Falkenblog

Fama on EconTalk

2012-01-30T17:39:00.007-06:00

Eugene Fama is interviewed by Russ Roberts over at EconTalk. Most of the time they talk about the Efficient Markets Hypothesis, and the mortgage crisis, but 'risk premiums' were mentioned in this little exchange:

Roberts: What are the lessons for me that finance has learned that are important? [bla bla]...
Fama: [blah bla] ... I think we've learned a lot about risk and return. Some of it is intuitive. But there is a lot of stuff on which stocks are more or less risky. A lot of stuff on international markets...[bla bla]

That was quite the elision! Risk is ubiquitious in modern finance as an explanation, as Robert Merton says: 'Risk is not an add-on … it permeates the whole body of thought.' Yet it receives only a minor mention that passes so quickly here, as if not to dwell on it long enough to elicit any follow up, such as "which stocks are riskier than than others?" If it's value stocks, why do they have lower betas and volatility than growth stocks? If it's small-cap stocks, in what way are they risky, other than having higher-than-average returns? If it's equities in general, why is the CAPM a failure cross-sectionally? It is, after all, the main focus of his oeuvre, so I think he's unconsciously signalling he's on the defensive here.

An interesting point is that the Efficient Markets Hypothesis (which I defend here), is something that started out without much enthusiasm, but over time has grown stronger, led mainly by the obvious fact that it is very difficult to make abnormal returns in the market. Fama gets a lot of flack for it since day 1, but it has been his most enduring idea (clearly, a group effort with Working, Samuelson, and Ruth). The risk premium, however, started off as a fait accompli around the same time, though the risk factor is like a Freudian's Oedipal complex, something that started out with supposedly clear empirical support but later was simply assumed. This is because the risk premium is a direct consequence of the most fundamental assumption of economics: a von Neuman-Morgenstern utility function, one that increases in wealth at a decreasing rate. Given that, risk premiums exist, so for most economists, one doesn't need proof. This is nice because we don't have any other than the supposed equity risk premium, which even if it is 3.5% as most experts think, should generalize to something other than the difference in return between equities and bonds (eg, cross sectionally, over time, across futures, currencies, bonds, etc).

What if Returns Don't Reach 7%?

2012-01-29T21:18:00.004-06:00

A review in the WSJ on the book The Hedge Fund Mirage by Simon Lack notes:

The return-on-investment targets of 7% to 8% that are structured into pension plans are beyond reach in today's artificial environment. To redeem their promises to retiring teachers, firemen and the like, managers are risking more money with hedge funds in hope of yields higher than those on safer investments.

And so it is, as I read subsequently that:

Just five years ago, it was illegal for South Carolina's public pension plan to invest in hedge funds, private equity and other complicated bets.

Now, nearly half its assets are in such investments. That is way too much for the state treasurer, who is charged with squeezing the most out of the $26 billion pension fund.

Unfortunately, hedge funds are doing worse than ever:

The "Global Macro" trading strategy, one of seven tracked by the Dow Jones Credit Suisse "Core Hedge Fund Index," finished last year down over 10%, worse than the entire index, which fell 7.4%.

This isn't going to end well. The risk premium of 5% that everyone expects is not going to happen, and this failure will act as positive feedback in the upcoming fiscal disaster; when the pension funds all under perform and need more money, it will be the nail in the coffin. I think the tinder will be inflation, which the central banks seem to think is the cure for their GDP ills (and those of underperforming pensions), so they will push until it comes back.

Is Arithmetic Return Bias Basis of Low Vol Anomaly?

2012-01-25T17:45:00.010-06:00

I created an index of the highest beta stocks from 1962 to present. Every 6 months I took those 100 highest beta stocks, excluding the lowest 20% in market cap (to get rid of dumb stocks you can't trade). The results are in the chart above, and summary data are as follows:

The top line, "AnnReturn", is the arithmetic return, and here the monthly returns for the high beta stocks are about 0.14% higher than the S&P500, which when multiplied by 12 is a 1.7% difference. But looking at the chart which shows a total return chart, and the geometric annualized return, we see a very different picture, with the high beta stocks underperforming by 3.5% annually.

The basis for this is the difference between geometric and arithmetic returns, which is

Geometric Return =Arithmetic Return - Variance/2

Thus, the differential annualized variance (in this case, 12% vs. 2%), generates the differential annualized return. Interestingly, the return rankings for these data are different depending on the horizon!

Mutual funds and individual investor holding horizons average about 1 year, and I think that's a good assumption for an investment horizon. It seems that 1 year would be the obvious horizon to apply data against, but the problem is there is so little of it. There's like twelve times as much monthly data! A simple fix would be to use log returns, but this doesn't always happen, and I think those who still find the Security Market Line to have a positive slope in general are looking at monthly percent return data, and this is why they see what they do.

Insurance and Pooling Equilibria

2012-01-25T09:04:00.014-06:00

In the bad old days, insurance was a way to smooth cash flows from improbable but large expenses: fire, health, auto mishaps. Through repetitious metonymy, 'health care insurance' and health care are now synonymous.

I was struck by Obama's mention last night that:

I will not go back to the days when health insurance companies had unchecked power to cancel your policy, deny your coverage, or charge women differently than men.

Emprically, women use more health care, they cost more, estimates are around 35%. Some of this is childbearing, but a lot of it comes from the simple fact they go to the doctor more often (notice women see their gynecologists rather regularly, whereas men have no comparable service). So now charging women more for something they use more of is illegal because it discriminates.

Interestingly, in the 1970's there was a law passed so that upon retirement, the annual payments to female retirees had to be the same as for male retirees even though women live longer, statistically. That is, the present value of their retirement packages, by law, are larger for women than men.

Government seems to be doing more and more to make it difficult to prevent 'pooling equilibria', cases where different types of applicants get into a pool, eventually pushing out the 'better' or 'lower cost' people who don't want to subsidize the other group. For example, due to legal rulings, it is now very difficult to give job applicants explicit aptitude tests, even though this would be very useful, and avoid the charade from those Microsoft/Google IQ tests given verbally. Interestingly, Nobel Laureate and prominent Big Government advocate Joe Stiglitz's most famous paper relates to an inefficiency from a pooling equilibrium, and his take-away was that markets were inefficient because of this problem. In practice, government encourages pooling equilibrium where it was never a problem before by preventing rational discrimination based on projected costs/benefits based on observable characteristics.

While the equilibrium efficiency loss in Stiglitz-Weiss is abstract, it usually creates something pretty simple, as if you can imagine what would happen to insurance if it could not price based on risk and allowed people to opt out: healthy people would leave in droves, which is why Obama-care made insurance mandatory. Think about the lawsuits on disparate impact for mortgage lending in the 1990s, where whites were rejected less often than blacks, and this was presumed discriminatory (in an evil way), and so the only way to make unequal groups equal is to stop making distinctions that differentiate them, which led to simply the idea that down payments and having a job were unnecessary underwriting criteria.

It's rather funny that Stiglitz's main theoretical contribution to the academic literature is so starkly in contrast to not just his politics but his obsession, which is increasing the size and scope of government which prioritizes preventing firms from rationally discriminating. Remember that in Stiglitz's model, like everything else in this literature (he didn't invent it), failure to discriminate types somewhat known by participants is what causes all the problems, the 'bad equilibria.' I guess that highlights no one takes these models very seriously--change one assumption here or there, different result.

