SENTIMENT

This is more art than science, but I believe it is very worth taking note of these sentiment extremes, they imply a contrary to intuitive reversal.

Regards

Mike

MY WAVE COUNT

 

HUSSMAN EXPLAINS THE SO-CALLED MONEY ON THE SIDELINES

“As I used to teach my students, if Mickey sells his money market fund to buy stocks from Ricky, the money market fund has to sell some of its T-bills or commercial paper to Nicky, whose cash goes to Mickey, who uses the cash to buy stocks from Ricky. In the end, the cash that was held by Nicky is now held by Ricky, the money market securities that were held by Mickey are now held by Nicky, and the stock that was held by Ricky is now held by Mickey. There may have been some change in the relative prices between cash, money market securities and stocks, depending on which of the three was most eager, but there is precisely the same amount of “cash on the sidelines” after that set of transactions as there was before it.

“I'm similarly convinced that Wall Street has no idea what it's talking about when it uses the word “liquidity.” While using the phrase “global liquidity” lends a further element of worldly sophistication, Wall Street still hasn't the slightest idea what it's talking about. The phenomenon that's being called “liquidity” is nothing more than a combination of fiscal irresponsibility and risk blindness, and will ultimately prove itself to be the time-bomb that it is when investors begin to “re-price” that risk.

All of that is as true now as it was at the time in 2007, when the S&P 500 was above 1400. Investors hoping to ride a “wave of liquidity” may eventually discover that the wave leads to a plunge over the falls.

 

GLOBAL SNAPSHOT

 

US REITS

I think we are so close to a pull back

LOW VOLATILITY

This chart shows the low volatility in the US markets which fits in with why we have been buying puts.

The ULTIMATUM GAME

Over the last 4 weeks I have become increasingly intrigued by the irrational psychological responses typical of players in a game economists call the Ultimatum Game. The game was developed in 1982 by Guth, Werner, Schmittberger and Schwarze.

The game works like this: Player A, receives $100 and is asked to share it with Player B in a ratio at his/her discretion. The twist in the game is Player B the receiver of Player A's discretionary donation has the right to accept the donation or interestingly decline it so that neither player A or B is entitled to hold onto any of the $100 windfall.
 
I decided to put my laboratory jacket on and conduct the experiment with my 2 children aged 9 (girl) and 6 (boy) so that I could witness first hand their behaviour.  Having studied some of the vast literature I had a strong feeling how the experiment would turn out; unfortunately I wasn't surprised. 
 
The essence of this simple experiment is to check the axiomatic construct of Classical Economics - "rational man or Homo economicus". Once again you will see by extrapolation that to rely on what the mainstream economic experts predict for the economy using their models, is to rely on theory so riddled with contradiction that not questioning its economic reality is probably similar to the way the fund of funds behaved whilst investing with Bernard Madoff. The Austrian School deals with this by basing their thesis on the "acting man" principle which Mises describes as the study of Praxeology in his magnum opus, "Human Action". I will leave a comprehensive look at this subject for another time, save to say that there is no 1 size that fits all, rather human action is the process of subjective marginal utility.
 
So what happened with the kids, I can hear you asking? Gabriella was given $10 and I asked her to please share it with her brother and I explained to David that he had the choice to accept or reject the offer with the consequences described above. Gabriella chose to keep $9 and share $1 with her brother (incidentally, this split is the most typical offer in the research), David in keeping with the typical response to an offer in this ratio (75% of respondents voted in this manner) chose to decline the offer so that neither of them got anything. The explanation I got from my son without any shame or rhetoric is exactly the same as what the literature suggested. He said, "if she gets more than me then I would rather that we both get nothing". Interestingly the more equitable the split, in other words the closer to a 50:50 split, the more willing Player B is to accept the offer.
 
Now I ask you as rational human beings does it make logical sense to reject an offer that makes you better off. The logical answer is NO, but who said we are logical/rational. Game theorists have tried to devise complex models for predicting outcomes to similar problems with varying degrees of success. So why am I sharing the Ultimatum Game with you? My reasons are to expose you to the idea that the world does not behave according to a formulae of logic; rather selfishness and perceptions of equity play powerful roles in our decision making process. So in conclusion when economic pundits, Chairman of The Federal Reserve, Presidents of Countries tell you with conviction that the economy is developing "green shoots" and we are about to sprout into an economic recovery, at least realize that the models they are using tell them that David Berman will accept the offer of $1 from his sister Gabriella.

TOPPING

The 1^st leg of the bear market rally is over or almost over. The bounce has been short in time but sharp in the pace of the rise.

We are position for and expecting at least a 10% drop from current levels.

The UNCERTAINTY GAME

I recently renewed my fascination with the game of chess and now spend a lot of my spare time either playing or thinking about the theory that encompasses this remarkable game; I might add that I am a relatively weak player in case you were wondering.
 
Using chess terminology there is a "book-line" for the ideal moves and responses for each particular opening. So if I begin with the Reti Opening, the chess gurus use optimization algorithms to analyse a massive database of games with this opening. These book-lines become the beacons along which the experts typically try and replicate the game so as to gain the advantage from the best road already travelled.
 
