Practical Speculation

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VICTOR NIEDERHOFFER LAUREL KENNER

John Wiley & Sons, Inc. nied_a01fm.qxd 1/24/03 10:40 AM Page i nied_a01fm.qxd 1/24/03 10:40 AM Page 1

More Praise for Practical Speculation “Practical Speculation distills an unusual breadth of hard-won (and costly) ex- perience and insight into an immensely readable and instructive book. Bulls and Bears are drawn and quartered alike by the authors’ exquisitely honed quantitative scalpel.” Stephen M. Stigler Professor of Statistics University of Chicago

“In my judgment, Victor Niederhoffer is the single most insightful speculator in the world. This new book displays Victor’s unique gift for recognizing the subtle confluence of seemingly disparate events. Although this book is par- tially a guide on investment strategy, it is principally a remarkable explanation of market function.” Herbert London John M. Olin Professor of Humanities, New York University President, Hudson Institute

“Whatever Victor Niederhoffer writes is worth reading—not once but at least twice. His analysis of markets is as brilliant as it is unorthodox. Readers will discover a host of nuggets in Practical Speculation that will stretch their minds and tease their imaginations.” Lawrence S. Ritter John M. Schiff Professor of Finance Emeritus New York University

“Victor Niederhoffer outdoes himself beginning with the first paragraph of the introduction. Victor and Laurel uniquely see the interrelationships and de- pendencies among the complex factors that are daily life and are able to inter- pret observations in terms of how people will react to the sequences of events. Practical Speculation is an extraordinary insight into the thinking of probably the most original thinker of our time.” Kenneth W. Rendell Founder, Kenneth W. Rendell, Inc.

“Vic and Laurel are breathtakingly insightful. They paint on a global investment canvas stretching across space and time. This is their dazzling journey through the art, science, sport, and literature of investing. Don’t risk a penny on stocks until you have read Practical Speculation.” Professor Elroy Dimson, London Business School Co-author, Triumph of the Optimists nied_a01fm.qxd 1/24/03 10:40 AM Page 2 nied_a01fm.qxd 1/24/03 10:40 AM Page i

Practical Speculation

VICTOR NIEDERHOFFER LAUREL KENNER

John Wiley & Sons, Inc. nied_a01fm.qxd 1/24/03 10:40 AM Page ii

Copyright © 2003 by Victor Niederhoffer and Laurel Kenner. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, e-mail: [email protected]. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data: Niederhoffer, Victor, 1943– Practical speculation / Victor Niederhoffer, Laurel Kenner. p. cm. Includes index. ISBN 0-471-44306-9 (alk. paper) 1. Speculation. 2. Stocks. 3. Investment analysis. I. Kenner, Laurel. II. Title. HG6041.N52 2003 332.63′2—dc21 2002190747 Printed in the United States of America. 10987654321 nied_a01fm.qxd 1/24/03 10:40 AM Page iii

A fragment of a wartime speech moved through my mind: ‘We shall fight them in the fields, and in the streets, we shall fight in the hills; we shall never surrender.’ True then for one people, it was true always for the whole human race.

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ACKNOWLEDGMENTS

his book was written from the firing line. Most of the ideas were sub- Tjected not only to the pitiless judgment of the market itself but also to the critiques, often withering, by readers of our columns for CNBC Money, worldlyinvestor.com, and thestreet.com. The list of those who helped us accomplish our writing task amid the daily fray is long. Almost everything in this book benefited from the insights of our editor at CNBC Money, Jon Markman. Pamela van Giessen, our editor at John Wiley & Sons, inspired this book and shepherded it through many iterations. Our thinking was sharpened and augmented by the daily discussions on our Speculators’ List, a group of extraordinary individuals who read and re- sponded to our columns and then accepted our invitation to join a philosoph- ical e-mail forum in the spirit of Ben Franklin’s junto. We are deeply grateful to James Goldcamp, who put the list together for us. From an original mem- bership of fewer than 10 people, the Speculators’ List now encompasses more than 150 experts on diverse subjects, united by a common interest in markets, statistical analysis, and mutually beneficial discussion. Dr. Brett Steenbarger, whose contributions appear throughout this book, was among the early readers who became dear friends. Our thinking and our lives have been enriched by Gitanshu Buch, Henry Carstens, Duncan Coker, Nigel Davis, “Mr. E,” Bill Egan, Glenn Escovedo, Ed Gross, Bill Haynes, David Hillman, James Lackey, John Lamberg, Paul Lewis, Alix Martin, Mark McNabb, Shui Mitsuda, Bipin Pathak, Tom Ryan, Ken Sadofsky, Dick Sears, Russell Sears, Saurabh Singal, Don Staricka, Gary Tate, Jack Tierney, and Steve Wisdom, to name only a few. There are many other eagles too numerous to mention.

