A Dash of Insight

Is This a Tradable Bottom?

We have had some inquiries about our "Gong Model."  They say that no one rings a gong at the bottom, so our marketing department thought this was a cool name.  This article showed a good description of the last time the Gong sounded.

Many traders are seeking "oversold signals" and calling the bottom.

The Gong is not now signaling a bottom, and it is not close.  The Gong model has two parts.  First the hammer must be drawn back, and we are not yet at that stage, nor close to it.  Second, the mallet must come forward.  We'll provide some updates.

Can We Be Wrong?

Of course.  We can certainly be wrong.  If tomorrow's payroll number is surprisingly good, given the +/- 100K confidence interval, the market could rally by a couple of hundred Dow points on a report showing surprising strength.  Our report on The Gong, and other methods, are available to readers on request.

Our intermediate-term outlook has grown increasingly bearish over the last month or so, as documented in our participation on the TIckerSense blogger sentiment poll.  We have reported this both there, and on the weekly updates of our TCA-ETF system.

It is entirely possible that we will have a rally without The Gong.  Also, the gong model gives an entry signal, but not an exit.  We have searched hard for the ultimate bottom-calling method, but we are realistic.  It is not easy.

The Importance of Time Frames

While our system signals have been negative, we have been less convinced by the fundamentals.  In our programs, we have the system (affectionately called the "Vince Model") and the fundamentals, (called the "Jeff Model").  The time frames are different.  The "Jeff'" model is geared to the long-term investor and has a great long-term record.  It is thematic, and the themes have worked over a period of more than ten years.  It is not a trading system, although we obviously try to find the most promising stocks and sectors.  We currently believe that people have become far too negative about the economy and economically sensitive stocks.  Vince sees more pain in the near term.

Readers may be interested in our discussion of the importance of time frames.  We also have written about how a single trade can have two winners -- those who have different time frames or investment objectives. It is not just a question of the immediate stock reaction.

Conclusion

In a difficult market it is important to have one's primary objective in mind.  Traders and investors can reach different conclusions.  One theme is the reaction of the individual investor -- scared out at market bottoms.

Is this the bottom?  Probably not, but that does not mean bailing out of one's retirement account.  We have a nice list of attractive stocks with good valuations.  When the Gong sounds, we will get more aggressive.

Employment Situation Preview: A Risky Outlook

Each month we report the results from our payroll employment model.  This is not really a forecast.  We take a number of different economic indicators from the middle of the preceding month and ask what change in payroll employment is consistent with the other data.  The variables are not causally related, but are all different measures of the economy.

We get a pretty good fit from the University of Michigan sentiment reading (yet another new low this month), the four-week average of initial claims (using the period ending in mid-month), and the ISM manufacturing report.

The data are all consistent with continuing weak economic growth and a loss of about 90,000 jobs.  The market is looking for a loss of 60,000.  Since the 90% confidence interval (sampling error only) is about +/- 100,000, we think that an actual gain is pretty unlikely, while a big loss is possible.

It is interesting that whatever is reported is overly hyped and interpreted as an official count, rather than as a statistical estimate.

Readers interested in learning more can do three things:

1. Take a look at last month's article, where we explored forecasting issues.
2. Check out Little Known Facts about the Payroll Employment Report.  They are still little known!
3. Try playing our Payroll Employment Game.  It shows you the range of different results the BLS might get even from a well-designed survey.  It is cheaper than trading the actual report.

A Lesson from Dad

The "Dad" I am talking about is Bill Miller.  No, not the one you already know, although we admire the Legg Mason fund manager.  I lost my Bill Miller last year, but the lessons are still there.  Some of them are quite relevant for investors.  (We did a little father/son bonding at Chez Dash this weekend.  Missions accomplished with only one circuit breaker kicked and a couple of buckets of water.  Dad was smiling.)

A Famous Miller Family Story

Here is a signature moment from the young Bill Miller.  I am quoting the key elements, but the tale is told in more detail in this article, Respect versus Arrogance.