This on the surface seems quite boring as the winner then should be the player with the greatest memory, as I used to naively assume. However, the game of chess with its 64 squares and 16 white and black pieces (each) is far more complex and intriguing. Let me just run through some of the numbers which are quite remarkable.
 
The average number of moves in competition level chess is 40. Therefore I wanted to establish how many different combinations or new games exist, so I posed this question to the chess theorists and was astounded at their answer. Their recommendation was that I should ask the question how many new games of 100 moves exist on this 64 square board, as if this would make the comprehension any more logical (I suppose there should be fewer 100 move games than 40). How many possible 100-move games are there then? For every move there are typically 10 variations. The answer is 10 x 10 x 10 .... x 10, one hundred times over, 10^100, 1 followed by 100 zeros. A "googol" of games. To give this some context, the number of atoms in the universe are around 10^78 -- 1 followed by 78 zeros.
 
So you may be asking where the heck am I going with this astronomical information? You see even though there may be an ideal way of playing a particular game of chess (according to the depth of the database analyzed) almost all games are different because human beings are not robots, we are thinking human beings governed by pre-cortex impulses and are prone to make mistakes (in my case far too many). So the game of chess never becomes boring as there are an infinite number of games to be played.

When it comes to the markets and economic theory there are the so called chess book-lines, but the number of possible responses to each step of the economic/market process is equally infinite. The reason is the same as in chess, we humans the actors in the economic world have free will to make our own choices, never mind whether they are logical or absurd. So a system that proceeds along the notion of the Neo-Classical, Keynesian or Monetarist Economic Theory, centered on the rational man, is likely to make for an elegant theory on paper but wanting when it comes to real world application.

The Austrian School of Economics ("Austrians") have built their theory of economics on a much firmer foundation, thus incorporating man and his actions as the central theme of their theory, known amongst Austrians as Praxeology. Praxeology is the study of those aspects of human action that can be grasped a priori; in other words, it is concerned with the conceptual analysis and logical implications of preference, choice, and so forth.

To fully explain the concept of Praxeology is beyond the scope of this letter, my point rather is to convey that even a school of economic thought that is far sounder in its logic and its worldly application is unable to accurately quantify the likely outcome of a given set of economic events. At best adherents to the Austrian Schools principles are likely to enjoy a more efficient market place than believers of a logically flawed system implemented by morally corrupt politicians.


The reason I make these statements is to try and convey the framework with which I develop our macro themes in the Freestyle Fund and of course the real world we live in. Whilst I remain interested in fluffy theories such as "double dipping" and "green shoots" and prepare our fund accordingly for the seemingly endless knee-jerk reactions in the market to new policy; as hedge fund managers we have to, our job is to meet the demands of generating positive returns in the medium to long term; however, I wish to emphasize that our macro constructs are based on theoretically sound economic principals that provide us with the necessary tools to build profitable strategies, not whimsical intuitions that are subject to random results.
 
Daniel Faraday the brilliant physicist in the science-fiction mini-series thriller, Lost, realizes the solution to his quest for changing history. As someone who has discovered the formulae for time travel, he theorizes that by going back in time and changing the variables not the constants he will indeed be able to change history. In other words we have no influence over the constants in the historic time travel equation, but the variables are us human beings. Humans are free to choose based on subjective preferences at any given point in time and therefore assuming we can go along the time continuum there is no likelihood of our history repeating itself, as the number of variations to the game called life are many more Googols than a game of chess or an investment in the stock market. Thus Faraday in Lost is suggesting what took Phil in Groundhog Day many identical days in a time-loop to figure out; we can and do change our history based on our actions influenced by subjective preferences at a point in time.
 
Understanding that there are no equations that can scientifically predict how thinking individuals (my theory differs slightly when dealing with group thinking) will react to a given circumstance is the first step in making a major leap forward in our understanding of the uncertain investment universe. The uncertainty that comes with this understanding is what separates science from fiction.
 
In conclusion, I leave you with a few thoughts on uncertainty. In his book On Being Certain, neurologist Robert A. Burton quotes F. Scott Fitzgerald – “The test of a first rate intelligence is the ability to hold two opposed ideas in the mind at the same time and still retain the ability to function.” Buddhist teacher Pema Chodron calls it “being comfortable with uncertainty” – being willing to take every aspect of reality as the starting point, without wasting energy wishing things were different, without denying reality as it is (even if your next step is to work toward changing things), and without needing to know what will happen in the future. “The truth you believe and cling to makes you unavailable to hear anything new. The best thing we can do for ourselves is to be open to an unknown future.” Burton offers the same advice. Tolerating the unpleasantness of uncertainty, he writes, “is the only practical alternative to cognitive dissonance, where one set of values overrides otherwise convincing contrary evidence.

Jaguar Inflation

Mises Daily by Robert R. Prechter, Jr. | Posted on 2/19/2009 12:00:00 AM

[The original version of this article appeared in the February 20, 2004 issue of The Elliott Wave Theorist, a year before the housing-credit bubble burst. An MP3 audio file of this article, read by Dr. Floy Lilley, is available for download.]

