Thursday, July 31, 2008

China Scrutiny

I'm glad I don't live in China, but they are moving in the right direction. As with any country, they are imperfect. Indeed, as a developing country, they are much less perfect than developed countries. But I think they need to ignore the brickbrats. China's president recently made a gesture to assuage their criticism, in light of the spotlight from the Olympics. I think it's good they understand their imperfections, but only in moderation. The WSJ reports:

Chinese President Hu Jintao, making an extremely rare direct address to the foreign media, defended his government's preparations for the coming Olympic Games in Beijing and pledged to continue reform policies despite increasing economic challenges.

Private apologies are often warranted, but public apologies are not. The Right was adamant that Clinton apologize for the Lewinsky affair, but that was just a camel's nose under the tent for more apologies and concessions. So too with the Left demanding that Bush apologize for getting WMD wrong. Every apology just leads to more requests: if you apologize for getting X wrong, why not do what you disagreed with when you asserted X?

As a prior litigant, I understand that there is a big difference between being reasonable with someone arguing in good faith, and being reasonable with someone who does not have good faith. A public apology will be used by everyone, and that will necessarily include lots of people with bad faith.

Your allies don't need apologies, they will understand mistakes are part of life; your enemies will use them against you.

Geography and Economics

Megan McArdle makes what she thinks is a very profound point:
Ten thousand years or so after the first humans built sailing ships for trade, the coast still matters immensely. In fact, there are only two prosperous landlocked countries of any size: Austria and Switzerland.

Geography does not drive economics. Look at Japan, Iceland, Singapore, Hong Kong, Finland. None are geographically rich, but the people are. Winston Churchill and his friends raved about the wealth of Africa, as Uganda and Kenya have fertile lands, lots of minerals ... and they are economic wastelands now.

But back to Megan's point. Non-communist Europe has 15 countries, and the two landlocked countries (Aus and Switz). The other 13 countries are prosperous, and have coasts, but it is not their coastliness that matters. Adopting free market policies, avoiding blatantly corrupt governments, is key (unlike the subtly corrupt Western governments). The problem with Zimbabwe or Uzbekistan is not their lack of regattas.

In North America, Canada and the US are on coasts, but then so is all of central America, which is dirt poor. South America has 13 countries, and the 2 landlocked ones are poor, but so are most of their countries on the coast, and with only 2, the standard error on this pattern is large. Most landlocked countries are either in Africa, or ex-communist states, and that's the real pattern, not water. But then that's not very interesting, because the problems of Africa, and the ex-Soviet satellites are pretty different.

In warfare, it is useful to remember that the tough terrain, geographically, is easier to go through than a heavily defended terrain. That's why you go through the Ardennes forest and not the Maginot line. It's people and the things they create that matter, not geography.

Solution to the Housing Crisis: Build More Houses

In the housing bill, there's a provision to build more affordable houses. So the current problem is house prices are too low. One of their solutions is predicated on the fact that they are, or will be, too high. Lest you think this is an anomaly, note that politicians and many journalists bemoan the high cost of gas, while trying to cut our carbon footprint.

This is a main reason why I think government should be shrunk. When it tries to do something, it just becomes a Christmas tree of giveaways to special interest groups like ACORN, often with inconsistent objectives.

Prices too low, too high, whatever. The key is, government is going to do something. Yea!

Wednesday, July 30, 2008

Why Cash Flow Works

Most bad business models will go on until the cash runs out. That's why cash flow is a useful predictor, because money losers keep losing money, and driving the stock down, until it goes to zero. Sort of like GM's strategy.

This is basically foreshadowed by Warren Buffet (p. 85 Investor's Anthology), when he wrote these common company foibles:
(1) an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategy studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Emerging Market Returns II

I'm trying to see what the returns were in emerging markets pre-1990, and it's very difficult. Campbell Harvey, current editor of the Journal of Finance, wrote a paper in 1995, and had the annualized dollar return for Argentina, from 1976 through 1992, as 72%! That's a cumulative 6000 fold return on one's dollar over that period. Google, one of the great success stories of modern capitalism, grew 'only' 53% annually since it was listed in 2003. Given the market capitalization at the end of his period, this implies that the market was worth about $4 million USD in 1976. However, on his web page, from 1979-1995, he has an arithmetic annualized return of 'only' 42%, and a geometric return of 8%. Clearly, if true (72%?), even referencing the arithmetic average is highly misleading.

Bloomberg has the total USD annualized return since 1992 (as far back as it goes) as -1% annually. Harvey's source in 1995 was the International Finance Corporation, which is part of the World Bank. Most data sources I see start their returns for developed countries in the 1990's, as I think no one wants to be 'Harveyed'.

Tuesday, July 29, 2008

No Premium to Developed Country Equity

One might think that, because systematic risk begets return, investing in developing countries might be a good place to sock away some money and experience the 'risk premium'. But over the past 10 years, the average USD returns to 17 prominent developed countries was about the same as the annual return is the US.

The only places I have seen a risk premium, are the following: the short end of the yield curve (overnight to 3 years), the Baa-Aaa spread, and the equity risk premium. If you know of any others, I'd like to learn of them.

Annual Equity Returns in USD, 6/95-6/08
AnnRet Country
29.00 RUSSIAN
20.88 BUDAPEST
19.72 BRAZIL
15.83 EGYPT
15.51 PRAGUE
13.60 SHANGHAI
12.62 TEL AVIV
9.73 POLAND
8.80 INDIA
8.52 SAFRICA
7.69 TURKEY
6.48 CHILE
4.25 ARGENTINA
2.78 TAIWAN
2.33 SKOREA
-4.40 THAI
-8.80 MEXICO
9.68 avg

8.65 S&P500 (USA)

Monday, July 28, 2008

Flattering Self Portraits


I've often read that most people consider themselves above average drivers, or have above average leadership skills. Further, this bias is worse the more educated you are, though presumably we think only because it's more true.

But Jonathan Haidt's delightful book, The Happiness Hypothesis, introduces me to another such manifestation. Its seems when you artificially enhance someone's picture to be objectively more attractive, they pick their image out of a collage faster than if it is not enhanced. We recognize ourselves faster when we look more attractive than we actually are.

The book has what must be a dig at the Freakonomics Spawn, when Haidt notes:

Proving that people are selfish, or that they'll sometimes cheat when they know they won't be caught, seems like a good way to get an article into the Journal of Incredibly Obvious Results. What's not so obvious is that, in nearly all these studies, people don't think they are doing anything wrong. From the person who cuts you off on the highway all the way to the Nazis who ran the concentration camps, most people think they are good people and that their actions are motivated by good reasons.

Best book I've read in at least a year.

Sunday, July 27, 2008

Lettau-Ludvigson vs. a Time Trend

Martin Lettau and Sydney Ludvigson’s “Consumption, Aggregate Wealth and Expected Stock Returns” finds that the ratio of consumption to wealth forecasts stock returns. In essence, consumption along with labor income form a more useful “trend” than the level of dividends or earnings. They find this factor can explain the 25 Fama-French portfolios, that is, the spread we observe when stocks are sorted by size and book/market value. Cochrane calls this a 'stunning result' in his new text on Asset Pricing.