Modern Robin Hoods

2012-01-22T20:10:00.004-06:00

My Sunday opinion section had a commentary piece arguing why we should tax the rich more. It ends with this:

Am I envious, Mr. Romney? You bet I am. But I'm also angry at the stark injustice of it all.

The author is the 'vice president of the Institute for Local Self-Reliance.'

Wikipedia Black Out Working

2012-01-18T16:57:00.004-06:00

Many of my favorite websites (Fark, Wikipedia) staged a protest against some intellectual property legislation coming down the pike, and it seems to have been successful. For example, Florida Senator Marco Rubio made this confession:

In a frank statement posted to his Facebook page on Wednesday, Rubio hinted at a Beltway truth that many other wavering Protect IP and SOPA supporters have been hesitant to admit: More than one lawmaker signed on to the legislation without understanding its technical workings and potential problems, believing it to be an uncontroversial, bipartisan bill that would support American industries.

Of course, this highlights that often senators vote for legislation without understanding its technical workings and potential problems.

MIT Economists Running Central Banks

2012-01-17T20:58:00.005-06:00

Bloomberg Magazine has a piece on the MIT economists who dominate central banking today. If you ask them why, they will say it's because of their particular blend of theory and practice (as if the idea of theory AND practice is really an outside-the-box idea).

I think it's more a matter of this was a group of smart kids who were really interested in macro, because in the 1970's they were still optimistic about its ability to be useful. A small group like that can create a positive feedback loop pretty easily, because having a recommendation from other successful macro economists is very important.

Yet, given the recently released Fed minutes from 2006, we see these Cambridge macro savants are a lot like the world's leading psychoanalysts all being from Vienna in 1930--experts to be sure, just not at actually helping people. Here's what US central bankers were saying about Greenspan when he left in 2006

For the Fed 2006 began with the departure of Mr. Greenspan, who presided in January over his final meeting as Fed chairman and was then widely regarded as the epitome of a central banker, a master who had guided the American economy through almost 20 years of remarkably consistent growth.
...
Ms. Yellen said: “It’s fitting for Chairman Greenspan to leave office with the economy in such solid shape. The situation you’re handing off to your successor is a lot like a tennis racquet with a gigantic sweet spot.”

If they didn't see our greatest recession since the great depression coming, why should we expect them to see inflation before it's too late?

Moderation in Deception

2012-01-16T18:39:00.010-06:00

One of the more important facts of life is that adults are often very disingenuous. When the executive VP says 'the United Way chairmanship was the most important job I had here at Amalgamated,' it is a lie; when they imply that their main satisfaction comes from knowing their customers or voters are better off, it is a lie. Sure, there's an element of truth to what they are saying, but emphasis is important too. So, lying is part of life, especially in regard to hierarchies, because any hierarchy needs some platitudes about the greater good to maintain their legitimacy.

Anyway, I was in Las Vegas last weekend and hung out with a Black Jack pro. His basic strategy was to find 2 deck black jack tables, which would give him enough time to count cards and generate an advantage. If they reshuffled too early, say after 52 cards, he couldn't make money, and this was part discretionary, part casino rule.

I won't give away all his secrets, but the bottom line is that it didn't seem worth it to me. As a job, not an avocation, it didn't seem fun, or even really well paying. The basic card counting part of the job is pretty mechanical and after repetition rather easy. Most importantly, he had a very interesting time with the dealers. Basically, you want them to know and like you, but just a little. Too much, and they will catch on to your game, too little and they won't do you any favors.

As they have a lot of discretion, and you are hoping to make say $300 off any on dealer, which in the context of their weekend is not a lot. Thus, they might choose to deal to you with only 25 cards left in the shoe, if they like you, whereas if they don't like you they will reshuffle after 50 cards. A great salesman is one who can make customers like them so much they don't mind paying a little extra, and don't like to even think about what is happening (like when dupes don't care their partner is using them because they are so adorable). Smarts are necessary to make this happen, but to make it a really valuable strategy you need the ability to make the opportunity cost seem a lot smaller than it is.

Refinement to The Neg

2012-01-12T14:30:00.013-06:00

Tucker Max is a populizer of The Neg, a technique whereby men strategically criticize women they're attempting to pickup. The idea is that by doing so you signal deep confidence from your high status, which makes you look more attractive, or at least makes a woman rethink blowing you off. It is intriguing, and I wrote about how Asian guys are picking this up to counteract their more restrained demeanor.

Interestingly, I read an interview with Tucker Max over at Psychology Today, and he specifically mentioned several influences that I also quite like to read: Geoffrey Miller (author of Spent), and Robin Hanson (blogs at Overcoming Bias), and the interviewer mentioned Robert Kurzban (author of Why Everyone Else is a Hypocrite). I guess there's a confluence of ideas here that appeals to those with all sorts of angles.

But as to The Neg itself, it seems there's a potential refinement that may take your game to the next level. It's called, 'the pratfall', and involves making a clumsy blunder after establishing your awesomeness. For example, after slyly dissing your target of affection by noting her lipstick is smeared, you sink the hook by secretly shaking up a can of soda and then have it 'accidentally' blast you in the face in front of her. Oh my! I'm so clumsy!

Here's Yale psychologist Peter Salovey on how it works (info needs only first 5 from where this starts). This is within a Yale Intro Psychology Lecture on Love.

Banks Discriminate Against Half Their Customers

2012-01-11T15:42:00.003-06:00

From the WSJ, I found this funny. It seems when you are being sued for Politically Correct crimes, the logic they use against you can be absurdly weak, because the evidence is clearly irrelevant:

Justice says that out of 4.4 million loans approved between 2004 and 2008, 525,000 went to African-American or Hispanic borrowers, of which some 210,000 paid higher fees or rates than the average paid by similarly situated "non-Hispanic White Borrowers."

It goes without saying large numbers of white borrowers also paid higher than the average of all whites. It also goes without saying large numbers of minorities didn't pay higher rates, though Justice isn't interested in the average of what minorities paid, only that some minorities paid higher than the average of whites.

If this sounds like statistical malpractice, it's apparently habitual. In a rare instance where defendants fought back, two Los Angeles car dealers recently won dismissal of a complaint accusing them of favoring Asian over Hispanic car buyers because 600 of 1,300 "non-Asian" buyers were charged higher loan terms than the average of Asian buyers. Notice that 600 is about half of 1,300. As the dealers noted, Justice's claim amounts to an assertion "half of one group is above average, which means that the other half is below average."

Fascinating Evo Biology lecture

2012-01-10T20:51:00.012-06:00

Anna Dornhaus gave an interesting lecture on evolutionary biology. I really like this thread ever since I read The Selfish Gene but am finding the stories repetitive, so these were all fresh. Here's some of her stories.

Warblers are very good at detecting which of their eggs are cuckoo eggs, something that is not detectable from a casual glance. Cuckoos know they have to at least remove one of the Warbler eggs before adding their own, so the competition is clearly into overdrive. Yet, occasionally the Warblers are fooled into letting the Cuckoo egg stay, and once hatched the Warbler raises the behemoth Cuckoo even though it looks nothing like its siblings (3 times the size, different color). It seems conscious minds can only afford to be so discriminating in certain areas, the rest apply simple rules.