I am tired of hearing economists argue that government and the Fed should expand credit for the good of the economy. Sometimes an analogy clarifies a subject, so let's try one.

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing Jaguar automobiles and providing them to as many people as possible.

To facilitate that goal, it begins operating Jaguar plants all over the country, subsidizing production with tax money. To everyone's delight, it offers these luxury cars for sale at 50% off the old price. People flock to the showrooms and buy.

Later, sales slow down, so the government cuts the price in half again. More people rush in and buy. Sales again slow, so it lowers the price to $900 each. People return to the stores to buy two or three, or half a dozen. Why not? Look how cheap they are! Buyers give Jaguars to their kids and park an extra one on the lawn. Finally, the country is awash in Jaguars.

Alas, sales slow again, and the government panics. It must move more Jaguars, or, according to its theory — ironically now made fact — the economy will recede. People are working three days a week just to pay their taxes so the government can keep producing more Jaguars. If Jaguars stop moving, the economy will stop. So the government announces "stimulus" programs and begins giving Jaguars away. A few more cars move out of the showrooms, but then it ends. Nobody wants any more Jaguars. They don't care if they're free. They can't find a use for them. Production of Jaguars ceases.

It takes years to work through the overhanging supply of Jaguars. The factories close, unemployment soars and tax collections collapse. The economy is wrecked. People can't afford repairs or gasoline, so many of the Jaguars rust away to worthlessness. The number of Jaguars — at best — returns to the level it was before the program began.

The same thing can happen with credit.

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing credit and providing it to as many people as possible.

To facilitate that goal, it begins operating credit-production plants all over the country — called Federal Reserve Banks, Federal Home Loan Banks, Fannie Mae, Sallie Mae, and Freddie Mac, all subsidized by monopoly powers or government guarantees — to funnel credit to the public through banks. To everyone's delight, banks begin reducing collateral requirements and thereby offering credit for sale at below-market rates. People flock to the banks and buy.

Later, sales slow down, so banks cut the price again. More people rush in and buy. Sales again slow, so lenders lower the price to 1% with no collateral and no money down. People return to the banks to buy even more credit. Why not? Look how cheap it is! Borrowers use credit to buy houses, boats, and an extra Jaguar to park out on the lawn. Finally, the country is awash in credit.

Alas, sales slow again, and government and banks start to panic. They must move more credit, or, according to its theory — ironically now made fact — the economy will recede. People are working three days a week just to pay the interest on their debt to the banks so the banks can keep offering more credit. If credit stops moving, the economy will stop. So the government announces "stimulus" programs and begins giving credit away, at 0% interest. A few more loans move through the tellers' windows, but then it ends. Nobody wants any more credit. They don't care if it's free. They can't find a use for it. Production of credit ceases.

It takes years to work through the overhanging supply of credit. Banks close, unemployment soars and tax collections collapse. The economy is wrecked. People can't afford to pay interest on their debts, so many IOUs deteriorate to worthlessness. The value of credit — at best — returns to the level it was before the program began.

See how it works?

Is the analogy perfect? No. The idea of pushing credit on people is far more dangerous than the idea of pushing Jaguars on them. In the credit scenario, debtors and even most creditors lose everything in the end. In the Jaguar scenario, at least everyone ends up with a garage full of cars. Of course, the Jaguar scenario is impossible, because the government can't produce value. It can, however, reduce values.

A government that imposes a central bank monopoly, for example, can reduce the incremental value of credit. A monopoly credit system also allows for fraud and theft on a far bigger scale. Instead of government appropriating citizens' labor openly by having them produce cars, monopoly banking and credit machines do so clandestinely by stealing stored labor from citizens' bank accounts by inflating the supply of credit, thereby reducing the value of savings.

Twentieth-century macroeconomic theory — both Keynesian and monetarist — championed the idea that a growing economy needs easy credit. But this is a false theory. Credit should be supplied by the free market, in which case it will almost always be offered intelligently, primarily to producers, not consumers.

Print $17

Audio $25

"Let's go back to using real money."

Would lesser availability of consumer credit mean that fewer people would own a house or a car? Quite the opposite. Only the timeline would be different. Initially it would take a few years longer for the same number of people to save enough to own houses and cars — actually own them, not rent them from banks. Prices would be lower because credit would not be competing with money to bid up these goods. And, because banks would not be appropriating so much of people's labor and wealth, the economy as a whole would grow much faster. Eventually, the extent of home and car ownership — actual ownership — would eclipse that in an easy-credit society. Moreover, people would keep their homes and cars because banks would not be foreclosing on them. As a bonus, there would be no devastating across-the-board collapse of the banking system, which, as history has repeatedly demonstrated, is inevitable under a system of central banking and other government-created credit factories.

Jaguars, anyone? More credit? Here's a better idea: let's go back to using real money.