But the Fama-French result was conspicuously absent in their ultimate Journal of Finance paper. And Brennan and Xia produced this devastating critique:

The empirical evidence that the consumption–wealth ratio, cay, has strong in-sample predictive power for future stock returns has been interpreted as evidence that consumers take account of future investment opportunities in planning their consumption expenditures. In this paper we show that the predictive power of cay arises mainly from a “look-ahead bias” introduced by estimating the parameters of the cointegrating regression between consumption, assets, and labor income in-sample. hen a similar regression is run, replacing the log of consumption with an inanimate variable, calendar time, the resulting residual, which we label tay, is shown to be able to forecast stock returns as well as, or better than, cay. In addition, both cay and tay lose their out-of-sample forecasting power when they are re-estimated every period with only available data.

Lettau and Ludvigson reply is threefold. First, they say that that the forecasting power of cay for future returns cannot be spurious merely because the full sample has been used to estimate the cointegrating coefficients. Second, tay likely contains more economic content that the authors realize. Lastly, they assert that that in-sample tests are more credible than out-of-sample tests for assessing forecasting power.

I think the bottom line is that when a time-trend does better than your economic variable as an explanation of the data, you're doing it wrong.

Getting Patterns Correct

I tore my rotator cuff and labrum, and I was struck by the fact that tendons and cartilage do not self-repair. That is, if you break your clavicle, a bone, it will find the other broken part, and glue itself back together. If you tear your rotator cuff tendon, it will never reattach to the bone without surgery. Same for ligaments and cartilage.

Thus, if you observed what bones do, you might come up with a rule: broken things in the body need rest, and they will repair themselves. But if you looked deeper, you would see that doesn't always hold. Those tissues without blood supplies have no way to 'reattach', because they have no sensors, they don't know they are broke.

Inferring Excellence from the Best

There are two ways to build an atheoretical statistical profit-making machine. In one, you look at a bunch of inputs--past returns, earnings misses, financial statement ratios--and then group into bins, and look at future returns. In another, you look at the best and worst performing stocks, and then try to identify their characteristics. I find the latter approach rather poor, because let's say you find that stocks with really high returns tend to have ratios of Accounts Payable/Sales that are above average. It may be that this ratio is associated with greater volatility, so that it generates both massive success and failure. From a portfolio, average, or expected basis, it is unclear whether this is good or bad. That's all an empirical issue, so you might as well be doing analysis from explanatory data to outcome from the beginning.

So I heard about this new book, Who Are You and What do You Want? and the authors noted they talked to all these really successful people, and then looked at their characteristics, as if this was a really great way to discover great habits. I'm not convinced. Say, you find that being really individualistic makes Steve Jobs a great CEO. What about all the other big dreamers? Perhaps, statistically, this is a bad strategy because for every Steve Jobs who happened to have an Apple, there are millions of cubicle drones who are despised and unrewarded for their seeming impracticality.

The problem is, 'success' is difficult to measure, so we have a tendency to choose people who are super successful, so that there is no debate over whether they are successful. Unfortunately, then the sample size is so small and skewed it's not valid for identifying a pattern.

But then again, the authors run a huge business consulting company that involves flattering CEOs so they send their subordinates to their little retreat. I suspect that's one of the main reasons it is a common way to structure such a book. The idea that interviewing CEOs is a way to find wisdom is very convenient.

Saturday, July 26, 2008

Defining Theoretical Success

I'm clearly never going to understand string theory, but as it has no falsifiable results, I just don't see the point. Or rather, I'm unimpressed by elegance and consistency, because if you take a fixed set of phenomenon, people are smart enough to create an elegant, consistent set of mathematics to describe it. But only if it predicts something new, integrates (simplifies), or solves a puzzle. I don't know how many times I've read an economic paper that has 'rich' results because it can accommodate everything in some very complex way. If you think that math is good in of itself, this is really great stuff, but math has too many 'degrees of freedom'. Sure there are examples of neat math seeming irrelevant and then becoming really useful, but those are exceptions (Riemann spaces and General relativity). Neat math is not useful in itself, especially today when there are tens of thousands of theorems published every year.

Leonard Susskind, one of the founding fathers of string theory, is interviewed here. He is asked, "Can you cite any published results that support the main contentions of string theory?" He answers, "Yes! The existence of gravity, the existence of particles."

That's what I would call an 'in sample' result.

Friday, July 25, 2008

Great Observation by Shiller

Bob Shiller called the internet bubble in 1999, and created the housing index now so valuable for monitoring the current economic crisis. Pretty good. He really nails this description of 'two types of people':

influential people seemed to be sharply divided into ‘cosmopolitan influentials,’ who habitually orient themselves with respect to the world at large, and ‘local influentials,’ who orient themselves with respect to their own town. As he and his assistants interviewed people, the division between the two groups became more intriguing, and significant, in his mind.

Merton did not say that the cosmopolitan influentials were influential outside Rovere — apparently none of them was. What stood out instead was their habitual frame of reference, which was tied to their personal identities. When Merton engaged people in conversation, any topic would remind the cosmopolitan influentials of the world at large, while local influentials were reminded of things in their own town.


I think there are advantages to both, and like anything, moderation is key. Blowhards totally ignorant of their city are pretentious and really not that smart--you learn a lot from the practicalities of your city's politics and trends. But then, people who don't know about Norway, Brazil, or Japan, are missing out on a lot too.

Thursday, July 24, 2008

Fund Manager in Cash


From the WSJ:
David Ellison, one of the most respected financial-stock managers in the mutual-fund industry, has had it. While he is pleased with the run-up in financials in recent days, he still sees signs of Armageddon in the sector.

He recently pumped up the cash level in his two funds to as much as half his assets. His FBR Large Cap Financial fund stood at 50% cash at the end of June, up from 2% at the start of 2007, and his FBR Small Cap Financial is at 38% from 0%, according to Morningstar Inc. "I don't want to lose any more money," said Mr. Ellison, an intense fellow who speaks about the stocks with barely concealed anger.

Even if he's right, this is dumb. You give money to a small-cap financial manager to pick the darn best small-cap financial companies, not to time the market. There are plenty of nervous Nellys on CNBC giving you contradictory advice on timing the market, and they are right about 50% of the time. If the equity market has a premium, listening to these guys merely means you get half the premium you otherwise would have.

Plus, I'm bullish on financials. It's not that bad.

Wednesday, July 23, 2008

The Coming Muni Crisis

There's a WSJ article about state shortfalls in tax revenues, because of lower home sales, high gas prices. My city makes about 75% of its revenues from property tax assessments. Every year I have been here they would go up 7% a year, in addition to all the new houses being built. This year, it actually assessed me at a 7% decrease, and house construction in my city came to a halt. Now, this was assessed in March 2008, and is for taxes payable in 2009, which are paid in March and September. As my city had a heck of a time cutting 2% off a projected increase of 5%, I wonder what they will do if revenues actually decline? I imagine they will borrow in the short run but that isn't a long term solution because the 7% valuation is permanent: they aren't going to raise my assessment 14% next year because yearly assessment increases are capped at 8%.

I imagine lots of cities will have this problem, and they won't do anything prior to a crisis, because all their money has interest groups that won't let them. The key trigger event for bankruptcy is not recognizing you have a failed business model, but rather, having a failed business model AND running out of cash, because at that point outsiders won't lend to you. Cities seem to increase expenditures as if they don't have to face the vagaries of business, but that was before the housing crisis. I haven't heard any peeps yet, but next year at this time, everyone will be howling. And I'm sure some cities will default. After all, the biggest housing decline in 30 years will catch more than just Wall Street off guard, but those humble public servants as well. Right now, it's best not to think of it.

