A Dash of Insight

Popular and Critical Acclaim

Over at The Big Picture Barry Ritholtz has some great suggestions about improving financial television.  We agree with the entire list, but especially like the following:

1. Stop Yelling. Stop interrupting. Stop Talking Over Each Other:  This is not Jerry Springer, its serious business. People’s retirement and investments are at stake. Please treat it that way.

5.  Lose the Octobox. Fire whoever came up with the Decabox.   ‘Nuff said.

6. Separate the Signal from the Noise.  Understand that most of the day-to-day action is simply noise. Look at a long term chart, you can barely see 9187 or 9/11. If those major events get lost in the long term trend, what does the intraday jags, kinks and reversals mean? Very little. Recognize that not every data release, slice of news, or rumor is at all significant. Stop treating them as if they were.

7.  Fact Check: An awful lot of things on air get stated with authority and confidence. Much of them are little more than junk or pop myths. Why is it that the more dubious a proposition is, the greater the confidence the speaker seems to muster? Consider fact checking as much of the statements that are made on air as possible, and making frequent corrections.

9. Bring Back Louis Rukeyser: Not the man, but rather, his style. Wall $treet Week — Rukeyser hosted it from 1970 to 2005 — was plain-spoken, thoughtful and accessible. Quiet, contemplative, discussions, with intelligent market participants, revealing helpful information. The investing public would appreciate something of that sort — again.

Improvements Unlikely?

There is a reason for the current TV programming:  Ratings!

The experts know what sells.  Everyone on TV is asked to state an aggressive and controversial opinion.  It is entertainment.

Would the current investing world give a high rating to Uncle Lou, no matter what the quality of the program?

Popular versus Critical Acclaim

We recently watched an old film for which a reviewer had noted that it achieved both popular and critical acclaim.

That is certainly great news for a movie, and one can easily see the distinction.  At nearly any time one can find a very popular movie (the "date movie" from back in the day) that has little artistic merit.  At the same time, there is something playing at the local Art Theater that scores high on artistic merit, but does not attract many teenagers.

It is a delight when a film can satisfy both criteria.  It is also a great challenge.

The Investment Audience

Here are a couple of key facts about the audience for investment news:

• Individual investors have dropped out.  (We'll get them back after another 25% or so in the major averages).
• Most readers are obsessed with the negative.  That is how to seem smart at a cocktail party.
• One can measure this with objective indicators, like our Seeking Alpha sentiment indicator.

The reader will note that we are moving beyond financial television, and considering all sorts of information.

The Conclusion?

With newspaper ad revenues disappearing, MSM are all turning to blogs.  Blog revenue is all about hit count.

If times were more prosperous, business managers could afford to think about the actual merits of analysis.  In times of stress, they look for the most popular.

So what happens?  We all know from behavioral finance that investors chase what worked most recently.   Today, that means that all of the doom-and-gloom predictors are geniuses.  Many of those writing and appearing on TV search relentlessly to find the most negative spin on any piece of information.

It is those people who are now featured.  It is not because of editorial bias on the merits.  It is financially driven.  These are the writers who are "popular."

This is what happens editors become pollsters.

How NOT to Think about Your Investments

Many stocks, perhaps most stocks, are trading at prices that do not reflect fundamental value, as determined by traditional methods.  The excellent team at Bespoke Investment Group, one of our featured sites, provides a great list of stocks trading at "crazy" P/E ratios.  (Since P/E is only part of the story, perhaps you should subscribe to their premium service.)  Unfortunately, we own a few stocks on that list.  Our cheap plays got even cheaper.

Bob Pisani's CNBC reports -- a good reflection of floor trader opinion -- pointed out the disjunction between the fundamentals and the price in stocks like IBM.  Great earnings, good prospects, no proximate link to subprime, but the stock is down 25% from the highs.

Briefly put, current prices are not a matter of analysis, but one of psychology.

It is time to check out our "go to guy" on such questions, Dr. Brett Steenbarger.

Great Advice from Dr. Brett

In any big event, whether it is a football game, the election, or the stock market, there is a nearly inevitable feeling that you "should have known."  He writes as follows:

When markets become unusually volatile, they make unusually large moves. To the short-term trader or the active portfolio manager, such moves look like phenomenal opportunity. This creates a kind of dissonance when their results do not reflect such opportunity. This dissonance is often expressed as regret: the word "should" becomes a prominent part of traders' thinking.