 

Yield Spread

The Yield spread in the US along with REITs has blown out to all time highs.
With the government spending program in place, and the strong possibility that REITs are about to put in a multi month low, I have gone short long bonds and long US REITs.
I put the trade on yesterday with the chart looking as below.
Fortunately there was significant weakness in the bond market and strength in REITs so it looks like our timing might have been spot on.

(for some reason the legend says it is bonds vs SAPY- this is an error as it is vs US)

IS THE SUN STILL SHINING ON S.AFRICA

I have marvelled for some time how SA and SA listed property in particular has side-stepped the world financial crisis, and the emerging market turmoil more particularly.
In the last few days I have watched a stream of negative economic data flow through my inbox in relation to SA's now clearly faltering economy.

The relative trade displayed below is once again an indicator for an excellent high probability profitable trade.

Short South Africa go Long Australia

I have been saying for some time that South African REITs are way too expensive.

One only has to look at their respective valuations against the worlds leading 1st world REITs to start asking questions. In South Africa you still have certain companies trading on historical yields below the long bond yield, history has proved this relationship should not exist and I have no doubt the necessary reversions will set in place before too long.
It wasn't along time ago when this phenomenon existed in the major REIT markets only to blow out well past the historical mean, and I mean well past.

I also get the familiar argument that the South African economy is stronger than many of the 1st world countries, which is currently reflected in the low vacancies and high (double digit) distribution growth numbers. Do not forget that the USA, Australia and other regions were also displaying similar fundamental strength preceding their respective swan dives into the abyss.

Do not be fooled by the fact that due to South Africa's relatively closed economy that it has been able to avoid much of the problems that have entwined the world financial system and in so doing buried the decoupling debate far below the average South African gold mine. Remember that SA is after all a 3rd world country with unemployment and crime at unacceptable levels. Remember that South Africa needs to export a lot of its resources to a shrinking world market, remember that South Africa's current account deficit is dependent on foreign capital inflows. Remember that South African politics is in complete disarray with alarming stories of corruption. Remember that South Africa is only able to grow its GDP in the 2 - 3% region far lower than the level needed to maintain and increase jobs. Before you get carried away with the growth story of South Africa's emerging black middle class, remember that China is growing at above 10% per annum and has a far larger emerging middle class, yet its share market is off 70% from its peak. Remember the World Cup was discounted into the share market years ago, and remember it was done so in an environment where the world traded on one of the lowest risk premiums in history. As the lustre begins to fade and the reality of the less than spectacular World Cup numbers come to pass and the many new white elephants that litter the metropolis and not the game farms, the markets may play catch up on the downside at a speed which will make the Rand's demise in 2001 a walk in the park.

So in conclusion wouldn't you prefer to own Westfield with its prime assets in Australia, UK & USA with low gearing paying a 10% dividend with muted growth if any than a Hyprop or Resilient with more debt on the balance sheet, in Africa, paying 7.5% with 10% growth for now with no real chance of maintaining this growth well into the future. (I haven't researched the numbers in the sentence above but are approximations used to illustrate my point).

At the end of the day the words used above are merely trying to explain the chart on the left which to me tells the whole story. Short South Africa and go long Australia, it is a no brainer.

Excitement vs Regret

Monday, February 23, 2009

I attended a workshop a couple of weeks ago (Van Tharp) and one of the exercises we did was examine where we may have conflict within ourselves.
One of the conflicts I brought up is the uneasy relationship between "excitement" which I usually associate with large positions and "regret".

What is interesting is that both emotions have positive intentions, in my case excitement is there to take me out of my comfort zone, to strive for more, to achieve my goals. Regret also has the positive intention of wishing to prevent feelings of I wish I never did that or I am such an idiot. What is clear from examining these 2 emotions is that they need not be apart and work against one another, rather if regret becomes a part of excitement in that certain ground rules are laid then there can be no cause for disharmony but rather on the contrary there should be better harmony.

How does one achieve this. The secret is to do ones homework and establish that in fact there is a suitable risk reward setup to place the larger trade. If in fact there is this payoff profile then regret has no place as the excitement is duly being rewarded for this increased risk. On the other hand if I am not going to do my homework then regret is correct in staying apart and that conflict should remain until such time as I am able to bring them together.

Trading Rules - Dennis Gartman

It is amazing how simple and brilliant these rules are, my only point of debate is reconciling these principles with a contrarian approach to trading.

If I have understood these rules correctly, Dennis is saying that you cannot trade contrarian profitably. You can have contrarian views, however, it seems according to him you need to wait for the new trend to take effect.

I need to give this more thought, however, those rules aside I think the rest make for a must when trading.


The "Not-So-Simple" (But Really Utterly So) Rules of Trading

The world of investing/treading, even at the very highest levels, where we are supposed to believe that wisdom prevails and profits abound, is littered with the wreckage of wealth that has hit the various myriad rocks that exist just beneath the tranquil surface of the global economy. It matters not what level of supposed wisdom, or education, that the money managers or individuals in question have. We can make a list of wondrously large financial failures that have come to flounder upon these rocks for the very same reasons. Let us, for a bit, have a moment of collective silence for Long Term Capital Management; for Baring's Brothers; for Sumitomo Copper... and for the tens of thousands of individuals each year who follow their lead into financial oblivion.

