Escapist Fantasies

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Image by pixabay.com


Warren Buffett on living in Omaha:
(from the book Supermoney)

"You can think here. You don't hear so many stories. You can just sit and look at the stock on the desk in front of you."

John Templeton on living in Nassau, Bahamas:
(from the book Sir John Templeton by Robert Herrman)

“If you’re going to have a superior record, you have to do something different from what the other security analysts are doing. And when you’re a thousand miles away from Wall Street in a different nation, it’s easier to be independent and buy the things that other people are selling, and sell the things that other people are buying. So that independence has proved to be a valuable help in our long-range performance. Then, the other factor is that so much of my time in New York was taken up with administration and in serving hundreds of clients that I didn’t have the time for the study and research that are essential for a chartered financial analyst. And that was the area in which God had given me some talents. So now in the Bahamas I had more time to search for the best bargains.

Reading these quotes, I feel a temptation to flee New York. An urge to retreat to a chalet in the Alps or a cottage on a hidden beach in the Caribbean. Unplug from the internet and read, think, and write all day.

Comedian Lewis Black captured New York’s noisy insanity best:

“I love New York City. The reason I live in New York City is because it’s the loudest city on the planet Earth. It’s so loud I never have to listen to any of the shit that’s going on in my own head. It’s really loud. They literally have guys come with jackhammers and they drill the streets and just leave cones in front of your apartment; you don’t even know why. Garbage men come; they don’t pick up the garbage, they just bang the cans together.”

After years of living here, I crave quietude.

Living in any financial hub, you have to deal with another kind of noise. You are surrounded by people who are “in the business.” They are driven, ambitious, competitive. Always looking for the next insight or idea. Always pitching, selling, connecting. There is a constant conversation, an energy driven by market volatility and the hunger for growth.

Will this market hold the support? What do you think of European equities into 2019? Are the homebuilders a buy here? Did you see that Insert Name Capital just went activist on Random Corp of America? And what about China? Hey, let’s set up a meeting with Yet Another Fund LP. Trust me, you’ll like those guys.

You get bombarded with information and sales pitches. The days are never quite long enough to deal with it all. Just one more meeting, just one more presentation. Being plugged in can leave you exhausted and distracted.

No wonder that Buffett removed himself from the circus:

"The difference between successful people and really successful people is that really successful people say no to almost everything."

In “Good to Great” Jim Collins suggests making a “stop doing” list. From his “Best New Year’s Resolution”:

“In cataloguing the key steps that ignited the transformations, my research team and I were struck by how many of the big decisions were not what to do, but what to stop doing.” 

“The start of the New Year is a perfect time to start a stop doing list.”

If you want to do fewer things, being exposed to fewer things seems like a sensible first step.
So, should investors all pack up their Bloombergs and run their portfolios from a trailer in the Rockies?

Let’s look at a couple of other quotes:

Julian Robertson (Institutional Investor, 1986):

“It’s not that Robertson does anything dramatically different from other money managers; it’s just that he does it so well. Throughout the day, he’s continually in touch with a dozen or so Wall Street and money management contacts to get ideas or discuss his own thoughts on the market and the various stocks he is interested in at the moment”

Michael Steinhardt (WSJ, 1986):

“All through the day, phone calls bring Mr. Steinhardt the news he needs. Other investors study annual reports, read trade journals or visit companies to get investment ideas. Not Mr. Steinhardt. He thinks the last time he visited a company was in 1973. Instead, he munches on bran muffins and hears daily from Wall Street personalities.”

These great money managers practiced a seemingly opposite approach. They plugged themselves into the flow of information at the heart of the market. They built their businesses around their networks. Not only to source new ideas, but also to get valuable feedback on their own thoughts.

From the book “Julian Robertson: A Tiger in the Land of Bulls and Bears” (Daniel A. Strachman):

“From the beginning of his career he had worked very hard at establishing a network of people around the world who he could turn to for information about potential investments and who he could use as a sounding board before he made investment decisions.

His use of the phones to gather information is legendary. A reporter once commented after watching him in action that speed dial must have been invented for Robertson, in that he is constantly finishing up one call and dialing anther. At Tiger, Robertson spent most of his time either on the phone, looking at charts, or reviewing information. He constantly developed networks in order to make sure that when Tiger got information it had the right people available to process it.”


I think the best quote on this topic belongs to the legendary investor Bob Wilson:


George Goodman: Some of the great investors do better out of New York. John Templeton lives in his flower garden in the Bahamas and Warren Buffett lives in Omaha, Nebraska. And both of them say that living out of New York keeps them out of everyday gossip and the hurly-burly of flow and overload of information. How do you survive in New York?

 

Robert Wilson: Well, in the first place, I would be bored to death simply living in either the Bahamas or Omaha. And so the most important thing is to enjoy life. But secondly, I never really did all that well in the market until I came to New York. Unlike these other distinguished gentlemen, I am not an original thinker. I tend to rely on other people to feed me, if you will, ideas. And I’m very interested in what a lot of other people are thinking. And more bright people are in New York, in this business, than anywhere else. I think the difference really is that they are original thinkers and I am not. I am a derivative thinker.”

I think that is a very self-aware statement. It all comes back to this: “you have to know who you are.”
Are you an original thinker or a derivative thinker? I think most of us are both, but with one side being dominant.

Think of your brain as a research firm and yourself as the CEO. This is from David Ogilvy:

“I have come to the conclusion that the top man has one principal responsibility: to provide an atmosphere in which creative mavericks can do useful work.”

 

That is your job. To create the conditions in which you can do useful work. You have to be thoughtful about choosing an environment that supports good habits and suits your personality. What environment makes you happy and productive? 

In my mind, that means balance. I may feel like retreating to the mountains for solemn reading and contemplation. But if I spent my entire year there, I would leave myself isolated and lonely.

