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Friday, May 02, 2008

They Never Taught Us This in Grad School

OK I know someone who had bought some shares of IAU, an ETF that holds physical gold. (The point was to have some exposure to gold in case things got really bad, late-1970s style.)

With gold falling so much since early April, the person decided he would sell off his IAU shares if it ever hit $84. He had bought in at $93 or so, and so that cutoff would limit his losses to an amount that was acceptable. I pointed out that he should have a point at which he would get back in, in case this dip down was just a temporary thing and gold really did soar up to $2,000 / oz. as some alarmists are suggesting. He agreed this was a good idea, and so decided $95.

OK, so everyone gets the idea? He bought in at $93, it was tanking, and if it hit $84 he was getting out to limit his losses. If it kept falling, that was good he got out. And if it zoomed up to $250, he would have gotten back in at $95, so he would only be out from the zig-zag, and would still be protected in case things really went to heck with the economy.

Now here's the kicker: He was incommunicado yesterday, when IAU sank below the sell-point. So he obviously didn't sell. (He hadn't set up anything automatic with his broker.)

Now today, IAU is back up above the sell-point.

So should he sell or not? On the one hand, you could say, "Yes! He should have sold yesterday; the fact that it got so low was a warning that things weren't playing out the way the alarmists had said, and so now just be grateful it bumped up a buck right before you sell."

On the other hand, you could argue, "No, right now IAU is at a price that would not have warranted selling two days ago. So if your strategy was to hold it unless it dipped below $84, you shouldn't sell it now when it's trading at $84.50 or so."

BTW, I really am talking about another person. All of my savings are in cheese curls (.wav).

17 comments:

  1. They Never Taught Us This In Grad School

    That's why it is dangerous trading with a grad school mentality (or running the Fed with such).

    Actually, what you describe is very similar to what brokers laughingly call Good Till Close (Close as in near). Many traders put in a set sell order, a GTC order (Good Till Cancel). But as the price gets close to the sell price, the aprehensions as to whether they should maintain the GTC or cancel the sell, would maket Hamlet look like a snap decision maker. (I realize your circimstances are a bit different, but not that much)

    The problem with these traders is that put in these buy and sell orders without rhyme or reason. You and your trader friend sound like you are in this boat.

    The answer you pose should be simple to solve, if, for example, your friend said, I will put in a stop loss sell order at X, because if the price of gold breaks below X this will signal a major technical breakdown in the stock price from which it will be difficult for the stock to recover on a short term basis.

    So Bob, did your trader friend actually have a specific reason to set a sell (in his mind) at a specific price or did he pick the number out of the air (which is guranteed to be a reason that a trader will eventually lose all his money). Once his "Ruling Reason" for putting in the sell is known, it can than be determined if the clinb back across the sell point has significnce? Thus, there are no great philosophical dilemmas here. You don't supply enough information to properly answer the question. What needs to be known is "How was the sell point picked?"

    From there your trading puzzle pretty much solves itself.

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  2. Mr. Wegner,

    He picked the sell-point using matrix algebra. (ha ha)

    I think I did give you the info in the post. He bought some exposure to gold as protection in case we had double digit inflation in 2009, war broke out, etc. When he did this, he thought gold would tread water and then spike if things got awful.

    But that's not what happened. Gold started dipping a lot. That should not have happened, if the Fed is printing up new dollars, credit markets are done for, etc.

    So he didn't want to just hang on to it and bleed away all his money on the position. He decided that if he got out at some point, he could always get back in if gold rebounded. Yes, he would miss out on the zig-zag, but in case gold went down to $500 and stayed there for the next 5 years, he would do better to bail out sooner rather than later.

    So he completely arbitrarily picked the number $84. Is that better than $83 or $85? No. But it's better than $60 if gold tanks and stays down, and it's not much worse than $90 if gold tanks then rebounds (and he gets back in at $95).

    OK now I am ready for you to calmly explain how stupid he is (and I am for now seeing why).

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  3. Oops--last sentence should have, "...(and I am for NOT seeing why)."

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  4. Bob,

    I tell you what drives me crazy about your comments is that you are obviously a very bright guy, who really hasn't traded a lot. The comments you are making don't fit in with the knowledge you have.