Minds aren't good at detecting things that never happen in nature. Omnivores like rats are good at figuring out what foods are not good for them, using the simple rule that if they get sick, anything they ate 2 hours ago is no longer considered tasty. Vampire bats only drink blood, and as blood is basically never poisonous, if you do poison the blood to make the bats sick, they will never associate it with the blood from that source. They can't make the connection because from an evolutionary perspective, it basically doesn't happen.

Different species of sticklebacks live in the bottom and top of lakes. The top-dwelling sticklebacks can't learn landmarks. It appears the bottom dwelling fish are very good at detecting landmarks, while the top-dwelling fish looks more at how things behave. So perhaps skills not useful in their evolutionary past are eventually lost. On the other hand, female birds are not very good at remembering where they stored food when they have mated because they rely on their mate. Unmated females, however, are just as good as the males at remembering seed caches. I imagine one could therefore argue top-dwelling sticklebacks failed their spatial geometry quiz because it had no value to them.

Some animals grow the brain during the part of he year they need it more, and then lose that in the part when they are less cognitively demanding part of the year. More evidence for the use it or lose it principle.

Interestingly, scientists bred fruit flies for intelligence. They made bananas taste bitter, which fruit flies don't like. They then gave the flies little markers, so the 'smart' ones would avoid the bitter bananas based on this learned signal, the dumb ones would not. After only 20 generations they generated 'smart' and 'dumb' fruit flies who could learn at different success rates. Then, they mixed them together and saw what happened: Idiocracy, the dumb flies out-reproduced the smart ones! Her take-away was intelligence is costly, and everything has trade-offs.

I especially like the idea that any ability comes with trade-offs and so in a sense we are all idiot-savants, good at some things, bad at others, especially with respect to really different people. I know a lot of smart people, but I've never met one who didn't have blind spots. It's good to remember that because if you think that because you have a really high IQ, are really rich, or are a good speaker, you are therefore the smartest guy in any room, you are going to make a very big mistake someday.

Stocks and Flows

2012-01-05T08:24:00.004-06:00

A pithy summary of our macro debate by Brad DeLong:

The government purchases $100 billion of goods, issues $100 billion of bonds, and raises taxes by $3 billion a year in order to amortize the bonds. Government purchases go up by $100 billion this year. Private consumption goes down by $3 billion this year. Net fiscal impetus is not $0 but rather $97 billion. Cochrane doesn't understand the Ricardian Equivalence argument he is trying to make.

Now, ignore the Ricardian Equivalence, but just note that Keynesians think $97B was created via this spending and taxes this year, which is why they love government spending regardless of what it is spent upon. But if they issued $100B in bonds to create this 'new demand', where would that $100B have have gone otherwise? I don't think this makes sense in general equilibrium; money is never 'idle' unless it is under your mattress. I guess if you could caricature the two views: one thinks supply creates its own demand, the other that demand creates its own supply.

Bank Lending Pathetic

2012-01-04T14:41:00.005-06:00

Banks are highly regulated institutions, in spite of what Amar Bhide implies in today's NYT editorial. He argues the Fed should insure all bank deposits, no matter how large, but in response regulate more. The regulators are already regulating a lot, choking off credit. When no specifics are offered, it highlights how clueless such solutions are, as with the current CFPB, which doesn't do anything I'm aware of, but create a new permanent bureaucracy. After all, more regulatory pressure pre-2007 would have just meant more ninja loans, not less, given the conventional wisdom back then.

A friend shares with me the following anecdote. He thinks real estate is cheap, and wants to buy houses, and make money renting them. Ultimately, he would sell out of the homes when they recover in value. He has been doing it for a couple years with good results. He went to a bank, to see if he could leverage this idea, say by getting loans for 50% of the purchase price. They said, only if you hold this in a 'compensating balance.' These are cash balances held by the borrower at the bank, and add fees and some safety to the bank. In this case, the bank wants the borrower to keep the entire balance as a cushion, borrow money for a potential liquidity event, that would be rather futile because once the borrower used said compensating balances to rectify a funding problem, it would then have a liquidity problem with the bank. So, in practice, the compensating balance would not be a cushion for tough times, nor would it earn interest for the borrower. My friend decided not to get the loan.

The regulators aren't letting bankers return to business as usual, as previously they got 100% loan-to-value, now can't even get 50%! Many still think the bankers basically are parasitic thieves. I maintain that without a healthy bank sector free from the fear of extinction, our recovery will remain weak.

Macro Imploding

2012-01-03T21:26:00.005-06:00

Not the macroeconomy, just the science. Not that it every really was a science, just that 40 years ago everyone thought it was, now, not so much. Yesterday I read a really fun catfight between Krugman and everyone (e.g, Tabarrok, then Krugman, then Cowen, then Krugman, but this is typical). Now, losing one's temper in an argument is usually symptomatic of losing the argument, and so I am quite pleased watching Krugman boil over. Yesterday's Krugman post was precious, as he defending being peevish by noting that he only treats people like 'mendacious idiots' if they are so, and civility is irrelevant when the stakes are important!

He doesn't understand that civility is more important the greater the stakes, because they are helpful and takes discipline. It's easy to lose it and just start calling someone names, questioning their motives, but this is just appealing to your base emotions, as highlighted by the behavior people with their frontal lobe activity reduced (i.e., drunk people). On the other hand, on issues that are not important, well, it's easy to be gracious about things that don't matter because it takes no effort, there's nothing to restrain, there's no cost of doing so because you don't care if you 'lose'. If you are trying to bring a crowd to your point of view, manners are very helpful, they are a better sign of good faith argumentation. If you are just being angry, this can help incite a predisposed mob, but little else because everyone knows that someone highly emotional is not reasoning at all, just rationalizing. Sure, we all do it, but if we don't at least pretend not to, we clearly are not coming close to the rational objective we all aspire to in less heated environments.

Then there's Matt Yglesias trying to mix it up with Chicago-school type John Cochrane:

Chochran: Defenders think that devaluing would fool workers into a bout of “competitiveness,” as if people wouldn’t realize they were being paid in Monopoly money. If devaluing the currency made countries competitive, Zimbabwe be the richest country on Earth.

Yglesias: Try this mode of argument on for size. If water made agriculture possible, then the Pacific Ocean would be the breadbasket of the earth.

I found that analogy incredibly lame, and it made me think of Bulwer-Lytton contests (this year's winner: "Cheryl’s mind turned like the vanes of a wind-powered turbine, chopping her sparrow-like thoughts into bloody pieces that fell onto a growing pile of forgotten memories."), but Keynesian Brad DeLong thought it was devastating, highlighting the importance of ideology.

In contrast to this, I listened to much of the two latest Nobel prize winning economists--macroeconomists--giving their Nobel speeches...and they are as boring as any you might have remembered from college.

So, it's either a rather unfocused, nasty fight about the Keynesian stimulus or experts unconsciously imitating Ben Stein in Ferris Bueller.

Econ grad students going to the big annual econ and finance meetings this weekend in Chicago should ask themselves whether this is a club worth joining. Sure, the top 10 make a good living, but no one else does, as companies and municipalities don't need macroeconomists any more than they need sociologists.