What I would like to balance:  

  • Time to read and think. Balanced with engaging discussion and feedback

  • Sourcing your own ideas. Balanced with tapping into a network of likeminded investors

  • Reading primary sources. Balanced with the knowledge of those who pondered the question before you

  • Meditation and focus. Balanced with the chaotic optionality of life surrounded by type-A people

  • Quietude balanced with conversation

  • Solitude balanced with connection

And let’s remember that even though Buffett physically removed himself from Wall Street, he worked hard to build and maintain a valuable network of friends and contacts. From Alice Schroeder’s Snowball: staying in touch with his friends in New York and elephant-bumping (at the annual Sun Valley conference and at Kay Graham’s Washington DC parties).

In March 1959, Warren took one of his regular trips to New York, staying out on Long Island at Anne Gottschaldt’s little white colonial house. By now she and her sister had adopted him as a sort of surrogate son, as if to replace the long-dead Fred. Warren kept spare sets of underwear and pajamas at her house, and Gottschaldt made him hamburgers for breakfast. On these journeys, he always set out with a list of between ten and thirty things he wanted to accomplish. He would go to the Standard & Poor’s library to look up some information. He would visit some companies, visit some brokers, and always spend time with Brandt, Cowin, Schloss, Knapp, and Ruane, his New York City network.

Buffett’s friend Tom Murphy referred to this kind of event as “elephant-bumping.” “Anytime a bunch of big shots get together,” says Buffett, “you can get people to come, because it reassures them if they’re at an elephant-bumping that they’re an elephant too.”

He developed a network of people who—for the sake of his friendship as well as his sagacity—not only helped him but also stayed out of his way when he wanted them to.


I will close with the full quote from Supermoney.
Omaha: “You can think here.”
But also: “I probably have more friends in New York and California than here.”

Buffett very deliberately chose his environment and built a balance in his life that worked well for him.
Go and do likewise.
Happy Holidays!

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What I Learned from the Optionsellers.com Blowup

By now you’ve probably heard of James Cordier who blew up his clients at optionsellers.com (full apology video).

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If you need a recap: He Blew Up His Fund. Now He’s a Laughingstock.
“The firm lost all of its capital in last week’s volatile energy markets and, in some cases, left clients on the hook to settle trade balances.”

WSJ: Energy Losses Prompt Emotional Video to Options Firm’s Clients

 

How This One Fund Blew Up Overnight – And What We Can Learn From It
“Mr. Cordier with his expert financial opinion thought it was wise to sell naked call options on Natural Gas. Nat Gas shot up nearly 20% in a single afternoon last week.
At the bottom of all this mess – it was his fault for setting up a negatively asymmetric (high risk – low reward) trade.”

“Process and method words abound on the website’s materials, because they must. Lip service to the value of diversification and conservatism are everywhere, too. … All of those blogs, all of that garbage about deep out-of-the-money options and black swans – is a cartoon of process. It’s a Nice Sweater.” (Epsilon Theory)


Perhaps the greatest irony is that optionsellers.com even used Taleb’s “black swan” concept in its marketing – and then proceeded to do the opposite (selling tail risk).



I think there is a broader lesson to be found here than “don’t blow yourself up writing naked options.”

Josh Brown touched on it in Yards After Contact:
“All around me I see examples of people, portfolios, strategies, messaging and business models that weren’t built to withstand corrections that persist for more than a month or so, as this one now has. Free asset management isn’t built for it. The phone banks won’t withstand the onslaught as millions of people learn that index funds aren’t any “safer” than the active funds they’ve exchanged them for.
Advisors who don’t charge any money for portfolio management aren’t built for it either.”



It has been some ten years since the last recession. Ten years since the last period of sustained volatility, widespread defaults, wrecked retirement accounts, and mass layoffs. During this long period of prosperity, new business models such as robo-advisors have been built. But also, new narratives, habits and expectations have been formed. Buy the dip. The next fund we raise will be bigger than the last one. The U.S. is the cleanest shirt in a dirty laundry. Shorting volatility is a license to print money. Markets go up, clients are happy, AUM grows every year.


The premise of Taleb’s book Antifragile is that “everything gains or loses from volatility.

It’s easy to dismiss the optionsellers.com debacle as overconfident, foolish speculation. But remember that most of us in the business of investment management are also, effectively, short volatility. Not in the reckless way that optionsellers.com was, but still. Portfolio managers and analysts, allocators and financial advisors: most of Wall Street depends on the positive performance of risk assets. We get paid when times are good. We may benefit from short bouts of volatility that create mispricings. But long and volatile bear markets are deadly.

 

Rising markets have also mitigated the impact of a key structural shift: the rise of passive management.

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The career risk of being short volatility is particularly severe if you are just a cog in a money management machine. If you just execute, analyze, implement. If you’re a cost center.

  • If you don’t own your track record.

  • If you don’t own the client relationship.

  • If you’re invisible, with no public brand or voice.


Or if you work for an organization that will eventually falter under the pressure of passive management. Maybe, after years of underperformance, even the ten-year track record is now lagging the benchmark. It’s getting impossible to hide this from clients and it won’t take much for them to bail.

How can you make your own career more antifragile?

Build call options that will increase in value when your main career asset becomes vulnerable.

  • Open up your days to randomness and seek optionality. Randomness is inefficient and can be stressful. But too much routine will slowly shrink your world and leave you with fewer opportunities.

  • Be a lifelong learner and invest in new skills.

    David Ogilvy’s advice to young executives: “Pick a subject about which your agency knows too little, and make yourself an authority on it. Plan to write one good article a year. Once you become the acknowledged authority on any of these troublesome subjects, you will be able to write your own ticket.”

  • Either build your personal brand and voice openly, or at least utilize social media and fintwit to constantly expand your network.

  • Burn the midnight oil and start a side hustle.


Unfortunately, I speak from personal experience. For the past two years, I worked at the investment office of a very wealthy family. Our team managed an endowment-style portfolio, allocating to managers and private investments. There was no track record to be owned. There was no incentive or desire to build a public brand. There was no growth: single family offices don’t raise new funds or solicit new clients.

 

During that time, I became complacent.

  • Even though I was learning, I was not aggressively investing in new skills.

  • I was comfortable in my daily routines and randomness in my life decreased.

  • I shared some of my work on Twitter, but I did not fully commit to the idea of writing and sharing. I did not go all the way.

  • I thought about interesting ideas for side hustles and deals. But ideas are a dime a dozen. Only execution counts.