Underneath this regret is what behavioral finance researchers call "hindsight bias": the exaggerated sense of predictability in retrospect.

After some typical wisdom, which deserves to be read completely, he concludes as follows:

Given the limits of what we know and what is ultimately unknowable, not all movement is opportunity. The key to trading success is finding the patience to capitalize on those things you do know and the wisdom to accept what is uncertain.

Applying Brett's Advice

The most important step an investor can take is to understand what is happening.  Here is our analysis.

• Our system has created a climate where banks will not lend with each other.  Why not?  After Lehman was allowed to fail, no one knows which financial institutions will get government support.  Why lend to an institution that might not deliver?
• We are de-leveraging at Warp speed, since any write down at one institution ripples through the entire system as required by FAS 157 mark-to-market rules.
• The lenders to hedge funds, all becoming regular banks, now have more conservative business models.  Leading fund manager Ken Heebner  made this point tonight on Kudlow.  See the video here and here.  The hedge funds can no longer take a strategy that makes 5 or 6 percent a year and leverage it five times.  This means that hedge funds are selling -- forced selling -- the good with the bad.
• Individual investors are dumping their mutual funds, as they always do in times of stress.

What not to do

Do not just make a knee-jerk reaction.  Think clearly.  Think about what is happening and the causes.  That is the only way to spot opportunity.

Somewhere between Miss Moss's Latin class in high school and Neil Browne's excellent instruction in critical thinking, we learned about a prominent logical fallacy.  Once you know it you will see it every day.

Post hoc, ergo propter hoc.

You can look it up, but it means "after this, therefore because of this."  It is one of the most common errors in logic.

The most important application right now, also pointed out by Ken Heebner, is that the market keeps going down after each new government move.  The cause of this has nothing to do with government policy, except perhaps that it was too slow for rapidly changing conditions.  We should have started sooner, since government moves slowly.  It is the de-leveraging, especially in hedge funds.  To those who do not understand, it seems to be an instant verdict that the government plan does not work.

And this verdict is being rendered before the $700 billion has even been deployed.....We suspect that legislators who voted for the Rescue Plan feel somehow betrayed by the market.  It will take some time before the impact of the plan is felt.

And finally, what you should do

Understanding the factors behind the decline is important in finding opportunity.  If one accepts Ken Heebner's observation of reality, there is one set of conclusions.  If one believes that the market is correctly signaling the next Great Depression, there is another.  We shall revisit that dichotomy.  It depends on solving the problem of counter party risk, which we described last month.

Meanwhile, let us consider more great advice from Brett Steenbarger:

The ability to adapt to changing conditions and maintain the search for opportunity amidst market panic is a great example of how times of crisis can also be times of opportunity.

We will follow up with more about how we are positioning our clients to take advantage of current conditions.

The New York Times Attacks Richard Syron

When does a good story get in the way of informing readers? Editors of all major publications face this decision each day. A recurring topic at "A Dash" is how many bloggers play fast and loose with facts. The Internet gatekeepers push along the stories placing the burden on readers. No matter how intelligent the reader, no one is going to check facts, sources, and analytical techniques for various stories.

With print media in competition with blogs, the distinction is starting to fade. Cyberspace is full of unedited and often unchallenged text. It lasts forever.

Background: The New York Times Attack

Charles Duhigg studied history at Yale and got an MBA from Harvard on the way to becoming a reporter for The Los Angeles Times and then The New York Times. His feature article on Freddie Mac and Richard Syron attracted plenty of attention and comment today.

The main contention is that Syron got a memo in 2004 from his Chief Risk Officer, David A. Andrukonis, warning that the firm was financing questionable loans. The next year Mr. Andrukonis left "to become a teacher." Duhigg has plenty of anonymous sources who confirm that Syron had this information.

Since we accept the factual authority of The New York Times, we do not challenge that there was such a memo. We also do not doubt that sources were confirmed. This leaves room for plenty of other complaints.

