Intelligent Finance Component IV – Financial Strategic Analysis

1. Second International Workshop on Intelligent Finance (IWIF-II) 6.-8. July 2007, Chengdu, China Intelligent FinanceComponent IV – Financial Strategic Analysis Prof Dr PAN Heping, Director of PRC, IIFP, SIIF & SSFI Prediction Research Centre (PRC) University of Electronic Science &Technology of China （UESTC） International Institute for Financial Prediction (IIFP), Finance Research Centre of ChinaSouthwestern University of Finance & Economics (SWUFE) Swingtum Institute of Intelligent Finance (SIIF)Swingtum School of Financial Investment (SSFI) Room 340/306 Yifu Building, Chengdu 610054, China Phone：+8628-83208728, Mobile：13908085966 Email: panhp@uestc.edu.cn, h.pan@iifp.net URL Chinese：www.swingtum.com.cn URL English： www.swingtum.com

2. Second International Workshop on Intelligent Finance (IWIF-II) 6.-8. July 2007, Chengdu, China Intelligent FinanceComponent IV – Financial Strategic Analysis 潘和平 （博士、教授、长江学者） 电子科技大学预测研究中心主任 西南财经大学中国金融研究中心国际金融预测研究所所长 形势冲智能金融研究院院长 & 形势冲金融投资学校校长 成都市建设北路二段四号逸夫楼340/306 电话：028-83208728, 手机：13908085966 电子邮件: panhp@uestc.edu.cn, h.pan@iifp.net 中文网站：www.形势冲.com, www.swingtum.com.cn 英文网站：www.swingtum.com

3. Contents • A Masterpiece of A Strategic Trader • Financial Strategic Analysis (FSA) – Why? • Objectives and Contents of FSA • The Four Levels of Financial Market Analysis • The Four Levels of Trader Transformation • The Master Trader • The Mechanical Trader • The Subjective Trader • The Intuitive Trader • Swingtum Trading Principles (Appendix: Analogies from the Art of War) www.swingtum.com/institute/IWIF

4. 1. A Masterpiece by A Strategic Trader - John TempletonShorting NASDAQ with a trigger – before the end of lock-up period www.swingtum.com/institute/IWIF

5. www.swingtum.com/institute/IWIF

6. A True Story about John Templeton, told by Mark Tier (2004, 2006) • Throughout 1999 until 13 March 2000, dot-com stocks zoomed to absurdly high levels. • Many value investors, realizing these stocks were wildly overvalued, shorted them all the way up. • This included some legendary money managers. • Having shorted even a bit too early before the peak could cause unlimited losses. • E.g. Julian Robertson eventually couldn’t bear the pain any more and quit in disgust, shutting down his fund entirely. (Soros took some painful loss too). • However, John Templeton, at the tender age of 87, made a brilliant and enormously profitable foray back into the stockmarket. www.swingtum.com/institute/IWIF

7. Three months before the NASDAQ peaked, he discovered a “trigger” that allowed him to initiate one of the most creative short selling strategies ever devised. • The venture capitalists and insiders who floated these internet companies were typically restricted from selling their stock until six months or a year after the company had gone public. • Templeton’s insight was to use the end of this lock-up period as his trigger. • He systematically initiated short positions in 84 different dot-com companies 11 days before the lock-up period for each stock expired. • 18 months later, he’d added $86 million to his wealth. www.swingtum.com/institute/IWIF

8. During the Internet bubble and anti-bubble • Fundamental Investors missed • Technical Traders lost • But Strategic Speculators made money- Integrate Fundamental, Technical and Strategic Analysis (like John Templeton) www.swingtum.com/institute/IWIF