When circumstances changed at this firm, I experienced a rude awakening.

Don’t make the same mistake. Don’t board up your house in the middle of a hurricane. Prepare yourself well in advance. You don’t have to speculate like optionsellers.com to be caught short volatility at the wrong time.



As always, feel free to contact me via email (neckarcapital@gmail.com) or Twitter.


This is not investment advice. Always do your own research and consult with your advisors.

Family Offices: The New Deal Masters?

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Family offices combine a long-term investment mandate with the flexibility to look for the best investment ideas in any asset class, anywhere. Without the risk of investor redemptions, they can venture out and invest in illiquid and exotic assets. In recent years, family offices have increasingly pursued direct private equity deals. Are they Wall Street’s new deal masters?

In the U.S., family offices date back to the days of Andrew Carnegie, and John D. Rockefeller. Growth accelerated in recent decades and today there may be as many as 3,000 offices in the U.S. alone and up to 10,000 worldwide. Growing global wealth, increasing wealth concentration, and disappointment with banks’ wealth management services after the financial crisis have led to this surge in new family offices. According to the UBS Campden Wealth 2018 Family Office Report, two thirds of its survey participants were set up after the year 2000. More than half serve the first generation of wealth.

Traditionally, a family office’s primary goal was the preservation of wealth for future generations. Diversification and a conservative investment committee would serve to avoid severe mistakes and permanent loss of capital. However, there are other kinds of family partnerships which are dedicated to building wealth through savvy investments. An iconic example is the Bass family empire which was shaped through its partnership with legendary investors like Richard Rainwater and David Bonderman. A wave of retiring Wall Street icons and billionaire entrepreneurs has also led to the creation of family offices with an entirely different DNA. Other offices have started to build institutional-grade asset management platforms by hiring specialized talent and raising funds with outside partners. George Soros’s family office is currently in the process of spinning out its private equity team into a stand-alone firm. The Pritzker family office recently raised $1.8 billion for its second private equity fund.

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Legendary dealmaker Richard “Dealmeister” Rainwater, (c) Forbes

The following is the Pritzker family office’s pitch to business owners: “our differentiated, long-duration capital base provides us with the flexibility to grow our companies and do what’s right for our businesses over the long term.” This message is reminiscent of Warren Buffett’s marketing pitch: to provide a long-term home for business owners unwilling to sell to traditional private equity firms. The promise to retain culture, employees, and management, in exchange for a less competitive sale (that is, a lower price than could be obtained through an auction).


But what about the thousands of offices that lack institutional scale and are not led by an investment or entrepreneurial maven? It seems they, too, are in love with the promises of private investing and dealmaking.

After decades of strong performance, private equity has evolved into a major allocation in family office portfolios. In search of higher returns, lower fees, and more control, family offices increasingly opt for co-investments and direct investments. According to the UBS Campden survey, the average North American family office is ten percent invested in private equity funds and fourteen percent in direct private equity investments. Half of all offices in the survey aimed to increase their allocation to private equity direct deals, the highest percentage of any asset class.

UBS Campden Wealth 2018 Family Office Report:

How do family offices find these private deals? A family’s operating business can offer a deep-rooted industry network and access to unique deals and domain expertise. However, the sale of the family business often serves as a catalyst for the creation of the family office. As a result, many offices lack a unique industry network or lose it over time. Family offices also typically maintain a low profile to protect the family members’ privacy. Unfortunately, this is an obstacle when trying to attract deal flow. Not surprisingly, attractive deal flow is a key challenge for most family offices:


I believe there are several other important challenges to consider.

Does the office have enough dedicated and experienced professionals to source and underwrite private deals? Hiring private equity professionals is expensive, especially if the costs are borne by one principal instead of a large group of limited partners. The average single family office has about 11-12 full-time staff, with three or four on the investment team. In the UBS Campden survey, only 21% of offices agreed that a staff of more than five was required to invest successfully in direct private equity. It appears that many smaller family offices are confident they can add direct private equity investing to the existing dues of asset allocation and manager selection, without substantially increasing their investment staff.

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2016 Report

Is the deal team competitive in the marketplace? I believe the best way to answer this question is to compare the team to stand-alone private equity sponsors. Would the family office allocate to its own team, if that team was a third-party sponsor competing with others to raise a fund? That should be the litmus test for any team that does not benefit from truly proprietary sources of deal flow. Since most deal flow is generated through personal networks, one must ask whether the team is truly competitive with established private equity players. Otherwise, the office will likely suffer significant adverse selection in its sourcing effort. Many family offices are notoriously cost-conscious and should carefully evaluate whether they are prepared to pay due diligence and legal expenses for the deals they pursue but don’t close.

Private deals also introduce governance and incentive challenges. How are the private equity professionals compensated? If they receive a share of the profits, are they potentially incentivized to invest in even mediocre deals to create a call option-like payoff? Are there prestige or financial benefits from being on the board of directors of portfolio companies, motivating the team to increase the number of investments? Does the family office have an investment committee with individuals experienced in evaluating private equity transactions? And what happens if the family’s risk appetite changes in a market downturn and private deals fall out of favor? The private equity team will presumably either be terminated to save cost or may leave for lack of new investment opportunities. Existing portfolio companies effectively become orphaned and other professionals must take on the role of overseeing and possibly working out the investments.

Lastly, is now the right time in the cycle to increase exposure to direct private equity? Private equity dry powder stands at a record $1 trillion. Average buyout multiples in the U.S. are at record highs. And it seems likely that a private equity investment made today will have to be held through a downturn. By adding direct deals to their portfolio today, family offices seem to be chasing returns late in the economic cycle, in an environment of intense competition and high valuations.


Undoubtedly, some family offices have an edge through their domain expertise or access to exclusive deal flow. Others have hired or partnered with exceptional investment talent. Combining this edge with long-term flexible capital can lead to excellent investment outcomes. However, this only applies to a small number of firms. Others may find themselves chasing an investment fashion at the end of a cycle and might struggle to sustain their private investment program through a downturn. If you don’t have an edge, it is best to keep things simple and stick to the first order of business: preserve capital for future generations.


