Thursday, May 27, 2010

Biggs vs. Sprott - Of Course My Money's on Sprott

Eric Sprott and Barton Biggs are quoted in the following article at two sides of the spectrum as to what the current market has got in store for us.  Biggs is very bullish and Sprott is very bearish.  I for one have been a fan of Biggs, as I believe he has made some clutch calls particularly last year.  Hoever, this time he has got it wrong, but he left himself some wiggle room.  The market theoretically could rally 1,200-1,400 points from the recent low and technically not break the head and shoulders pattern, but its stick a fork in it after that.  My money is with Sprott, and Barton's money I bet is with him too;-) 

It makes me wonder if Barton is working with a survivability bias...Survivability Bias in Indexes

$DJI / $SPX / COMPQ / UUP / XAU comparison chart, UGLY

Bloomberg News, sent from my iPhone to my Blog

Barton Biggs Says Stock Market Set to ‘Pop’ in Days

May 27 (Bloomberg) -- U.S. stock markets are oversold and may rally strongly in the next few days, said investor Barton Biggs, who runs New York-based hedge fund Traxis Partners LP.

“I think they’re going to stabilize in this general area, and then we’re going to have a significant move to the upside,” Biggs, whose flagship fund returned three times the industry average last year, said in a Bloomberg Television interview.

Biggs recommended buying U.S. stocks last year when benchmark indexes sank to the lowest levels since the 1990s. The Standard & Poor’s 500 Index rallied 23 percent in 2009 as governments worldwide mounted stimulus programs to counter a recession. On March 22 this year, Biggs told Bloomberg TV U.S. stocks had the potential to rally a further 10 percent. The S&P 500 has since declined 8.4 percent.

The gauge is down 10 percent in May, poised for its worst month since February 2009, as credit-ratings downgrades of Greece, Portugal and Spain add to concern some European nations will struggle to fund deficits. Futures on the S&P 500 gained 1.9 percent to 1,080.90 as of 9 a.m. in London today. The gauge closed at 1,067.95 yesterday.

“The market is very, very oversold, and I think we’re going to have a big pop to the upside some time in the next couple of days,” said Biggs. “I wouldn’t be surprised to see us go to a new recovery high, just to make everybody squirm.”

Beginning of Collapse?

His views are at odds with Eric Sprott, manager of the best-performing Canadian mutual fund with at least $1 billion in assets in the past 10 years. The S&P 500’s month-long slump is the beginning of a collapse that will drive the measure below its weakest level of 2009 in the next year, Sprott said.

The $1 trillion European rescue package announced May 10 has failed to stop the global equity slump, indicating investors are skeptical that efforts to address the debt crisis will work, said Sprott, who manages the Sprott Canadian Equity Fund. He’s buying gold and betting against stocks.

“The European concerns are serious, and I take them seriously,” Biggs said. “I just don’t think that the worst is going to happen.”

Templeton Asset Management Ltd.’s Mark Mobius said yesterday he’s been buying stocks in Brazil, Russia, India and China in the past month and called the slump in emerging-economy shares a “correction” in a bull market.

“Despite the fact that a lot of people think that we are entering into a bear market, we don’t believe so,” Mobius, who oversees about $34 billion in emerging markets as Templeton’s Singapore-based executive chairman, said in an interview in Cairo. “When the time comes, emerging markets will recover faster and in a big way.”

To contact the reporters for this story: Shani Raja in Sydney at .

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Are You a Survivor of Index Performance?

Is There Survivorship Bias In Index Performance?

In the performance analysis of hedge funds, survivability bias, -- the logical error of concentrating on the funds that "survived" some process and ignoring those that didn't -- can skew the performance results significantly for an investor or hedge fund of funds interested investing in hedge funds with similar strategies. For instance, many weak funds are closed and merged into other funds to hide poor performance i.e. GLG being bought by MAN, or Amaranth closing its doors for good can augment a historical view and spin a positive bias on the results of the "Survivors". If you were to exclude GLG and Amaranth (granted they were dissimilar strategies) in your measure of return performance in a given basket of hedge funds starting by including only those funds existing as of today in a five year look back, you would be susceptible to creating a positive skew in your performance return numbers. More often than not, even sophisticated investors seeking the best performing hedge funds or mutual funds will inadvertently be relying on fund or peer performance data that is positively skewed mainly because it doesn't include the return performance of weaker or dead funds.