Challenges from our Blogging Colleagues

The best job of analysis on this article came early in the day from Tanta at Calculated Risk, one of our featured sites. She was clearly on a mission. Among other points she noted the following:

• The Times short-changed Syron's resume;
• Too many anonymous sources;
• No recognition that this was one memo of many; and
• Faulty grasp of the role of the GSE's.

Nice work.

Matt Stichnoth, writing for Bankstocks.com, has some other good points. He draws our attention to the following:

• There was a big change from 2004 to 2005. These problems were not so obvious in 2004, and might not even have applied to loans at that time.
• Recognition of Congressional pressure for Fannie and Freddie to pursue social missions; and
• Recognition that the worst crisis in history might not have been totally foreseen.

Both of these articles deserve to be read in their entirety, as well as the original article.

Our Take

There is a common statistical problem involved here. In any large organization there are many people warning about many things. Sometimes the warnings are completely unnoticed. Sometimes they are evaluated but found to be unpersuasive.

If one starts with all of the situations where there is "a warning" the executive might have done very well. Who knows how many problems Syron correctly anticipated and solved or how many bogus concerns that he ignored.

If one begins with the conclusion, it is usually easy to spot something. Finding the warnings that should have alerted someone to the big mistakes is a classic revisiting of history. Some examples include the following:

• FDR did or should have known about the attack on Pearl Harbor.
• NASA should have known about the defective O-Rings before the Challenger disaster.
• President Bush should have known about 9/11 before the attacks.

We are surprised that these incidents were apparently not covered sufficiently in the Yale history program, nor the statistical problem in the Harvard MBA program.

There is also the policy perspective. The reason that GSE's had implicit government support is that they were following national policy, using prescribed rules (including degree of leverage), and overseen by appropriate authorities. It was a balancing act.

Whether these organizations, neither fish nor fowl, are appropriate mechanisms of policy is a question for another day. Second-guessing the executives confronted with difficult decisions is another matter altogether.

The Consequence of Journalistic Choices

We doubt that most readers, on their own, thought about the many points raised here or by Tanta and Matt. Since The New York Times has a much larger circulation than the bloggers, only a few will be alerted.

Our guess is that most will accept this as just another case of corporate greed. For every issue there is some simple heuristic, a lowest common denominator if you will, that resonates with those who have conclusions in mind when they read news. We are disappointed, therefore at the conclusion reached by another of our favorite sources. After noting that Syron has received $38 million in compensation since 2003 while the stock prices have declined, here is the conclusion offered:

This was simply greed on the part of an executive, a transference of wealth from Shareholders to himself . . .

Full Disclosure

While we have no position in Freddie Mac (FRE), we have a recent and very successful position in Fannie Mae (FNM) -- long stock and short the pumped August calls.

The Psychology of Risk

Each year millions of sports fans enter bracket pools for March Madness, the NCAA basketball championship.  Participants buy an entry or two for modest amounts like ten or twenty dollars.  Most who join in rarely, if ever, make even small wagers on specific sporting events.  March Madness  and the Super Bowl are different.

With tonight's championship game we have an opportunity to use the bracket pool to gain a little insight on risk and how it affects behavior.  The situation described nearly always arises when the championship game is to be played.

A Typical Case

Let us suppose that a player enters a large bracket pool for $25.  Through a combination of a few astute guesses and a lot of luck, our hero is in line for a useful prize.  If Kansas wins, he will win about $1500.  If Memphis wins, he will win about $1200.  A celebration will be in order either way.

When asked his opinion about the game, our ace handicapper tells us that it is a coin flip.  Why did he make the choice he did?  It was a close call, with no real reason to favor Kansas over Memphis.  Asked if he would make a bet on either team, our hero says "No."

Hedging, Anyone?

Let us now suppose that a friendly neighbor happens to be a big Jayhawk fan.  He offers to bet $150 with the lucky pool prize-winner.  The effect of this bet would be that the expected victory will be $1350, regardless of the outcome of the game.  Should he accept the bet?

Our experience, observing scores of friends and pool participants in these situations, is that they stick with their original entry.  They may think that it is "unlucky" to hedge -- a silly notion since they are locking in a set amount.  They may think that it does not matter, since they are in for a nice prize either way.