Who is the Father of Low Volatility Investing?

2011-12-28T15:45:00.019-06:00

Any good idea is found independently, and there are always early works that seem to unambiguously imply the ultimate result even if they never really focused on it. So it is with low volatility investing.

Bob Haugen has been touting unconventional investment tactics for decades, starting with The Incredible January Effect published in 1987. Alas, the January effect was one of those anomalies centered on low-priced, small-sized, firms, that usually don't scale well. Do you remember the 'low price' effect? It was popular in the 1980s, along with the size effect, as small size and low priced stocks were highly correlated and both seemed correlated with very high returns. The low price funds are now something anyone associated with them at the time conveniently forgets, because trading them is very costly, like trading options instead of stocks.

Anyway, I saw him being interviewed at a Dutch conference, with the talk 'The Low Volatility Anomaly' on the screen, where he was arguing investors should move their equity exposures to low volatility oriented equity funds. At one point the interviewer asks if 'will you be known as one of the big heroes of the twenty first century?' In sum, I would say he was the first to publish on this, but he didn't know what he found, so the importance of his early work only appears with hindsight, or to those who took his facts and ignored his interpretation and emphasis.

Haugen did publish a very prescient piece in 1975, Risk and the Rate of Return on Financial Assets, that clearly empirically addressed the basis of the CAPM, and found beta was not related to returns as expected. He even states 'we find little support for the notion that risk premiums have, in fact, manifested themselves in realized rates of return.' Right on! Unfortunately, I think the issues then were on methodologies for simultaneously estimating betas and expected returns, so this was not very highly cited, and Haugen, like the rest of the profession, turned to highlighting factors that seemed to explain expected returns irrespective of risk (eg, calendar effects, value). The testing of the CAPM was left to the econometricians, with work by people like Gibbons, Shanken, and Ross.

In 1996, Haugen again argued that low-risk stocks tend to outperform high-risk stocks. But the emphasis on this paper was this was a consequence of market inefficiency. He created a model with many factors, grouped into 1) risk (eg, beta, volatility, 2) liquidity (eg, volume, price), 3) value (eg, P/E), 4) growth potential (eg,ROA), 5) past returns (eg,past 6-month return), and lastly 6) sector variables. Each class had ten or so highly correlated metrics within them. A more recent paper he did (again, with co-author Nardin Baker), basically applied the same idea. He noted the highest returning portfolio constructed via this backfitting were of lower volatility and beta than the lower returning portfolios, but that was incidental.

The emphasis was clearly on a model that predicted returns, and even now he touts 70 factors, many of which are highly correlated. The factor risk premia are calculated on a rolling basis, so signs on these factors bounce around. It's a classic kitchen sink regression. I don't see the emphasis as being 'low volatility', rather, that is a characteristic of his 'highest expected return' portfolios, which is his focus. For example, his 1996 Journal of Portfolio Management article on this riff was titled 'The Effects of Intrigue, Liquidity, Imprecision, and Bias on the Cross-Section of Expected Returns.' Lately he discusses three types of volatility--event-driven, error-driven, and price-driven--which he tries to separate and use differently. I think he's slicing this too thin, as you get pretty similar results using total or idiosyncratic volatility. That's a lot going on, but clearly volatility and risk are not emphasized as prime movers, he just found that risk was inversely correlated with these more interesting factors.

I do think he's a bit disingenuous with his performance. His page showing the cumulative returns for his various models shows a rather incredible upward growth since 1999. However, I remember some using his factors in the latter half of 2003, and the model generated a significant draw down, well-outside the scope of his backtests. Interestingly, there's no evidence of that in his charts. I presume that was an earlier version that got dropped down the memory hole.

In sum, I think he didn't prioritize volatility until the low-volatility movement get really going to get credit for 'low volatility' investing per se. While I wrote my dissertation on this back in 1994, but it went over like the Hindenburg with academia, and I never got refereed publication on the volatility result, so I wouldn't say I'm a founding father (I didn't have an equilibrium story then, and this was before Freakonomics and the popularity of behavioral finance, so back then it just didn't make sense). I would say that the two main academic pieces I relied upon for my finding then were Bruce Lehman's 1990 Residual Risk Revisited, and Ed Miller's 1977 Risk, Uncertainty, and Divergence of Opinion. Both focused on volatility, and implicitly noted that there appeared an attractive investment strategy implied by the poor average returns to highly volatile stocks. Indeed, in 2001, Miller mentions this strategy in the Journal of Portfolio Management. It seems, one needs a theory to see something, and because Miller had this theory (winner's curse) he had thought relevant to equities, he saw the investing implication before others. That is, one could deduce it as a corollary of Fama and French's 1992 finding that beta was uncorrelated with average returns, but as Fama and French merely extended the standard model to other risks, they missed the low-volatility/beta bandwagon. For example, Haugen's big theory had been that markets are inefficient, and so I think he wasn't focused on volatility for the reason that this insight is incomplete: inefficient in what way?

By the mid aughts, several academics had discovered this in various guises. There's Analytic Investor's Clarke, de Silva, and Thorley (2006) and Robeco's Blitz and van Vliet (2007), which focused on low volatility portfolios. Then there's Ang, Hodrick, Xing and Zhang (2006) highlighting the poor cross-sectional returns to higher volatility stocks, and that really was seminal for academics. Firms like Analytic Investors, Robeco, Arcadian, and Unigestion all started low volatility funds around this time, so they had all seen this years earlier. Indeed, many of these guys read Haugen and Baker (1991), which documented this first, but again, Haugen inferred something different from this and went on a return-factor hunt. While all this was becoming common knowledge, I was fighting a lawsuit by a former employer trying to stop me from using volatility as an investment factor, and I remember thinking how crazy it was that I had to fight to use something I had been touting since 1993 that then had a pretty large publication thread.

Quantitative Easing Tough on Pensions

2011-12-27T20:04:00.003-06:00

From the WSJ:

While quantitative easing boosts the value of pension assets, it lowers investment returns and increases estimates of future liabilities. Because typical defined-benefit plans are only 70% funded and face liabilities several years longer than their assets, that leads to wider deficits...But many trustees say the best response would be for the BOE to stop buying long-dated gilts and buy bank bonds instead. Not only would this ease bank funding difficulties, and thereby improve the supply of business loans, it would allow gilt yields to rise.

With interest rates at historic lows, pension funds are in a tough spot. If interest rates rise, they will suffer capital losses and actually be in a tougher spot. I'd say this is good reason to avoid bonds that are attached to entities with large, unfunded pensions (eg, states, munis).

When the government tries to improve prices, it creates winners and losers.

IMF Chief Economists Blames Problems on Investors

2011-12-26T20:30:00.005-06:00

Olivier Blanchard is a very well-respected academic economist, and currently also Chief Economist at the International Monetary Fund. He sees today's current big problems primarily due to investors.

Self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.
Incomplete or partial policy measures can make things worse.
Financial investors are schizophrenic about fiscal consolidation and growth.
Perception molds reality.

So, the unsustainability of Euro member fiscal policy is supposedly irrelevant, compared to the insane, self-fullfilling prophesies of investors. As John Cochrane noted, the Euro leaders keep looking for the Big Announcement that will soothe markets into rolling over another few hundred billion euros of debt. Alas, the problem is reality, not psychology.