When hedge funds and mutual funds develop marketing materials for their funds they will often include a benchmark (S&P 500, MSCI Hedge Fund) and their return performance as compared to their peers (funds with a similar strategy). They will often utilize a universe of funds that exclude dead or merged funds, as this puts their returns in a better light. This can result in a discrepancy of up to 1.6% of additional return performance (Alpha). Essentially you will have a fund that has an 11% return with the bias instead of a 9.4% return as calculated without the bias. When you are discussing amounts greater than $1MM this 1.6% is substantial. Since this bias can occur in many situations it is not inconceivable that this can also occur in indices, etf's or any defined basket of funds that trades or that can be invested in. It is also likely that positive survivorship bias has pushed indices like the DOW 30, S&P 500, NASDAQ 100 and Russell 1000 to an un-natural positive skew over time.

Survivability bias in effect plays into a lot of how we perceive the world and it can make a very real impact, positive or negative. Let's look at a couple of different examples.

Bullet holes: A brain teaser - During World War II the English sent daily bombing raids into Germany. Many planes never returned; those that did were often riddled with bullet holes from anti-air machine guns and German fighters. Wanting to improve the odds of getting a crew home alive, English engineers studied the locations of the bullet holes. Where the planes were hit most, they reasoned, is where they should attach heavy armor plating. Sure enough, a pattern emerged: Bullets clustered on the wings, tail, and rear gunner's station. Few bullets were found in the main cockpit or fuel tanks. The logical conclusion is that they should add armor plating to the spots that get hit most often by bullets. But that's wrong. Planes with bullets in the cockpit or fuel tanks didn't make it home; the bullet holes in returning planes were "found" in places that were by definition relatively benign. The real data is in the planes that were shot down, not the ones that survived.

This is a literal example of "survivor bias" — drawing conclusions only from data that is available or convenient and thus systematically biasing your results. Another great example of survivorship bias can also be found in Business Advice books – Here are some specific examples of survivor bias in business advice –

So far I've ("a smart bear") been asking rhetorically whether survivor bias might be severely skewing business advice. Steven Levitt (of Freakonomics fame) investigated this question directly.

He (Mr. Levitt) was reading Good to Great by Jim Collins, a book that analyzed eleven companies that were mediocre, but then transformed themselves into stock market sensations. A conclusion was that the common trait was a "culture of discipline." This book has sold many millions of copies, so it's a good example of popular writing on business advice. One of the eleven "great" companies was Fannie Mae, and Steven Levitt was reading this book just as Fannie was collapsing in financial disaster. Hmm, he thought, I wonder how those other "great" companies are doing. Turns out, had you invested in those eleven companies in 2001 (when the book came out), your portfolio would have underperformed the S&P 500! (Fannie Mae wasn't even the only case of total disaster — also extolled was the now-bankrupt Circuit City.) Why didn't these companies continue to succeed?

It turns out Jim started by combing through 1435 companies looking for good candidates for the book, and picked eleven. With such a large sample size he was bound to find companies that fit his criteria however, that didn't mean that they were great due to his hypothesis. On top of that, Jim doesn't bother asking whether any of the 1424 other companies also displayed a "culture of discipline." Maybe that's something that many public companies have regardless of performance. Is this book an aberration? Nope, Steven investigated another business book from the 1980s — In Search of Excellence — and found the same effect.

Given the previously mentioned scenarios for survivability bias we can extend this to the process of selecting and or deselecting stocks that are listed in the major indices, e.g. DOW 30, S&P 500 and the Russell 1000. Specifically, in the process of rebalancing the indices it is the tendency for failed companies to be excluded from indices because they 1. No longer exist, 2. Their market capitalization has fallen or 3. Their industry is in decline (which likely caused the first two reasons); this is considered Type 1, survivor bias. Inherent in this type of bias is the error you make in just counting the survivors.

