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Gamblers, Scientists and the Mysterious Hot Hand

IN the opening act of Tom Stoppard’s play “Rosencrantz and Guildenstern Are Dead,” the two characters are passing the time by betting on the outcome of a coin toss. Guildenstern retrieves a gold piece from his bag and flips it in the air. “Heads,” Rosencrantz announces as he adds the coin to his growing collection.

Guil, as he’s called for short, flips another coin. Heads. And another. Heads again. Seventy-seven heads later, as his satchel becomes emptier and emptier, he wonders: Has there been a breakdown in the laws of probability? Are supernatural forces intervening? Have he and his friend become stuck in time, reliving the same random coin flip again and again?

Eighty-five heads, 89… Surely his losing streak is about to end.

Psychologists who study how the human mind responds to randomness call this the gambler’s fallacy — the belief that on some cosmic plane a run of bad luck creates an imbalance that must ultimately be corrected, a pressure that must be relieved. After several bad rolls, surely the dice are primed to land in a more advantageous way.

The opposite of that is the hot-hand fallacy — the belief that winning streaks, whether in basketball or coin tossing, have a tendency to continue, as if propelled by their own momentum. Both misconceptions are reflections of the brain’s wired-in rejection of the power that randomness holds over our lives. Look deep enough, we instinctively believe, and we may uncover a hidden order.

More here – The New York Times

Apparently Its All Over For Commodities

Commodities form an important part of my trading universe, in fact as a I par back my universe of instruments they form a more and more integral part of what I do. This pivotal role occurs for a few reasons ranging from ease of trading, price discovery and familiarity. The first trade I ever did was on a gold stock and the interest has stuck with me for decades.  You would therefore expect that I take an interest in the market so I had more than a passing interest when this article dropped into my news feed. There are a few points I want to dissect. However before doing that it has been my experience that there are two interesting phases in the life of any market. The first is when people start to tell me this time its different. Etched indelibly into my brain are the words of Irving Fisher who could be considered one of the worlds first celebrity economists who days before the 1929 crash uttered the immortal phrase stocks have reached a permanently high plateau. The second phase is that when someone tells you that a given instrument is stuffed beyond repair and will never go up again. Neither sentiment is reflective of either the cyclic nature of markets nor the psychology of traders.

Point 1 – Firms leaving the business.

This is an interesting point because it points to the number of prop firms leaving the business. However the number of retail investors exposed to commodities via ETF’s has grown dramatically so there has been a shift in the markets demographic away from wholesale to retail. The five largest commodity ETF’s managed almost $6 billion in assets.

Point 2 – Low Volatility

This point highlights one of my enormous bug bears it is the confusion between volatility and trend – the two are not the same and one doe not rely upon the other. I thought I would take a further look at this and just have a look at the distribution of volatility within the gold market. The first thing I did was simply look at the average 15 day volatility for a given number of years ranging from 15 years to the YTD and the results are shown below.


Depending upon the look back period you can make a point that there has been a drop off over time in volatility . However volatility is relative concept and the current volatility in the gold market is sitting at 11.8% which is just below the average volatility for the YTD. Yet price has trended from around $1,000 to $1,350 and then back down to around $1,000. Looking at short term volatility tells us nothing about the trend. When looking at volatility I thought I might be missing something so I broke the look back period into five year blocks to get a sense of how it might have changed over time and the results are below.


When volatility is broken into blocks you can see that over time volatility has increased and then tapered off a little. The so called halcyon days of two decades ago that every longs for actually had markedly lower volatility than recent times.

I should also point out that volatility in the crude oil market regularly spikes to beyond 60% so i am not sure where this missing volatility has ended up. Again it is probably the perennial confusion between trend and volatility.

Point 3 – Correlation

This point always interests me because people very rarely make it clear whether they are talking about price correlation or returns correlation. Most people when they talk about correlation talk about price without meaning to. The correct measure in such situations is the correlation between the returns across asset classes. True diversification is generated when you generate uncorrelated returns. Te first chart below looks at the daily performance correlation for gold, S&P 500 and crude oil.


There is what appears to be an emerging positive correlation between gold and the S&P 500 and this surprised me a bit and I was suspicious that it was an artefact in the data so I generated a new series of data that looked back to the beginning of the century because my suspicion was that what I was seeing was actually the stagnation in gold and the rise of the US market post the GFC.


Looking at the data over much longer term gives a clearer picture of what is actually happening. As US markets collapsed gold recovered and as US markets recovered gold suffered so to my eye the emerging correlation is somewhat of an artefact in the data. Much is implied in the article about how good commodities trading was in the past but it needs to be remembered that gold took 31 years to surpass its 1980 highs. That’s a long time between drinks if you are a long only trader as many commodities firms were. Commodities are the magic swing through mutli hundred dollar range tools that people think they are.

Point 4 – Leverage

An irrelevant point if you know what you are doing. Leverage has been a function of commodities markets from day one and is the staple of FX markets and they dont seem to have any problem coping.

Point 5- Liquidity –

I am not certain what the point is here since volume in the majority of commodity markets has increased dramatically over the past decade.