Carbon Credits Being Gamed

The WSJ reports on a French company operating in Korea (which is designated as 'lesser developed'), that makes 30 times more money by selling “carbon credits” to fight global warming than it makes by selling chemicals.

its Onsan project was approved by both local authorities in South Korea and administrators of the U.N. program. Its projects prevent tens of thousands of tons of nitrous oxide -- which is 310 times more potent a greenhouse gas than carbon dioxide -- from floating into the atmosphere, the company says.
...
Under the global agreement known as the Kyoto Protocol, developing nations don't have to curb their greenhouse-gas emissions, but they get a nice bonus if they do: Each ton of emissions cut generates a credit that can be sold through the U.N. program. Rich countries (most of which are required to cut emissions under the Kyoto treaty) can buy the credits in lieu of cleaning up what comes out.

The advent of credit sales under the U.N. program in 2004 made nitrous-oxide abatement lucrative. In 2006, Rhodia turned on the furnace to destroy the gas at the Onsan plant. The furnace cost roughly $15 million to install. It was a good investment: The plant is projected to generate more than nine million credits a year, and Rhodia is initially authorized for seven years of credits.

So, build in a 'poor' country like Korea, and then, add some modern emissions saving technology that generates more in pollution credits than you get making widgets, or whatever. As Kyoto was designed for stereotypical basket cases like Africa, these credits generally pay much more than modern technology costs, merely because these countries are so unproductive that anything created there endogenously need ridiculously high bribes to make sense.

This is like Roosevelt's famous 'paying not to farm' subsidy from the 1930's. Instead of cutting production, farmers figured out they could designate marginally productive land for farming, and get paid not to farm that, while then paying attention to the most productive acres (see Mitchell, Depression Decade: from New Era Through New Deal). Your total production increases even as more and more cropland is taken offline--acreage that probably would have been offline anyway. If you are getting paid to not do something, the number of ways to not produce something are infinite. This is why a straight carbon tax is more efficient than a cap and trade, because cap and trade, worldwide, need taxes and subsidies. You can't tax the lesser developed countries, as they are already poor (eg, Africa). But then, like the definition of a disadvantaged minority, the definition of less developed grows over time. You then cherry pick the subsidies by looking at existing plant, or building them, in the appropriate locale. Brilliant!

Every top down government solution has these problems, because the rich companies are more efficient than the poor companies. Thus, the recent $300B federal mortgage bailout, I suspect, will all end up a subsidy to lenders. If you want to give poor people money, raise taxes on the rich and write them checks. These indirect schemes are very inefficient.

Tuesday, July 22, 2008

Banks Miss, Rally

I remember reading a piece on earnings analysts, and they found that some analysts had skill at forecasting earnings and some at predicting stocks returns. But they weren't the same people. No better example than today, where many banks missed badly (KeyCorp, WaMu, Wachovia, Regions), but they rallied strongly! It wasn't that they lost less than expected, they actually lost more than expected, and still rallied. Thus, anyone good at fundamentals got burned; those who were wrong, were right, and vice versa.

The real point there is that if you are a fundamental investor, your horizon is not a day. It's several quarters, if not years.

It reminds me of this economist I worked for. He was telling some senior guy we should buy grain commodities, because there was going to be a drought (economists like geeky stuff like weather). It turned out there were floods. Sign error. But floods kill crops just like a drought! So wheat went up.

Reboot Windows Daily

Some diligent geeks were scouring internal e-mails turned over in the antitrust suits by Microsoft. There's a funny internal email from Bill Gates, circa 2003, complaining in some detail about some Microsoft products. It seems he actually tries to download Moviemaker, and found it slow and confusing. While Mac lovers thought this showed their superiority, I thought, gee, how many CEOs actually try to put themselves in their user's shoes like that? Not many. Anyway, at one point, he writes:
What the heck is going on during those 6 minutes? That is crazy. This is after the download was finished.

Then it told me to reboot my machine. Why should I do that? I reboot every night -- why should I reboot at that time?

If Bill Gates reboots everyday, it's probably a good idea.

Monday, July 21, 2008

Bad Reasons to Invest

From the WSJ, Why Buy Airline Stocks? by Scott Mccartney:

Lots of very smart people, often savvy investors and experienced executives, tell me they would never buy an airline stock. “Lunacy!” they cry. “It’s a terrible industry and companies continually burn through investors’ capital.” And that’s all true.

But there are two very good reasons why people do buy airline stocks:
–They are extremely volatile, so you can make a lot of money correctly playing the cycles.
–They are a very good hedge against high oil prices.

Reason 1 simply says these are volatile, so if you can forecast them, they are good investments. An investment ploy for suckers if there ever was one, why high volatility assets tend to have negative returns.

Reason #2 made me do a double take, but means to say they are hedges against declines in oil prices. Supposedly, one needs to hedge this bit of good news, because one is generally long oil. But as the US is an oil importer, I would think on average, the stock market's beta against oil is negative. That is, if oil is trading at $100 next year, that would be good for equity markets, not bad.

The Birthday Problem


One of the most fun statistical results, is The Birthday problem, and it is a favorite for Intro to Probability courses.

Imagine you're at a party with 23 other guests. If you randomly pull aside one of them, the odds he or she will share your birthday are 1 in 365. But the probability that anyone at the party shares a birthday is far higher: about 1 in 2. The intuition is that the probability someone shares a birthday, is not 1/365 times the number of people present, but rather, the probability two people do not share a birthday (364/365) raised to the power of the number of pairs of people. For example, consider the number of combinations of people which is about (N^2)/2 for a sample of N people. So the probability that no one shares a birthday, with N people, is about (364/365)^[(N^2)/2]=49%ish.

Thus it was fun to read lawyers getting all excited about a new piece of research refuting DNA statistics by noting that some people share 7 o 13 gene loci at about 1 million times the frequency presented, a large error. But the error was the researcher. The odds are for a particular set of 13 loci sharing 9 chromosomes. But state crime lab analyst Kathryn Troyer looked at all the combinations of men in a group of 63,000, giving her about 2 billion pairs, and thought she discovered a massive rejection of the hypothesis. She also appears to have looked at many different sets of 13 loci, and ignored the fact that some prisoners are related.

Steven Myers, a senior DNA analyst at the California Department of Justice, gave a presentation to the Assn. of California Crime Lab Analysts, titled "Don't Panic".

Lawyers. They're so cute when they try to do statistics.

InBev to the Rescue


Budweiser is one of America's most popular beers. It has the bland flavor one expects from a popular beer, which makes sense because beers in America really developed their inertia because after prohibition, just as breweries got up to speed, WW2 started, and young women were the main beer drinkers left in America, so their preferences were very influential. This is unfortunate because women don't appreciate good beer, or even bad beer for that matter, as much as men. Thus, popular American beer is watery, with little bitterness, and has a lot of rice because that has very little flavor. (Thank God wine coolers weren't available then. The horror.)

