misusing the Most Powerful Computer

There is a perfect storm tempting many traders and investors.  The increased power of computers, the easy availability of data, and the user-friendliness of software have made it possible for nearly anyone to backtest trading systems.  The result is that people with no background or training in research methods are using the most powerful tools, but not knowing how to do it.

The sad result is the story of the system trader we covered in an earlier post, and the need for a scientific method for using the tools.  One of the comments to that post did a nice job of summarizing the best approach — saving lots of out-of-sample data, making sure the method works in different eras and markets, testing equity curves during the relevant periods, etc.

Here we introduce a new idea, one that I have never seen before.  Perhaps readers will alert me to some other mention of this notion, so that I can cite it (since this is a blog about a book).

Suppose I told you that my computer discovered a certain technical "set-up".  Let us say that it was a double bottom, followed by a five-month rally in the stock or index.  The wise system tester might ask how many such instances there were, the comparative results, and expect an out-of-sample test after discovering an apparent relationship.  Such are the methods used by system gurus like James Altucher (whose book on trading systems we recommend in our reading list) and our own Vince Castelli.

Computer systems are evaluated with scientific skepticism and rigorous demands on testing — and rightly so.  That is the world of the system trader.

Most market participants do not have the requisite skill set to evaluate systems.  They do, however, have another "skill" that is exceedingly dangerous — looking at charts.  Everyone believes in his own ability to look at a chart, see trends, see breakouts, and see correlations.

They use the most powerful computer — the human mind — to follow a process vaguely similar to the development of a trading system.  The human analyst takes the current market situation and seeks out some past situation that seems similar.  Instead of using a computer technique, the human comes up with an old chart and compares it to the new one.

There are multiple problems:

  • No one asks how many such "set-ups" there were, or what happened in all of the cases.
  • There is no question about whether there are enough cases to form a conclusion.
  • There is no out-of-sample testing.

The effect on the average reader, including market professionals, is very powerful.  The charts seem quite similar.  It is very much like the behavioral finance concept of anchoring, where a totally irrelevant fact predisposes humans to accept the fact as a base point for reality.  In the behavioral science literature a random number is often used as the base point.  Even though people know that it is random, it still has a powerful effect.

In the case of the old chart, the human parses through history to find the desired example.  Since almost no one understands how to test this, but all think they know how to read charts, the effect is powerful.  There is often little effort to compare the fundamental similarities and differences between the two time periods.

Sometimes the chartist offers several different stocks or indices from the same period.  Since the indices are all highly correlated, this actually provides no additional information, but it seems to make the argument more powerful.

While on vacation last week I read an analysis of this type at Barry Ritholtz’s site, The Big Picture.  Barry, who is more skilled than most on behavioral finance traps, thinks that this is relevant to the current market.  In fact, Barry cites similar work in Barron’s.

At "A Dash" we believe that such comparisons lack the requisite testing, the sort that we would routinely perform on technical predictions.  Barry is doing what everyone does, and he does it well.  Our objection is that the method is unsound.

Expert humans, even the most astute fund managers, are unduly influenced when someone does what we call human data dredging.

Since the influence of this is powerful, it provides an opportunity for those who reject the approach.  Let us be completely clear.  We are not saying that the conclusion is false.  Our position is that the analysis provides no useful additional information, yet it influences many in a specific direction.

One of the major themes at "A Dash" is that astute Wall Street professionals are subject to the same behavioral finance problems as individual investors.  Knowledge of the literature does not necessarily inoculate one against the effects.

The lessons for investors and traders alike is to view such comparisons with the same skepticism they would have for computer models.  If many others are influenced by the questionable information, the contrary trade is indicated.

The Psychology of Fear

When markets become volatile (the media euphemism for declines) fear often takes hold.  In this environment investors and traders who are operating on "feel" or advice from media sources often react emotionally.  Dr. Brett Steenbarger, who writes extensively and expertly on these subjects identifies the operating elements today in his article on how to handle volatile markets.  As usual, Dr. Brett draws upon scientific literature, in this case from neuroeconomics, to describe the biases we all face.  Everyone should read his article and follow his links to get a better understanding of the problem.  Whether or not one agrees with our particular approach, it is important to proceed from reasoning and not from emotion.