The passing of my father, William H. Miller, last week, and some hours of thought on the road have sparked some introspection.  What we try to do at "A Dash" bears his mark.  In a way, that is strange.  Dad went to war instead of to college.  Growing up in the Detroit area, he understood engines.  The principles are simple:  Fuel, Oxygen, Ignition.  It is amazing how people can get this wrong.

As a sailor on his first ship he found himself in an interesting situation.  The engines had been overhauled, but would not start.  Experienced machinists could not figure out the problem.  Officers were hovering and complaining.  The young sailor asked if he could try something.  There was a lot of skepticism, but he was given his chance.  He knew that the fuel and air were OK, so he removed the spark plug and tapped it on the deck, narrowing the gap.  When the plug was replaced, the engines started!

If you could see a picture of the young sailor, cap tilted at a jaunty angle, you might guess the mixed reaction.  The officers were delighted at a problem solved.  Those in charge of the engines were less enthusiastic.

This story was repeated many times over in his Navy career.  While he never got all of the promotions he deserved, he was a fixture on the boats deployed by his Captains.

No Substitute for Knowledge

A crucial lesson from this is that there is no substitute for actual knowledge about a subject.  It does not matter what your rank is.  It does not matter how many years you have served.  It does not matter how many other people call you "Sir."

If you do not have the knowledge, you cannot make the engine start.

The Investment World

There is an interesting difference between social science and engines.  When a theory about an engine is incorrect, the results show up right away.  When a theory about social science is incorrect, the idea may persist for many months -- even years.

This makes it much more difficult for the consumer of information. How do you know when the engine is not going to start?

Here are some red flags.

Misuse of the word "rigor."  A long causal chain with a lot of unsupported assumptions may seem powerful, but it does not meet the definition of rigorous.  A strong argument begins with an assumption that everyone would share, and then provides evidence at each point.  The longer the chain, the more evidence that is needed.  Whenever someone makes a big argument about "rigor", make sure that he has some credentials for each step in the chain.  Big hint:  Rigor usually means peer review.  Those with thin skins about criticism of their work are usually not rigorous.

Selection Bias.  This happens when one starts with a pre-conceived notion of the world and distorts evidence to fit the conclusion.  It is a characteristic of many of the leading investment blogs.  Ironically, many of the same bloggers talk frequently about behavioral economics and the dangers.

The "Slick" Factor.  Many of the top-ranking pundits are there because -- well -- because they are top ranking pundits.  They are cited as "friend/buddy/pals" of someone, or called "doctor" or "professor" to amplify credentials.  Most of them are good with sound bites on TV.  None of them could actually start the engine.  Most of these guys have never created a quantitative model, and would have no idea how to begin.  They do not know SPSS from American Idol.  Their charts come from others -- those with a world view they want to sell.  Many become famous by making a prediction that works--eventually.  There is no real accounting of the investment impacts.

The "Big Money" Managers. Statements from the "big-time" fund managers carry a special warning.  Does it really need to be stated that these people always have an agenda?  If a manager has a fiduciary responsibility to clients and a fund, and then gets a spot on TV, what do you expect him to say?  It would be irresponsible and deceptive to talk against his own book.

Conclusion:  Strong Voices are Leading You Astray

Here is Bill Miller's lesson, some great principles applied to investing.

• Don't take some long-winded analysis to be "rigorous."  Check whether the author has the relevant expertise -- research methods, economics, government, etc.
• Check your sources.  It is pretty easy.  If your favorite source dishes up a constant stream of one-sided commentary, you should already know the answer.  You can enjoy reading your source for entertainment, but not for investing.
• Look beyond the "talkers" and check the actual predictions.
• Do not conclude that someone in a uniform with braids really knows how to start the engine.

And finally,  realize that everyone is an expert on something.  Learn to listen instead of pretending that you already have all of the answers.  Be willing to challenge, but do not be arrogant.

Thanks, Dad.