    You are not alone in this BTW.I remember once when Rothbard was visting a trading floor where I was working. I was obviiouly very excited. A trader friend of mine (a Keynesian) said to me. "You know Rothbard doesn't get it." I, of course, considered this a sacrilige and brushed it off as the madness of a Keynesian. He had met Rothbard once before and just brushed him off.

    So Rothbard arrives, and I forget what was going on in the markets at the time, but I went out to lunch with him and it was obvious in talking to him that he just wasn't paying attention to how traders think to provide insights at that level.

    If I recall correctly, I think it was Joey Rothbard who wrote somwhere that Rothbard never made money investing.

    The comments you make about investing are, forgive me, the type brokers hear all day from non-professional traders who have no idea how complex the markets are.

    Getting back to your friend, he should put in sell if it breaks below 77.49. There are a lot of reasons that a break below that is significant, but obviously I am already over any reasonable space alotted for a comment.

    But, actually, I wouldn't sell at all. Your friend isn't a seasoned trader. If the "ruling reasons" (See Gerald Loeb, The Battle for Stock Market Profits)for why an investment was made remain iintact: potential double digit inflation , potental war in Iran, you hold the position. Yes, I know gold is down a bit, but this gets back to those direct immediate corollaries you are pushing that just don't exist.

    You seem to have a a strong interest in this trading/investing stuff. I don't know what you are doing now, but maybe you should work for a year as a trader or a broker. And I emphasize as a trader not some quant in a back room. It would really open your eyes and that knowledge would be powerful. There aren't many economists who really understand trading. I think Ludwig Lachman did. Machlup less so.

    If you want to pick up a couple of books that would give you a bit of an insiders feel, here are two. Read them in this order. First, How To Manipulate A Stock by Marchand Sage. Then read The Professional Commodity Trader by Stanley Kroll

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  5. Whoops, I don't know why Lachman came to mind. I meant G.L.S. Shackle.

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  6. The comments you make about investing are, forgive me, the type brokers hear all day from non-professional traders who have no idea how complex the markets are.

    I am only mildly insulted, and even there only because I think the markets are wickedly complex. In fact, I can't believe you followed the above paragraph with this:

    Getting back to your friend, he should put in sell if it breaks below 77.49.

    Do you see the irony? Back when you were criticizing me for saying one could profit from studying a renowned textbook on international trade, I didn't take it too seriously because my (half tongue-in-cheek) comment about matrix algebra may have led you to think that I actually "believed in" formal models of the economy. I thought you were saying, "People have subjective tastes and so if somebody is trying to lay down 'rules' about the economy, he is full of it."

    So you can imagine my surprise at your statement above.

    You have probably got at least 20 years on me so I will take what you so more seriously than if I found out you were a high schooler. And it wouldn't surprise me that if we both started with $100,000, you would have more money in two years than I would.

    But since we're sharing, I should let you know that professional economists are pretty amused when certain traders think that if you want to forecast prices, you don't need to worry about supply and demand. Instead you can look at a chart and figure out where its head and shoulders are etc. That really cracks us up.

    And also, I'm not knocking the predictive power of some of these mental frameworks. Obviously, the people who survive as traders are better than their peers, and certainly would crush a PhD economist teaching at MIT. But what I'm saying is, it cracks us up when you guys try to explain how you make money.

    I will honestly order those books from Amazon though. Thank you for the recommendations.

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  7. One of the best economists at investing was Keynes!

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  8. Bob,

    Again, it's a case of not understanding a traders mentality. Although charts are used incorrectly by many, a chart can really tell you a lot about supply and demand. (See: Technical Analysis by Edwards and Magee). There is huge demand until 77.49, then it dries up. You'll get why from the Marcahnd Sage book.

    Actually, I probably do have a few years on you. But, I was trading foreign currencies as a senior in high school,and already had the Theory of Money and Credit down and Marchand Sage. I actually attended investment seminars (including a Gary North seminar) and economic seminars (e.g.at FEE) before I was old enough to drive. Sometimes I got my father to drive me, sometimes my grandmother. It really would have paid to listen to me even when I was a high schooler.

    BTW: I consider myself an economist first and trading just a sideline. As an economist, I still think, that you are weak on methodology.