So it was fun to watch a beer taster for InBev, the new owner of the Bud brand, not patronize Americans in this WSJ video. He basically says its bland. He does like InBev's Hoegaarden, a very flavorful white-ale, and I must say that is my current favorite. It's like Blue Moon, or Paulaner (banana and clove esters), only better. Unlike many brews preferred by beer tasters, this one has low bitterness, which would make it an easy comparable for Americans used to low bitterness beers. I'm a homebrewer, so find this interesting (and being a homebrewer helps me appreciate how inefficient fermentation is an an energy source--lots of work to make beer out of complex carbohydrates found in beer mash). As George Will wrote recently, beer is deeply ingrained in human evolution: no beer, no civilization, so betterment here is up there with fixing the subprime mess.

Sunday, July 20, 2008

Curious

On the IndexFunds website, there they list the heroes in their pantheon. They mention that Burton Malkiel's A Random Walk Down Wall Street, clearly laid out the argument for indexing. He presented these theories to the private investor, even making a plea to any institution to sponsor an index fund. "Fund spokesmen are quick to point out you can't buy the market averages. It's time the public can." This was in 1973.

Also in 1973 John McQuown at Wells Fargo and Rex Sinquefield at American National Bank in Chicago both established the first Composite Index Funds. Clearly, the idea was in the air. John and Rex are now very rich. With hindsight, their idea seems rather obvious. It highlights that sometimes you can be successful doing something pretty obvious that others are afraid to do merely because it hasn't been done.

Saturday, July 19, 2008

Not Sustainable


In the Irish Potato famine of 1845-8, many people starved to death. The census in Ireland showed a population of 6.5 million in 1851, down from 8.2 million in 1841.

In contrast, 1984 - 1985 famine in Ethiopia was the cause for the single "Do They Know it's Christmas", and much international concern. But population growth clipped along at a 2.8 percent for the the 1980-1985 period, greater than it was in the 1970's. It's now over 3%. And there's always talk about some new famine in Ethiopia (the magazine cover above is from 2000).

Poverty relief is based on the idea that you give someone something, they will pull themselves out of their current circumstances and become self-reliant. Instead, it appears it just increases the numbers of those who can't support themselves. Rephrasing Bagehot, one of the most melancholy of human reflections is that charity does more harm than good.

The Price of Oil in Mexico


The US Oil companies are up for a lot of abuse. One of Obama's big line's on the stump is that Energy companies are getting rich, so we should impose a windfall profits tax on them. After all, if they didn't expect prices to rise, why should they make money on their inventory?

Well, Mexico is a nice example of what happens when your oil company loses money in such an environment. The government owns the gas company, PEMEX. PEMEX loses money most years, even this year, when the cost of oil was 40% higher than anticipated. It should have been a revenue windfall.

How can this be? Gas is about $2 a gallon cheaper in Mexico than the US. As their production falls (investment stifled because there's no profit in it), they found they had to buy oil to make up the difference, and so lost money because they 'have' to sell it at this ridiculously low price to their citizens. Bad for the environment too.

There are worse things than profits. Losses, for example.

Friday, July 18, 2008

Formula for Var(XY)

The variance of two random variables, X+Y is in the beginning of every statistics book. The distribution of X/Y is a standard Cauchy variable. So when I tried to find the variance of X*Y, I figured no problem. But it is actually very difficult to find on the web, and tedious to derive. As a public service, here is the result when X and Y are both normally distributed:

Let V(x) and V(y) be the variance of X and Y respectively
Let C(x,y) be the covariance of X and Y

then the variance of the product XY, is

V(xy)=[E(x)]^2*V(y)+[E(y)]^2*V(x)+2*E(x)*E(y)*C(x,y)
+V(x)*V(y)+C(x,y)^2

note: see derivation from anonymous commenter (I can't get math in html for my blog, so God bless him)

Origin of a Rumor

Ever hear the phrase 'terrorist fist jab' to describe Obama's knuckle bump? It was news to me that terrorists also used this friendly, rather trendy gesture. It came from a lone, unknown commenter:

A commenter to a Cal Thomas story at the Human Events website made the assertion. The initial comment was deleted, but reaction comments, almost all rebuking the comment, stayed on the website. Someone at Fox News, reading the comments on the deleted comment, assumed that it was a legitimate meme though it was merely proffered by a lone commenter. Somehow this made it to Fox News anchor E.D. Hill, who noted on air that some 'in the media' considered the fist bump a terrorist fist jab, though she was the first to bring this to the attention of the world. Then people reacted to her reaction, and the idea that 'some people' consider this a 'terrorist fist jab' was born.

Commenters of the World, Unite!

Thursday, July 17, 2008

Jeremy Siegel's Interesting Note

Quotes by Jeremy Siegel, talking about his new book, The Future for Investors:

For example, compare the performance of Standard Oil with IBM, from 1950-2003. IBM beat Standard Oil by wide margins in every growth measure that Wall Street uses to pick stocks: sales, earnings, dividends and sector growth. Yet in the end, Standard Oil earned 14.42% in total return compared to IBM's 13.83%. Why? Because despite the better fundamentals, investors paid too high a price for IBM, while old Standard Oil was cheaply priced. I call this the "growth trap." Investors make the mistake of buying the new thing, irrespective of price. Inevitably, the price is too high, and investors get bad returns.

Since 1957, the railroad sector has shrunk from representing 21% of the S&P 500, to just 5% today. Yet, railroad stocks have actually outpaced the index. Financial stocks have grown from 1% of the S&P 500 to over 20% today, and they’ve underperformed the index.

It's funny. People go to the race track, and look at the odds. But in the stock market, people look at a stock and say, "this is the best stock" and don't look at the price.

Skousen: I read that you like the "low P/E" stocks. But they are slow movers, right?

Siegel: Right, they're not exciting, but they're often the best performers over the long run.

I heartily agree. In the book, he notes that IBM handily outperformed various other S&P components in earnings, sales, etc. but it had such a high P/E, it actually underperformed as a stock.

Don't Let Readers Make Stupid Inferences

"Past performance does not guarantee future results."

"We are talking about averages here. Some women are actually taller than many men. Every individual is different"

"Obama is not the same person, nor a disciple of, Osama (Bin Laden)"

You always have to put these disclaimers in there, because otherwise you are aiding and abetting false inferences by the great unwashed.

The latest kerfluffle over Obama reminded me that outrage has little cost as a negotiating gambit. Say you are offended and hope for some act of contrition, if not legal damages. In today's zeitgeist, you have to really push it to be publicly rebuked, though I suspect in private, most people find this tactic tiresome.

So I want to state for the record, that drawings that will probably be misconstrued by morans, even though demonstrably false, show bad judgment or taste. Only accurate pictures, such as those taken in Obama's Houston campaign office, or Ohio state court judge James Burge (who recently blocked the state's death penalty), should be shown. That way, no one takes the wrong inference.

Wednesday, July 16, 2008

Global Warming Not About Science?

I was watching a snippet from Blogging Heads, and the UK's Minister for Europe noted that he was surprised to learn that some Americans thought 'climate change' was a pretext for a liberal agenda. I guess the idea never occurred to him because as Al Gore noted, the science is over.

He noted that the upside of Global Warming is there are tons of 'green collar' jobs to be had! And he has a point. If we don't let companies burn fossil fuels like coal or gas, and don't build any more nuclear plants, all of us will have full time jobs collecting biomass for fuel as they do in Africa, or washing our clothes in the river, or walking to work. The smell of dung can really add a little zest to your smoked ribs.