As always, feel free to contact me via email (neckarcapital@gmail.com) or Twitter.


This is not investment advice. Do your own research and consult with your advisors.

Time to Hit the Panic Button?

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After a sharp decline in October, is it time to stick a fork in this bull market?

The rats have been abandoning the ship of cyclical stocks this year. @modestproposal1 put it best, so I will just quote him:

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Housing

Autos

How about some Industrials

Some of those international markets don’t look too hot either

In the US, we could be seeing:

  • Run-off-the-mill pullback/correction

  • Beginning of a deeper pullback and quasi-bear market (like 2015)

  • First leg of a true bear market: recession and credit default cycle

The last one is the one I care about. I would really prefer to watch that one from the sidelines. But as of right now, a number of indicators are not suggesting a turn in the economic cycle.

Unemployment Claims - not rising

Yield Curve - flat but not inverted

Credit Spreads - no signs of stress yet

Leading Economic Indicator - not rolling over yet

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While housing-related stocks look terrible, homebuilder sentiment has held up.

That said: global growth momentum has turned down and borrowing costs in the US are now rising. I like these two charts by Bodhi Tree Asset Management:

Global Growth:

I think in October a multitude of worries hit the market at a time when it was vulnerable.

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Add to that:

  • Italy’s fight with the EU over its budget

  • Fears over ‘hard Brexit’

  • Mid-term election coming up 


And all of that more or less hit the buyout blackout period:

And buyouts continue to be pretty important in 2018:


 Abwarten und Tee Trinken?

That’s what they say in Germany. Sit tight and have a tea. It’s true, the sell-off was (is?) ugly and the market could well be leading the economic data to the downside. But we have also seen a “mini cycle” before during this bull market such as the energy-industrial recession in 2015/2016. If the economy cools from hot to mediocre, why wouldn’t the market take a breather. If we roll over into a full recession that’s another story.

I will admit to being spooked by the recent market action, ugly charts in cyclical sectors, and weak global markets. The combination of Fed tightening, cooling global growth, and a continued trade war is concerning. But to me, this seems to early to call. If (when) domestic data deteriorates and the credit market starts showing stress, it will be time to re-evaluate. Of course by then the market could have taken a lot more damage.

Just one last scary chart before we finish off.
”If the market closes October at these levels we will see a MACD sell signal“
(Plot twist: it did and the signal triggered.)


As always, feel free to email me or contact me on Twitter.
What indicators do you look at? What sources and people do you trust to read the macro tea leaves?

neckarcapital@gmail.com

@neckarvalue


This is not investment advice! Do your own research and consult with your advisors.


Beware of Market Timing Rules of Thumb (1959)

PDF: Beware of Market Timing Rules of Thumb
1959 Article
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In 1959, Fortune published an article called “A New Kind of Stock Market.” The Dow Jones had risen by 34% in 1958 and for the first time in 25 years, the stock market’s dividend yield had declined below the yield on long-term bonds.

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Market sentiment was still influenced by memories of the Great Depression and investors were looking for income and safety. Stocks, being riskier than bonds, were expected to provide a higher yield.

“Only in eight of the past-nine years have stocks sold so high in terms of dividends. Only for short periods in 1929, 1930, and 1933 have stocks yielded less than government bonds.”


With the dividend yield below the bond yield, was the market headed for another crash?
“It has been practically an article of faith in the U.S. that good stocks must yield more income than good bonds, and that when they do not, their prices will promptly fall.”

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But sentiment was changing. Institutional investors were increasingly investing in equities for their growth, rather than their dividend yield:

”A more basic reason for the market’s strength was the phenomenon largely responsible for its unprecedented rise in 1958: a growing belief that the time had at last arrived when quality stocks, because they appreciate in both intrinsic and market value, should normally sell to yield no more – or even less – income than bonds.”

“Although [pension funds, mutual funds and life insurance companies] together hold only some 10% of all the stock outstanding in the U.S., they have been increasing their share of the total rapidly. They have become a dominant force in the stock market… they are accounting for more than half of the net purchase of equities.”


The recession of 1958 was mild and earnings recovered quickly. Optimists were ready to discard the fear that every recession could be the next Great Depression:

“The specter of economic catastrophe that has haunted the U.S. since the 1920’s now appeared to be only a bogeyman.”

“Suppose, that investors cease to fear massive declines in earnings. The risk premium is then clearly unnecessary, and stock prices can be bid up to much higher price-earnings ratios.”


However, Fortune noted that the same sentiment had prevailed in the 1920’s:

“The doctrine that equities should be valued for more than mere yield, furthermore, is by no means new. It was the subject of a much-discussed book published in 1926, Edgar Lawrence Smith’s Common Stocks As Long-Term Investments, and it was a doctrine that helped whoop up stock prices to absurd levels in 1929.”

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And not everybody agreed:

“[He] maintains that inflation is not so “inevitable” as it is cracked up to be, that bonds should by nature yield less than stocks and that the present market is headed for a major readjustment.”


But stocks did not fall. There was no major readjustment. Instead, the economy kept expanding, earnings kept growing, and the 1960’s brought the first speculative bull market since the 1920’s. Meanwhile, bond yields were just beginning their ascent. The “article of faith” stopped working.

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Wells Fargo Asset Management


Today, nobody argues that the stock market should yield more than the bond market. But other indicators are being used as rules of thumb to judge whether the market may be at an extreme. Typically, these charts show a compelling and simple relationship that appears to identify cyclical market peaks and bottoms. I will touch on a few of the charts I encounter on a regular basis. My point is not to argue whether the U.S. stock market today is expensive or not, but merely to point out flaws in these indicators that suggest an easy answer.



Stock Market vs. GDP

This is how Buffett described the ratio of the stock market to GNP in 2001:

“The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.

If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire. As you can see, the ratio was recently 133%.”

This measure has since become known as the “Buffett Ratio” (most charts use GDP instead of GNP, hence the different percentages from Buffett’s quote). One obvious issue with this ratio is that it compares companies with increasing international exposure to domestic economic activity. Another potential issue revolves around higher corporate profit margins. While profit margins fluctuate with the economic cycle, changes in industry composition and industry concentration could be elevating margins long-term.