Another type of survivability bias, is associated with companies which are successful enough to be included, but because they have not met the criteria for inclusion until recently, their 5 year look backs tend to include uncharacteristically high rates of return.
This is described as "The error of inclusion prior to qualification" or Type 2 survivor bias. This can introduce abnormally high return data if you were to include a company which today was added to the index vs. a company than has been "qualified" and in the index for some time. I imagine ETF's as a group have a propensity for huge performance survivorship bias, but this is just a hunch, not something I am interested in determining, but you might.
Does this mean that indices like the S&P 500, The DOW 30 and the Russell 1000 are inherently flawed?

Frankly I don't know and it is difficult to determine. I am not advocating that the indices are flawed… well ok they are flawed, but it's more a shortcoming than a handicap. Moreover the issue becomes how the underlying components of these indexes are viewed by people whose job it is to deconstruct the indices for a living. Think about this, a company gets dropped from an index. While a large amount of care is taken that the weighting of the indices isn't impacted negatively, a smaller amount of care is taken that a stock might perform too positively at the point of inclusion, but what of the next few years? With inclusion of the new next generation up and comer company, it is likely that it has been viewed as a leading contemporary of the future economy.

This suggests in essence an inherent upward bias in the indices. It's like changing out tired horses on the pony express for fresh legs. In December 2001, Enron was replaced in the S&P 500 with NVIDIA which brought the S&P to include approximately 77 NASDAQ weighted stocks. NVIDIA a 21st century stock replacing a 20th Century also ran, shenanigans notwithstanding. As an offset to the previous example TYCO was also replaced, by Northeast Utilities (NU). So while there is a bias in the indices, it's not something to be running from. The propensity of the index though given the selection and de-selection process suggests that it is positively biased.

What are the possible ways that survivorship biases affect the indices?

Money managers, fund managers, investors and even Traders struggle with this issue of survivability bias because it can cause a real discrepancy between a thoroughly back tested trading model and the real life market. In mutual funds many well regarded fund managers believe that survivorship bias can also overstate a mutual fund's performance returns by more than 1.6%. A trader struggles with it when the universe of stocks they selected by measures of liquidity and market capitalization changes over time. This assumes that their universe stays static and the indices of course do not.  The problem with indices relative to a static universe of stocks a trader is likely to select for their portfolio is outlined here in a white paper by Tick Data:

Universes where membership is based upon capitalization, such as the Russell and S&P indices, reward (include) companies whose stock prices have been outperforming, i.e. rising in relative ranking based on capitalization, and punish (remove) companies whose stock prices have fallen such that their market capitalization no longer qualifies for inclusion in the index.

For example, the 1050th company in market cap experiences relative outperformance versus existing members of the index and its market cap increases in rank to 990th. That stock then becomes a member of
the index on the next index rebalancing date. In the meantime, an underperforming company that was a member of the index is crowded out as its market cap now falls below the 1000th largest.  The outperforming stock is in and the underperforming stock is out. A trader that defines his/her
universe on the day following such a theoretical event will test his/her trading strategy only on the outperforming company and will never see the impact of the underperforming stock on the strategy's results. This is survivorship bias. 
However, it gets worse. Real-time practice begins to disconnect from simulation almost immediately. The next stock that rises up the ranks of capitalization to merit inclusion in the index will not be added to the universe. Again, I am assuming the universe, once defined, remains static. The underperforming company that was just crowded out of the index is not
removed from the universe. As a result, in real time the trader is not trading the outperforming company, is trading the underperforming company, and both are in direct opposition to what was done in simulation.

Moreover, how can survivorship bias impact index performance?

Well consider this scenario which Tick Data provides in their white paper, which I borrow heavily from to make my point. Enron, Worldcom Global Crossing, and endless dot com blowups maintained substantial influence in the Russell 1000 during Tick Data five year test period, 1998 - 12/31/2003. However by virtue of defining the universe (RUS1000) as of 12/31/2003, these companies, and their negative downside performance had been excluded. As time and distance from these points of failure increased so did the positive skew in the Index data from which many traders made their assertions and recommendations for investment decisions.