    If we ever meet, I can't do it publicly, but I will mention to you a, shall we say an EXTREMELY respected textbook writing econometrcian, who calls me fairly often about trading the markets. I make it clear to him that I think his work is junk, but he keeps calling (I think he agrees).

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  9. Gene,

    I thought Bob would jump on the economist comments and come up with Keynes.

    But, hey, welcome to the discussion.

    Actually Keynes was as big a blowhard about his investing skill as he was in his economic theorizing. Whatever money he made early on, he made prior to the 1929 crash, and who wasn't making money then? Think of him as a current day house flipper, until the music stopped. Then he got wiped out. The really big money he made was after that, when I suspect he and Bernard Baruch got FDR to manipulate the gold market. (FDR was probably clueless as to what was really behind their "advice"). Gold was going down in the 1930's like all other commodities, as it should have.

    Then Baruch and Keynes take huge positions in gold mining stocks and then suddenly FDR announces a gold support program. Gold stocks soared and some even ended up paying dividends monthly so much money was rolling in.

    Baruch and Keynes made money the old fashioned way, they manipulated government for their own personal gain.

    Oh yeah, BTW, it is also a myth that Baruch made money shorting the market before 1929. He was short for awhile but he got scared out of his positions before the crash.

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  10. It really would have paid to listen to me even when I was a high schooler.

    Gene, what do you think? He's definitely cocky enough to get Crash Landing privileges. Now he just needs to offer his opinions on philosophy of science and bar hopping, and he's in, right?

    BTW: I consider myself an economist first and trading just a sideline.

    Do you teach somewhere? I assume you're not the deer historian.

    BTW I looked at your website for the first time today. Again, I was surprised by all the talk of recession predicting and yield curves and such. I thought you were giving me a purist lecture before.

    So what gives? A Misesian can say the yield curve predicts recession, but not that a spike in PPI predicts a spike in CPI?

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  11. LOL. No, I am not the deer historian. I am a financial and economic consultant.

    So what gives? A Misesian can say the yield curve predicts recession, but not that a spike in PPI predicts a spike in CPI?

    There's a bunch of stuff going on here that makes a difference in the two strings of data.

    First, the yield curve is dealing with market prices, while the CPI and PPI are dealing with aggregations of market prices, further subject to massaging by the government. See my comments, How To Monitor The Economy http://nationaleconomist.com/blog/2008/05/04/how-to-monitor-the-economy/

    Second, you are trying to make a very specific correlation. PPI up today, CPI up in two days. This can get you in to loads of trouble, because there can be all kinds of time lags.

    PPI up therefore CPI up just isn't to me a very fruitful observation. We see the Fed's huge money printing, we see prices going up all over the damn place, so what is the PPI number telling me that I don't already know?

    On the other hand, suppose for a minute that there were no money supply numbers to look at and we could see PPI climbing, then it would be reasionable to comment that CPI is probably headed higher. BUt, I wouldn't be as comfortable with that forecast as I would by knowing what money supply is doing and what actual various other prices are doing.

    But the thing that really got me with your CPI/PPI comment was the exactness in your comment that PPI was up this month therefore CPI will be up, making such a comment accurately is way beyond the scope of economics.

    The most we can do are Hayek's "pattern predictions". All these guys who come out with numbers like, inflation will be up by 4.2819% in the second half, are nuts.

    My yield curve comment, again,is about actual prices and futher there is a very deductive logic to why it works. Banks borrow short term and lend long, with short term rates lower than long rates there is a lot of incentive for banks to put money out there. But notice, I don't put specific dates on when I expect all this to kick in. Again, specific dates on this kind of stuff is beyond the scope of economics, the economy is too complex. We can get a good idea of general trends but that is it.

    BTW: My site does not make any predictions of a recession. Since the start of the crisis, I have said that this was a sector problem related to housing and financial firms involved in housing. Now that Bernanke has goosed the money supply to near record annualized growth rates, the chances of an overall recession seem even less likely. Inflation will be the real problem.

    As for bar hopping, I can actually walk into bars in five different cities, sit down at the bar, not say a word and the bartender will know what drink to pour me.

    I do have a philosophy book in the back of my head, but that won't be out anytime soon,since I am currently working on a book tenatively titled: The Myth of Government: Why I Live In A Private Property Society and You Do Also, Except I Do So More Efficiently.