Last week we addressed this problem, but it deserves further analysis.  We look today at the general issue, but will try to provides some specific stock examples in future posts.

How Fear Develops

  1. There is a background of frightening forecasts.  This goes with the territory.  Some of those writing have short positions and want to cash in.  Others are promoting their blog or their book, catering to a specific audience.  Even though the forecasts may have been incorrect for months (or even years) their audience is primed.
  2. Something happens that seems to validate the hypothesis.  Quantification and formal modeling is not necessary.  Anecdotal evidence is sufficient to gain attention.
  3. Mainstream media pick up the story.  This is a natural result of the need to "explain" any market move.
  4. Technical analysts point to the market moves as validation of a new trend, breaking of support, and deep insight into the future.  It is interpreted as a message from the market.

In short, an initial move in the market (or in specific stocks) is interpreted as a validation of a theory.  This can take place even when the theory itself has limited factual support.  (Last year we described an interesting example of this knee-jerk reaction in a specific stock, Intel, when media coverage presented an opportunity.)

The Current Issues

The current selling relates to two major issues, the sub-prime mortgage market and the yen "carry trade".  The question for a rational trader or investor is whether these are phenomena that are limited and localized, or whether the issues extend to many stocks and the market in general.

Those promoting fear suggest that the problems of a few companies that were too aggressive in lending is a harbinger of overall economic weakness.  They do not have a formal model or any quantification, but use slogans like "a fungus among us" and imply that that major financial institutions are threatened by bad loans.  When management of these firms assert that their loan portfolios are sound, the fear promoters are skeptical.  They believe that CEO’s ignore Sarbannes-Oxley requirements and risk legal sanctions to hype their businesses.  They see the worst, even when earnings records are solid.  These vocal bloggers and pundits are mired in the 2000 era — fighting the last war.

Finding some Clarity

At "A Dash" we pride ourselves in finding the real experts on any topic.  Often this means placing little reliance in bloggers who take pride in never studying economics and looking to those who have a proven record and a great feel for current conditions.

Rich Karlgaard’s column today presented a fresh piece of analysis from David Malpass.  When he gets permission to reproduce Malpass’s proprietary work (which we always read and often quote), everyone should jump at the chance to read the entire piece.  It is well worth the time.  Here is the key quotation:

We disagree with the view that
the U.S. expansion is fragile due to housing, mortgages or past rate
hikes.  Since 2003, housing-related industries have accounted for only
4% of the 7 million in net new jobs (including residential
construction, mortgage brokers and Realtors).  Mortgage equity
withdrawals have substantial correlation to net acquisitions of
financial assets but little correlation to consumption (as shown
clearly in 2006’s weak MEW and weak net acquisitions versus strong
consumption growth).  The economy grew steadily through 17 interest
rate hikes, arguing that it may turn out to be sensitive to the level
of interest rates but was not very sensitive to rate hikes from low
levels.

For anyone who chooses to look at evidence rather than to react emotionally, this means that the market is punishing stocks that are sensitive to economic growth.  (Obvious full disclosure:  We own such stocks and we are buying into the decline).

Malpass wrote another piece, not reported on the Karlgaard site, showing the relatively small proportion of global liquidity linked to the yen carry trade.  While it seems obvious to us that those borrowing in yen and using eight or ten times leverage are buying bonds, not investing in Caterpillar or FedEx, the current market reflects a different viewpoint.

Forming a Plan

Mr. Market is offering investors an opportunity to buy good companies at discounted prices.  My most astute long-term investors are adding to positions.

For traders the problem is trickier.  Part of the reason for the current decline is that traders are waiting to see when these stocks — and the market — will catch a bid.  The trading problem involves guessing the psychology of others as well as being right on the fundamentals.

It is still helpful for the trader to understand the dynamics and be prepared for action. 

Wallstrip: A Peter Lynch Agenda?

Our daily read of the always-entertaining Wallstrip.com (now added to our recommended sites) today took us to consideration of International Gaming Technologies.  After enjoying Lindsay Campbell’s undercover work in Atlantic City (you should, too), we started talking about how the site might help us in choosing investments.