9. 2. Financial Strategic Analysis (FSA) – Why? In order to gain and keep gaining absolute positive and nontrivial returns of investment in the global financial markets, it is not enough just to have - theoretical knowledge (financial economics), - mathematical models (quantitative finance), and - empirical methodologies (fundamental and technical analysis). We need something more, something very fundamental, something which requires mentality, courage, and integration. There are Limitations of Economic, Fundamental, Technical Analysis: • Economic Analysis is mostly about the macroeconomic factors, but lack of a comprehensive picture of the macroeconomic trends, cycles, capital distribution and money flows on the global, national and regional levels. • Fundamental Analysis is mostly about the company-specific financial factors, but lack of a comprehensive picture of the company situation in the market, in the sectors, and in its own life cycle, including the situation of strategic investors relative to the other share holders. • Technical Analysis is mostly about the market prices and volumes, but lack of a comprehensive picture of the global or market-wide distribution of strategic investors and their intentions relatively to the other investors. www.swingtum.com/institute/IWIF

10. 3. Objectives and Contents of FSA • Global Macro Economical Situation and Intent AnalysisGlobal macro economical trends, cycles, seasonalities, and probabilistic projection of politico-economic events, situations and strategic intents of governments, multi-national companies, etc • Global Macro Financial Situation and Intent AnalysisGlobal macro financial market trends, cycles, seasonalities and probabilistic projection of financial events, situations and strategic intents of international investment funds, possible or developing financial bubbles and anti-bubbles as well as market crashes, etc. • Market-Specific Situation and Intent AnalysisFor a specific market of interest, are there market makers? Who are the minority of strategic investors? Where are their capital allocations? Where is the market price in its primary trend – accummulation, lifting, distribution or dumping? Where are the secondary and minor trends – bull or bear trending, or range trading, or breaking out of volatility or range? What are the strategic investors thinking on, planning to do, or scheduling to execute? How will the retail investors react to possible scenarios? www.swingtum.com/institute/IWIF

11. 4. The Four Levels of Financial Market Analysis Strategic Analysis Size Gap Mind Analysis Psychological Gap Technical Analysis Market Reality Gap Fundamental Analysis(including Macro- & Micro-economics) www.swingtum.com/institute/IWIF

12. Fundamental Analysis (FA) is typically economical approach, which looks most scientific, but there is a market gap from fundamentals to prices where there are all human investors/traders interpreting the fundamentals and the prices in extremely nonlinear ways. However, the number one weakness of FA is not to factor in other traders as variables, so there is a market reality gap between what should be and what is actually. • Technical Analysis (TA) fills in this market reality gap by studying the market activity and price patterns and macro-phenomenological behavior patterns of market participants. TA is far superior to a pure FA as it keeps the trader focused on what the market is doing now in relation to what it has done in the past, instead of focusing on what the market should be doing based solely on what is logical and reasonable as dictated by an economic theory or model. However, TA has missed a critical point: it does not factor in your own conditions as variables, so it creates a psychological gap between your prediction using TA backed by FA and your actual trading. www.swingtum.com/institute/IWIF

13. The Shift to Mental Analysis (MA) Masters of Trading Psychology – Mental Analysis: • Van K. Tharp (1998): Trade your Way to Financial Freedom McGraw Hill. • Van K. Tharp and Brian June (2000): Financial Freedom through Electronic Day Trading. McGraw Hill. • Mark Douglas (2000): Trading in the Zone – master the market with confidence, discipline and a winning attitude. New York Institute of Finance. • Larry Williams (1999): Long-Term Secretes to Short-Term Trading. Wiley. • Alexander Elder (1993): Trading for A Living: Psychology, Trading Tactics and Money Management. Wiley. • Oliver Velez & Greg Capra (2000): Tools and Tactics for the Master Day Trader. McGraw Hill. www.swingtum.com/institute/IWIF

14. The Final Gateway through consistently profitable trading to your financial freedom is Mental Analysis (MA). • The aim of MA is to let you develop a compact set of states of mind of consistently profitable trader, which we call the master trader’s mindset. • The master trader’s mindset consists of beliefs about the market and trading, beliefs about yourself, your confidence, your conviction, your carefree detachment and your conduciveness. www.swingtum.com/institute/IWIF