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  12. Gene, I would look a little more into the Keynes great investor story. I will be off on the facts, but he blew up a couple of times. And, maybe he just died before his next blow-up? Anyways, this is something of a project of mine. All these investors who are killing the market in good times with high leverage and volatility and then blow-up. Not my definition of a good investor. Yet, many get second and third chances, why?

    Merton and Scholes were great economist investors until 1998 and Irving Fisher was great until 1929. Actually, I might say mises was great by not being in the market in 1929.

    As for Mr Wegner, do you have like a $100 million? You berate Bob and tell him he does not get it...I take it you get it and have the cash to prove it?

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  13. "He was incommunicado yesterday..."

    Hey, Lew and I were in Communicado yesterday! We had another meeting with Wright.

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  14. Hey Pepe,

    Don't worry about me berating Murphy and Callahan. They can handle themselves. Didn't you see "The Departed"? These guys come from a pretty tough tribe.

    Now, just for practice, let me blow up some of your other comments:

    do you have like a $100 million

    So you want to make this a who has the biggest wallet thing? If mine's bigger than yours, do I win?

    Or are you saying that superiority in wealth translates into superiority in economic knowledge?

    If that's the case why don't we just follow Warren Buffett around and nod our collective heads,as he casts his pearls of wisdom around, such as, a huge death tax, and his blessing of Bernanke's bailout of Bear Stearns?

    As for your comment:

    Actually, I might say mises was great by not being in the market in 1929

    I am hoping that this is just some huge typo, but it appears not. I have never seen anywhere any reference to Mises as a market trader. Which implies you are saying Mises was a great investor because he didn't invest and had no intentions of investng in a bull or bear market. Thanks I thnk you just elevated my sweet dear great grandmother along side Mises as a great investor, since like Mises she never even thought about investing.

    As for my abilities as a forecaster, I put it out on the line, you will know whether I am right or wrong without having to peak at my bank account. ( I will tell you this though, after one particularly tricky period in the market I did quite well, my account was with a discount broker where I really didn't know any of the brokers or the traders, I decided to cash out a bit of my proceeds. Two traders I didn't know came out of the back to shake my hand when they heard I was in the office to pick up a check).

    As for my current forecasts, I see no recession, I see major inflation and I believe the bond market will decline for the next 30
    years. So Pepe, what are your forecasts?

    As for your poor arguing technique, the apprpriate away to go at is to find flaws in my arguments and hammer me with it. Have you found any flaws made by me in this back and forth with Bob and Gene?

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  15. As for bar hopping, I can actually walk into bars in five different cities, sit down at the bar, not say a word and the bartender will know what drink to pour me.

    Me too! There are special places in Chicago, New York, San Fransisco, D.C., and Las Vegas where the bartenders know to have a Shirley Temple waiting before my cheeks hit the stool.

    But the thing that really got me with your CPI/PPI comment was the exactness in your comment that PPI was up this month therefore CPI will be up, making such a comment accurately is way beyond the scope of economics.

    I am going to present two statements below. You tell me which is a more exacting abuse of economics.

    Quote 1: For the real thinkers out there, who might wonder whether the PPI and CPI move together: The PPI is certainly more volatile, but they tend to move together.

    Quote 2: Getting back to your friend, he should put in sell if it breaks below 77.49.


    OK just so you know, I am done posting on this thread. I will check back to see if you blow me up. We can argue some more when I post on the consumption tax tomorrow. I am going to dedicate the post to you.

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  16. Bob,

    Quote 2 is all about supply and demand, nothing more nothing less. Proper technical analysis is based on the logic of human action. There is admitedly a lot of nutty stuff done under the name of technical analysis, e.g. moving averages, just as there is a lot of nutty stuff said under the name economics. It's really funny but the one example you use, the head and shoulders formation, is all about human action. It's Misesian to the core!!

    Quote 1 is an empirical observation (which also happens to be faulty). Rothbard wrote a whole damn book, America's Great Depression, discussing the fact that during the 1920's capital goods, i.e. producer goods, climbed in price while consumer goods didn't.

    The fact that on top of this error you tend to imply, not only a relationship between PPI and CPI, but seem to imply pretty close to a rhythmic time relationship between a climb in PPI and CPI, is falsified by factual evidence.

    I haven't blown you up, Rothbard did 45 years ago.

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