True enough.  The $300 difference may not seem like much when viewed in terms of the overall prize.  In a few days, however, when the contest has been forgotten, the result of the game will have a net effect of $300 in actual spendable money.  A week later, the winner will be making decisions about saving a few bucks in amounts much smaller than $300.  Even Doug Kass could fill up his Range Rover three times at the most expensive gas station in Palm Beach, Florida with the difference in prizes!

A Point of Comparison

By way of contrast,  let us suppose that our  pool  hero had failed to submit his entry on time.  Would he now be betting $150 on Kansas?

Conclusion

While the situation here is, of course, completely hypothetical (err--Go Jayhawks!!), the circumstances cited are quite real.  Some of the winning disparities are much larger.

A key difference between professionals and the individual investor is the ability to assess and limit risk and to realize that every result counts.

If you cannot pass this investment test, turn over the car keys

Here is a key question for investors and traders alike:  Do you want to be entertained by the colorful opinions of bloggers about what government should do or would you rather profit by understanding what they will do.

Background

We have highlighted the distinction between normative and empirical analysis -- opinions about what ought to be done versus the dispassionate study of behavior.  We suggested in December that the Fed was on a mission, using creative tactics.  We highlighted an excellent article from Abnormal Returns describing the difference between "Positive and Normative Blogospheres."  We have suggested that those offering opinions should first get some information -- at least reading some Fed briefings and old transcripts of meetings.

A Good Explanation

While doing research for our sister site, Election Stocks, where we analyze candidate issues and link them to specific investments, we came across a five-year analysis of the Iraq war.  We recommend checking out our comment on this subject, and the complete study.

Meanwhile, the explanation of the work provides an excellent insight into the distinction between those doing "politics" and those doing public policy analysis.  The report comes from a private sector group.  They make money by providing analysis, not opinion.  The following is the explanation of their mission, taken from the report:

The debate is over whether the invasion was a mistake in the first place, while the divisions over ongoing policy are much less real than apparent.

Stratfor tries not to get involved in this sort of debate. Our role is to try to predict what nations and leaders will do, and to explain their reasoning and the forces that impel them to behave as they do. Many times, this analysis gets confused with advocacy. But our goal actually is to try to understand what is happening, why it is happening and what will happen next. We note the consensus. We neither approve nor disapprove of it as a company. As individuals, we all have opinions. Opinions are cheap and everyone gets to have one for free. But we ask that our staff check them — along with their personal ideologies — at the door. Our opinions focus not on what ought to happen, but rather on what we think will happen — and here we are passionate.

Conclusion

The Stratfor description is exactly what makes public policy analysis valuable.  It is just what we are trying to do at "A Dash."  While we have opinions about what government should do, our mission is in helping investors understand past actions and predict future moves.

Those who do not understand this distinction are failing an investment Breathalyzer test.  They have become intoxicated with the  punditry and the debate over policy while losing focus on the cumulative effect of the many incremental policy changes.  These changes are starting to add up, (yet another future topic.)

Meanwhile, if you do not see the difference in these types of analysis, you should do the following:

Turn over your investment car keys to an index fund manager!

Investors Look at the Wrong Information! Why?

It is difficult to beat the market.  Individual investors who try to do so have, on average, results that are decidedly inferior.  And not just by a little.  It is more like half of the market return.  They try to time the market using all of the wrong methods.  They are afraid when they should be active.  They are "all-in" when they should be cautious.

We are developing some general themes -- common mistakes -- but our effort is one of building the case a step at a time.

An Example

Before departing on a long weekend of pure relaxation, we tried to leave investors with an insight that we felt was particularly valuable.  Our experience shows why getting perspective is important.

Earth to OldProf:  They do not get it! We posted an article on why accounting rules may be misleading investors.  We know that this is important for several reasons:

1. It affects all of the financial stocks, an important key to the  market;
2. General understanding of the issues is poor and reflected in the prices of many stocks:
3. The financial write-downs get plenty of daily play, with each new story changing analyst estimates.
4. The crucial element of understanding requires knowledge of accounting rules, the immediate effect, and the longer-term implications.
5. The big mainstream media sources report each fact, but often do not provide an analytic framework.