15. 5. The Four Levels of Trader Transformation Strategic Trader Intuitive Trader Subjective Trader Mechanical Trader www.swingtum.com/institute/IWIF

16. 5. The Four Levels of Trader Transformation There are inviolable principles on each level A higher level should never violate the principles of its lower levels Strategic Trader Intuitive Trader Subjective Trader Mechanical Trader www.swingtum.com/institute/IWIF

17. A consistently profitable trader is a natural human being, who dances with the market peacefully with many little contacts but without hard conflicts. • There are three levels a trader has to climb up to a strategic master trader through self transformation which generally takes 10 years or more before becoming a master trader. • The first level is mechanical trader with objective beliefs, neutral attitude, and mechanical tactics. • The second level is subjective trader with his evolving set of advantageous strategies. • The third level is intuitive trader who trades carefree with his intuition and instinct without deliberate analysis. www.swingtum.com/institute/IWIF

18. The Master Trader • Master Traders belong to the stardom of the civilization of mankind, as great as other great political leaders, military commanders, intellectual thinkers, scientists, innovators, entrepreneurs and alike. • The Master Trader lives a peaceful life, trades the financial markets with his personalized trading system, generates consistent profits with a steadily up-trending equity curve. • The Master Trading System is a crystal-clearly structured integration of market selection, trade planning, market timing, entry, stop loss, exit, position, portfolio and risk management. • The Master Trader and his trading system are unified together, so the Master Trader possesses a complete set of mental qualities required to run his trading system reliably. www.swingtum.com/institute/IWIF

19. Ref: “Money Masters of our Time” by John Train, 2000 • T. Rowe Price: Mr Growth Stock • Warren Buffett: A Share in a Business • John Templeton: Search Many Markets • Richard Rainwater: Ring the Changes • Paul Cabot: All the Damn Facts • Philip Fisher: The Cutting Edge • Benjamin Graham: Quantify, Quantify • Mark Lightbrown: Firsthand Knowledge • John Neff: Systematic Bargain Hunter • Julian Robertson: The Queen Bee • Jim Rogers: Far Out • George Soros: Macro Games • Philip Carret: Think Small • Michael Steinhardt: Strategic Trader • Ralph Wanger: Zebras and Other Small Metaphors • Robert Wilson: Without A Rope • Peter Lynch: Relentless Pursuit www.swingtum.com/institute/IWIF

20. Ref: “Money Masters of our Time” by John Train, 2000 There are several schools of investing in Master Traders: • Growth • Value • Technology • Emerging Markets • Specialty Companies • Micro-Caps • Turnarounds • Top-Down • Bottom-Up • And so on www.swingtum.com/institute/IWIF

21. Ref: “Market Wizards - Interviews with Top Traders” by Jack Schwager, 1989 • Michael Marcus: Blighting Never Strikes Twice • Bruce Kovner: The World Trader • Richard Dennis: A Legend Retires Futures & • Paul Tudor Jones: The Art of Aggressive Trading Currencies • Gary Bielfeldt: Yes, They Do Trade T-Bonds in Peoria • Ed Seykota: Everybody Gets What They Want • Larry Hite: Respecting Risk • Michael Steinhardt: The Concept of Variant Perception • William O’Neil: The Art of Stock Selection Mostly • David Ryan: Stock Investment as a Treasure Hunt Stocks • Marty Schwartz: Champion Trader • James B. Rogers, Jr.: Buying Value and Selling Hysteria A Little Bit • Mark Weinstein: High-Percentage Trader of Everything • Brian Gelber: Broker Turned Trader • Tom Baldwin: The Fearless Pit Trader The View from • Tony Saliba: “One-Lot” Triumphs the Floor www.swingtum.com/institute/IWIF