Living in Minnesota, we could use a couple more degrees. Indeed, cold spells are generally worse for mammalian life than heat spells, but that's no mind. The reason why some of us think there's a pretext here is we have heard many similar warnings about the acid rain, Carter's malaise speech about the 70's energy crisis, the ozone hole, deforestation, and then when the metrics don't continue their trend and life goes on, they find a new boogie man. There's always a greater good, whether it's not discussing the gulag when coming back from the Soviet Union, exaggerating the risk of heterosexual AIDS, downplaying the corruption by the latest African kleptocrat, or promoting the "4 food groups", many, if not most 'big ideas' are merely pretexts for people wanting to push various selfish agendas.

A coal plant was up for construction in Minnesota, and it seems like it will not be built because the environmentalists convinced the judge, that private business could not build this plant, because the energy provided 'could' be produced by energy efficiencies and/or wind. I found this amusing as currently there are thousands of windfarms scattered around 27 states, all heavily subsidized, and they generate--when the wind is blowing--only the output of about two 750-megawatt gas-fired plants. Furthermore, most of the cost estimates for wind power are generated by those with a direct interest in wind technology, including the governmental units that would regulate, and thus control, this new technology. As most of the cost of wind is the capital cost, and these costs are generally private, and they are currently heavily subsidized by a network of agencies, as well as state, federal, county and city governments, who knows their cost i within a factor of ten? But just mention 'climate change' and the judge thinks you've properly referenced your assertion. If an energy company that gets paid to deliver energy and wants to make profits, decides it wants to build a coal plant to generate the energy, my guess is that it is because coal is the cheapest practical way to deliver the energy even after the subsidies.

Ethanol was co-opted by the agriculture industry, and now we have a permanent new entitlement that is adding pollutants to what remains of our water table, and raising food prices. The basic liberal plan is to reduce our ability to provide energy so that it is rationed, and thus take the myriad decisions of individuals and put them back into the hands of the government, who will dictate that we all move into 'sustainable lifestyles': living in city high rises, eating Soylent Green.

So yes, I think 'climate change' is primarily driven by liberal activists who wish to give the government more power (and because power is zero-sum, implicitly less to individuals), and the corporate sycophants who think playing the game is the best way to stay in power. I'm not saying climate change is indefensible, I just think it's sufficiently unproven that it shouldn't even be a determinant, let alone the main determinant in making capital decisions like building energy plants (tech note: 'climate change' refers to costs related to climate change and its myriad effects, not the costs of soot and smoke on lungs and crops). For example, estimates of the potential carbon tax can range from $10 to $100 per ton, so if one chooses $100, basically nothing will be built. Further, if one can merely assert that 'energy efficiency' pays for itself and obviates a new oil well or coal plant, and lots of people assume it is true because it helps fight climate change. Pretext allows people to veto all sorts of development, all they do is mention the phrase 'global warming'.

A politician should understand that about half of what we say, isn't what we mean. But then again, I shouldn't take him at his word.

Dogged Research by Earnest Young Men

The guys at GeneExpression love to analyze all sorts of non-PC topics related to human biodiversity, often getting into technical issues related to the HapMap project, which attempts to identify all the common Single Nucleotide Polymorphisms (SNPs). In 30 years I expect there will be lots of genetic scoring as is done for consumer loans, where one knows one's propensity towards X based on the distributional frequency of your SNPs relative people with X, where X could be a disease, a psychological trait, IQ, athletic ability, etc. As genetic sequencing becomes cheaper, I imagine this will be done, and as with consumer credit scoring, millions of datapoints make theory pretty irrelevant, people look at the patterns. It should be very interesting.

But they are still primarily young men, and so it is refreshing to see they turned their analytical gaze towards the highly controversial and important question of whether the average age of Playboy centerfolds has risen, fallen, or stayed constant. As you can see from the graph below, the average age has, indeed risen from about 21 to about 23 over the past 50 years, about the same change in age of Hugh Hefner's girlfriends over that same period.


But what about robustness? Fear not, dear reader, as the intrepid blogger 'Agnostic' also dug up data on the average age of pornstars since 1968 (no trend), while Miss America has trended up from about 16 to 22 over the past 90 years. A later post looked at the relative preferences for blondes vs. brunettes by looking at Maxim, and found There was no significant trend in blondness over the past 11 years (bold in original).

This kind of research needs more NSF funding.

Tuesday, July 15, 2008

Why Should I Believe You?

On Sunday evening, Paulson announced a proposal by Treasury to have Congress raise the $2.25 billion it is allowed to loan the two firms, and even open the door for the federal government to buy shares in the two companies if needed. The Fed announced it stood ready to loan money to the firms if they needed access to funds ahead of congressional actions.

Today in congress, Bunning, a longtime critic of Fannie and Freddie, said ``The taxpayers have reacted and the market has reacted to your plan by driving down Fannie Mae shares 26 percent today, right now,Freddie Mac's are down 29 percent at this moment, just in case you are interested in how the markets are reacting to your wonderful plan.''

Then Paulson said, though he wanted the guarantees, but he did not expect to use them. Bunning then said "There's a lot of us who would like to believe what you're saying, But we're skeptical. Anytime we approve something, it gets used."

Now this is very interesting, because I can sympathize with both positions. If the government gives authority, is it money potentially it will never see again. But, this is a truly exceptional case. The essence of managing a Treasury or central bank, is to follow two rules: don't inflate the currency and provide conspicuous liquidity in panics. Pulling money out of the system during panics is counterproductcive, as Friedman and Schwartz documented in their seminal Monetary History of the United States. This panic is highlighting why Hoover and the Federal Reserve chiefs at that time thought it was prudent to take money away from banks during the depression: don't throw good money after bad. But the issue is, people do occasionally panic en masse, as exampled by the lines outside of IndyMac, even though their deposits are guaranteed and the government has never Welshed on this guarantee.

But the question was put well by Bunning: Why should I believe you? This was in reference to Paulson's opinion they would not actually use the guarantee. Paulson's answer was, he believes it himself, and has worked in finance for a long time. I think instead he should have outline why he things Freddie and Fannie are viable long run. One thing he could have pointed to, was that delinquency rates for new pools are declining, so we have turned the corner. A second reason is that a big part of that reason is that they get cheaper funding than all their competitors via the government backing, which is a huge advantage in a scale game. Of course, this is kind of embarrassing, because Fannie and Freddie have traditionally been the primo patronage jobs in DC, and and so it's pretty sordid thing we are saving. But now is not the time to kill them. I would rather provide them with liquidity, then slowly constrain the relevant mortgage sizes for which they get Federal backup.

Monday, July 14, 2008

Case Settled

My intellectual property case with my former employer has been settled with prejudice (see here), meaning, both sides agreed to withdraw their claims and cannot refile them. I have no comment on the case or the settlement.