Forecasting the Payroll Employment Number

Each month credit and equity market observers alike pounce on the Employment Situation Report from the Bureau of Labor Statistics.  Markets gyrate wildly when the actual result is 40,000 or 50,000 payroll jobs away from the economic forecasts.

This is a big mistake.  Here is the problem.  The level of change that the market believes to be significant, is not great enough to be measured by the BLS tools.  It is like measuring a hair with a grade-school ruler.

And that is just the measurement issue.  It is even more difficult to forecast the results.  We always enjoy reading Bob McTeer, whose blog is one of our featured sites.  His recent commentary notes that economists are not very good at forecasting.

Unfortunately for the reputation of economists with the general public is that they think the job of economists is forecasting.  That's unfortunate because economists can't forecast very well.  It just can't be done.  Economists know that, and most will admit it, but they are stuck with it, especially if they wish to be employed as an economist outside academia.

His main point is that these predictions are difficult.  People making forecasts should provide probability figures and ranges.  (For a similar argument, check out Barry Ritholtz on The Folly of Forecasting).  The problem is that when the forecaster is honest about the error range, the consumer becomes less interested.  Well, so be it!

McTeer has a number of excellent points on using models and some Greenspan stories, so enjoy reading the entire article.  After noting that most everyone is a "closet extrapolator" he writes as follows:

I've always been amazed at economists who presumed not only to see around a corner, but to see around more than one corner, as in "the economy will pick up through year-end, then slow for several months, and then take off again stronger than ever."  To me that sounds as silly as what they would say to the waiter after sniffing a wine cork.

It is something to think about the next time you hear some elaborate, multiple-turn economic or market forecast.

So with this in mind, here is our monthly update on the employment report, (also appearing in the Columnist Conversation on RealMoney).

The Employment Report

Each month we take a look at the likely change in payroll employment jobs, given other economic data. This is not really a forecast, since the data are all contemporaneous indicators of current economic conditions. We simply use the already reported data to ask what we expect from the payroll number.

Our model takes Michigan Sentiment (hitting new lows), the ISM index (hanging in there at just under 50), and the four-week moving average of initial jobless claims (weak, but not recessionary). Be careful not to consider today's jobless claims numbers. The non-farm payroll report is based on a survey where respondents are asked to tell about employment during the week including the 12th of the month. Revisions to the report come because many employers do not submit the information on time. Some never report, since for many there is no legal requirement to do so. The BLS tries hard to make it easy, and get a complete response.

Our approach suggests a loss of 82,000 jobs, weaker than consensus guesses of -60K or so, and much weaker than the ADP estimate. It may surprise readers to learn that losses in this range are still consistent with modest GDP growth of 1% to 1.5%, as are the other economic numbers. I don't recommend any big bets, since the 90% confidence interval on the survey is +/- 100,000 jobs! And that is after all of the reports are in and revisions done. The excessive attention to this report creates a dangerous trading situation. You can make your own (risk-free!) guesses at our Payroll Employment Game site. This shows you that even if you know the answer in advance, the reported number can be far away. The "official" answers will eventually converge on the "truth" but there is plenty of error along the way. In addition to this resources, you can check out some other little-known facts in this prior article which has links to other references.

Fishing in the Right Pond

Having a good trading method is only part of the problem.  One must also find the right trading "universe."

The original Turtle Traders learned this, and so should we.

We have been getting some good questions about our TCA-ETF system and why we chose the IShares universe that we have reported each week for many months.

Our criteria were logical and not overly restrictive:

• We wanted an open-ended ETF, since we did not want to be concerned with a possible discount or premium to NAV.
• We wished to avoid ETF's that were cap-weighted in sectors where a very few stocks would dominate.
• We wanted plenty of liquidity, so that the program could be scaled up as our assets grew.
• We also wanted enough trading action so that the slippage from our moves would not be too great.
• We needed enough data so that the model could be employed effectively.

The last point has been a big restriction, since we needed about one year's worth of data before a new fund could be added.  Unless there was a simulated history, we could not effectively employ a new ETF for nearly a year.  (At one point we were devising our own sectors and avoided this problem, but the ETF's are a popular and inexpensive alternative.)

