Sunday, February 11, 2007

Baron Rothschild / hussman

good analogy. netter vergleich


Let's play a little game – it's called “Baron Rothschild,” who once said “I made my fortune by selling too early” (a comment also made by Bernard Baruch). It's a lot like various kids' games where you know something bad will happen but you don't know when. These include “Musical Chairs,” “Don't break the ice” (where you take turns hammering out little ice blocks hoping that you won't cause the whole surface to collapse), or “Kerplunk” (where a load of marbles rests on sticks that have to be removed one by one). My impression is that investors are playing this sort of game here.

Suppose that the dealer lays cards down, one after another. Each is an annual market return. At any time, you can call out “Baron Rothschild” and go to a defensive position, or you can gamble and get the entire market return the dealer shows next. The gain cards read, say, 15%, 20%, 25% and 30%. If you're defensive, you lag the market by 10% when the market return is a gain, but you get, say, 5% if the market return is a loss.

There is one -20% loss card. Once it appears, the game ends and everyone counts their dough, compounded.

It turns out that if the loss comes anytime before the 5th card, you're almost always ensured to beat or tie the dealer by immediately blurting out “Baron Rothschild” even before the first card is shown. For example,

20%, 20%, 20%, 5% beats 30%, 30%, 30%, -20%.

15%, 15%, 15%, 5% beats 25%, 25%, 25%, -20%.

20%, 10%, 5%, 5% beats 30%, 20%, 15%, -20%.

5%, 5%, 5%, 5% ties 15%, 15%, 15%, -20%.

You can easily prove to yourself that even for a six-year market cycle, you still generally win even if you call out “Baron Rothschild” after year two.
It just doesn't pay to risk the big loss.

Less than half of the typical bull market gain is retained by the end of the subsequent bear market. Once stocks become richly valued, the remaining gains achieved by the market are almost always purely speculative – they are generally erased over the remaining course of the market cycle. There are reasonably good tools, based on the quality of market action, that have historically allowed the capture of a substantial portion of those “speculative” gains.
But once the market becomes not only richly valued, but sentiment becomes broadly bullish and stocks become overbought on a shorter-term basis, the return/risk profile of the market becomes unfavorable even for speculation.

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