Point 6- Regulation

This is an old catch cry – if you dont know what you are doing blame the regulator. In some ways this is the same as football coaches who blame the umpire for their team being rubbish.

Point 7 – Its downright difficult

There is a particular sentence here I want to highlight –

For one, their idiosyncratic characteristics can make price forecasting practically impossible.

Price forecasting for all instruments is impossible. For those who need a quick refresher on how stupid this sort of thing is I give you Jon Boormans wonderful, regularly update guru predictions chart.


Any attempt to predict price in any instrument is an exercise in delusional stupidity of the highest order.

The upshot of all of this is that the majority of things written about markets that have any sort of predictive narrative about the trajectory of a given market or markets is largely irrelevant and that includes this piece. The simple fact of all markets is that they are cyclical in both tone and the level of investor involvement. If I can defer momentarily to a local example. If you were to look at a comparison between housing and equities as an investment choice you would say that equities are dead. Yet funds continue to invest in them and prices continue to go up and down and some prices go up a lot.  The same is true for commodities and I doubt it will ever stop being true.



Guru Predictions Chart

Following on from using sentiment to try and predict the future Jon Boorman has updated his wonderful guru predictions chart.

Predictions 2

Source: Jon Boorman

Investor Sentiment….Who Cares….

This is a chart of investor sentiment as produced by the American Association of Individual Investors. Each week the association polls its members with the question where do you feel the stockmarket will be in the next six months. The results are tallied to give a percentage bullish, bearish or undecided. These sorts of metrics are given great status in certain parts of the investing community and I have to admit when I first entered this business back when we all rode dinosaurs and wrote on slates I spent many and evening looking at sentiment indicators trying to work out exactly what they actually did, if anything.


A simple maxim when looking at  survey data is to look at the population that is generating the results you are looking at. In this instance individual investors are being asked their perception of the market over a given time period. It is important to note that investors are being ask to rate what is effectively and emotional response to the market – do they feel bullish, bearish or disinterested. They are not being asked a quantitative question. A quantitative question would something simple such as how tall are you? A sentiment or emotional question would be how tall do you feel? Such questions can be considered context questions and are such are dependant upon circumstance. For example I stand about 1.93 metres tall and yesterday I attended a 10 year birthday party so my perception of my height is that I am  giant. However, if I was playing in the NBA where the average height is over 2 metres then I would be less cocky about my height. To put it into the context of this survey around 10 year olds I am bullish about my height, around NBA players not so much. My height has not changed, what has changed is the context of my height. The same is true for these investors when polled, there is no context given to the circumstances that generated their response. For example if you have just come off a winning trade then you are apt to be bullish about the future. If you have just come off a losing trade then your confidence would be shaken and you might be more circumspect about the future.

However, there is a further point to be considered and that is the somewhat blunt one of who cares what average investors think about anything? The narrative fallacies of individuals is of no concern to any other market participants. But more importantly it is of absolutely no concern to the market. There is no way to communicate either the perceptions of individuals or the results of their collective perceptions to the market and given that average investors are consistently wrong in their perceptions it doesn’t seem to matter what they think.

This does raise the question of what about the polling of professional investors  and professionals are often surveyed about their perceptions of the market and people attempt to divine something from this sentiment. However, this approach also runs into problems. Consider the table below which was drawn from the Investor Intelligence Database. The table operates on a simple maxim. When fund managers are bullish they move out of cash and into stocks. When they are bearish they do the reverse. This cash/asset ratio was measured and then compared to the Dow to see whether the move was prescient in any way. Unfortunately, it wasn’t. The professionals managed to be correct in their interpretation of sentiment on only 7 out of 33 occurrences. You would have been better off tossing a dart.

Mutual Fund Record

At the heart of much of this surveying is an attempt to generate some sort of predictive modelling about markets. I note that the current fad is to look at social media tools such as Twitter to see if they tell us anything about the underlying emotional intensity of the market. Whilst I sympathise with the need for the average investor to try and predict where the market is going for the time being trading remains a reactive profession that is best served by simply looking at price, making a bet and managing the trade. Despite what many would have you believe it is not rock science.

What Crisis?

In somewhat of a similar vein to the post on scary charts I came across this piece yesterday –

For the past 40-50 yrs, those years ended with “7?” always spell trouble.
1977? – International Currency Crisis
1987?- Oct 19 Black Monday Crash
1997?- Asia Financial Crisis
2007?- US sub-prime Crisis
2017? – ?

There is a certain silliness on this sort of financial numerology and I understand that certain cultures place a lot of stock in such thing. But then my ancestors used to paint themselves blue and hit each other with bits of bone, something that we have grown out of. However, as with most so called patterns I was intrigued as to what the data actually said, so I generated a list of major financial shocks going back nearly a century. I did this because going back 40 to 50 years is cherry picking as is leaving out most of the events that occurred during that time. I found the following –


As you can see there is no pattern nor are there any magic numbers or dates. This one can go in the same bin as the trope that October is the worst months for the stockmarket.