With this in mind, we wrote about how the rules affected a key company, AIG, and the market impact.  Quite frankly, we hoped and expected that this would generate some interest and comment. Wrong! What were we thinking?

We checked this with our own small focus group and got a big yawn.  No one wants to think about FAS 157.  It is over the barrier of complexity.  If things get too technical, everyone tunes out, no matter how important the topic.

The focus group was correct.  We pay little attention to daily traffic at "A Dash" since we are not doing advertising, but we do periodic checks to see what resonates.  FAS 157 causes eyes to glaze over.  No one cares.

This myopia is empowering for those who take each issue to the lowest common denominator.  FAS 157 was a big story when the bearish bloggers saw last November 15th as a doomsday date like Y2K.  When it did not happen, the powerful writers in mainstream media did not point this out.  There is no accountability.  It is easy to make big predictions of write-downs.  And it is newsworthy, picked up by all of the popular media sources and financial television.

Conclusion

There is always a way to appeal to an audience without providing understanding.  Realizing this is the biggest challenge and the biggest opportunity for investors.

The credit market issues are difficult to understand.  Investors and traders are not really capable of making independent decisions.  Even if they work to get the facts, it also requires a solid analytical framework.

We shall pursue this with some other examples.  Meanwhile, we need to work on article titles!  Maybe if we had called the article DOW 15000 and included the Sports Illustrated swimsuit indicator, with a picture or two, it would have gotten more attention.

Understanding why FAS 157 is important is both more important and more challenging.

Another Round of Panic

Trading and investing are quite different things, a matter of time frames.

Today's trading was sparked by the ISM services report, something that has not attracted much attention in recent years.  The Market has focused more on the traditional ISM manufacturing survey, partly because it has a longer history, and a clear link to GDP.  For those who have forgotten that report, released two trading days ago, it suggested GDP growth of 3% as of mid-January, the time of the survey.

The ISM service release was surrounded by some controversy because of a change in the method of calculation and the early release of the data.  The ISM, in circumstances nicely reported by Kelly Evans of the WSJ,  admitted in a conference call that information might have leaked, so they announced the result before the opening.  We are always amazed to see that people do not realize that big traders can always find a way to play information when regular stock markets are closed.  Globex futures trading, anyone?

Significance of the Report

Most market participants realize that the service economy has assumed greater importance in recent years.  The large move in the index played into the recession fears of many.  As the market declined, this seemed to be confirmation of increasing recession odds.

The market and media reaction was that if many react to a piece of data, it must be right.   Let us look a bit deeper into this information.  When so many stampede, there may be a contrarian opportunity.

We have tested the ISM service series against employment changes and other economic data, and we find it to be pretty good.  When comparing it to the ISM manufacturing index we discovered that it did not add much information.  We now have a single data point where there is a significant divergence.  This would be nice to test, but there are not many other divergences to use.

Our review of today's news did not find anyone else who highlighted this statistical fact, or wondered about the meaning.  This provides an edge for our readers.

Other Interpretations and Advice

We realize that those with a predisposition to seize upon any evidence of incipient recession are touting today's number, even if they never mentioned it before.  Readers might want to compare the current interpretations from these sources with those from past months when the services figure was stronger than manufacturing.  There is a lot of selective perception at work.  Pick your favorite source and do a search to find out whether this number was ever highlighted when it was strong.

Briefing.com, an unbiased interpreter of information, reports as follows:

The data seem inconsistent with the harder figures on spending and investment and world trade which really provide the trends for domestic growth.  We also believe that the intent of this ISM index -- to reflect on growth for the entire economy outside of manufacturing -- is a mighty grand objective given the simplicity of the survey questions. 

For each component (e.g.  activity, employment, orders), the question to the survey respondents is simply, "Are conditions stronger, unchanged or weaker than the prior month?"

Gary D. Smith, who has a strong multi-year record of market forecasting, provides excellent daily commentary on his blog.  Unlike some other providers of links,  Gary cites information from every possible source.  He tells the "whole truth" without any cherry-picking of information.  Here is his take:

I continue to see the US Fed as now “ahead of the curve” and the odds of an intermeeting rate cut are rising meaningfully. The VIX is rising 8.0% today to a high 28.0. The ISE Sentiment Index hit a below average 102.0 and the total put/call is hitting an above average 1.12. Finally, the NYSE Arms has been running very high again all day at 2.47, which is also a positive. I still view the odds of a full retest or new lows in the market as unlikely and further weakness providing good entry points in favorite longs for investors.