Some Additions

In response to a suggestion from one of our smartest and most knowledgeable investors, we reviewed several of the Van Eck Global Market Vector ETF's to our trading universe. 

Since some of the prime candidates did not have the requisite trading history, although all other criteria were met, we asked Vince to revisit his methodology.  Without giving away Vince's secrets, let us say that his approach does a lot of filtering to reduce the signal-to-noise ratio.  He made some adjustments to achieve greater stability.  It is non-linear filtering that involves a "pathological time series."

The happy result is that we can now include ETF's with a four-month data history.  One of the new choices is currently in the top eight, so we will be buying it on tomorrow's opening.  The new ETF's will become part of our weekly report.  The new alternatives include alternative energy, gaming, coal, agribusiness, Russia, and nuclear energy.

An Invitation to Readers

We have offered our results as a general benefit to the community, reporting with a one-day lag on a weekly basis.  We now have a weekly program for investors as well as our sector partnership which trades daily.

We are open to suggestions about new ETF's that should be part of the universe.  Our experience has been that any ETF that meets our screening tests, improves long-term performance.  Feel free to make suggestions.

The Financial Commentary 'Peter Principle'

The world of financial commentary now has its own version of the Peter Principle.  There are so many outlets -- financial television, podcasts, mainstream blogs, individual blogs -- that the editorial process has been overwhelmed.

In the old days -- that would be a couple of years ago -- publication in certain trusted sources would provide some confidence about the general reliability of the sources and the content.  No more.

The hunger for content, ratings, and hit count is driving the process.

The Herb Greenberg Example

Tonight's Kudlow and Company included a typically aggressive exchange between Herb Greenberg and Don Luskin. [link apparently unavailable] Luskin's point, for which we cannot find any particular defense from Greenberg, is that he makes quite a number of "common man" general assertions without any particular evidence.  Since he is a handsome, intelligent, and articulate speaker, he probably has quite an impact with viewers.

And that is the problem.  The world of financial media has become very democratic.  In voting, this is a good thing.  In expertise, it is not so good.

Luskin praises the Herb Greenberg of old --- someone we also followed every day.

I remember a decade ago Greenberg was a razor-sharp newspaper columnist who had a well-earned reputation for blowing the whistle on companies who were playing fast and loose with financial facts. Back then if you owned a stock that Herb wrote about, you were in trouble (and so was the company you were investing in).

That is how we remember it also.  What happened?  Luskin continues:

Whenever I see him now, instead of talking in depth about subjects of his own choosing about which he has real knowledge, he is trying to improvise uninformed responses to ad hoc big-picture market or economic topics or stocks in the news -- and he's no good at it. To live up to his "brand image" as the bear, the skeptic, the curmudgeon, he just spouts contentless generalities -- he raises doubts, he adduces dark possibilities, he emphasizes the risks. But there is no value in that. Everyone has doubts. Everyone knows there are dark possibilities. Everyone knows there are risks. Value is added when you take a stand, express an opinion, synthesize the possibilities into probabilities.

Luskin does not have comments, but he reproduced an email from one Forbes Tuttle (who seems, via Google, to have made a number of astute comments in various places):

Years ago (10-15), when I wrote research -- on special situations -- Herb Greenberg used to phone me up and ask questions about certain stocks, and stories. He was a good reporter. He asked insightful questions. He wrote interesting and thought-provoking stories. Now he is asked to have opinions of the broad market and the economy of which he has no background in experience or training upon which to base such opinions. This is the mistake of television news and opinion broadcasting, where reporters and journalists interview other reporters and journalists. From a substantive perspective, it is really quite boring...

Our Take

A few months ago we noted Greenberg's own words -- his belief that economic expertise really did not matter.  He figured that his years as a journalist were just as good as training in economics.  We urge readers to review the entire article, where we explain the error in this idea.