I've been in the business of trading since the early 1970s as a bank trader, as a member of the Chicago Board of Trade, as a private investor, and as the writer of The Gartman Letter, a daily newsletter I've been producing for primarily institutional clientele since the middle 1980s. I've survived, but often just barely. I've made preposterous errors of judgment. I've made wondrously insightful "plays." I've understood, from time to time, basis economic fundamentals that should drive prices--and then don't. I've misunderstood other economic fundamentals that, in retrospect, were 180 degrees out of logic and yet prevailed profitably. I've prospered; I've almost failed utterly. I've won, I've lost, and I've broken even.

As I get older, and in my mid-50s, having seen so much of the game--for a game it is, with bad players who get lucky; great players who get unlucky; mediocre players who find their slot in the lineup and produce nice, steady results over long periods of time; "streak-y" players who score big for a while and lose big at other times--I have distilled what it is that we do to survive into a series of "Not-So-Simple" Rules of Trading that I try my best to live by every day ... every week ... every month. When I do stand by my rules, I prosper; when I don't, I don't. I am convinced that had Long Term Capital Management not listened to its myriad Nobel Laureates in Economics and had instead followed these rules, it would not only still be extant, it would be enormously larger, preposterously profitable and an example to everyone. I am convinced that had Nick Leeson and Barings Brothers adhered to these rules, Barings too would be alive and functioning. Perhaps the same might even be said for Mr. Hamanaka and Sumitomo Copper.

Now, onto the Rules:

NEVER ADD TO A LOSING POSITION

R U L E # 1
Never, ever, under any circumstance, should one add to a losing position ... not EVER!

Averaging down into a losing trade is the only thing that will assuredly take you out of the investment business. This is what took LTCM out. This is what took Barings Brothers out; this is what took Sumitomo Copper out, and this is what takes most losing investors out. The only thing that can happen to you when you average down into a long position (or up into a short position) is that your net worth must decline. Oh, it may turn around eventually and your decision to average down may be proven fortuitous, but for every example of fortune shining we can give an example of fortune turning bleak and deadly.

By contrast, if you buy a stock or a commodity or a currency at progressively higher prices, the only thing that can happen to your net worth is that it shall rise. Eventually, all prices tumble. Eventually, the last position you buy, at progressively higher prices, shall prove to be a loser, and it is at that point that you will have to exit your position. However, as long as you buy at higher prices, the market is telling you that you are correct in your analysis and you should continue to trade accordingly.

R U L E # 2
Never, ever, under any circumstance, should one add to a losing position ... not EVER!

We trust our point is made. If "location, location, location" are the first three rules of investing in real estate, then the first two rules of trading equities, debt, commodities, currencies, and so on are these: never add to a losing position.

INVEST ON THE SIDE THAT IS WINNING

R U L E # 3
Learn to trade like a mercenary guerrilla.

The great Jesse Livermore once said that it is not our duty to trade upon the bullish side, nor the bearish side, but upon the winning side. This is brilliance of the first order. We must indeed learn to fight/invest on the winning side, and we must be willing to change sides immediately when one side has gained the upper hand.

Once, when Lord Keynes was appearing at a conference he had spoken to the year previous, at which he had suggested an investment in a particular stock that he was now suggesting should be shorted, a gentleman in the audience took him to task for having changed his view. This gentleman wondered how it was possible that Lord Keynes could shift in this manner and thought that Keynes was a charlatan for having changed his opinion. Lord Keynes responded in a wonderfully prescient manner when he said, "Sir, the facts have changed regarding this company, and when the facts change, I change. What do you do, Sir?" Lord Keynes understood the rationality of trading as a mercenary guerrilla, choosing to invest/fight upon the winning side. When the facts change, we must change. It is illogical to do otherwise.

DON'T HOLD ON TO LOSING POSITIONS

R U L E # 4
Capital is in two varieties: Mental and Real, and, of the two, the mental capital is the most important.

Holding on to losing positions costs real capital as one's account balance is depleted, but it can exhaust one's mental capital even more seriously as one holds to the losing trade, becoming more and more fearful with each passing minute, day and week, avoiding potentially profitable trades while one nurtures the losing position.

GO WHERE THE STRENGTH IS

R U L E # 5
The objective of what we are after is not to buy low and to sell high, but to buy high and to sell higher, or to sell short low and to buy lower.

We can never know what price is really "low," nor what price is really "high." We can, however, have a modest chance at knowing what the trend is and acting on that trend. We can buy higher and we can sell higher still if the trend is up. Conversely, we can sell short at low prices and we can cover at lower prices if the trend is still down. However, we've no idea how high high is, nor how low low is.

Nortel went from approximately the split-adjusted price of $1 share back in the early 1980s, to just under $90/share in early 2000 and back to near $1 share by 2002 (where it has hovered ever since). On the way up, it looked expensive at $20, at $30, at $70, and at $85, and on the way down it may have looked inexpensive at $70, and $30, and $20--and even at $10 and $5. The lesson here is that we really cannot tell what is high and/or what is low, but when the trend becomes established, it can run far farther than the most optimistic or most pessimistic among us can foresee.