This is inherently problematic on two levels. On one level it creates a false level of optimism when looking at the Russell 1000 Index as the companies included in the index on or by 2003 excludes a significant number of major deadbeats, and in the same vein the companies that were replacements to the dead beats most likely exhibited extraordinary growth in a short time period, Type 2 bias e.g. Carmax which was added to the index in December 2002 and since they had a relatively short existence their 5 year historical analysis include returns of 477% in 2001 and 66% in 2000 this gets added to the mix and causes people deconstructing the indices to their basic components to drastically overstate an indexes relative performance.

This further compounds the optimism as you now have a company included in the data and the five year look back feeds the current optimism about the future value of the index. This is why you can have some people convinced that stocks are undervalued and other(s) are convinced stocks are way overvalued. Leaving investors thoroughly confused and scratching their heads wondering whether to stay or go.

The second level is a bit more sinister as when the "deconstructionists" forgo inclusion of the dead beats in their five year look backs it glosses over the amount of risk you take on, ignoring the very real possibility that a future bunch of drop outs like an Enron, Global Crossing etc. etc. can be modeled in your risk profile or their risk analysis. The end result is that it can't, and this creates a problem in modeling and assessing future risk appropriately, because you have sheltered your model from Enron/Lehman/Bear risk. This over simplified, can provide a good context with which to put the 2003-2007 rally into context, led by AAPL, GOOG, EBAY and a stalwart of other 21st century companies. All of a sudden stocks got really undervalued because the dead beats were gone and new thoroughbreds were added. It's akin to having a market that resembles a narcissists' selective historical view of their own performance attributes.

So what does this mean right here and now?

Well much like the survivorship bias was likely skewed positively from 2003-2007, we have ascribed that notion to the 2009 rally, especially since December 2009 – March 2010 many bad performances fell off the horizon. What this means is that the "deconstructionists" and their chief prognosticators are likely to start getting bullish when the Bear Stearns, Lehman's etc. etc. are just specks in the rearview mirror, and the inclusion of a new batch of upstarts creates an open road off into the horizon. However, we need to learn more about the planes that were shot down, before we can move forward otherwise we will unnecessarily risk very possible repeat of 2008-9. Be a survivor.

My name is William Tell Henderson and I Blog at

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Survivability Bias in Indices, Survivability Bias

Wednesday, May 26, 2010

The Case For DOW 4500 WATCH IT Unfold! - Week 4

Gee another down day, it'll not be too much longer before the Bulls DUCK and RUN... 

One thing I have been patiently waiting on is the fall out from this month's slide and impact -- almost certain -- to hedge funds from that near fatal whiplash hit from the "fLash Crash" (Not a Typo).  Keep your eye on the Hedge Fund Implodes in June it'll likely start to heat up as the redemptions start coming in if it hasn't already. 

In my last post John Henry vs The Steam Shovel, hedge funds were likely unwinding a good portion of their trades in mid-March and again in mid-April, whether they were the ones responsible for the May 6h carnage is up for debate.  Either they were the initial cause or they got caught flatfooted, in any case I suspect they started to accelerate their selling since, perhaps in anticipation of massive redemption requests. 

Fortunately for the market the hedgies could sell to the folks fleeing the carnage in Europe and the Euro, although their selling and the institutional selling in May quickly stunted that inflow into the US markets.  

One thing that will be different than last years' breakdown is the manner of selling by hedgies.  Remember all of the current hedge fund agreements with investors were revised post March 2009, and are fundementally different.  Nearly all the hedge funds changed their agreements with investors to require 90 days notice of redemptions and gates of only 25% of the investors money per month/quarter.  How this affect the hedgies and their holdings is not certain, but you can bet the next 30-60-90 days will likely be a great deal of them dumping their portfolios and moving to Cash?.?

I still expecting the DOW to rally into the end on May at least up to the 10,262-363 level, but given today's action, likely hedge fund redemption risk and North Korea's proclivities, we may not get back above 10,088.  Ouch!  

One thing for certain is that the right shoulder has been made confirmed as it broke the February 11th low.  It is inconceivable, but not out of the realm of possibilities that it could retrace this long Black/Red candle, and resume it's upward trend.  