But, if you are involved in intellectual property, here is what I think are good ideas based on thinking about legal issues the past couple years (Any relation to my specific experience is entirely coincidental; this is not legal advice; see a lawyer before destroying any confidential information; this is exactly why there is no good legal advice on the web):

1) After you leave your employer, search all your hard drives for any file 'created' or 'modified' during the period of your employment. It doesn't matter if you think it is not a secret or even work related. Delete them, regardless of their public domain nature, because ‘public domain’ is a subjective assessment. Transfer any remaining files onto an external device. Install software on new hard drives, then transfer over any legacy files from the external device. Finally, destroy the external device used in the intermediate transfer. You want nothing remotely connected to the tenure of your employment in your position, regardless of relevancy, including deleted files, cached snippets of files from Google Desktop, shadow copies, etc.

2) Note the prior legal activity of your business associates by searching the state and federal district websites. Read the actual cases, there's usually a good bit a detail, so it rarely requires a law degree or insider knowledge to assess the merits (the court has to assess cases using the law, individuals can rely on their common sense). Also, look at the experience of ex-employees. If they all seem to get ‘different’ jobs, this suggests there might be some legal intimidation that never made it into the court record. Remember, everyone but total psychopaths consider themselves to be acting righteously, and smart people can rationalize anything. Look at what they do.

3) Expect your adversary to take everything your write down or have said out of context, because that's what good lawyers do. The US legal system is predicated on the idea that justice comes from two highly biased, opposing perspectives, so they see tendentious arguments as part of a greater good. The more things you have written, the higher the probability that some snippet can be made to look incriminating. Therefore, to the degree possible, get in the habit of using the phone, or meetings, to discuss strategy, tactics, or anything substantive.

4) In large corporations, legal action needs to be justified to higher-ups who don't give a damn about petty slights and injured egos. Therefore, if you are in a case that seems not justified by some cost-benefit calculation, avoid big corporate lawyers because they will be flummoxed by your adversary.

5) Civil litigation is about pretext, process, and justice, in various degrees depending on the players and issues involved. Making a pretext look like a principle, and working the process, is where lawyers earn their money. Most civil litigation does not go to trial, which means the merits or consistency of the case is not very relevant because such issues are mainly relevant at trial, and judges like to defer anything close to a judgment on merit to juries.

6) Get counterclaims inserted in your case ASAP, and be sure to mention specifics of bad faith and damages in these counterclaims.

7) If your jurisdiction does not have a precedent for some ruling that is common in other jurisdictions and seems common sensical, do not expect your judge to create one.

8) It does not take very long for your specifics to become unfamiliar to every lawyer in America, so your field’s specificity is irrelevant in choosing a lawyer. You will pay at least $50k, so like buying a car it's worth a 30 minute discussion and a few visits to find one you like at a good price (don't simply go with your buddy's recommendation).

9) Litigation is combat, sometimes necessary to protect one’s livelihood, justice, or reputation. But like fistfights, the vast majority are stupid. While fighting can often be blamed on too much beer, excessive litigation is caused by people overestimating their grievance and underestimating the legal costs.

And most importantly,

10) Be rich. As most cases are settled, this implies negotiation, and having the ability to inflict and withstand greater expense gives one an advantage.

Sunday, July 13, 2008

Mortgage Paper Quality Turns Corner

The always insightful Thomas Brown notes that the delinquency rate for mortgages is going down.
See how newer delinquencies, especially 30-to-60 day and 61-to-90 day, are lower now than they were last October? That’s a big deal: new delinquencies are falling, regardless of what’s gone on with total delinquencies. Once the later-stage delinquencies drop out of the total, the overall delinquency numbers will fall, and everyone will start to see what we know now, that subprime credit quality has indeed turned the corner.

Strategy a Function of Skill

Simon Ramo identified the crucial difference between being a good at 'amateur' tennis, and professional tennis: for the best of the best, you need good 'winning' shots; to be a good 'average' player, you need to merely lower your failure rate. In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. Thus, a book about being good, to be relevant, should target what group you are in.

I think this is relevant to investing, in that for retail investors, who don't have an edge, they should prioritize the following: minimize costs and diversify. For that select few with an edge, the focus is on fundamentals (financial statements, business model), and though you minimize costs and diversify to the degree you can, it isn't a priority.

Saturday, July 12, 2008

Philosophical Puzzle Solved

One question that was really good for college 'shrooming: how do you know other people are conscious? You don't think about it until you take 'Intro to Philosophy', and then you realize you don't really have a good reason. You can imagine a robot passing the Turing test and being 'non conscious' (e.g., Searle's Chinese Room), so why do we infer consciousness without thinking about it, if we can't explain it?

Well, in the 1990's they discovered 'mirror neurons'. This book review goes over a couple of new books on this fascinating subject, here's a snippet:
The experience of artificial-intelligence researchers has taught us that what seems simple for humans (like recognizing faces) is difficult for computers, and what is difficult for humans (like playing chess) is easy for computers. Imagine that you are at a café with a friend. He reaches out toward a cup on the table between you and picks it up. What he is doing, and why, is obvious: He is drinking his coffee. But how does your brain figure all of this out in a split-second, without any need of conscious reasoning?
...
When you see a woman grinning broadly, how do you know she is happy? Apparently not through some abstract reasoning process that analyzes the visual information coming from her face and makes a logical inference that her expression is associated with happiness. Instead, you instantly activate parts of your brain that are active when you are happy. You may even make subtle, unconscious muscle movements to imitate her expression.
When I see someone smile, I don't have to infer what it means, I know instinctively because the exact same neurons fire in my head when I smile. This has a lot of implications about empathy, language acquisition and autism, in that they argue there is something in these mirror neurons that is different in autistic people. Thus, even though there is no logical reason we must assume consciousness in others, it is a built in feature.

This explains why we naturally infer consciousness and emotions so much easier than AI--it's an assumption! I wonder how many other puzzles can be solved in the same way, that is, we wonder why people believe X, and the answer is, because it's hard wired.

Friday, July 11, 2008

Must Patronize Voters!

Econ PhD and former senator Phil Graham's gaffe where he stated that America is full of a bunch of whiners was immediately retracted by McCain, because the last thing a Presidential candidate can say is that those voting for him are anything but suffering, which is modernity's primary virtue. I posted on whiners last week, and I think not all whining is bad. But most is. McCain is losing badly anyway, so he might as well say something unconventional. He could have picked up some votes if he said 'it's true, real GDP/capita is at a historic high in the history of mankind, and because housing prices have fallen from their historic highs, you would think we've been hit with the most grievous afflictions since God pwned Job. Man up.'

Obama Typical Politician

Politicians are like drum majors. To many unaccustomed to what marching bands do, it seems they rule the roost. In fact, they merely are little garnishes, of what composers, and directors, and first chairs, have done. So too politicians, they are, and desire to be, inkblots, whatever you read into them as long as it's positive.

Anyway, I read a snippet from Obama's Dreams of My Father, that Barack Obama thought that his brother Ray was "The person who made me proudest of all, .. he converted to Islam." Sounds nice at the very superficial level, but it actually reveals what a typical politician Obama is.

So his half-brother Ray is so authentic he was more admirable than Obama's half-brother Mark, a Stanford physics major who avoids the spotlight. But isn't Barack a Christian? Isn't the essence of Christianity accepting Jesus Christ as your Lord and Savior? I don't believe in any of that stuff, but my parents gave it a try and I did learn the basics, which at the very least said you had to believe in your heart that Jesus Christ was God's conduit, and no one else. Thus, logically, if I were a Christian (ie, believed in Christianity), I would think my brother becoming a Muslim would be turning his life to eternal damnation and a tragedy much worse than being 'inauthentic'. Indeed, 'authenticity' seems to mean 'doing what your race primarily does', which in the context of heaven and hell is irrelevant. I mean, heaven is +inf, hell -inf, and so your brother chose -inf, but, he was keepin' it real! WTF?