22. Ref: “New Market Wizards - America’s Top Traders” by Jack Schwager, 1992 • Bill Lipschutz: The Sultan of Currencies • Randy McKay: Veteran Trader • William Eckhardt: The Mathematician • The Silence of the Turtles Futures • Monroe Trout: The Best Return that Low Risk Can Buy • Al Weiss: The Human Chart Encyclopedia • Stanley Druckenmiller: The Art of Top-Down Investing Fund • Richard Driehaus: The Art of Bottom-Up Investing Managers • Gil Blake: The Master of Consistency & • Victor Sperandeo: Markets Grow Old Too Timers • Tom Basso: Mr Serenity Multiple • Linda Bradford Raschke: Reading the Music of the Markets Market Players • CRT: The Trading Machine • Mark Ritchie: God in the Pits The Money • Joe Ritchie: The Intuitive Theoretician Machines • Blair Hull: Getting the Edge • Jeff Yass: The Mathematics of Strategy www.swingtum.com/institute/IWIF

23. Ref: “Stock Market Wizards - America’s Top Stock Traders” by Jack Schwager, 2001 • Sturt Walton: Back from the Abyss • Michael Lauer: The Wisdom of Value, the Folly of Fad • Steve Watson: Dialing for Dollars • Dana Galante: Against the Current • Mark D. Cook: Harvesting S&P Profits • Alphonse “ Buddy” Fletcher Jr.: Win-Win Investing • Ahmet Okumus: From Istanbul to Wall Street Bull • Mark Minervini: Stock Around the Clock • Steve Lescarbeau: The Ultimate Trading System • Michael Masters: Swimming through the Markets • John Bender: Questioning the Obvious • Claudio Guazzoni: Eliminating the Downside • David Shaw: The Quantitative Edge • Steve Cohen: The Trading Room www.swingtum.com/institute/IWIF

24. Ref: “Trend Following – How Great Traders Make Millions in Up or Down Markets” by Michael Covel, 2004 • Bill Dunn • John W. Henry • Ed Seykota • Keith Campbell • Jerry Parker • Salem Abraham: Texas Pioneer • Richard Dennis • Richard Donchian • Jesse Livermore and Dickson Watts www.swingtum.com/institute/IWIF

25. Ref: “The Super Analysts – World’s Leading Stock Market Investors and Analysts” by Andrew Leeming, 2000 • Stuart Baker: All that glitters is not gold • Mark Mobius: The true believer • Brian Johnson: A champion team will always beat a team of champions • David Fisher: The holistic approach • Lise Buyer: Keep your eyelids up to see what you can see • Tim Jensen: Nothing is forever right or forever wrong • Pierre Prentice: Patience is a virtue • Murdoch Murchison: Buying pessimism and selling optimism • Michael Mauboussin: Shift happens • Joe Petch: Asian values • Godon Hall: The first virtue • William Low and Alistair Veitch: The weighting Game www.swingtum.com/institute/IWIF

26. New Players Come In:From Tacticians thru ‘Rocket Scientists’ to Financial Strategists with Economics, Maths, Physics & CI For Example • Larry Williams – World Record Holder on Robins Futures Trading Competition, turned $10,000 to $1.1Million in a year. • Jim Simons, a mathematician, founder and driver of the Medallion Fund, the Best Performer of Hedge Funds in the last 10 years. • The Prediction Company, Santa Fe Institute. • …… www.swingtum.com/institute/IWIF

27. Observations about Masters Traders • Consistently profitable trading is a finest art which takes 5-10 years for a quality trader to climb the learning curve before reaching the paradise of financial freedom. • There is no luck in professional portfolio investing, any more than in master chess or weiqi. It is a skilled craft, involving many decisions a week. • There is no holy grail to trading success. The methodologies employed by the master traders cover the entire spectrum from purely technical to purely fundamental and everything in between. • The population of all the traders follows a pyramid or even a power-law distribution with a minority of winning traders on the top in contrast with the rest majority of other traders down under. www.swingtum.com/institute/IWIF

28. Although the styles of master traders can be very different, many common denominators are evident: they all - have a driving desire to success- have absolute confidence- have a personalized methodology - have absolute discipline- are very serious, devoted and passionate- have rigid risk control- have sufficient patience- act independently- understand that losing is part of the game- love what they are doing. www.swingtum.com/institute/IWIF