Tuesday, May 25, 2010

John Henry vs. The Steam Shovel

The more I think of the "flash crash" the more it brings to mind this quote from Vernor Vinge.
"Within thirty years, we will have the technological means to create superhuman intelligence. Shortly after, the human era will be ended. ”
— "The Coming Technological Singularity" by Vernor Vinge, 1993

What he was describing was "the singularity", the point in time where machine or computer thought will surpass human thought. He based it on Moore's Law -- which states that the number of transistors that can fit on a chip would double roughly every 18-24 months -- extrapolating from there to suggest that in thirty years time the processing power of a microchip might be equal to or exceed that of the human brain. Technical singularity is akin to Vinges' prophecy but based on the advance of technology, to the point where better technology -- sans humans -- can create even better technology a recursive scenario. Yes... exactly like the movie iRobot.  
"Technological singularity refers to a prediction in Futurology that technological progress will become extremely fast, and consequently will make the future (after the technological singularity) unpredictable and qualitatively different from today. It is most often associated with the ideas of futurist Ray Kurzweil.[citation needed]
It looks as if that point in time has started to lap against our shores. It was fascinating to witness the "Flash Crash" first hand, which in my view has brought to the forefront the argument of man vs. machine. What hit home watching the CNBC coverage after the close of business on March 6th, 2010 was the rare interview with Mark Fisher, a trader of legend on the Chicago Mercantile Exchange, a super PIT Trader, a veritable John Henry character. Here warning of the dangers of relying on machines for trading. Lamenting the speed with which machines can trade at and the and the dire circumstances it will wreak on the markets, without the ability for humans to step in. This interview still in the heat of the moment was a poignant event.

We are clearly at a crossroads, the fundamental question being does having a human element interspersed with machines make it inherently more dangerous or does having a fully electronic marketplace make it less. Clearly a hybrid of an electronic/analog market is fraught with issues, just ask the heads of the NYSE and NASDAQ respectively who pointed at each other's platform as the culprit. '

The questions that have been asked and still at this point haven't been answered are

a. Is/Was the system design flawed?,
b. Was it gamed?
c. Is/Was this machine or human error, or both?
d. Was it all of the above?

My guess is that the explanation will be a long time coming. It is likely that we will never know what happened for certain mainly because any one of these answers in and of itself is too unsettling when 10's of Trillion of Dollars is held and accounted for by a system that is either flawed in design or can be gamed. I'm guessing that we will never get the equivalent of the thorough NTSB investigation of a fatal airliner crash when it comes to these market scenarios. For instance, where is the "black box"? Granted even if we do learn what happened it will have come out many months when we've likely to have forgotten or the findings deemed obsolete. Theoretically, we should be able to roll back the tape pretty quickly and do an instant replay but I'm guessing that the platforms are reticent of offering this capability. I am a little worried because all the focus apparently is on the systems and the trades of that day, and doesn't appear to be including the scenario of market manipulation, and I am not insinuating anything I'm just saying it needs to be ruled out. I don't think that can happen if the SEC is focusing on just what happened that day instead of focusing on the days leading up to and several days after that point. We need to do that to eliminate or rule out that the system was gamed.

On the question is or was the system flawed? My guess is that it wasn't and that the system worked as designed however, no one had anticipated a breakdown that would literally run down to the point past the built in circuit breakers. When it was realized that this literally could have snowballed into a real 1,000+ point loss in the 90 minutes left of trading, that is if the NYSE left the control rods out, they instead opted to pushed them in.

A lot of people have been making this out to be a technical glitch, and the facts don't seem to bear this out. What the commentary has been alluding to was that there is one glaring weakness of machines, and that is its ability to determine a company or stocks relative value. The idea that a machine would sell a Procter & Gamble at $39 a share without being able to recognize that this price was clearly incorrect or that the value of the company fundamentally wouldn't support this price is something that needs to change or does it? I was thinking of a most recent example with Intermune which in two days went from $17 to $48 in two gap ups and then went from $43 to $9 in one gap down, it didn't seem to be a problem with machines recognizing value there, granting of course that trading was either halted or the run up took place pre-market. Dendreon is another one that also comes to mind when you discuss break necking prices in a stock "Flashes".  If there are no buyers what price do you want to buy at?

What makes one "Flash Run" worse or better than another?

Here I thought Felix Salmon's article on Alpha Hedge, put it into perspective, that basically there was no difference from the Day of May 6th to this past May 20th Thursday when we went breathlessly towards the falsh crash low twice Intraday.