R U L E # 6
Sell markets that show the greatest weakness; buy markets that show the greatest strength.

Metaphorically, when bearish we need to throw our rocks into the wettest paper sack for it will break the most readily, while in bull markets we need to ride the strongest wind for it shall carry us farther than others.

Those in the women's apparel business understand this rule better than others, for when they carry an inventory of various dresses and designers they watch which designer's work moves off the shelf most readily and which do not. They instinctively mark down the work of those designers who sell poorly, recovering what capital then can as swiftly as they can, and use that capital to buy more works by the successful designer. To do otherwise is counterintuitive. They instinctively buy the "strongest" designers and sell the "weakest." Investors in stocks all too often and by contrast, watch their portfolio shift over time and sell out the best stocks, often deploying this capital into the shares that have lagged. They are, in essence, selling the best designers while buying more of the worst. A clothing shop owner would never do this; stock investors do it all the time and think they are wise for doing so!

ADVERTISEMENT
Introducing The New Forbes.com Portfolio Tracker
Get the Web's best portfolio tracker... bar none. FREE! The new Forbes.com Portfolio Tracker is a user friendly yet powerful tool to help you track your holdings, conduct in-depth research and analyze performance for all stocks, mutual funds and indices listed on any of the major North American exchanges. Perfect for new and experienced investors alike. Visit www.forbes.com/portfolio today.


MAKING "LOGICAL" PLAYS IS COSTLY

R U L E # 7
In a Bull Market we can only be long or neutral; in a bear market we can only be bearish or neutral.

Rule 6 addresses what might seem like a logical play: selling out of a long position after a sharp rush higher or covering a short position after a sharp break lower--and then trying to play the market from the other direction, hoping to profit from the supposedly inevitable correction, only to see the market continue on in the original direction that we had gotten ourselves exposed to. At this point, we are not only losing real capital, we are losing mental capital at an explosive rate, and we are bound to make more and more errors of judgment along the way.

Actually, in a bull market we can be neutral, modestly long, or aggressively long--getting into the last position after a protracted bull run into which we've added to our winning position all along the way. Conversely, in a bear market we can be neutral, modestly short, or aggressively short, but never, ever can we--or should we--be the opposite way even so slightly.

Many years ago I was standing on the top step of the CBOT bond-trading pit with an old friend Bradley Rotter, looking down into the tumult below in awe. When asked what he thought, Brad replied, "I'm flat ... and I'm nervous." That, we think, says it all...that the markets are often so terrifying that no position is a position of consequence.

R U L E # 8
"Markets can remain illogical far longer than you or I can remain solvent."

I understand that it was Lord Keynes who said this first, but the first time I heard it was one morning many years ago when talking with a very good friend, and mentor, Dr. A. Gary Shilling, as he worried over a position in U.S. debt that was going against him and seemed to go against the most obvious economic fundamentals at the time. Worried about his losing position and obviously dismayed by it, Gary said over the phone, "Dennis, the markets are illogical at times, and they can remain illogical far longer than you or I can remain solvent." The University of Chicago "boys" have argued for decades that the markets are rational, but we in the markets every day know otherwise. We must learn to accept that irrationality, deal with it, and move on. There is not much else one can say. (Dr. Shilling's position shortly thereafter proved to have been wise and profitable, but not before further "mental" capital was expended.)

R U L E # 9
Trading runs in cycles; some are good, some are bad, and there is nothing we can do about that other than accept it and act accordingly.

The academics will never understand this, but those of us who trade for a living know that there are times when every trade we make (even the errors) is profitable and there is nothing we can do to change that. Conversely, there are times that no matter what we do--no matter how wise and considered are our insights; no matter how sophisticated our analysis--our trades will surrender nothing other than losses. Thus, when things are going well, trade often, trade large, and try to maximize the good fortune that is being bestowed upon you. However, when trading poorly, trade infrequently, trade very small, and continue to get steadily smaller until the winds have changed and the trading "gods" have chosen to smile upon you once again. The latter usually happens when we begin following the rules of trading again. Funny how that happens!

THINK LIKE A FUNDAMENTALIST;
TRADE LIKE A TECHNICIAN

R U L E # 10
To trade/invest successfully, think like a fundamentalist; trade like a technician.

It is obviously imperative that we understand the economic fundamentals that will drive a market higher or lower, but we must understand the technicals as well. When we do, then and only then can we, or should we, trade. If the market fundamentals as we understand them are bullish and the trend is down, it is illogical to buy; conversely, if the fundamentals as we understand them are bearish but the market's trend is up, it is illogical to sell that market short. Ah, but if we understand the market's fundamentals to be bullish and if the trend is up, it is even more illogical not to trade bullishly.

R U L E # 11
Keep your technical systems simple.