Regulators Don't Help

2011-12-22T19:51:00.006-06:00

One of the reasons why I'm a libertarian comes from my experience with financial regulators. They are totally out of their depth, not understanding where risk really lies because the essential information simply can't be grasped by flying in and looking and talking to people for 2 weeks. I have never worked in a financial firm where I felt I understood what was really going on for at least a couple years. They fill out reports conceived by someone ten years ago that would have caught last decade's big error, and come back next year. The good ones, and there are many, realize the futility, but it's a paycheck.

Anyway, now here's the European regulators repeating the mortgage fiasco. Remember pre 2007 regulators encouraged mortgage lending without qualification. Now, the issue is Greek debt. John Cochrane nail it:

Indebted governments have been pressuring banks to buy more debt, not less. As banks have been increasing capital, they have loaded up even more on “risk-free” sovereign debt, which they can use as collateral for ECB loans. The big ECB “liquidity operation” that took place yesterday will give banks hundreds of billions of euros to increase their sovereign bets...So much for the faith that regulation will keep banks safe....They keep looking for the Big Announcement that will soothe markets into rolling over another few hundred billion euros of debt. Alas, the problem is reality, not psychology

Banks Lend, Charge, Too Much

2011-12-22T08:36:00.006-06:00

The suit against BAC/Countrywide was based on disparate impact, basically looking at averages for Blacks and Latinos vs. EveryoneElse. Presumably they controlled for some kind of credit metric too, but as Thomas Sowell has noted many times, it is common to run a regression looking for discrimination with an incomplete proxy for education like whether they had a degree, then put in a dummy variable for race, and find discrimination by looking at the loading on the race dummy, even though given the lower socio-economic status of minorities the variable omits a lot of other important variables (eg, what kind of school? what kind of degree?).

The key point is as follows:

In 2007, for example, Countrywide employees charged Hispanic applicants in Los Angeles an average of $545 more in fees for a $200,000 loan than they charged non-Hispanic white applicants with similar credit histories. Independent brokers processing applications for a Countrywide loan charged Hispanics $1,195 more, the department said.

So, they were charging the victims too much. But another narrative of the 2008 crisis is that they foisted loans upon people who couldn't afford to pay them back. Isn't price the key way a supplier rations goods to consumers? As Jesse Van Tol of the National Community Reinvestment Coalition (NCRC) argues: "the major contributing factor to the foreclosures crisis was reckless and irresponsible lending.” By this, I presume he thinks banks lent too much. In 1994 Obama was party to a class-action lawsuit alleging banks rejected too many minorities.

Back in the bubble, I'm sure a lot of borrowers were less worried about closing costs because many builders, non-profits, and even our government's own HUD would bundle those into a loan. The borrower then has a costless call option: if prices rose--as they had for the past 10 years--they would win big, if prices fell they could walk away and leave the bank with the property. Mortgages are non-recourse, banks can't take anything more than your mortgage back. Thus, I don't see the overpaying minorities as victims here so much as greedy dupes who were part of the mortgage fiasco.

So, banks lent too much at too high a price, when not lending enough. These are simply inconsistent allegations, highlighting the no-win situation for bank lenders. With such rules, no wonder political insiders like Peter Orszag, Henry Cisneros, and Bob Rubin are essential banking executive talent.

True Value Weak Guide

2011-12-19T15:38:00.006-06:00

I remember seeing an update of investment bank analysts, and they separated their ability into two groups: those good at predicting earnings, and those good at predicting stock prices. There wasn't much overlap. So I found a spreadsheet from a colleague's thesis that looked at the Pound/dollar exchange rate from 1973-2005, and noted while there was a pretty boring pattern in purchasing power parity ratio, but the market's value of the pound against the dollar fluttered around it quite a bit. It seems that if for some reason you were the only person in the world who knew the inflation rates in these two countries, your investment strategy would only be marginally attractive.

Keynesians Believe in Markets Too

2011-12-14T14:15:00.006-06:00

Paul Krugman argues that the fact that interest rates are currently low in the US proves his standard Keynesian diagnosis is correct. Here he is in the NYTimes arguing again why the fiscal and monetary stimulus dials should be turned to 11:

Early on in this crisis I and quite a few other economists — but not enough! — declared that we had entered a classic liquidity trap ... even large government borrowing won’t drive up interest rates, and you can print as much money as you like without causing inflation...[non-Keynesians] declared that soaring inflation was just around the corner, and that interest rates would spike...

So how’s it going? Interest rates have, of course, remained very low. As I post this, the real interest rate on 10-year bonds is actually negative.

He sounds like a caricature of an efficient markets theorist. Well, Markit's A-tranche for the all their vintage mortgages traded above 99 cents on the dollar at the end of 2006. By the end of 2007 they were around 45 cents, and today they all trade around 7 cents.

I remember GM being a zombie for years and their stock defied my expectations for a decade, but eventually equity owners were zeroed out and they went bankrupt. You can go a long time with negative profits if people are willing to give you credit. Yet as any small business lender knows, the only thing that stops these institutions is a lack of cash. Currently, US debt is so liquid, and has such a strong history, it remains a top credit. Yet it's good to remember that when I was in charge of economic risk capital allocations back in the 1990s for bank, mortgages had the lowest economic risk rating for any non-sovereign debt. Now it is on par with credit cards (ie, the worst credits).

I don't think this is going to end well for US debtholders, but time will tell. I don't expect Krugman to ever say he was wrong regardless given he called for a housing bubble in 2002 to stimulate the economy, and later explained that was an economic analysis, not a policy statement, as if that makes a difference.

Willpower for the 99%

2011-12-13T20:51:00.014-06:00

The 99% is a story that fits many journalist's favorite narratives about the major problem today: inequality. This seems like altruism, but focusing on the top 1% is also consistent with envy. Many think the top 1% are responsible for the poverty of the 99%, especially the truly poor, those in the bottom quartile. Yet the poor are pretty far removed from anything the top 1% can do. Graduate from high school, get married before you have children, work at any kind of job, even one that starts out paying the minimum wage. Fewer than 10 percent of families that follow his blueprint live in poverty, while 79 percent of those who don't follow the three-step plan end up poor. There is no redistribution scheme imaginable close to this in reducing poverty.

A good Christmas gift for the poor would be Roy Baumeister and John Tierney's Willpower, a great little book with timeless advice. It notes that Willpower has an effect on life outcomes as great as IQ, and more importantly, is much more amenable to nurture as opposed to nature. Perseverence, discipline, patience, all take practice, and make you a happier, healthier, and more productive person. The basic premise comes from the Stanford marshmallow experiment, where a group of four-year-old children were given one marshmallow, but promised two on condition that he or she wait twenty minutes, before eating the first marshmallow. Some children were able to wait the twenty minutes, and some were unable to wait. The children able to delay gratification were tested in later adolescence and found to be psychologically better adjusted, more dependable persons, and had higher SAT scores. Given hardly anything is predictive at that age, this is quite remarkable.