What his simple but insightful research suggests is that the flash crash although very fast was rooted in fundamentals. There is only one conclusion that May 6th was a bona fide and legitimate rush for the exits and May 20th confirms this.

Is the possibility this "Flash Crash" was instigated for some reason if who or what is the benefit?

Personally I am of the opinion that the "flash crash" was caused by human hands and quite possibly deliberately, not criminally, but deliberately executed. For what motive? Well to basically enable an orderly exit by big institutions and block traders out of huge positions, and likely save the US markets and potentially economy from a likely catastrophic event. This is clearly selling that could have fed on itself and burned itself to the ground, in what can be described as a race to the bottom. There is a scene in the movie Days of Thunder when Cole Trickle, intentionally redlines and blows his engine so that he doesn't have to face the fact that he has lost his nerve, how is that for a visual.

This is akin to the problems we witnessed several years ago in the wildfire prone west, where in our effort to create awareness and eradicate wildfires we have created a 30-50 year fireless environment and due to our complacency and false sense of security chose to build homes closer to danger. The build up of decades of underbrush created maelstrom's that were devastatingly fast, all consuming and deadly. The stop orders accumulating underneath the market action were the underbrush, when triggered, acted as natures perfect accelerant. What the NYSE did in essence was a controlled burn, if the NYSE market makers hadn't slowed down there systems deliberately the fire would have burned significantly more acreage.

What was so amazing about the "Flash Crash" -- watching it unfold -- was the rumor of a fat finger trade was rampant no more than 30 seconds after it started/ended and that it was immediately picked up by all the news outlets particularly by CNBC, which really should have had the story straight from the get go because they have reporters on the floor of the exchange, and apparently were not aware that the market makers themselves redlined the engine so that it blew. This action immediately, caused the stop loss orders to be blown out and the standing buy orders sitting at 10-20% discounts of the current prices to trigger creating a massive swell of buying momentum that they could easily sell into without driving down the prices too quickly. This worked brilliantly over the next few days as the fat finger trade or pointing to the machines made it seem like an anomaly, and created seemingly good bargains to get into really quickly. That is until the Fat Finger turned into a fist slamming on the sell button.

The selling had started a couple of months before this episode, but really started to accelerate after the Goldman Top, in fact it looked as if the market was settling into a flag, when all heck broke loose a la flash crash, and the follow through the next day created a wonderful buying opportunity of the stock "bargains". The fact that the selling took place late in the first week of the month was pretty telling as well, as during this rally they have ended as bullish weeks, it has been the 3rd week which has been  generally been bearish.

The selling continued into this "artificially" created demand for lower priced stocks, but the since supply is too great for the bulls to eat up and now as no real explanation has been forthcoming for the "Flash Crash" the more it appeared that the selling was real and highly motivated, the bulls got spooked. It is likely that the selling isn't over as we see the folks who bought into that early swell realize they just got their lunch eaten once again. They will likely get out this week if the market still struggles and bring us down to the next level of down. Or we will rally this week and trade in a range and wait for the first week in June. This should be a fun quarter end for everyone.

Has the technological singularity in the markets been achieved and were we there on Thursday? My hunch is no, but we are not far off. Do we need an all electronic market system? My personal conviction is a resounding Yes, the sooner the better. They may be steam shovels now, but we need fully transparent and accountable markets to fuel the next stage of our growth and this will not do.  With the proper safe guards -- think Toyota spontaneous acceleration problem -- we can limit the impact of bad system design and code until such time we can overcome it.

We are just three years removed from Vernor Vinges prophecy and it isn't so farfetched that trader's will likely be replaced by machines and that the true ideal of a fast and equal market will result. Many systems are already processing news signals on stocks and acting on signals and world statistics and signals quicker than a human can, (Blackrock's Aladdin System, Goldman Sachs, JPM and Renaissance Technologies, just to name a few. The one thing that we need to be aware and scared of is human intervention or gaming. As this will maintain the status quo.

My name is William "Tell" Henderson, and I blog at

singulariy, flash crash, crash, technological singularity
— "The Coming Technological Singularity" by Vernor Vinge, 1993


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