We realized that the stories had a "Peter Lynch" quality, setting the table with companies that had products people used and knew.

We see the stories not as an answer, but as an agenda.  The companies covered are all about where the action is, and what is attracting customers.

As always, an investors must do their own homework, but many will find the companies reviewed to be an interesting place to start.

And they will have a lot of fun doing it!

no positions — yet …

Pinch-hitting for Lenny

Lenny Dykstra was scrappy and successful as a major-league baseball player.  I often had Dykstra on my fantasy baseball teams, since I was always willing to "pay up" for him in the draft.  Since his retirement from baseball, he has been putting together an investment fund for athletes.  This is important since their big earnings years end early but their needs continue.  Dykstra has gotten some nice media exposure and also writes a column for theStreet.com’s premium site, RealMoney.

Reading his column today, I shouted out, "Hey, Ryan!  Lenny Dykstra recommends buying the July doubles (calls with a 55 strike, expiring in July) in Amgen."

Ryan is our (very astute) trader and also a sports expert.  He asked, "Do you mean THE Lenny Dykstra?  Is this good news, or should we be selling?"  Ryan was joking, because we also hold a deep call in Amgen, one of our favorite positions.

Dykstra, according to this story, learned to identify key buying points by studying with Richard Suttmeier, chief market strategist for Joseph Stevens & Co., and also a RealMoney contributor.  Suttmeier uses technical analysis to determine key trading points and has a model that projects fair value for various stocks and sectors.  Dykstra uses this information for buys.  He chooses to sell quickly when the stock makes a small gain.  It is a very active trading style.

It is not our mission to tell Lenny Dykstra how to trade his positions, particularly since he says it has worked well for him.  For our readers, however, we would like to recommend an alternative approach.

What Seems Wrong

These options have a very high delta, making them stock equivalents.  Playing for a one-point move in the option, as Dykstra does, increases trading costs and caps the gain.  Dykstra does not offer any advice on what happens when the position moves against him.  This must happen with some frequency.  Is there a trading stop?  The strategy described runs counter to traditional trading advice about letting winners run and limiting losses.

What Works for Us

What we do is to use deep calls as a stock substitute in positions where we have a long-term fundamental view.  We use technical analysis to aid in entering the position and adjusting it.  We start with a call that has low premium over parity (15% or so) and about 85 deltas.  If the stock sells off, we have protection because the option gains more premium as it declines toward the strike.  The deltas become smaller and the premium over parity increases.  There is also an absolute limit to losses in case of some disaster.  If the stock declines and our fundamental reasons for owning it remain intact, we roll to a lower strike, perhaps in a longer month, and add dollars.

If the stock price increases, we roll the position up, taking money off the table.  This allows us to continue to profit from a big run while managing risk.

Summary

It all starts with identifying good stocks.  No system will work without a sound stock-selection basis.  We choose the same stocks in our fund that we buy in our successful program for individual investors.  We have proven that the deep-call approach has higher gains than a buy-and-hold strategy, while taking less risk.

A crucial concept is taking the right position size.  We do not buy more exposure in options than we would take if buying the underlying stock.  Those who use deep calls to take outsize positions are adding too much risk and getting too little diversification.

There are many ways to trade successfully.  Time horizon and attention to risk are both critical. Traders and fund managers who have some longer-term positions might wish to consider our approach.

Meanwhile, we wish Lenny Dykstra the best of luck in his efforts.  We hope that he can help many of our favorite athletes.

Margin Debt and Sentiment

Margin debt tracked by the New York Stock Exchange has hit a new record high.  Traditionally, this is viewed as a sentiment indicator reflecting extreme bullishness.  The interpretation is bearish and contrarian.  It is a risky thing for stocks if anyone interested in buying has already done so — and borrowed money to do it!  That is the interpretation placed on the data by the Wall Street Journal.  Here is the lead from their report:

A rising stock market continued to inspire investors to go into debt to
buy stocks last month, sending margin-debt figures past their previous
record, which was set several years ago in the waning days of the
tech-stock boom.