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Share of foreign profits rising:

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Citi

“In 2017, the percentage of S&P 500 sales from foreign countries increased slightly, after two years of measured decreases. The overall rate for 2017 was 43.6%, up from 43.2% in 2016, but down from 44.3% in 2015 and 47.8% in 2014, which was at least an 11-year record high. S&P 500 foreign sales represent products and services produced and sold outside of the U.S.“
S&P Indices

“Over 75% of U.S. industries have registered an increase in concentration levels over the last two decades. Firms in industries with the largest increases in product market concentration have realized higher profit margins, positive abnormal stock returns, and more profitable M&A deals, which suggest that market power is becoming an important source of value.”

Are US Industries Becoming More Concentrated, Grullon, Larkin, Michaely

Corporate profits as a share of GDP:

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Economic Innovation Group


Changing sector composition in the U.S.:

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Comparing Stock Market Valuations

Another type of chart I encounter in conversations about asset allocation compares the valuation of the U.S. stock market to international peers (often the ACWI ex-US or emerging markets). Over the chosen time frame (1995-2018) the message seems obvious: the U.S. is historically expensive and it’s time to bet on mean reversion.

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WSJ/Bank of America


Lawrence Hamtil discussed the flaw in this argument in his blog: aggregate market valuations are not directly comparable due to the differences in sector composition. The sub-industry composition can also be very different (for example, consumer discretionary can be weighted towards automotive components vs. internet retail).

“The U.S. market is obviously very heavy in tech and health-care stocks, which historically have traded at premium valuations, while the rest of the developed world is heavy in financial and industrial stocks, which tend to trade at discounted valuations.”

“It is a common, - but false, - belief that global equity markets are somewhat interchangeable, and all an investor has to do to earn superior returns is to shift capital to whatever may be cheapest.”

“So, yes, U.S. stocks are expensive, but the rest of the world looking cheap by comparison does not automatically make it a bargain.”

The Correct Way to Frame Relative Valuations

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Stock Market vs. Commodities

These charts compare the stock market with a commodity index. They seem to make a compelling argument: are commodities historically cheap and about to rally dramatically (or are stocks perhaps about to crash)?

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However, as Sri Thiruvadanthai pointed out, these charts are flawed as they compare a total return index (GSCI Total Return Index) with stock price indices.

In his words:

“Here is the corrected version. Does it suggest anything to you?”

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Stalking Bubbles: Paul Tudor Jones 1987-1990

 

Introduction

Many legendary money managers don’t like to share their views in public. It’s understandable: making a call opens you up to criticism and the potential embarrassment of a mistake. And an isolated comment could easily mislead the audience, since the manager may change his or her view and position at any time. When a manager of David Tepper’s acumen appears on CNBC, people tend to listen. But as the months go by, there is no answer to the question: “David was bullish at that price, what about now?” We only see the prediction and the outcome. Unless you receive a fund’s letters, or speak to the manager directly, you don’t see how they react to new information. This makes it difficult to really understand a manager’s process.

I was excited when I learned that Paul Tudor Jones had participated in the Barron’s Roundtable for several years. In the wake of the 1987 crash, Jones sat down every January and shared his views on markets and the economy. We can peek over this legendary trader’s shoulder and watch him trade the U.S. and Japanese stock markets. One market was forming a massive bubble, the other merely looked like one.

I don’t want to encourage anyone to adopt a global macro strategy, or to look for bubbles to short, or even to actively trade in general. Rather, I think of Jones’s extensive comments as a kind of case study. His principles have been studied by generations of traders. How does this episode illustrate his philosophy? What can we learn about his decision-making process? How did he implement his ideas?


The Crash of 1987

“The week of the crash was one of the most exciting periods of my life.” Paul Tudor Jones[1]

The year 1987 made Paul Tudor Jones famous as the man who had predicted the crash. Jones had started his firm Tudor Investment Corp. three years earlier after years as a commodity pit trader. In the summer of 1987, he was profiled by Barron’s and discussed his bearish outlook on the U.S. stock market. Jones thesis rested on two key ideas. First, Jones used an “analog model” that his research director Peter Borish had developed. The model was an overlay chart of the stock markets of the 1920’s and the 1980’s and showed an “astonishingly robust” correlation. Jones also pointed to a chart showing the Dow Jones Industrial’s deviation from its trend. Prior spikes had occurred in 1836, 1929, and 1966 - all followed by bear markets. He observed that there was exuberance in other markets (for example, in fine art), and noted some troubling debt and economic statistics.[2]

In the article, Peter Borish admitted to “fudging the exercise somewhat by juggling the starting periods”. Nevertheless, the bearish outlook paid in spades on October 19. On the day of the crash, Jones covered his short position and went long bonds, expecting the Fed to ease financial conditions. That month he made 62%.[3]

“I feel that you have to start getting short now because the panic, when it comes, will be so violent and sudden that the longs won’t be able to get out nor the shorts get aboard.” Paul Tudor Jones, June 1987[4]

 

The famous overlay chart:

PTJ Barrons 87 - 8 - Dow 1920s Overlay.jpg

The Dow Industrials “Deviation from Trend” with spikes in 1836, 1929, 1966, and 1987:

PTJ Barrons 87 - 7 - Dow Cycles.jpg

 

January 1988: “Concerned about the future welfare of the world.”

After the crash, Jones did not shy away from publicity. He participated in the January 1988 Barron’s Roundtable and was also profiled by the Wall Street Journal in May of 1988. The Journal called him the “Quotron Man” who “swaggers through Wall Street with a flair worthy of the movies”. The article described his “rock and roll” trading style, his lifestyle, and his eye-popping returns: “last year he had a 200% return, mainly because he dumped stock-index futures just before the crash, then bought heavily while other money managers were still reeling.” It noted that Jones was focused on the Japanese stock market and thought it might trigger another wave of selling in the U.S.[5]

 

At the roundtable, Jones discussed his concerns in greater detail:[6]
“I’m not as concerned about the direction of the market as I am about the future welfare of the world … will we be able to avoid a worldwide depression like we saw in the early Thirties?”
“The only real operative historical parallel to what we have right now is the Twenties. And the similarities are so striking, so rampant and so numerous that one has to use that as a basis.”
“If you anecdotally go back and read Barron’s, it’s the exact same newsprint with different names and characters in January of 1930. Everyone was optimistic.
All the earnings that we’re talking about can disappear overnight, if the stock market makes new lows. The stock market is a leading indicator, and if it starts back down, you could see commerce literally grind to a halt like in the Thirties.”