If Obama were a Unitarian I would give him a pass, because that's atheism for people who want it both ways, a nonoffensive religion that no one takes seriously. But the United Church of Christ? That would seem uniquely advantageous for a South Side organizer with big aims. I guess it works.

Thursday, July 10, 2008

Cramer, Busted


I don't think being wrong is so bad, because everyone is wrong sometimes. But when you try to rewrite the past, and make it seem like you were right all along while changing your opinion, that's just wrong, and people should be held accountable. With the benefit of YouTube, Cramer has been busted here. On June 13th after a small rally, he promotes the financials and tech, and says stay away from oil (June 13, 2008), after the Dow subsequently drops 500 points, on June 20, 2008, he says you are an idiot for owning financials and tech, and not owning oil. The guy who put this together nails Cramer for inconsistency pretty well.

I think Cramer is a smart guy (see here), but clearly he has sold his soul, and his signal-to-noise ratio --> 0. People ask questions on his nightly show on virtually any stock and he seems to have memorized the basics for about 2000 companies, which is very impressive. But intelligence without wisdom is ultimately like a 'good' trivia book, and I think Cramer is like a trivia book, interesting with no depth.

Words of Wisdom for Many

Great quotes in empty suitism, while watching Paul Winfield's character in Mars Attacks! with the boys:
[phone call to wife] "I get to meet the Martian Ambassador! Ain't that great? Oh, it's a hell of an honor. But didn't I always tell you honey, if I just stayed in place and never spoke up, good things are bound to happen."

Wednesday, July 09, 2008

Benford's Law


Benford's law states that the frequescey of the first digit in a set of numbers obeys a power law, so that for base 10 the odds of getting a "1" in the first digit is about 30%, a 2 about 18%, and decreasing to about 5% for a 9. This has to do with numbers generally having logarithmic distributions (for normally distributed variables, like IQ, you don't see Benford's law).

Anyway, I was reading about how you can apply Benford's law to accounting fraud, because fools who make up numbers will put in equal distributions of numbers starting with 9 vs. those starting with 1. But then I thought, most fraud pertains to a classification issue, such as classifying an expense as an investment, or accelerating income--the numbers are real, just relabeled. Further, someone might take a big number and back into it, but usually by adjusting a handful of numbers. If you are targeting the number X, and you have Y, all you need is one number (X-Y). You can't use Benford's law, which applies to frequencies, to disprove a handful of fudged numbers.

I see there are lots of conferences and books on this, because it's a neat finding, but I can't imagine is has significant practical value.

Good Investing Rule, Too

From Steve Sailer:
Time Magazine has an article on how John McCain, no surprise, loves to roll the dice in casinos, while Barack Obama played poker every Wednesday night in Springfield with other legislators and lobbyists. Most nights Obama won.

In fact, that would have to be just about my number one tip on how to win at gambling: Be a state legislator and play poker against lobbyists.

Tuesday, July 08, 2008

"I'm Not Here to Make Friends"

In frustration, many people say 'I'm not here to make friends', as if to provide a logical though unsympathetic rationale for their behavior. The YouTube clip below highlights just how cliche this statement is, and given the demographics of these TV shows, this is not a group you would want to join.

The statement is counterproductive, and not because it's a cliche (many cliches are tired, yet still true and important), but rather because it lowers your odds of succeeding. It makes explicit that you look at the people around you as competitors or tools, not human beings that are also trying to improve their position in various ways. Everyone needs friends, people who help promote their ideas, or at least don't actively trash your reputation. If you state you are just in a zero-sum game with all the others, they will at best not help you, and those you are trying to impress with your brilliance are rarely indifferent to your lack of sociability (if everyone hates you, you are probably a shmendrik).

This is where indifference is so tactically useful, because it is impossible for someone to know if your indifference is because you dislike them or are merely preoccupied, and it is impolite to press the point. Indifference can be cruel, but there are worse things (eg, litigation).

Monday, July 07, 2008

Money Follows Latest PnL

Money is now pouring into commodity funds, and any other strategy that has worked for the past 18 months. Do these strategies have higher expected returns, or lower risk than 18 months ago? I don't think so, but I do think it plays off a common investing tendency to use the recent past as large indicator of future returns. This reminds me of a Gallup poll put out by Paine Weber in 1998, at the beginning of the stock market boom. They surveyed an expected return of 13% from investors. After back to back 20%+ returns in the S&P500, and the Nasdaq more than doubled, investors raised their expectations to 18% in February of 2000, right before the peak. Two years later, after a 50% correction, they anticipated only a 7% expected return. Steve Sharpe and Gene Amromin also looked at survey data, and found investors were insanely simple: when the market has risen, they raise their estimate of future return and lower the perceived risk. On this dimension, investors are stupid.

I remember pitching a strategy to a hedge fund guy in 1999 and he said, it worked fine, but not so much in the past year. Could I tweak my model to work that year too? 1999 saw the Nasdaq double, so anything less, especially negative, seemed positively lousy. Another instance in the 90's I was talking to someone in the equity index group at my bank, and said that, since low vol stocks outperform high vol stocks, you could generate a couple percent premium by investing in low volatility stocks and have low aggregate 'risk' as measured by vol or beta. He said, 'couple of percent? I can get 10%!'

Another peculiar bias is that no matter how long a backtest, people want the model to have worked in the past 12 months. Looking at the rise in Commodity ETF and commodity hedge funds, it seems that people merely following the money. I know a very smart and famous economist charged with coming up with a futures strategy because commodity futures have been going through the roof. And of course, all you have to do is rationalize a long commodity bias over the past 5 years and whatever strategy you have will have done well. Smart guy that he is, I'm sure he'll rationalize his model very well, but it's all pointless because there's an appetite to invest in what has worked recently. The only trick is some logic to convince yourself, or you backers, that this isn't so dumb as merely going long those commodities that went up over the past 5 years.

If you look at mutual fund inflows, you see a distinct inflow pattern that's highly nonlinear and dependent only on the past year's returns (Sirri and Tufano, 1998 JoF; Chevalier and Ellison, 1995), and convex payouts are more valuable the more risk you take (e.g., higher vol increases the option price). Risk metrics or benchmark returns don't matter AT ALL in mutual fund inflows, it's just past year's absolute return, because for someone who knew, there was no risk, and the strategist will swear there was no risk, he just knew. This is probably relevant to momentum, in that initially something works for real reasons, it's eventually accentuated by those putting capital into what has gone up, which causes positive autocorrelation.