Baumeister has spent much of his career as a psychologists studying and designing tests on willpower. He notes it is a finite resource, and so quitting smoking is much harder when you are also studying (the rigorous study of common sense!). But willpower is like a muscle in that it weakens while you use it, but also strengthens the more you use it, so practicing it daily by doing things like standing up straight and not swearing transfers to other areas. Making decisions is exhausting, it depletes one's willpower, so its useful to design simple rules for much of your daily toil. Being low on energy from lack of sleep or nutrition also hurts your willpower. Basically, practice daily acts of self-control to become more productive.

This reminded me of a Eric Kandel's work on brain memories. He won a Nobel prize by looking at snails and finding that long-term memory, unlike short-term memory, involved the synthesis of new proteins. You get long-term memories through repetition in the same way you build muscle through exercise, so if you practice something daily and it becomes a habit--the muscle memory of a golf swing, the neural memory of saying 'please' and 'thank you'--you actually have altered your brain. Your habits are not just abstract character, but have a biological substrate. This surely encourages cryogenics fans who want to freeze their dead heads in vats of liquid nitrogen so that they can be re-animated in the future.

Life is a journey from ignorance and instinct to higher virtues, including the prudence needed in a complex world. Such prudence comes mainly from acting with thoughtful resoluteness towards the many petty people and temptations around us. Willpower is a great book that reaffirms the power within us to become better people.

The 1 Percent

2011-12-12T17:05:00.002-06:00

From Sports Illustrated, discussing the kick return phenom Patrick Peterson, who ran back a 99-yard kick to beat the Rams in overtime:

Peterson, 21, had also ignored instructions. In his case it was an order to not field the ball inside his own 10-yard line. He apologized to Spencer several days later. The two had a long talk, and Spencer informed Peterson that average players need rules. Special players need guidelines. Peterson now has guidelines.

Physical vs. Emotional Trauma

2011-12-12T17:03:00.002-06:00

The issue seems to be we remember the emotionally traumatic events more than the physical. From When hurt will not heal, by Chen et al:

The present study examined an important distinction between social and physical pain: Individuals can relive and reexperience social pain more easily and more intensely than physical pain. Studies 1 and 2 showed that people reported higher levels of pain after reliving a past socially painful event than after reliving a past physically painful event. Studies 3 and 4 found, in addition, that people performed worse on cognitively demanding tasks after they relived social rather than physical pain.

Aaron Brown's New Risk Book

2011-12-11T19:11:00.007-06:00

I got a copy of Aaron Brown's latest book Red-Blooded Risk, which is kind of like My Life as a Quant by Derman, in that's it's a very personal account of how finance works. I think it's very useful for 50-somethings to write retrospectives like this, because otherwise it's written by people too far removed or too naive. For example Michael Lewis's Liar's Poker is now a classic, but he was a mere bond salesman for 3 years; while his anecdotes were interesting and well-told, his big take-aways on how finance fits with the modern society and the economy were as naive as your typical 25-year old bond salesman.

Brown makes several important points. For example,he notes that the 99% value-at-risk might capture more relevant data, but it needs so much data one should look at 95% value-at-risks. While you can derive this from statistics, it is a practitioner point that clearly is better appreciated from experience. He clearly comes across as someone who understands both the math and how it is applied.

The book tries to deal with how to manage risk, mainly from the point of view of a hedge fund, or something where one is looking at a bunch of strategies. That is, in my experience as a risk manager at KeyCorp, most of our risk there was incidental as a market maker with customer flow, and such risks were rather trivial once one had 'rogue trader' risks under control. His view is more like if you are looking at a book with pairs traders, a momentum trade on government debt, and other such strategies.

Brown mentions early on that he is thinking about risk differently than the standard model, where risk is a cost, and return a benefit. He never really boils it down to something concrete, but rather over the course of the book tries to argue about his view of risk that is qualitatively different. It's kind of like trying to present the meaning of life, not with an aphorism, but rather a bunch of examples. On one hand, this can get you closer to the truth, on the other hand readers can come away confused.

As any professional realizes, however, the gestalt nature of 'risk' limned in this book is the way risk feels to most people--something important and hard to pin down, like meaning and justice--and so Brown's experience is illuminating and should save people a lot of time rediscovering these insights themselves (better to learn via a book than trial-and-error). I'm very sympathetic to the idea that standard risk models are misleading.

Brown's book is very opinionated and has the feel of a smart guy looking at lots of real situations. I think for big ideas, such as risk, meaning, and justice, it's good to have strong beliefs weakly held. That is, you only learn in these ambiguous domains by taking stands, trying to defend them, learning from the process and adjusting your prior prejudices.

It's a cliche to say risk management is the combination of art and science. You need to know something about history, statistics, and programming to be useful as a risk manager. You also need common sense, and that is best informed by experience, which is greatly abetted by reading insider memoirs like this.

Private Sector Incentives

2011-12-07T19:33:00.010-06:00

A Northwestern grad student (just like I used to be) blogs on academic papers over at A Fine Theorem, and I was struck by this snippet:

The benefit of capitalism can’t have much to do with profit incentives per se, since (almost) every employee of a modern firm is a not an owner, and hence is incentivized to work hard only by her labor contract. A government agency could conceivably use precisely the same set of contracts and get precisely the same outcome as the private firm (the principle-agent problem is identical in the two cases).

This is wrong. I've worked in small and large firms, and in either case, being part of any initiative that makes money increases your pay and stature rather clearly. Now, the bigger the firm, the more people involved in any initiative, and the more people will exaggerate their involvement with successful projects and downplay their involvement in losers. But the bottom line is the bottom line, and the best way to get your boss to appreciate you more is to help him make more money for the firm. The scope of your command is rarely specified in detail, though increases in scope are the most obvious ways of increasing your power when the 'contract' comes up for renegotiation: work is a repeated game. The government principle has a very different objective function than the private firm principle, the former with a diverse set of stakeholders to satisfy, often with vague and inconsistent objectives, the latter to simply make more profits.

It's true that some people, especially those in over their heads, who are overpaid, dislike productive and smart direct reports because they sense their boss will recognize an attractive replacement. Yet even here the incentive clearly exists for this bad boss to be replaced by his boss, because his boss is not optimizing this position in that case (and watching the bad bosses employees leave when they recognize this is a really good signal that their boss is not a good one). It's also true that salaried employees like cashiers and secretaries may not be proactive about increasing their stature within the firm and simply follow orders, but their bosses recognize this and so are less likely to increase their responsibility.Every ambitious worker tries to make more with less all the time, because they can quantify this, which is the best way to go into an annual performance review. Just because you do not have shares in the firm does not mean you aren't highly incented to make money for shareholders, because the shareholder desire for more profits truly trickles down.

If this kid doesn't appreciate this, he's missing a big part of what makes private organizations work as they do. The nice thing is that it isn't a really fragile result like some of these theoretical models based on the types of agents and some envelope theorem. Common sense tells you the more you appear to be creating profits, the better your future will be in the firm and the industry, and the best way to appear to create profits is to actually do so. Economics, as Tom Sargent notes, is 'organized common sense.' Unfortunately, while you can formalize and thus teach models, you can't formalize and teach common sense, which is why game theory is so ambiguous on these important matters.