 

Jones was worried about the lack of “structural shock absorbers.” He pointed to vulnerable corporate balance sheets, the decline in interest rates, the dollar devaluation and “five years of incredible [public] spending orgies.” His argument was that these factors had already boosted the market and asked: “tell me, what policy tool is available?” He concluded: “We’re a debtor nation that acts like a creditor nation.”

However, he balanced his negative long-term view with a pragmatic short-term stance. He expected a bounce “back to the 2200-2300 area,” similar to the bounce into early 1930. For the second half of the year 1988 he expected new lows and a decline to the “1200 area.” His argument was based on market sentiment and positioning:

“Right now […] it’s sold out.” “you’ve got phenomenal insider buy/sell ratios, mutual-fund cash at […] extremes; you’ve got all types of internal indicators that would indicate the market should rally.”

 

Jones’s expectation of the Dow Jones in January 1988:

DJIA Early 1988 markup.jpg

(charts from  macrotrends.net)

 

In 1988, Jones also sat down with Jack Schwager twice for his Market Wizards interview. Schwager noted that by the second interview, Jones had become worried about a potential “governmental witch hunt.” He feared that vocal short sellers would be blamed if the U.S. market declined further. Even in that interview, Jones balanced his long-term bearish view with a short-term neutral stance.[7]

 

Short-term, technical view:
“I don’t just use a price stop, I also use a time stop.”
“According to the analog model, the market should have gone down – it didn’t. I think the strength of the economy is going to delay the stock market break.”

 

Long-term, fundamental view:
“I think the financial community was dealt a life-threatening blow on October 19, but they are in shock and don’t realize it.”
“I know from history that credit eventually kills all great societies.”
“Whether it was the Romans, sixteenth-century Spain, eighteenth-century France, or nineteenth-century Britain. I think we are going to be in for a period of pain.”

 

Jones was not alone in his pessimistic outlook. After the crash, Robert Shiller published a working paper called “Investor Behavior in the October 1987 Stock Market Crash.” Based on surveys, he found that the crash of 1929 was an important analogy for investors as they tried to make sense of the 1987 plunge: “comparisons with 1929 were an integral part of the phenomenon. It would be wrong to think that the crash could be understood without reference to the expectation engendered by this historical comparison.”[8]

 

U.S. Debt/GDP And Deficit/GDP, 1792-1987:
(chart from ZeroHedge)

US Debt to GDP Since Independence_1 -2.jpg

 

Early 1989: “My job is to get with the flow.”

The U.S. stock market climbed higher throughout 1988. In January 1989, Jones sat down for another Barron’s Roundtable: [9]
“I think the Fed has done a fantastic job. I really thought last year that there were macroeconomic forces at work that no one would be able to control. And I have learned a lot over the past 12 months, because they have done a good job.”
“I think that [Greenspan] is going to do everything in his power to try to avoid letting the yield curve invert.”
“I think the big mistake that I made last year […] was not recognizing the difference between 1987 and 1929. In 1929, the dollar value of the U.S. stock market was almost 175% of GNP. Today, it is 50%.”

 

Despite his praise for the Fed, Jones was hesitant to abandon his bearish view:
“Unfortunately, I still believe in the charts first.”
“There are too many instances of 35-40% breaks, followed by 12-16-18 month rallies, where a market did subsequently go back and either double-bottomed or make new lows. Until I see a Dow close significantly above 2240 on a weekly basis – which may be this week – until I see advance/declines turn, I am not going to be invested.”

 

Dow Industrial in early 1989:

DJIA Early 1989.jpg

 

Both the economy and the market had defied Jones’s pessimistic expectations. Jones recognized this, but he was still skeptical:[10]
“If it goes above 2250, then I would certainly think about buying the market much more.”
“This thing keeps acting like a bear market, in the sense that the price action is not strong.” “
Maybe we’re in the nascent stages of a bull market. It is either that, or we are at the top of a bear market.”
“My job is to get with the flow. I will make a forecast, but my job is simply to trade the range.”

 

January 1990: “Everything comes back to the Japanese quotient.”

Jones was wrong again in 1989 as the market made new highs. By January 1990, Jones was very bearish on Japan and feared spillover effects from its bursting bubble. He also described the U.S. economy as being “late in the business cycle” and noted an acceleration of inflation. He observed that short sellers were doing well in an advancing U.S. market. His interpretation was that the market internals were weaker than the index level suggested.[11]

“This time last year, there were many reasons not to be negative on the stock market. Now, I can see an external event that can be very negative. I see internally a number of events that can be very negative.”
“Everything that is being sold on Wall Street today, whether it’s a company, a fund, everything ultimately comes back to the Japanese quotient. I refuse to believe they are not at the base of probably all the asset inflation we have seen.”
“There are a million reasons to be negative on our stock market, but Japan is the biggest factor.”
“If the Dow takes out the December low - you cannot find an instance since 1960 where you have taken out the December low in the month of January and the stock market has not subsequently declined.”
“I can have money with four different managers playing the market from the short side – amid a tremendous explosion in the stock market- and they all make money. So, something tells me, intuitively, that something is not right in the landscape.”

 

At the same time, he described the U.S. market as “seemingly bulletproof” and noted “a tremendous amount of pessimism,” as indicated by measures like mutual fund cash levels and put-call ratios. Again, he was willing to let market the market overrule his bearish fundamental bias: “I would have to see the market take out 2800 and exhibit amazing upside volume before I get too excited about U.S. stocks.”

 

S&P 500, 1977 – 1992:


January 1988: “In particular, I want to be short Japan.”