Over the years we have listened to inordinately bright young men and women explain the most complicated and clearly sophisticated trading systems. These are systems that they have labored over; nurtured; expended huge sums of money and time upon, but our history has shown that they rarely make money for those employing them. Complexity breeds confusion; simplicity breeds an ability to make decisions swiftly, and to admit error when wrong. Simplicity breeds elegance.

The greatest traders/investors we've had the honor to know over the years continue to employ the simplest trading schemes. They draw simple trend lines, they see and act on simple technical signals, they react swiftly, and they attribute it to their knowledge gained over the years that complexity is the home of the young and untested.

UNDERSTAND THE ENVIRONMENT

R U L E # 12
In trading/investing, an understanding of mass psychology is often more important than an understanding of economics.

Markets are, as we like to say, the sum total of the wisdom and stupidity of all who trade in them, and they are collectively given over to the most basic components of the collective psychology. The dot-com bubble was indeed a bubble, but it grew from a small group to a larger group to the largest group, collectively fed by mass mania, until it ended. The economists among us missed the bull-run entirely, but that proves only that markets can indeed remain irrational, and that economic fundamentals may eventually hold the day but in the interim, psychology holds the moment.

And finally the most important rule of all:

THE RULE THAT SUMS UP THE REST

R U L E # 13
Do more of that which is working and do less of that which is not.

This is a simple rule in writing; this is a difficult rule to act upon. However, it synthesizes all the modest wisdom we've accumulated over thirty years of watching and trading in markets. Adding to a winning trade while cutting back on losing trades is the one true rule that holds--and it holds in life as well as in trading/investing.

If you would go to the golf course to play a tournament and find at the practice tee that you are hitting the ball with a slight "left-to-right" tendency that day, it would be best to take that notion out to the course rather than attempt to re-work your swing. Doing more of what is working works on the golf course, and it works in investing.

If you find that writing thank you notes, following the niceties of life that are extended to you, gets you more niceties in the future, you should write more thank you notes. If you find that being pleasant to those around you elicits more pleasantness, then be more pleasant.

And if you find that cutting losses while letting profits run--or even more directly, that cutting losses and adding to winning trades works best of all--then that is the course of action you must take when trading/investing. Here in our offices, as we trade for our own account, we constantly ask each other, "What's working today, and what's not?" Then we try to the very best of our ability "to do more of that which is working and less of that which is not." We've no set rule on how much more or how much less we are to do, we know only that we are to do "some" more of the former and "some" less of the latter. If our long positions are up, we look at which of those long positions is doing us the most good and we do more of that. If short positions are also up, we cut back on that which is doing us the most ill. Our process is simple.

We are certain that great--even vast--holes can and will be proven in our rules by doctoral candidates in business and economics, but we care not a whit, for they work. They've proven so through time and under pressure. We try our best to adhere to them.

This is what I have learned about the world of investing over three decades. I try each day to stand by my rules. I fail miserably at times, for I break them often, and when I do I lose money and mental capital, until such time as I return to my rules and try my very best to hold strongly to them. The losses incurred are the inevitable tithe I must make to the markets to atone for my trading sins. I accept them, and I move on, but only after vowing that "I'll never do that again."

WHAT SEEMS LIKE AN ETERNITY

I have stated in my last 2 newsletters that I expect the November lows to be broken.
Well almost 3 months later we are about to witness this happening. No matter how firm ones conviction there is always the fear of being wrong. From my perspective I was never planning on betting the farm on this trade as the risk reward for being short this trade in size didnt permit excessive risk taking.

The question of course is how much further will this wave take us. In markets like Australia we have been beneath November for some time so the possibility of Aussie leading the recovery is quite high. This is the reason why I continue to purchase the Australian REITs despite the shocking news coming daily from their most recent quarter financial releases.
I continue to level out our short position as I anticipate a massive buying opportunity as a medium term bottom is formed. So in short what I am saying is that although this last leg of the selloff has good profit potential the risk of not being well positioned in the coming weeks for the mother of all buying opportunities is the basis for my continued buying into weakness.

MARKET VIEWS

I attach a chart of the Australian listed property trust sector (AREITs) over the last 5 years.

After enjoying what seemed to be a fantastic bull market, we have seen a precipitous fall that has no doubt caught most investors on the wrong foot.

One can certainly make the argument that this is no different to the performance of REITs across the globe, but the fact is this is only partly true, as yes global markets have suffered a similar fate yet Australia on a relative basis has fared worse. In the chart that follows you will see that over the last 5 years the relative performance has been steadily dropping and is close to 2 std-deviations from its mean; despite the attempt in the 4^th quarter of 08 to march ahead.

My simple explanation for this relative underperformance is due to the fact that Australia through its forced savings legislation (Super) amassed a pool of capital for investment that was far greater than the investment opportunities in Australia itself. As we know that money burns a hole in our pockets, the investment managers we placed our faith in clearly failed to heed this age old lesson and plunged head first into every conceivable investment venture around the globe. I am focusing on real estate but the same can be said for other asset classes. I recall being amazed at the statistics a few years ago when reading research reports that Australia was the 2^nd largest and in some countries the largest foreign investors in real estate.