Does News Move Markets….Sort Of…Maybe…Well No Actually

I was chatting the other day with someone who was having trouble with their trading system. Their approach was based on trading news events. Such a plan is predicated on the notion that news events move markets in certain ways and whilst this movement might not be wholly predictable it will at least generate some form of activity. Such a trading system has a single giant assumption – that news and news related events move price. If this maxim does not hold up then the system is a bust.

It has been sometime since I looked at this question and I had a vague recollection of research done in the 1980’s that looked at this question and found that news as a source of trading ideas was a bust. So armed with the dimmest of memories I went looking through my archive and found what I was looking for. David Cutler, James Poterba and Lawrence Summers produced a working paper titled What Moves Stock Prices for the Department of Economics at MIT in 1988. This paper looked at the 50 largest single day moves in the US market since World War Two – I have included the events from the original monograph below.

Event 3

If you take a cursory look at the events above you could argue that news events do move markets. However, there is a glitch in that some movements defy explanation – there is simply no event that can be seen as a casual trigger for a market move. Cutler et al stated that news events could really only be useful as an agent for movement in about half of all cases of the variance in stock price movement and in my world half is a fluke.

The interesting side issue with the work of Cutler et al is that it puts another hole in the Efficient Market Hypothesis because stock price movements according to the EMH reflect the assessment of investors to new information. If markets move without the the addition of new information to the system then something else is happening that is not explained by the EMH. And it seems in the case of broad brush analysis as performed by Cutler that prices move without any significant input.

This initial work has been expanded upon by Ray Fair at Yale University who looked at outsized movements in the S&P500 futures contract. This new work had much greater granularity to it in that it looked at five minute data, something that would have been difficult in the original work by Cutler and crew simply because the available technology would not have allowed it. Fair compared what he defined as big movements with news items emanating from the Dow Jones News Service, Associated Press and New York Times. The upshot of this investigation seemed to be that the majority of large events have no news based driver. They were only able to attribute a news item to 69 of the 1159 big moves that were examined. Recent  flash crashes seem to support this notion of significant market moves  occurring without a notional driver.

So we come back to the original assumption that news events drive markets and that these moves offer opportunities that can be traded. It would seem on the evidence available that this notion is false.

‘Earnings bonanza’ to fuel strong growth for Australian shares in 2017

I do enjoy it when people email me to ask me about something they have read in the media. My enjoyment comes from the simple fact that I dont read business publications. I find them irrelevant, stupid, depressing and generally lacking in original thought. However, in the spirit of being polite I did take a look at this article from the Fairfax trash pile. The basic contention is that corporate earnings will go through the roof and that this will drive share prices through the roof. Implicit within any such article are two very basic assumptions and these assumptions are the foundations upon which this argument sits. At the heart of the piece is the assumption that analysts are capable of making accurate predictions regarding the direction of earnings. Secondly, it is assumed  that perceptions of future earnings drive share prices.

With regard to the former, the forecasting track record of advisors is poor with a tendency to consistently overestimate earnings as shown by the image below. Analysts are persistently in the grip of optimism bias when it comes to forecasting and this adversely impacts their ability to make any form of accurate forward judgement. This lack of ability is also clouded by the hubris involved in thinking that you can make an accurate prediction about anything.


Source – Dr Ed Yardeni

The psychology behind this incompetence is reasonably easy to understand once you understand the nature of the finance industry. This is the dont bite the hand that feeds you syndrome. Within the finance industry very little money is now made by the sell or advisory side of the industry. The big money has always been in corporate advising, that is restructurings, capital raising and the like. It is here that the fees total in the tens of millions of dollars. As such you dont want to offend companies that you might do very lucrative work for by telling everyone that their business is crap and that the company is run by people who would struggle to run a Mr Whippy van. It is much better to tell everyone that that the sun shines out of their proverbial and that everyone will get a free unicorn in the morning.

The second assumption is whether or not earnings drive share prices and this to my way of thinking is a more interesting problem since it moves into the realm of investor perception. To get a sense of this I looked at the year on year changes in earnings for the S&P 500 and compared that to the yearly return for the S&P 500 and plotted these initially in the form of a simple bar chart to get a sense of any form of relationship.

earnings bar

However bar charts dont really give a true sense of relationships or correlations so I  plotted the data as a smoothed scattergram.


So the question is what do the squiggly lines tell me. They tell me that sometimes earnings growth and share prices move together and sometimes they dont and if I do a bit of dodgy stats-fu on my trusty old Casio I find that that changes in earnings and share price growth have a very weak correlation of 0.37. The reverse intepretation is that most of the time they dont share a relationship. But there are some caveats in generating correlations. The correlation I generated is what is known as a Pearsons correlation, this looks at the linear interdependence of variables and it can be affected by outliers such as we see in the rebound from the GFC. I also wonder about true independence between variables over time – my concern comes from the fact that markets seem to have memory and this in turn loops back to the impact of data on investor perceptions over time.

The wonderful thing about being a trader is that our perceptions and our benchmarks are very simple and they revolve around the idea of whether something can help us to make money. In this instance neither the faulty predictions of analysts nor their profoundly weak impact upon price movements convinces me that that either idea lives up to their hype.







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