Investing Rule

2011-12-05T10:46:00.009-06:00

I was on the Chicago Tribune website, and the top banner ad contained the following picture links to a site promoting penny stocks. The link went to a site with those annoying pop-up ads that are difficult to destroy. I think a good investing rule, or at least guideline, is to not buy stocks promoted at websites with half-naked women. Another might be to avoid investments that present +1000% returns as examples (see here or here), which are often common on these sites. As mentioned, average penny stock returns are pretty dismal, the ultimate lottery stocks.

Business Cycles and Barrier Options

2011-12-04T10:50:00.010-06:00

I was at an NBER conference in early 2008 when we really didn’t know if we were in a recession, and Markus Brunnermeier explained to a group of esteemed economists that while the housing collapse was real, it represented only a couple hundred billion dollars, and by then the stock market seemed to have lost three times that, which seemed an overreaction, a sign of excessive volatility due to behavioral biases. This was not a contrary stance, rather, the conventional expert opinion. This turned out to be the tip of the iceberg, but the fundamental anomaly just continued. From a destruction in value of a couple trillion dollars in home values ultimately, the global economy lost around 60-80 trillion in value. No one knows how such small losses amplify in size and scope to create economy-wide downturns, because we have no good theory for it.

Banking expert Gary Gorton noted the strange metastasis of economic downturns:

But, when the crisis came, there was no distinction between pre‐ and post‐2006 vintages. Everything went down in value, including bonds linked to the earlier subprime vintages! Moreover, bonds completely unrelated to subprime risk, like triple‐A bonds linked to credit card receivables, auto loans – everything went down in value! [Hedge fund maven John] Paulson was right in targeting subprime, and he got the timing right. But, like everyone else, he got the magnitude of the crisis wrong. The tidal wave was much, much bigger than anyone expected.

That is, in the crisis everything lost more value than anticipated, the amplification or accelerator mechanism was underappreciated. Savvy investors may have seen the housing debacle, but no one thought this would generalize this to autos, commercial real estate, everything, even though these market prices fell as well. This error was not because they were stupid, but rather we do not have any good model for how this works.

Here is my theory on business cycles. First, the impulse of the downturn I presented in my post on Batesian Mimicry. One could also count explicit tight interest rates as a cause, in that both would adversely affect banks. Here's my new idea, how a small loss transmogrifies into an economy-wide collapse:

Merton first created an option model to describe the value of a stock, which is really a call option on the assets of a firm. A firm’s debt is its 'strike price.' That is, owners of stock get all the upside, but if the firm loses all its value, the owners lose only their equity, the rest of the loss is born by debtowners. The average stock is levered 50%, so in general, stocks are options on the value of the firm. When I was at Moody's we were active in modeling public firm default rates using the Merton approach, where using the value of the stock (aka the 'call option'), the value of the debt (the strike price), and the volatility of the stock, you can back out an estimate the probability of default.

Interestingly, recovery values on defaulted debt tend to be well below the amount of total debt, about 50% on average. That is, if lenders could seize assets immediately, once the asset value of the firm hit the value of the debt, the lenders would take over with minimal loss of principal. In practice debt holders are able to sieze the firm only after the firm’s value is well below its strike price.

This implies there is an 'absorbing barrier'. The absorbing barrier on companies is that firm value where debt owners force the firm into bankruptcy. A company can live forever, but at some point debtholders stop the clock, declare 'game over', and cut their losses. Thus stocks are not just call options, but barrier call options (specifically, down-and-out calls). Good models of down-and-out-options weren’t available prior to the late 1990’s (see Haug and Zheng).

Vega is the change in option value given a change in volatility. Positive vega means the option value increases with an increase in volatility, and regular puts and calls always have positive vega: more volatility increases their value. For a regular option vega is always positive, peaking at the strike price (when it is at-the-money). To make this clear, consider the bank owners (ie, equity owners), are managing the option value, and so the vega corresponds to its directive to take more risk.

Now, when banks are suffering due to some exogenous shock created by batesian mimicry, the depositors become worried. Their liabilities are generally shorter than their liabilities, where depositors have an option to call them back at any time. A bank run is statistically unlikely in normal times, but if people think the bank may be insolvent (ie, assets less than liabilities), they will rush to take out their deposits prior to anyone else, creating a self-fullfilling prophesy, so that the effective absorbing after a big decline in some parochial sector leads investors to wonder if their bank was overexposed to this sector. Quarterly balance sheets do not indicate the region, industry, and seniority, and underwriting behind, various assets, so when investors see a conspicuous asset decline they are rationally wary, as invariably some lenders will have been too concentrated in the affected sector. Thus, depositors become skittish, raising the barrier of a firm, because if depositors so much as smell a risk, they will create a run, killing the firm (eg, Bear Stearns).

Yet when the barrier rises, the vega changes considerably.

The vega becomes negative when the barrier rises because now if a bank loses value, its option premium, its equity value, is extinguished. Previously the equity lived on, and volatility was unambiguously a good thing, but with the barrier threatening its existence, the game changes entirely. Here, the value of the option becomes zero forever at 90, so the vega is zero there and below. Another way vega can switch signs is if the barrier is a certain level, and the asset value falls below a certain level, vega becomes negative. See below for how the vega changes as the asset value (ie, L+A) falls, for a special barrier value.

This vega switching is the unappreciated key to the transmission mechanism. To repeat: barrier call options, where there is a down-and-out option, switch to negative vega as the barrier rises, or for specific barrier levels when the asset value falls. This is unlike regular call options where the vega is always positive.

It also creates a positive feedback loop, because if banks are in this negative vega regime, they are not incented to buy any risky asset such as a failing bank. This means banks aren't able to buy other banks, effectively raising their absorbing barriers because no one is their to salvage their (non-barrier) option value. Regulators pile on, becoming more insistent on enforcing regulatory standards in order to safeguard banks, again creating a more tangible barrier above the strike (debt) price.

In a negative vega regime, banks add value by reducing risk, not increasing it. They all flee to safe assets, trying to replace risky assets with less risky ones, and avoiding the absorbing barrier. In bad times, banks have negative vega, they don't want more risky assets, and a failing bank adds a lot of risk (especially legal, as Bank of America is finding with their purchase of CountryWide).

A shock to banks causes creates a negative vega, which causes them to cut risk by cutting new lending and instead buying Treasuries (which causes interest rates to fall). This negative vega creation could be due to barriers increasing due to potential bank runs, or from vega becoming negative as the asset value falls (which holds for certain barrier levels). That may seem like a lot of steps, but consider the Krebs cycle has 8 steps, and it's ubiquitous and natural.

The implication is that the key to business cycles is pushing banks back into their positive vega position, so they again have an incentive to make risky loans. Currently there are several outstanding class-action suits, and a suit by the Department of Justice, that could wipe the banks out. Many liberal economists are indignant that government money was used to rescue the banking sector, and suggest that banks be forced to write down all their underwater mortgages as a payback to the public. Thus, even though profitability is rather high, bank asset values are still very low because they discount this possibility, and so depositors are wary, keeping banks in the negative vega region.

In contrast, the tech bubble of 2001 had fairly limited affect on banks because most of the value destruction was in the equity, private capital. Thus banks were quickly back in the positive vega zone and the recession was pretty small. In contrast, bank stocks today are still well below prior highs. Below is a graph of the drawdown from the prior peak for the bank stock index, as generated via Ken French's data. The past peak is a high water mark, so it tops out at zero, but in recessions falls (IndexValue/Max(prior Index values)-1). The current drawdown is comparable to that in the great Depression, and notice it is still at historic lows (data is through October 2011).