I was reading the latest Bloomberg magazine, and it had an article by Kambiz Foroohar on recent successful stock market pickers. It highlighted the 'best' calls, meaning, analysts were highlighted for choosing the biggest winners. It didn't give average stats for the individuals, though it did show 'averages' by firm, which ranged around 50% for 'correct' picks. Also, it didn't count a pick correct if it was called too early, so if you were bearish on Bear Stearns in 2006, the fact that it failed in March 2008 doesn't count, even though the fundamental (weak housing market, too much housing exposure) was baked in then. Some statistics only targeted the 'highest volatility stocks', meaning, if you analyzed a low vol stock, you couldn't be right. The market seems to evaluate investors using a metric that clearly gives an incentive for merely taking big gambles on highly speculative plays, updating them frequently, and if one comes in, you ignore everything else and ride it. Given the nonlinear inflows or media attention to a 'big winner', professionals are very much like stupid retail traders, all stalking Peter Lynch's ten-bagger (something that can rise 10-fold).

I was talking to someone running a hedge fund recently, and he said they were looking for strategies that produced 'out-of-sample' Sharpe ratios of 2+, preferably 4. It was like a mutual fund manager saying he wanted people who outperformed the benchmarks by 10%, preferably 20%. It was a big fund. Most (all?) people who would surpass this filter are ignorant or deceitful, because such objectively good strategies are about as rare going forward as they have been in the past (the average fund, which is a composite of strategies, generally has a Sharpe below 1.0).

In sum, institutional preferences are for investments or strategies that 1) have huge potential returns or 2) work all the time. I think positive thinking is healthy, but at this level it's a little bit like candidate criteria that no one passes, so the choice is made for some highly unquantifiable reason because the alternative is to choose no one.

This suggests that stacking the odds in your favor is easy, if you just have a long horizon that avoids high fliers. You won't win any single tourney, and you may never get a chance to ply the strategy, because people with capital want someone to gamble their money on something that can win huge though rationalize it well. This preference isn't going away, so I say, invest in conspicuously boring assets (though, not as boring as 'cash').

Saturday, July 05, 2008

When Theory Fails

Horgan and Johnson have a neat dialogue, as usual, over at Blogging Heads.tv. Horgan notes the Tetlock's book documented that experts did worse than chance at predicting major events, relative to a naive alternative (discussed in this good New Yorker here). The idea is that experts are incented to create innovative theories, and the more they know, they better they become at defending, and cherry picking the evidence to support it.


Another example of this is an experiment discussed in the video clip above, where rats were presented with a maze where they were presented food 60% of the time on the left. Quickly, the rats would always go left, successful 60% of the time (smart rats). In contrast, Yale students were presented with the same puzzle but were only successful 52% of the time because they were trying to guess complex patterns. Theory can be an impediment when you infer theories that aren't there.

Friday, July 04, 2008

Happy Independence Day!

My boys are watching the movie Independence Day, and it's perfect for them, and enjoyable for me. I especially like end, where we infect the Alien Operating System with a computer virus, which disables all their defense shields. The first alien ship is taken down by a kamikaze mission with a loaded nuke. I guess everyone does this, and the aliens can't defend it. In one brief scene, a bunch of African natives with spears are seen celebrating over a downed spacecraft. Hooray for America!

Thursday, July 03, 2008

Post on Overcoming Bias

I have a post on the Overcoming Bias Blog today, see here.

Warren Beatty on Risk Taking

Warren Beatty said this about trying to bed every woman that he met
You get slapped a lot, but you get f*&ked sometimes, too.

Of course, his odds were objectively higher than for most men, because he was good looking, famous and rich. But it does highlight the old saying, 'the greatest risk is not taking one'.

Wednesday, July 02, 2008

Long Tail Study Questioned


The Long Tail theory, is basically that the internet has made holding inventory less costly, so instead of having a couple of top brands, you can make more money catering to a large number of niche buyers. The example is iTunes, where much of their sales is in small bands. Narrowly-targeted goods and services can be as economically attractive as mainstream ones, so it's the long tail that we should care about.

Anita Elberse, a marketing professor at Harvard's business school, has found this isn't true, that brands are just as important online as anywhere else (Long Tail author Chris Anderson has a response here).. There's a neat WSJ article on this, and the author notes:
Some of the reasons for the popularity of the Long Tail were as interesting as the idea itself. For one, it flattered its readers, many of whom were in the tech industry, by suggesting (yet again) that the Internet was changing everything. What's more, since many in the tech elite have a contemptuous view of traditional cultural gatekeepers like record labels and movie studios, they were predisposed to appreciate anything that predicted an erosion of those institutions' cultural power.

Ah, the old 'flatter the audience trick'. Appeal to their vanity by showing, empirically, they are The Vanguard, and they will tell their colleagues, in all sincerity, 'this guy is a genius', because he is saying what they are doing is important.

Many successful books are filled with disingenuous flattery disguised as thoughtful analysis. I was reading an awful business book, and it was blurbed by famous Nobel Prize Winner X. X remarked on what a beautiful and important book was in these covers, even though it was basically a taxonomy of ideas from the eighties, with tables of data from the past 10 years. Coincidentally, there was a 2-page, irrelevant, aside about the brilliance of X's work stuffed within the book. I wonder how many book blurbers are in tit-for-tat mode (either for gratuitous veneration within the book, or as payment for future blurbs from this publisher)?

The secret is in flattering your audience without appearing to do so, a skill to be sure.

Tuesday, July 01, 2008

One Cheer for Whining


As a parent of small children, I can say that whining is something every parent loathes. Every constraint on the child, be it a parental command, a perceived privilege granted to a sibling, or frustration with not getting things to work as they want, can generate tears and screaming. As a parent, 'no whining' is a constant refrain. I was in the local Staples, and saw they had a book, Shut Up, Stop Whining & Get a Life! It was a good read while I was waiting for the geniuses there to create a document for me. You see, no one likes whiners, and it's just self defeating. True that.

But just as poison can be a tonic in small doses (hormesis), so too for some whining. Kids are the biggest whiners, but they are also the biggest learners. Its only because they get so excited and upset that they are sufficiently motivated to figure stuff out. A baby that doesn't cry, or an 8-year old that smiles when he strikes out or gets fewer cookies than his brother, is insufficiently whiny. We are motivated to relieve frustration, and whining is a symptom of this angst, but these episodes are often very insightful. A life with merely the Unbearable Lightness of Being, or the Eternal Sunshine of a Spotless Mind, are fantasies because they imply an indifferent life, which would be both ignorant and ineffective. We all have to learn how to deal with constraints so that we both move on, but also address problems most efficiently, and you can't avoid frustration and a little inevitable whining. Like anything, it's a balance.

Aristotle noted
Anybody can become angry—that is easy; but to be angry with the right person, and it the right degree, and at the right time, and for the right purpose, and in the right way—that is not within everybody’s power and is not easy.
Whining, and the frustration and sense of justice that motivates it, is like anger. The popularity of the book Shut Up, Stop Whining is probably because most of us are sick of today's cult of victimization, which celebrates pathetic people who have been wronged, clearly too far in the whiny direction--solve your own damn problems! But in the right situation, in the right amounts, it is wise, and very few people figure this out--it takes a great deal of discipline and intelligence.

There's a story about the French Reign of Terror, where the aristocrats generally went quietly to their executions. But at one point a woman who went up there screamed for her life, acting very 'beneath her station'. Seeing this, the crowd suddenly lost its appetite for executions, because they were no longer some abstract extermination, but real people who were being killed. It is among the bravest of things to face death with equanimity, but in this case some hysterics saved lives.

My kids generally whine for no good reason. But I appreciate their frustration, and try to channel it, hoping they learn when something is spilled milk, an opportunity, or a learning lesson.