Anyone who thinks that it is possible to draw valid economic conclusions without understanding economic methods is like the pigeon at a poker table full of pros.  In future articles, we shall provide a few examples.

A Final Thought

Ratings and popularity generate momentum.  Since so many are seeking higher hit counts and ratings, no one wants to criticize a big player (like Greenberg).  When the popularity is so high, and there is no criticism, the journalistic community pays more and more attention to the most visible bloggers.

The result is a dangerous, lowest common denominator system.  Those who cater to the impressions of investors build a readership, but do not serve their readers well.  By comparison, the best economic analysis is often a bit dull.  It requires data and expertise.  It may challenge existing beliefs.

A challenge for investors is that most of the "economic commentary" is noise, not signal.

Fear, Investors, and Marketing

The most powerful selling approaches go with the flow.

Let us compare "selling" investment opinions with the positions of politicians seeking the Presidency.  Both topics hit our sweet spot.  We have also been talking with many individual investors and also many voters.  It is interesting.

The Election

A reader who wants to understand candidate behavior should imagine that he/she was hired as an advisor.  Many voters have strongly-held beliefs, often based on scanty information.  For candidates many issues have a clear choice:  Educate voters to change opinions or go with the flow.

The astute political strategist knows the answer to this one.  It is the easy explanation for the Democratic candidates' positions on NAFTA, capital gains taxation, health policy, payroll taxes, ethanol, and social security.  There is little that a candidate can say to change the viewpoints of voters, especially in the sound-bite era.

The result:  Candidates take positions that will win the day to gain electoral success.  What they actually propose and what they deliver may be quite different.  Readers who are old enough may recall the senior Bush promise to "read my lips, no new taxes."  The reality of governing is quite different from campaigning.

If a Democratic candidate wins the election, we expect the eventual  positions to be more moderate, but that is not that market expectations.

Selling Investment Strategies

We received in our email an appeal from a very famous investment manager.  It was all about fear, the recession, and danger to stock portfolios.  The  oft-quoted manager  had the answer to this -- proven success in the last recession.

This is a message that resonates with the average investor, so it is a good campaign -- not  unlike what  political leaders are doing.

Voters and investors have opinions.  Catering to those opinions is good marketing, regardless of the underlying wisdom.

The email approach described investment returns that were pretty good, although less than we have accomplished.  The proposed strategy is also not much different from what we are doing.  His recession performance in 2000 was not as good as ours.  The sales technique is much better.  The author points to success in the 2000 era and asserts that he will do as well in the coming challenges.

There is no effort to analyze the economy, earnings expectations, or what is already "baked in."  It is just a play on fear.  He is (wisely) going with the flow.  We are (perhaps unwisely) trying to educate investors.  Hmm.

Investor Reaction

Our conversations with individual investors have revealed several significant reactions.

• Some investors bought pre-1847 gold, to be placed with retirement trustees.  They soon learned that they could not sell these positions for anything like the prices they paid.  Big commissions were already deducted.
• Some investors bought variable annuities that guaranteed a rate of return, but with a cap.  The cap was not carefully explained in the expensive and colorful brochure.  These were sold to elderly people, with a high surrender value, and included upfront commissions of 10% or so.  The valuation of the portfolio is done in a way that shows an investment account value quite different from what can actually be withdrawn.  There are assorted provisions allowing investors to withdraw funds on a schedule.  Existing clients are happy with what they see.  None of them understand the function of the cap, how the biggest years are lost in their program, or how the big years contribute to overall returns.
• Most baby-boom investors, looking to retirement, are very heavily in real estate, bonds, and cash.

The Climate of Fear

Many investors took these retirement actions based upon their Internet research.  They are consumers of a climate of fear.  These consumers, encouraged by television advertising to manage their own accounts, read about the "fundamentals" of the economy and the stock market.  They use the same skills that helped them to success in their businesses -- reading, research, and logic.

The problem is that the value of information depends upon the analytic method.

Unless one knows how to interpret data about the economy and forward earnings expectations, the raw data is useless.