Japan fit perfectly into Jones’s 1929 analogue. At the 1988 Roundtable he explained:[12]

“In particular, I want to be short Japan. Everyone is so worn out from trying to sell Japan, and yet, the reality of the situation is that – and I hate to use the word – on a ‘fundamental’ basis, it has the greatest downside.”
“Today, the U.S. is analogous to what Great Britain was back in ’29, and Japan is analogous to where the U.S. was. The U.S. market still finished 1929 on a positive note. The biggest correction in 1930, in the world, was in the U.S. stock market.”

 

Japan in the 1980’s and the US in the 1920’s: two prosperous creditor nations, two stock market bubbles. However, as Barron’s pointed out: the bears had been wrong for some time. For example, George Soros had been short Japan and even penned an op-ed in the Financial Times, days before the 1987 crash. He was badly bruised as the U.S. markets cracked first.[13]

There was another catch: the Tokyo market did not have its own futures contract at the time. Said Jones: “If they ever start a stock futures market in Tokyo, they’re talking about the sale of all sales.”[14]

 

Nikkei in January 1988:

Nikkei Early 1988.jpg

Dow Industrial in January 1930:

DJIA 1929.jpg

 

 

January 1989: “Every time that market breaks, I am going to sell it.”

The Nikkei roared higher in 1988. But Jones was not about to give up:[15]
“Japan was, obviously, the best stock market in 1988. I was 100% wrong.”
“Being short in Japan in 1988 probably cost my fund about 4%.”
“The Japanese market right now is 127% of GNP. And if there is going to be a problem – if there is going to be an external shock that creates a problem here – it is going to come from Japan.”

I have not been short since it came out of that consolidation range last November. But every time it breaks 5%, I will sell it. I will probably try to market-time it, and risk 2-3% of my portfolio.”
“And it will probably cost me another 4-6%. But it is going to break. I will catch it, and I will get paid 25% or 30% or 35%. That is my function, to try to get with it.”

 

Nikkei in January 1989:

Nikkei Jan 1989.jpg

 

We can observe how Jones implemented his bearish view of this runaway bull market. He would short the market on every break of 5%. That break represented a possibility of the top and he wanted to catch the first big decline. However, if the market recovered, he would cover his short. The market had consolidated in mid-1988, then shot up into January of 1989. Therefore, at the time of his comments, he was bearish but not short.

 

The risk-reward expectation seems to have been: a loss of 4-5% on every false breakdown and a 25-35% gain when the market broke. Jones was willing to endure repeated small losses while waiting for the big payoff.

 

Also, stock index futures began trading in Japan in September of 1988. Jones visited the country two weeks later and observed trading live at one of the brokerage houses. He remarked that dollar volumes had already eclipsed U.S. pre-crash volumes.[16]
“From an intellectual standpoint, during ’88, watching that market [Japan] defy conventional logic was a lesson in humility for me. The great thing about markets is that you learn something new every day.”[17]

 

 

January 1990: “I am extremely negative right now.”

Jones was wrong again in 1989. The Nikkei advanced all year and only declined into January of 1990.

Nikkei in January 1990:

Nikkei Jan 1990.jpg

At the Barron’s Roundtable, Jones turned into a raging bear.

The Japanese market advance had become increasingly narrow: [18]
Jim Rogers: “When you look at the advance/decline there, the market has gone up 4,000 or 5,000 on very few stocks. They drove up a few very big stocks.”
Felix Zulauf: “That advance/decline line goes down for 10 years.”
Jones: “When you see that kind of chart patter – I don’t care what it is – it is a signal to watch out for the terminal point in that particular market.”

 

“[Japan] went parabolic. Its rate of acceleration was as great as any other period in the history of the stock market.” [19]
“I first started getting bearish on it when it was around 24,000, and now it now is 37,500. So even if it declined 40%, I would still be completely wrong as far as that forecast went.”
“The sustainability of the bubble, though, is directly dependent on a continual progression in prices.”
“The fact that it has actually doubled without anything even approaching a 6% decline makes it all that much more of a candidate to ultimately burst.”
“You have the potential for that market to decline 20% or 30% in a rapidly accelerating fashion.”
 

 

 

Playing the Player

At this point, Jones turned his attention to the institutional players in the Japanese market. He analyzed market sentiment, positioning, and institutional incentives. This allowed him to form a thesis of how the key players were likely to react if the market weakness continued.[20]

 

“There was a euphoria building up in that market because of the perceived January effect … And you have now started out in the beginning of January with a 3.7% decline, which is the worst two-week performance in Japan since the 1947 era.”
“Look at the breakdown of assets held by Tokkin funds and/or insurance companies and/or investment trust. In the past seven years, their holdings of stocks have almost tripled, going from 14% to over 52%.”
“Their bogey is 8%. They have to 8% in some fashion.”

“Now, you are looking at a situation where they are down 4% in the first two weeks of the year. And, they have an alternative that they haven’t seen since the early 1980s. That is, 7.25% short-term rates.”

“So here you have a very compelling reason for the Japanese stock market to decline – much in the same way that portfolio insurance down the market in the U.S. in 1987. Every day the market does not advance, and particularly, every day that it declines, it becomes that much more compelling for a manager to shift his assets from stocks.”

“So here we are, at the beginning of the year, and I posit that, from a fundamental standpoint, there’s probably the greatest opportunity for a reversal of that flow that has ever existed.”

 

 The Japanese Stock Market Bubble, 1977 – 1992 (Nikkei)

 

May 1990: “Past the Peak”

In May 1990, Jones met with Barron’s for a follow-up interview. He was up 30% for the year. When Barron’s called his prediction on Japan a home run, he humbly noted that he had made the same prediction in both 1988 and 1989. Jones described the Japanese top as a peak like “1929 or 1966” that would not be exceeded for another 25 years. In his view, the market had “a long way to go on the downside” and little “real liquidation” had taken place yet.[21]

 

Despite this long-term bearish view, he was long Japan at the time of the interview. He was acting in a tactical manner because of “too many U.S. buyers of puts anticipating an easy money play for the market to accommodate them.”

 

He described his strategy:
“My investment strategy springs from developing a fundamental view of a particular market.”
“Under- or overvaluation is only part of the battle. The key thing is to be able to time one’s entry into a position at the precise moment when the market is about to move in your favor.”