At the Big Picture, Barry Ritholtz starts with the traditional interpretation, writing that "As of today, more people have borrowed money from their their brokers to buy stocks than ever before."  Barry goes on to explore some factors that prevent a direct comparison with the old record, set in 2000.  His readers also make a number of good comments.

A fundamental question is whether margin is also used for short selling.  Bill Rempel (aka No Doo-Dahs!) raised the question in a thoughtful analysis of Bloomberg’s report on the story.  The  Bloomberg author did not himself know the answer.  In a second story, Bill lays out several factors to consider before using margin debt as a sentiment indicator.  He raises excellent questions for anyone interested in making careful comparisons.

When we entered the hedge fund business, all of the prime brokers wanted to know how much short selling we would do and whether we would use margin.  The money generated from the short sales is profitable for the brokers since the interest they earn is greater than that paid to the hedge fund.

Perhaps readers will help enlighten us on the factors making up the margin debt measure.  Meanwhile, regular readers of "A Dash" know that we regard market valuation as the best long-term sentiment indicator.

The Most Expensive Investment Research of 2006

I had an interesting call this weekend from my most astute investor.  Since he wants to be anonymous, let’s call him "Bob".  Here is our conversation, with a few pointers and charts included — items that he requested I send him by email.  [Readers will benefit from taking the time to follow the links to past posts.]

Bob:  I enjoyed reading your research reviews last year, and I have a question.  What was the most expensive Wall Street research for 2006?

Jeff:  Do you mean the report that had the highest price tag?

Bob:  (chuckling) No!  I mean the one that cost people the most money.

Jeff:  Ahh.  Good question and the answer is easy.  The research on what happens when the Fed is trying to achieve what people call a "soft landing."

Bob:  That would not have been my guess.  I was thinking the election cycle or something.  What was so bad about the Fed and the soft landing.

Jeff:  It was a perfect storm for harming the individual investor and average trader.  First, the original work was a poor research design, but subtle enough that it took some skill to see the problem.  Second, it came from a big name firm so it got a major play in the media – basically accepted as gospel on CNBC.  Third, the concept was elusive, and subject to misinterpretation.  Finally, the leading blog sites gave it a big play.  The result was that anyone listening missed a big rally.

B:  You sound like a professor.  But I asked the question, so what was wrong with the research.

J:  Lack of data is the main problem.  There have not been enough Fed tightening cycles to draw sound conclusions.  You have to reach too far into the past, and then you still do not have enough cases.  The researchers used all of the data they had without regard for relevance.

A technique used in Research Design 101 is to look at a time series of results.  The reported research results assumed that the Fed is no better now than it was in the Hoover Administration.  This is typical of Wall Street.  Fund managers all figure that they are smarter and better.  In any other field of study we expect that there has been great progress – nuclear power, space exploration, biotech, DNA matching, weapons development, better airplanes and cars – you name it.  Despite this, the Street thinks that decades of Nobel Prize winning research in economics and the development of computer modeling make no difference.  Criticizing the Fed is a game, like second-guessing football coaches.

Take a look at some real data on recessions.  A good question is what proportion of the time the economy has been growing versus in recession.  This chart shows that by decade.
Recessions_by_decade It is readily apparent that the economy is now more resilient.  But the chart does not tell the whole story.

Fed tightening cycles have also had less impact on stocks.  Recessions — whether or not they result from tightening cycles — have had little impact on the overall earnings prospects of the market, as measured by earnings expectations for the S&P 500.
Sp_500_earnings_timeline_1
Recessions, when they occur, are briefer and with a smaller impact.  This is the best way to look at the data — as a continuous process of economic performance.  It reflects many factors, not just the Fed.

Even if one looks at the data from the perspective of a discrete series of Fed moves — the wrong method in my view — the stock market effect is quite different from that suggested in the original research.

After_the_fed_3If one  looks at "recent" data — say from the last thirty years or so — the  result is much different  from the conclusion drawn from the  "dead ball"  era used in the original research.  If you are trying to forecast, would you think that thirty years was far enough back to go?  In running your business, would you look at the recent trend or go back to the 20’s or the 50’s?

B:  I remember hearing and reading about this repeatedly.  Everyone said a soft landing was nearly impossible.