A Summary Anecdote

One of our investors, perhaps the wisest man we have ever encountered, likes to make his own calls and argue about ours.  He read a news article about a stock -- something that had been widely known in the market for months -- and wanted to buy it.  When asked whether others might have this same information, and he was a bit chagrined.  He often questions our contrarian picks -- but he stays with us.

The ability to discern what is "in the market" on a specific stock is well beyond what  most investors can do.  They do not think in those terms.  Not at all.  Information alone is not enough.

And by the way -- some of the investors making bad decisions on gold and annuities got their information from big-time Internet blogs with advertising or other ties to these products.

A little knowledge -- too little knowledge -- can be a dangerous thing.

Traders, Plans, and Systems

Regardless of time frame, anyone expecting investing or trading success needs a plan.  Two of our favorite and featured sources -- Dr. Brett Steenbarger and Bill Rempel -- take apparently different viewpoints in a discussion about discretionary trading versus system trading.

It is a constructive discussion.  Somewhat to our amazement, we found ourselves agreeing with nearly all of the twenty-two bullet points in both lists.

There is plenty of good advice, so we encourage readers to check out Dr. Brett's A Few Trading Psychology Observations.  He mentions some lessons from his most recent book which we reviewed a while back.  We have recommended the book to those engaged in various performance activities, not just trading.  (Now if I can only get my autographed copy back from that bridge expert in Wisconsin who walked off with it!)

Bill Rempel is actually much closer to what we do.  His observations characterize the approach of the careful and disciplined system trader.

It is a delight to read these articles back-to-back and we encourage you to do so.

The Trader

Here is a crucial point from Dr. Brett's list:

A sizable proportion of traders who have been having problems are trading methods and patterns that used to work, but are no longer operative. The inability to change with changing markets affects traders intraday (when volume/volatility/trend patterns shift) and over longer time frames (when intermarket patterns shift).

And following this up, he notes:

Traders develop plans and trade patterns that simply don't work; they're based on randomness. When the patterns don't work, traders become frustrated and abandon their plans. So it looks like lack of discipline causes trading failure. But planning doesn't create success; sound planning does. Sticking to plans based on randomness is no virtue.

The System Guru

Bill Rempel does a fine job of describing the approach of the system developer.  It is almost like listening to our own Vince Castelli.  Bill writes:

Systems can be optimized to work in one market regime, with a signal or overlay allowing the system to switch when regimes change, or the systems can be optimized to work “overall” regardless of the particular regime in place at the moment. The significant downtime that systems traders have (since they’re not watching the market every minute) allows them to step back and take a look at longer-term market patterns.

Bill has confidence in his plans because they are tested and proven:

Sound planning, i.e., BACKTESTING, is the basis on which the systems trader approaches the market. Not only are the plans based on sound market analysis, the plans are EASY TO STICK TO, because the system trader has REASONED CONFIDENCE in its backtesting.

Our Take

We have only provided a sample of the observations.  We strongly recommend that anyone who develops models or engages in discretionary trading should read both articles several times. 

Unfortunately, most people who should be reading this exchange will not.  This includes the audience that we think about the most these days, all of the people who have been convinced by television commercials that they can be great traders.

Meanwhile, our own conclusion is that there is less difference between the two approaches than one might think at first.

The trader needs to have a real plan -- one that has been tested and proven.  Then he must stick to it.

The system trader may not view the system signals as mere suggestions.

At the risk of oversimplifying this discussion, we sense that both viewpoints lead to a similar place.

Doug Kass on Housing Predictions: An Update

At "A Dash" we have frequently cited the work of Doug Kass, a colleague at TheStreet.com.  Even before we contributed to RealMoney, we were paying customers to get Doug's work.   We found it to be a source of trading profits, as long as you understood the perspective.

We were therefore a bit surprised when Doug, writing on RealMoney Silver (where we can make no reply), took issue with our conclusions in an article about a survey.  Discussing reasoning and conclusions is fine, of course, but his comment was completely lacking in substance -- nothing about the article in question!