“If you put a gun to my head and ask me to choose between fundamental and technical analysis, I would take the technical every time.”


Takeaways: “Don’t be a hero. Don’t have an ego.”

Long-term stock charts tempt us to look at history in a simplistic way. The crash of 1987 is followed by a steady recovery and, eventually, the roaring dot-com bull market. The 1990 bear market appears as barely a blip. Investing looks easy and straightforward in retrospect. We know it is important to think of the future in a probabilistic way, as a range of possible outcomes. But the same is true for the past. The path we see in a stock chart represents just one of multiple possible scenarios. Was another depression in the cards after the crash of 1987?

 

When analyzing a decision-making process, I find it helpful to look at the historical context and try to empathize with the actors. What were the conditions of their situation? What information did they have to form their view? How did they weigh contradictory information?

 

I hope I was able to shed some light on these questions and show how Paul Tudor Jones made decisions under uncertain and volatile conditions. His comments and behavior illustrate several trading principles and touch on interesting dichotomies.

 

The big idea (top-down) vs. pragmatism (bottom-up)

“If you put a gun to my head and ask me to choose between fundamental and technical analysis, I would take the technical every time.”[22]

Jones developed a fundamental thesis and tested it. The crash of 1987 looked like the confirmation he had been waiting for. It makes sense to me that he retained a fundamentally bearish outlook after his narrative seemed to unfold perfectly at first. But he didn’t let that big idea keep him from entering short-term bullish positions when technical factors suggested it.

 

 

Risk management and sizing

“The most important rule of trading is to play great defense.”

“First of all, never play macho man with the market. Second, never overtrade.”

“Risk control is the most important thing in trading.”

“If I have positions going against me, I get right out.”[23]

When Jones’s fundamental view aligned with the technical picture, he was willing to bet big. However, when the U.S. market was oversold, or when sentiment was overly negative, he was tactically neutral or bullish. While the Japanese bull market was roaring, he patiently watched and waited for a break to enter. When the market rallied again, he would cover instead of letting the losses compound. Jones was a bear on Japan for years before the market crashed. Arguably, his risk management discipline was more important than his analysis of the bubble.

The following is a quote from a 1994 memo about risk control that Jones sent to his traders:
“The key to putting together a good year of trading is to never fall behind early in the year. I can only remember one instance when a trader has been down at mid-year and recovered to have a really good year. At best, people claw their way back even which in itself is only a mental victory. It is so critical to be disciplined, patient, and precise in the early going.”

 

No ego

“Don’t be a hero. Don’t have an ego.”

“Who cares where I am long from. That has no relevance to whether the market environment is bullish or bearish right now, or to the risk/reward balance of a long position at that moment.”[24]

Jones had a fundamental view, but he did not proclaim to know better than the market. He was open to new information. He didn’t complain about how irrational the market was. He just observed and waited for opportunity. If the U.S. market made new highs on strong volume, that meant that a new bull market was beginning. His job was to “go with the flow.” In the words of Jesse Livermore: “the only thing to do when a man is wrong is to be right by ceasing to be wrong.” It’s ok to be wrong, but not to stay wrong.

 

The historical analog vs. the specifics of the current situation

John Templeton said the four most expensive words in the English language were "this time it’s different." But I think this episode illustrates how deceptive it can be to rely on a simple historical analogy. Some key factors will align and tell a compelling narrative of how everything will unfold. But confirmation bias will discount other, conflicting facts.

 

Playing the cards (fundamental information) vs. playing the player (market participants’ behavior)

I think it’s notable that Jones visited Japanese trading floors a couple of weeks after index futures started trading. He wanted to know the players. He wanted to have an intimate understanding of this marketplace. He watched the New Year’s ceremony at the Tokyo stock exchange and analyzed the portfolios and incentives of the major institutional players. All of this was part of a mosaic: he wanted to understand positioning, sentiment, and behavioral biases.

 


 

“I avoid letting my trading opinions be influenced by comments I may have made on the record about a market.”[25]

I do wonder to what extent Jones’s public commentary affected his market views. It seems that he was aware of this potential pitfall. But being a vocal bear, or bull, year after year carries a danger that one wants to eventually be proven right.

 

 

In a 1997 article, a market observer noted: “Time and again I’ve heard traders say, ‘You can always see Jones coming, but you can never see him going.’” That’s something to keep in mind when hearing Jones’s public opinion, such as his bearish call on bonds in early 2018. He may be a bear today, but he might already be going with the flow tomorrow.


 

 

 

“You guys [Barron’s] talk about buying stocks and holding them for the long run. I’m flipping $300 million every four or five days in the futures markets, because I’m a product of the day. I’m a consumer at heart, because that’s the way I was raised.”[26]

 

   

Sources

 

 

[1] Market Wizards, Jack Schwager

[2] “Trader With a Hot Hand,” Barron’s, June 1987

[3] Market Wizards, Jack Schwager

[4] “Trader With a Hot Hand,” Barron’s, June 1987

[5] “Quotron Man,” Wall Street Journal, May 1988; see also: Paul Tudor Jones, the Quotron Man

[6] Barron’s Roundtable, January 1988

[7] Market Wizards, Jack Schwager

[8] “Investor Behavior in the 1987 Stock Market Crash,” Robert Shiller, NBER Working Paper No. 2446

[9] Barron’s Roundtable, January 1989

[10] Ibid.

[11] Barron’s Roundtable, January 1990

[12] Barron’s Roundtable, January 1988

[13] “This Time the Turning Point Has Been Reached,” George Soros, Financial Times, October 14, 1987

[14] Barron’s Roundtable, January 1988

[15] Barron’s Roundtable, January 1989

[16] Ibid. And New York Times “Japanese being trading in stock index futures,” 9/5/1988

[17] Barron’s Roundtable, January 1989

[18] Barron’s Roundtable, January 1990

[19] Ibid.

[20] Ibid.

[21] “Past the Peak,” Barron’s, May 1990

[22] Ibid.

[23] Market Wizards, Jack Schwager

[24] Ibid.

[25] Ibid.

[26] Barron’s Roundtable, January 1988.