J:  That’s right.  We pointed out these problems in mid-August, but the media was running with the story.  CNBC quoted the study repeatedly.  Major writers featured it.  The big-time bearish blogs called it a myth.  They utilized pejorative symbolism which frightened the individual investors.  I warned about this out on "A Dash" and also in individual conversations.

B:  So those who listened to the mainstream media and the blogs lost out?

J:  Big time.  Those who did not understand this Fed cycle  have missed a big rally.  Even if there finally is a correction or recession, stocks may not dip back to the August levels.  Look at the chart.
[click to enlarge]Sp_500_6_months
Investors have missed 15% in the S&P 500 and 20% in the Nasdaq while waiting for a Fed-induced correction.  (Meanwhile, Vince’s intermediate-term models gave us a buy signal on August 8th.)

Even if we eventually have a correction or a recession, the pullback may not take us down to the August levels.

B: What do you mean about "understanding this Fed cycle."  You are not suggesting that this time is different are you?  We all know that is a mistake.

J:  When the tightening starts from a level that is far below "neutral" and proceeds very gradually to a point that is slightly above neutral, it is different.  It is not like a tightening cycle where inflation was already out of control, and the Fed needed to choke the economy.  I repeat that there are not enough cases for a quantitative analysis of tightening.

B:  Personally, I have followed your advice and remained invested.  Some of my friends have not.  What would you tell them?

J:  I am not surprised that many have missed out.  The misinformation on this subject reached many — perhaps millions of investors, while "A Dash" has a loyal readership best measured in hundreds.  That is actually a good thing for those who are just now getting involved. Most still do not understand, and we will see some fund managers chasing for performance.

Despite the rally, I feel that most of the opportunity remains.  Stocks have only begun to catch up with the record run of earnings growth.  I have tried to illustrate that in my valuation stories on "A Dash".

B:  I have been reading that earnings are going down, reverting to the mean.

J:  That just means that we are returning to normal growth instead of exceptional growth.  Don’t confuse a lower rate of growth with an actual earnings decline.  Take another look at the chart of forward earnings.

Meanwhile, I’ll try to cover the subject of misleading articles on earnings.  The list of topics grows….It is more difficult when writing fresh analysis.

And our conversation reverted to the normal subjects — sports, bridge, poker, kids, and good restaurants.  It is nice to have some astute investors who ask good questions.

Build your own trading system? Hmm…

Not so long ago, designing a trading system was viewed as a highly technical problem that required talented developers, special background, and great skill.  An individual investor would no sooner build a trading system than he would a refrigerator.

Advertisements for brokerage firms signal that this has all changed.  Several of the leading discount brokers now bombard television watchers with the same message:  You CAN do this at home.  One firm explains how easy it is to develop and back test strategies with their online software.  Another uses rotoscoped images to capture the indignation of some investors who are all smarter than their brokers.  A third shows investors making smart moves while taking a minute away from running the restaurant or the construction site.

At "A Dash" we have tried to show the challenges in developing systems and interpreting data.  Making powerful software simple to use and data more readily available just makes it easier for non-experts to lose a lot of money.

One graphic example is better than many admonitions from us.  Check out the story of a rookie prop trader and his foreign exchange system, as reported by Tyro.  Tyro’s friend was intelligent and methodical.  He did a lot more work than most and took what he believed to be a cautious approach.  After a month of awakening at 5 AM to test his system through paper trading, he was ready for the real show, going carefully with 2% positions.  You can guess the result.

He did many things right, but it is so easy to go wrong.  Go to Tyro’s site and read the entire well-told tale.  Thanks also to Trader Mike for highlighting  story.

Aspiring system traders should read (at least) Fooled by Randomness and the Portfolio Management Forumulas, the first book in the Ralph Vince "trilogy" (both featured on our recommended list at the right).  These books will explain many of the traps as well as some good methods for testing a system.

If you do not find these books to be real page-turners, (we did), then system trading is probably not for you.

Enhancing Trader Performance by Brett N. Steenbarger

At "A Dash" we have been reading Dr. Brett Steenbarger’s recent book, Enhancing Trader Performance, now featured on our recommended list.  (Some time spent in air travel is always good for serious reading.)  Our audience will find this book quite helpful.  In general, we feature work as we specifically cite it in our own analysis.  There are so many applications in this book, that we will be pointing to it repeatedly.