Instead, Doug engaged in an ad hominem attack.  Here is a key quote:

You (and many others) have been dead wrong on the magnitude of the drop in housing while the housing Cassandras have been dead right. (Just go back to your site and reference your reaction to my housing "hyperbole" several years ago.)

Those are the facts. They are not debatable.

We are delighted to see this statement of the issue.  Since we have no ability to reply where Doug wrote, we will have to write here.  As we have often done in the past, we invite Doug Kass to write something in response.  We promise to publish it without any edits.

Let us examine the quantification question.  But first, a bit of background on the housing issue.

Our Position on Housing

In the days before we were writing on this blog, we sent a quarterly newsletter to our investors.  Here is a quotation from the issue of June, 2005:

Housing

Is there a bubble? We see some disturbing facts, all signs of market tops.
People who were formerly day-traders in stocks or had good jobs in software development are now going into real estate.

If you tried to look at housing like a stock, using a PE ratio (rent/price), the number is about 35, 75% above the historic norm and double that of the major stock market averages.

Average folks with absolutely no real estate experience are buying properties with interest-only mortgages expecting to make their profits on appreciation.

We can smell some toast burning here.

We advised our clients against over-investment in real estate and those who followed our program for individual investors did quite nicely in stocks.  Doug Kass was not the only one seeing a problem in housing; he was just too early -- way too early -- in predicting the impacts.  (Check out Doug's timing here).

The "Batman" Chart

Since the issue is quantification, not direction, a great example to consider is Doug's prediction about personal consumption from a year ago.  He had this impressive chart with a distinctive pattern that we called "Batman" around our office.  The time period and the scales had been adjusted to give a false illusion of a strong correlation.  Here is the original chart.

Doug highlighted this chart in his column multiple times and took it on CNBC calling it a .9 correlation.  Charts of this sort are very dangerous for investors.  They do not understand statistics and causal modeling.  They are especially susceptible to visual evidence.

We reconstructed the data and did the calculations.  In one of the best articles we have ever written, we showed the problem in this analysis from a causal modeling perspective.  We expect this article to have a prominent place in our forthcoming book in the "Misleading Charts" chapter.

The obvious implication was that PCE would rapidly decline to below the 2% growth rate.  We analyzed the intermediate results in this article where we showed that the prediction had failed.  We think that Doug was a victim on this entire story.  Someone sent him this chart -- someone with dubious quantitative skill -- and convinced him to go with it.  He should have renounced it at some point.

Current Chart Update

The most recent evidence, one year after the original article, is even more dramatic.  As one might expect, the lending restrictions of banks have increased dramatically.  The changes are actually off of the scale.  The Fed altered the question to split out lending on qualifying mortgages versus subprime and Alt-A.  Bending over backwards, we have used the prime mortgage series in the chart.

Conclusion

As one can readily see from the chart, the precipitous change in lending standards (Doug used an inverted scale so that tighter standards would match lower PCE) did not result in a similar decline in Personal Consumption.  The direction was correct.  As we stated in the original article this is called a "spurious relationship" by those who do causal modeling.  A weakening economy causes all sorts of effects that do not have a causal relationship.

Doug Kass never cited this chart again, nor did any of the other blogs who picked it up.  The conclusion from this chart is inescapable:

Kass grossly overestimated the impact on Personal Consumption in March, 2007.  As he says, "Those are the facts.  They are not debatable."

 

Sentiment is Slow to Change: a Basketball Lesson, Part One

At "A Dash" we realize how difficult it can be to understand investment principles.  It is important to have good examples.  It is even more powerful to step outside the normal investment world, where the reader already has a strong opinion.

In our classroom days we would frequently set up a different and unfamiliar problem.  Students would examine and discuss the case with enthusiasm.  Then we would reveal the analogy that was the point of the lesson.  Some in the class would object, of course, but that was fine.  Discussing whether or not an analogy is apt is part of the process of education.