Read the entire article to get the full context.

The Earnings Mythology

The recession hypothesis is getting an additional boost from commentators who claim that forward earnings are in decline.  Briefing.com has some great information on this:

According to Thomson Financial, fourth quarter 2007 earnings are expected to decline by 20.7%.  The main reason for the decline is the financial sector's whopping 105% decrease in earnings.  If the sector was removed, earnings would grow by 11.0%.  Homebuilders are also a drag.  For example, the consumer discretionary sector's earnings would grow by 7%, instead of declining by 15%, if homebuilders were removed from the calculation.

In general, we do not like throwing out the worst or best sectors from the overall S&P 500 earnings.  This might be an exception.  The last quarter is a bit unusual because of the forced write downs of mortgage securities.  Some believe that there are many more write downs to come.  We think that the FAS 157 losses might actually overstate the impact on these firms.  They voluntarily chose to keep securities on the balance sheet, probably because the expected performance to exceed current value in an illiquid market.  The jury is out on that question.

Meanwhile, the rest of the market sectors are not showing mean reversion, recession, or any other sort of earnings decline.  For example, Colin Barr's nice review of the Disney report highlights a good past quarter, and good future prospects.  This is a company that one would expect to be hit by consumer distress, if it were already an important factor.

Forward earnings will depend greatly upon how financial stocks rebound from current conditions.

Conclusion

Markets look forward.  Even in recessionary times, a fact not yet in evidence, forward earnings look through the recession, setting the stage for rebounds in stocks prices.

Three Business Decisions

One of the valuable things for us in writing a blog about a book, what we are doing at "A Dash",  is that we can see what is working and what is not.  By "working" we mean helping readers to understand something important that will be profitable in their investing.  This is not strictly a function of popularity of the article.  Reader comments are especially valuable.

It is a bit tricky, because the current audience in the investment blogosphere is much different from the one we will see in a year or so, when many new investors will turn to the Internet.  We are writing to the future readers, the audience for the book, where we will review many of the current blogs.  By contrast, the current roster of most popular blogs is aimed at the present.

Our purpose here is to illustrate something important, a concept which would have helped individual investors and traders alike last week.  To do so, we must find a different starting point.  So let us talk about three real public companies and important decisions they made.  All three companies are big names that you know.

Company A

The first company was engaged in a market share battle with a competitor.  Within the company came an idea for a new product that moved closer to the competitor's product in characteristics.  The idea was to skew toward a younger demographic and win market share.

Company A conducted field studies in the heartland, went through internal debate, and did extensive planning.  It worked up an advertising campaign.  With much fanfare, the product launch took place.

Company B

Company B was also fighting for market share.  Company B stimulates ideas from within, launching many of them as "beta tests."  Some work, some do not.  Those that work get further development.  Those that do not are dropped.  There is some internal planning and decision making, of course, but the hurdle for trying something is relatively lower.

Company C

Company C is in a business with some domestic competition and a lot of foreign competition.  The established business is threatened by changing circumstances, so it is in a struggle to maintain market share, revenues, and profits.

Company C was presented with an idea that might provide an immediate boost to sales.  The company did not know, of course,  whether the idea would work.  Since the idea came from outside the company, it was subjected to many meetings and reviews, including representatives from many different departments.  At each meeting, questions were raised from a variety of perspectives.  The company considered both the merits of the idea and whether it needed to use the outside source.

When the idea reached the key decision maker, it was presented not by those who proposed it, but by an internal manager who listened to the meetings and conveyed the ideas.

Reader Challenge

We could have chosen many cases for each of the three examples.  Readers are invited to nominate situations that they think might fit.  While we will reveal specific examples, there is no single right answer.

Here is the key questions:

Which method do you think works best?  Which approach is used by the most successful corporations?

Which method do you think best describes the behavior of major corporations?

Following Up

We shall return to this topic to show the relevance to current stock market issues.  The key idea is that understanding organizational behavior is important to successful investing.