I recall the main theme of NAREIT end of 2004 (I haven't checked the date) was the subject of the JV model, whereby US REITs would sell a few assets into an SPV which would be capitalised by typically an Australian fund whereby the newly capitalised SPV would then go on a spending spree. The beauty for the US REIT was they got to earn management fees on the properties they sold to the SPV plus all the new ones bought. This JV model I believe gave what used to be regarded as modest income growth stocks a fuel injection that led multiples to levels that were destined to fail.

The question we need to ask ourselves is for how much longer will Australia choke on its excessive offshore investments.

Knee Jerk Reaction

I have come to realise that the majority of people, even those with the knowledge to act differently, seem to act in the same way when we are confronted with certain circumstances.

I must confess this 1 dimensional thinking irritates me in its simplistic understanding of the complexity of the stock market. Let me explain what I mean.

You will find that around specific news events many people and I have one particular fund manager in mind when I write this will think that if the FOMC is about to announce a rate decision tomorrow they will wait until tomorrow and then place their trade on, in the expectation that the market will then go up if it is a rate cut or go down if it is a rate hike. The statistics will tell us the market behaves very noisily around news events which means the behaviour is typically random, and of course the market has long been discounted what the news event is likely to produce.

It therefore irks me when people say I am waiting to buy the market after the cut tomorrow. We have been witness to an increasing amount of market behaviour that has been contrary to these news events, such as major stimulus injection announcements and rate cuts, etc.

Volatility is Smiling

The volatility picture that I see is a sell off in volatility that is about to pick up as the IYR makes new lows. I do not foresee new highs in volatility, this ties in well with a 5th wave new low.

To play it particularly safe in the short term I am applying a delta neutral strategy by buying both calls and puts at spot, hoping that there will be an increase in Volatility.

Mr Gauss gets Killed by a Fat Tail

After spending a lot of time on my own and with the quiet to reflect I look back on this last year and draw the most satisfaction from the way our kids have adapted and thrived in their new environment. Ever the libertarian I was adamant that the kids adapt in their own time. Now for those believers in the Gaussian Distribution or better known "Normal" distribution of the Bell Shaped Curve I want you to know there is nothing normal about it. Just like the financial wizards and mainstream economists who believed the economy and the stock market behaved according to this "Normal" Distribution curve were unceremoniously killed by the bear markets "fat tail"; so do we make the mistake in believing kids/people develop according to a normal distribution. This distribution curve is nothing more than an elegant statistical equation which groups people in probabilities based on an observed historical sample. Unfortunately the formulae hopelessly fails to capture the reality in which a far greater proportion of the statistical outliers occur within the main body of the bell than the statistics would have us believe. What am I saying? I am saying that the world doesn't exist in an orderly patterned way, yes nature may present some order on the surface but beneath the veneer is a chaotic process developing in a manner that is far from normal. Take the current financial malaise, according to many Nobel winning economists this type of event should only happen once every few million years, but history shows us that it happens surprisingly frequently. Noted French Mathematician Bernard Mandlebroit published a book a few years ago where he provided excellent scientific proof refuting the normal distribution, so if you want to understand what I said more eloquently turn there for guidance. So Berman what is your theory now that you have bashed one of the most relied on, trusted, statistical tools the world has ever known.

 

If we as a people develop chaotically or as I would prefer us to believe, in patterned chaos (no this is not a contradiction, far greater mathematicians can prove patterns within Chaos Theory) then we need to provide broader scope in our categorization of what seems to the narrow thinking mind as normal. If a child achieves mastery of mathematics at 10 instead of 8 is that abnormal? If a child develops their 1st friendship at 8 instead of 5 is that abnormal? Yes I am speaking from an idealistic perspective as we as humans are  part of society and within society there are norms. It isn't well accepted for a 20year old to be in grade 7 I take the point, and it does a child no favours emotionally to be in a class that they are not coping with, and by the same token a child a lot older than his or her peers is not done any favours either as their emotional self worth is challenged by the school scoring system and the perception of their intelligence. The same theory applies to those positive outliers. For instance there are some kids who develop far quicker physically or mentally than others, by teaching them that they are special often backfires when the laws of nature slow down this early growth to more normal levels and the kid who was so special becomes average. This too leads to emotional baggage.  What we as parents need to accept is that societies ranking system of what is generally considered as normal is far from accurate and furthermore we as parents need to tap into the patterned chaos that provides us with the most accurate clues in our most precious assets development and potential.

 

As a libertarian committed to a free market my views on letting the kids develop in their own way needs to be tempered with the reality that kids are not fully comprehending participants of the game called life, and we as parents have the unfair advantage of experience which we need to use to coach these bundles of energy/potential. To achieve this balance one needs to almost be like a composer of a complex orchestral score. Where I lean too far to the left Ilana balances the equation with her exquisite intuition to the right,and when the discipline components sees me too far to the right she balances me to the left. Together this year we have made music, as our kids have developed at school, made friends and gained in health, albeit at a pace much slower than "normal" but quick enough to make a parent more happy than any material possession could achieve.