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vi Acknowledgments

Market Warriors (Artist: Susan Slyman, 2000). nied_a01fm.qxd 1/24/03 10:40 AM Page vii

Acknowledgments vii

The traders in Vic’s office contributed research and analysis in addition to their daily duties. Shi Zhang and David Ciocca produced many of the studies and scatter diagrams. Patrick Boyle researched the chapters on physics and Benjamin Graham. Rob Wincapaw located books, letters, and articles with unfailing patience. Gitanshu Buch kept track of a multitude of projects while simultaneously running the trading operation. Bill Egan, John Lamberg, Gaylen Larson, and Adam Robinson reviewed drafts and made many helpful suggestions. Rip MacKenzie contributed much of the material for the hubris chapter. James Cramer at TheStreet.com and Jeremy Pink at worldlyinvestor.com encouraged our early writing endeavors. We are grateful to Steve Stigler and Jim Lorie of the University of Chicago, and to Lee Henkel, Vic’s long-time mentors, and friends. Also to Dan Gross- man, Vic’s partner of 30 years, for valued insights and steadfast friendship. Laurel thanks her music teachers, Aube Tzerko, Bruce Sutherland, and Robert Winter, for teaching an approach to music she has found valuable in all areas of life. We thank our families for sharing the pain and the pleasure.

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CONTENTS

Introduction 1 Part One: Mumbo Jumbo and Moonshine 21 1 The Meme 23 2 Earnings Propaganda 43 3 The Hydra Heads of Technical Analysis 71 4 The Cult of the Bear 115 5 “We Are Number One” Usually Means “Not Much Longer” 133 6 Benjamin Graham: Mythical Market Hero 165 7 News Flash: Computer Writes Stock Market Story! 173 Part Two: Practical Speculation 181 8 How to Avoid Spurious Correlations 187 9 The Future of Returns 205 10 The Periodic Table of Investing 217 11 When They Swing for the Fences, We Run for the Exits 235 12 Boom or Bust? 247 13 Market Thermodynamics 263

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x Contents

14 Practical Market Lessons from the Tennis Court 281 15 The Fine Art of Bargaining for an Edge 291 16 An Amiable Idiot in the Biotechnology Revolution 301 17 Earnings Impostors 313 18 Finale 341 Afterword 367 Notes 369 Index 377 nied_a02cintro.qxd 1/24/03 10:38 AM Page 1

INTRODUCTION The Hope Snatchers

Look! You fools! You’re in danger! Can’t you see? They’re after you! They’re after all of us! Our wives . . . our children . . . they’re here already! You’re next!

—Dr. Miles Bennell, Invasion of the Body Snatchers (1956 film version)

he nightmare is always the same. I am lying in bed, staring at headlines Tflashing across a huge monitor installed on my ceiling: Stocks Fall on Earnings Pessimism Stocks May Fall for Fifth Consecutive Week on Fears Economy Is Sputtering Money Market Yields Fall to 1 Percent as Stock Market Woes Deepen Stocks Fail to Top Y2K High for 450th Consecutive Day Study Shows More Than 60 percent of All Issues Below 52-Week High Markets Plummet as January Barometer Signals Decline for Rest of Year Oracle of Omaha Says Investor Expectations Are “Too High” Market Plunges on Fears Before Fed Meeting Break of Revered Gann Pivot Triggers Massive Selling Dividend Yields Now 25 Percent Below 1996 “Irrational Exuberance” Speech