29. Virtually every master trader has experienced innumerous bloody mistakes, unforgiving lessons, and multiple wipe-outs. • A master trader developed his personalized methodology – trading system guaranteed by his absolute discipline and confidence through self transformation, more like zen – the enlightenment. • The final gate to paradise of trading is a compact set of states of mind – your beliefs about the markets and about yourself together with your trading system with edge and your conditions to live through. www.swingtum.com/institute/IWIF

30. 7. The Mechanical Trader • Prerequisitesyou have a working knowledge of Fundamental Analysis and Technical Analysis and you have a proper capital to start trading. • Foundation I – Beliefs about the Marketyou have a set of objective beliefs about the market. • Foundation II – Beliefs about yourselfyou have a set of firm beliefs about yourself. • Foundation III – Your System with Edgeyou have a working trading system of your own with an edge • Foundation IV – Your Conviction on Your Systemyou are convicted that your system wins in the long run, so you dare to use your system, and you are using your system to trade for a living and for your prosperity. www.swingtum.com/institute/IWIF

31. Your Beliefs about the Market and Trading[based on Douglas (2004), with extension] • The Uncertainty Principle – Reality Check on the micro-level: the market can do virtually anything at any time. • The Probability Principle – Feasibility Footing on the macro-level:Events that have probable outcomes can produce consistent results if you can get the odds in your favor and there is a large enough sample size. • The Gambling Principle – the Gambler’s Mindset The best traders treat trading like a numbers game similar to the way casinos and professional gamblers approach gambling. • The Consistency Principle – Mechanical ProcessThe best traders consistently predefine their risks before entering a trader, cut their losses short, and have a systematic regimen for taking profits. • The Edge Principle – Get the Odds in FavorThe best traders have developed a personalized trading system which can seize opportunities where the odds are in their favor and only trade with an edge. • The Opportunity Principle – Go with the FlowThe best traders enter a trade whenever one of their edges is met with the current situation even uncertainty is always there. • The Multi-Level Principle – The Micro-Macro Transcend In order to have a significant edge on a day, one needs to work on the intraday time frame according to the Probability Principle. www.swingtum.com/institute/IWIF

32. 8. The Subjective Trader Virtually most of the quantitative intelligent finance is about Converting Information to Advantage to Consistent Profits Involving the following decisions: • Market Selection – Relentless Pursuit • Market Timing – Dynamics Modeling and Prediction (Price, Volatility, Impacts) • Entry – Sub-Time Frame • Stop Loss – Beyond Volatility (or Hedge) • Profit Taking – Price Projection or Let Market Push • Position Sizing – Reward/Risk Ratio • Portfolio Management – Multi-Market Dynamics • Arbitrage – Market Ecology www.swingtum.com/institute/IWIF

33. 9. The Intuitive Trader (not much to say) • Follow Trends in Motionand • Dance with the Market www.swingtum.com/institute/IWIF

34. 10. Swingtum Trading Principles (Pan 2006) For Expert Trader: • Survival of the Fittest • Enter Your Zone of Freedom • Avoid the Markets of Your Disadvantage • Be Practical • Be Empirical • Keep It Simple, Stupid! (KISS) • Trade Carefree For Master Trader: • Only Trade High-Probability Events • Invest First, Investigate Later • Exit First, Analyze Later • Concentrate with Minimal Diversification • Ride Reflexivity Process Consciously • Use Leverages, but Judiciously • Follow Your System Religiously www.swingtum.com/institute/IWIF

35. The End of Intelligent Finance Component IV – Financial Strategic Analysis Thank you for your attention! www.swingtum.com/institute/IWIF

36. Appendix: Analogies from the Art of War(Sun Zi “Art of War”, 500 BC) www.swingtum.com/institute/IWIF

37. Mao Zedong “10 Major Principles of War” (20th century) www.swingtum.com/institute/IWIF