We have tried this a few times in the past.  The normal result is that Seeking Alpha does not run the story and many of our normal (and abnormal!) gatekeeper friends do not see it as relevant to the markets.  We respect their judgment about the interest of their readers.  Meanwhile, we are trying to write a book.  Getting people to think in an open-minded way is crucial.  Undaunted, we present an analysis of sentiment that uses a subject of current interest.

A Basketball Example

One way to analyze cognitive biases is to take an example completely outside one's own experience.  We have found  TradeSports.com to be a useful laboratory for this analysis.

Background.  TradeSports, the sister site of (Intrade.com where there are various political, economic, and event markets)  has real-time trading in futures contracts on the outcome of sporting events.  There is a lot of volume and those participating in the market are watching the game in question.  This adds a new dimension to the concept of interactive television.  There is even trading pit chatter, featuring the viewpoints of a number of arrogant, opinionated participants.   Their language is even more colorful than that found on the sites of stock market bloggers.

At "A Dash" we are obviously not advocating participation in this market, deemed illegal for US residents.  It is just another interesting piece of information to follow when watching the game.

The Case.  Saturday's semi-final contest between North Carolina and Kansas is a great example of market sentiment.  We have observed trading on many sporting events, so we urge you to take our word for the general interpretation.  Readers should note that we are not offering an opinion about the respective teams.  If the game were to be played 100 times, there would be many different outcomes.  The general result would be much closer than what actually occurred.

The market began with a bias about which team was better.  That opinion persisted, in defiance of the apparent results.  Sentiment changes very reluctantly.

The initial condition was that North Carolina, the overall #1 seed in the tournament, was favored by 3 1/2 points, 60% to win on a straight-up basis.  The TradeSports futures contract for a team settles at 100 for a win and zero for a loss.  The chart can therefore be interpreted as the percentage chance of victory at any point in time.

Let us start by looking at the chart.

Kansas had a very hot start to the game.  Since we are analyzing sentiment, not basketball, we shall just note that with ten minutes played, Kansas had a twenty-point lead.
At this point, the futures contract still showed a 20% chance for a North Carolina victory.  Let us think about this.  At the start of a game, a team that is a twenty-point favorite in the point spread is over 97% to win the game.  There was a clear disconnect between trading and reality, with North Carolina over-valued by the market.

A few minutes later, the lead grew to 28 points.  North Carolina futures still held a minimum bid of 5, reflecting 19-1 odds.  Market sentiment still held that UNC had a chance.

Now one might expect a team with such a lead to change strategy, but it is difficult to do so in practice.  Bill Self later stated that his team went "brain dead" for about thirteen minutes, allowing the margin to be narrowed at the end of the first half and for the first ten minutes of the second half.  Anyone who watched Gene Hackman in Hoosiers understands the difficulty in getting players to follow the coach's strategy!

Did this mean that the UNC investors were correct?  The television analysts opined that the game was over.  Despite this, with ten minutes to go, the lead was narrowed to five points.  The futures contract got as high as 50, reflecting a continuation of UNC momentum.

The best trade of the contest was to buy North Carolina at 5.5 and sell at 48 or so, a nine-bagger in less than fifteen minutes of playing time.  This profit could have been accomplished by investing in a team that ultimately lost by a wide margin, and never got the lead!  One does not need to predict the result to make money, only to predict the market reaction.

In fact, this was a highly improbable result.  That it actually happened seems to confirm the sentiment.

When Kansas slowed things down a bit and worked the ball inside, their lead grew once again.

As the clock ran down, the inevitability of the result became clear.  It was only at this point that sentiment switched.

Conclusion

The lesson here is that market sentiment is very "sticky."  Those investing in UNC futures were not just fans.  Most were regular players of many sporting events, seeking a profit on this one.  They began with an opinion, and the opinion was slow to shift.

The value of looking at an example like this is that the entire picture of sentiment and reality can be captured in the space of a few hours.

In the stock market, a similar process may take many months or even years.  We shall explore this further.