For now, let us consider a very general review, showing who will find the book helpful and why.

Greatest Strengths

The greatest strength of this work is the authoritative combination of theory and practice.  Dr. Brett draws upon a body of theoretical literature showing a logical progression from building competence, moving from competence to expertise, and using that expertise to become successful.  It is the whole package presented by a great writer who understands the theory.

Unlike many works where the strictly academic approach renders them inaccessible to most readers, this book is fun.  Each theoretical step is salted with examples from those who have achieved great success by implementing the principles.  The reader learns about how noted athletic performers like Dan Gable, Wayne Gretzky, Muhammad Ali, and Lance Armstrong employed the specific methods described.  This does not mean, of course, that these athletes had all read the relevant literature.  Instead, they learned or developed key methods on their own.  Nonetheless, their success demonstrates the power of the theories.

For traders, another great strength of the book is the application of theory to practice.  Because of his personal work in observing and helping traders with their problems and methods, Brett’s writing really comes to life.   Anyone has done some trading will recognize the characters in themselves or someone they know.  Any trader has experienced many of the same foibles as the featured characters, who are all real traders. The reality of the examples gives the lessons
and advice the ring of authenticity.

Wider Applications

While the book is aimed at a trading audience, it is quite useful for anyone engaged in competitive activity where performance is measured.  This is not just about trading.  Those competing in athletics or games of the mind will find the work most helpful.  Our own experience involves competing and coaching people in competitive activities like bridge, backgammon, chess, sports handicapping, poker, and debate.  Nearly every chapter has lessons for those striving for success in these fields.

An Important Lesson

There are also important lessons for the individual investor.  So much of today’s marketing makes it seem easy for anyone to beat the market.  Enhancing Trader Performance shows that learning the key lessons to become successful is hard work.  It requires a level of commitment that many would not have.  It is better to know this before starting, than to learn the hard way.

Summary

Briefly put, this is a must-read for traders and for system developers.  It is also recommended for those engaged in any competitive activity.  Finally, it is useful for individual investors.  Taking the time to understand the problems faced by top traders is the first step.  Those unwilling to make the time commitment to read and learn are unlikely  to achieve long-run success.  Read this book first!

The Black Swan Challenge

Trader Mike is one of my daily reads.  If you are serious about trading or investing, he should also be on your list.  He is always a source of great ideas, information, and links.  Today he has done a beautiful job of describing the key elements of the Amaranth blowup.  To get a complete understanding you should follow the links in his post.  (He has the tagging implemented nicely, and I am just trying to learn it.  It is one thing to have information and another to convey it.  In my classes, I had notecards and legal pads.  I wrote things on a blackboard and challenged students — no PowerPoint, which had not been invented yet!!  The old guy is trying to learn the new tagging tricks.)

On to today’s challenge:

Suppose that you had a trading strategy that would normally just break even, or perhaps even lose a little each month.  That does not sound very good, does it?  Now let’s further suppose that the strategy scored big on any "black swan" event.  In short, it could be genuine portfolio insurance.

How should you present this to the world?  Is anyone interested?  How many managers have something like this as part of their portfolio?

(For those following the job applicant series, there is a scheduled applicant with a method like this, but circumstances and Mike’s great post have prompted me to advance the "challenge").

The Risk Challenge

Can you specify the risk in your positions?

  • What is the worst thing that could happen?  How much would you lose?
  • How should you measure risk?  Is it a question of daily volatility?  What about absolute risk?
  • You may have positions that seem uncorrelated to the market.  The positions may even seem negatively correlated (think airlines and energy stocks) so that they offset each other.  Could anything happen to change the relationship?
  • Do you have a plan of action if something negative happens?  Do you "fade the move" getting bigger, or do you stop out your positions taking a loss?  Without an advance plan, it may be difficult to think clearly in a crisis situation.
  • Does backtesting accurately reveal risk?

These are certainly not all of the questions, but they are important ones.  Traders and investment managers who do not have good answers may find themselves facing a day of reckoning.