Logic Test Solution

Spoiler --

This is the solution to yesterday's Logic Test.  Readers should check out the test before reading the solution.  The source of the problem (which we obviously modified) is poker expert Steve Zolotow.

Solution

We sympathize with several respondents who said, "I don't get kings that often and I am going to play them!"  That is a real-life solution, but this is a logic problem.

The key element is to evaluate what the first player might have said.  Here is a clear explanation from one respondent.  Nice going, Nemo!

The small blind is telling the truth.  Fold.

A bear would honestly claim to be a bear.  A bull would lie and claim to be a bear.  It is unknown whether the player to your left is a bull or a bear, but either way, he must have said "I am a bear."

Therefore the button was lying and the small blind was telling the truth.

Among respondent answers, David Lehman, a veteran CBOE trader solved the problem most quickly, in 45 seconds.  Other correct solutions came from regular readers RB and Eric B., with somewhat longer times.

In our earlier testing, there were two faster times.

Ralph Katz,  a top options trader and clearing firm owner, is currently competing in the finals of the Bermuda Bowl, the world bridge championship.  (In a future post we will take up the question of why so many top investors are also involved with bridge.  Hint:  Those thinking tea and crumpets do not understand the game).  Ralph asked one clarifying question and then announced his answer, taking less than twenty seconds.

The overall prize goes to young Ryan, Financial Analyst and Trader in our office.  He reviewed the conditions out loud and announced the answer.  Time:  About ten seconds.  (Note to hiring employers: You cannot coach speed!)

The Lesson

We suspect that many more would have solved the problem, or gotten it faster, without all of the poker trappings.  Suppose, for example, we had just posited three people making statements....

Something about presenting an actual poker hand throws people off track.

We suspect that similar things happen to those invested in a specific trading position.  There is a focus on one's holdings rather than the logic of the situation.  Discipline is lost.  We would love to see the problem presented to two different groups -- with and without the poker background.

This is a question for Dr. Brett!

A Logic Test

At "A Dash" we are seeking ways to help investors and traders fight the traps described in the literature of behavioral finance.  One method, which we used successfully in the classroom many years ago, is to present problems wildly different from the main theme.  Later, we try to show the connection.

This problem came from two different sources. We will credit the poker source tomorrow, but the inspiration to present it came from The Trading Goddess.  Like many thousands of others we read her blog every day as a source of information and ideas.  What sets the blog apart is the originality and style of presentation -- educational and always .....entertaining.  (We congratulate two of the bloggers we also read daily, the inimitable Muckdog and Bullish Jim, on their selection by the Trading Goddess as contributors.  Nice recognition!)

Here is what caught our attention. 

This  image reminded us of the problem, which we have already tested on a strong group of very smart people.  It may seem familiar to you.  If so, you may be able to solve it quickly.  Keep track of your time.  Even if you do not play poker, you can solve this problem.  It has a clear answer.

Here is the situation:

You find yourself visiting Chicago and the Old Prof answers your request to find a poker game.  To help you play, you are reliably informed that the players -- all options and futures traders from the Merc and the CBOE-- are either bulls or bears.

The bears ( spoofed last week,  and the good guys now) are completely honest.  They always tell the truth in their statements, and they never bluff.  The bulls always lie and frequently bluff, although they might fold a worthless hand.

You are playing with three others, but you do not know whether they are bulls or bears.  You are the big blind, and when you look at your hand you are delighted to see two kings.

Trying to get a read on the table, you ask the next player whether he is a bull or a bear.  He answers, but you cannot make out what he says.  He folds.

The next player, the button, looks at you.  He says, "He told you that he was a bull."  The button now folds.  The last player, the small blind, looks at the player on the button and says,"You are a liar!  You are a lying bull."  She now looks at you and says, "I have pocket rockets (two aces, for the non-poker players) and I am going all in."

Does she have the hand in the picture?  Who is telling the truth and who is lying?  What should you do with your kings?

Please do not post your solution in the comments.  You can email me for recognition in tomorrow's post, where we will reveal the solution.  The range of answers -- all from very intelligent people, many of whom play poker -- include complete failure and rapid solution.  Keep track of your time to solve.