This is why need strong banks, 'rich banks', as my old mentor Hyman Minsky used to say. Without them financing collapses, and the economy stagnates. Only banks, with their many professionals evaluating idiosyncratic criteria with the sole objective of making money, can create the investment needed for economic growth. One can generalize ‘banks’ to any lender, which faces similar incentives and constraints. The best thing to do would be to stop threatening bank solvency with unlimited liability. All this focus on government stimulus and zero interest rates while simultaneously trying to punish banks for the past recession, is guaranteed failure because we need banks back in positive vega mode.

Bloggingheads to Downsize

2011-11-30T18:46:00.005-06:00

Robert Wright announced today that he is scaling down his Bloggingheads.tv site, in part because as a business it clearly has no potential to make money. The basic problem, he found, was that his site tried to have people on both sides talk about issues, as opposed to what is much more popular, having people who agree with each other talk to each other (MSNBC, CNN, Fox):

Too bad, because I'm a big fan. It's rational to listen more to people you agree with because you think what they saying is more correct than others, so I don't find this a bad faith equilibrium. But on the other side, I do like listening to those I disagree with more on the radio drive time because invariably the host, and especially the callers, will come up with a horrible argument for their side. I much more enjoy listening to this when my intellectual adversaries are speaking than when someone says something stupid as an argument for something I agree with. That is, many (most?) people I agree with on taxes, abortion, affirmative action, war, etc., agree with me for reasons I don't think are correct or relevant.

Unsophisticated Investors Circa 2005

2011-11-29T20:13:00.002-06:00

From the LA Times back in 2005:

"If you paid your mortgage off, it means you probably did not manage your funds efficiently over the years," said David Lereah, chief economist of the National Association of Realtors and author of "Are You Missing the Real Estate Boom?" "It's as if you had 500,000 dollar bills stuffed in your mattress."

He called it "very unsophisticated."

Anthony Hsieh, chief executive of LendingTree Loans, an Internet-based mortgage company, used a more disparaging term. "If you own your own home free and clear, people will often refer to you as a fool. All that money sitting there, doing nothing."

The financial services industry is doing all it can to avoid letting consumers be foolish. Ditech.com touts home loans as a way to pay off credit cards, and Morgan Stanley says they're a good way to fund education expenses. Wells Fargo suggests taking a chunk out of your house to finance "a dream wedding."

Nothing like spending your market value capital gains on fancy weddings. When people say that we should return to common sense, the problem is, how do we know what that is? (presumably this is code-speak for everyone should now agree with my hindsight diagnosis and cure).

Nationalize the Fed!

2011-11-28T17:44:00.010-06:00

Paul Krugman's wife, Robin Wells, came out with a piece arguing Occupy Wall Street's issues are something economists should address. I wonder whether she thinks biologists should all teach about creationism because so many students believe in some sort of transcendental spark to life. Probably not. I do think there should be classes on free markets vs. Keynesian debates led by different professors, because it's not like this issue isn't always there, but I don't think OWS has made this any more pressing.

That is, in graduate school we never had any formal presentations by professors as to why Keynesians/Supply Siders are right, even though eventually this is the question everyone wants to know from macroeconomists. It was as if they thought they could be above such practical questions, and focus like Tom Sargent on technical issues. This is naive, avoiding the elephant in the room. Such debates or presentations wouldn't generate nice problem sets, and they would often be talking past each other, but it would be good to get this in front of the 24 year-olds so they don't have to figure it out themselves reading between the lines. Further, it would highlight to the presenters what kinds of questions they need to answer, what sort of arguments are most compelling, to thoughtful young people who at that point just want to pick a side they think is winning.

I find the Occupy Wall Street movement profoundly pre-adolescent, like when my 4 year old daughter throws a tantrum with inconsistent or impossible demands (indeed, Miley Cyrus has a video supporting them). For example, they generally are proud of not having explicit objectives, being grass-roots and all, and so fundamentally do not understand that decisions will never, can never, reflect everyone's preferences. Some souls did create a wiki of beliefs, that are the best we can address of this movement, which includes things like 'balance' and 'protecting human rights' . It's easy to want such things, and such rights were in the Soviet Union's 1936 Constitution just after committing genocide against the Ukrainians and right before finishing off the remaining Kulaks (alas rights conflict, and you always have priorities). They act as if Rousseau's social will exists, that everyone shares some trans-human soul with a preference towards drum circles and organic legumes.

I got a kick out of these items from the OWS set of demands:

Transitioning the IMF and World Bank into transparent, publically owned and operated entities

Ending the Federal Reserve Bank and replacing it with an accountable, decentralized, transparent and publically owned financial system

These institutions were created by democratic governments, populated primarily by those on the left (my friends who went this route were all conventional Liberals). That they are considered insufficiently transparent and unaccountable highlights that reality never creates the social vision they seek, which is some sort of transparent consensus on matters of incredible technicality. You see the same thing with Noam Chomsky, were socialism always is to be encouraged, but any time it happens, as in the Soviet Union, the Eastern Bloc, or Cambodia, these aren't considered 'true' socialist countries (if only Trotsky won!). Their naive beliefs do not work because they aren't feasible, and so too the idea that large banks can be some big cookie jar for agreed-upon investments as opposed to being administered by professionals.

Overconfidence vs. Optimism

2011-11-27T19:28:00.003-06:00

In 1971 Robert L. Trivers gave us the idea of reciprocal altruism, the idea that helping someone else although incurring some cost for this act, could have evolved since it increases the chance that such niceness might be returned some day. This really expanded the conception of self-interest to be semantically indistinguishable from altruism in many cases. Biologists have observed this behavior in bats, where they share blood harvested, but only with those who share with them.

Trivers has some great anecdotes in his new book The Folly of Fools: The Logic of Deceit and Self-Deception in Human Life. In one, people's pictures are distorted to make people better and worse looking than they really are, using data on what 'good looking faces' look like. Looking at fMRI data, we actually recognize ourselves in pictures faster when we are about 20% better looking than we really are (they had models that generated statistically validated better and worse refinements to pictures). In other words, we really think we look better than we actually do.

In another study, children were told not to look in a box that contained intriguing toys while a researcher left them alone. Most of the children did look, of course, and most lied about it. Interestingly, the higher the IQ of the child, the more often they lied.

In this TED video, Trivers argues that we continually paint a distorted picture of the world so that we might more easily get our way with others. This involves constantly inflating our acheivements and abilities, and playing down our failings and rationalizing our mistakes. You are a better liar to others if you first lie to yourself. Lying to others and ourselves is evolutionarily selected for the same way that pale skin is selected for in northern latitudes. [The video is better than the book. He has many riffs on his Chomskian view of the world. I don't mind so much, remembering that Isaac Newton was a grade-A looney]

This is important for asset pricing because highly risky assets within any asset class often have lower-than-average returns, and Edward Miller (1977), Diether, Malloy and Scherbina (2002), and Baker, Bradley and Wurgler (2011) argue that overconfidence--and short sale constraints--lead to poor return for highly volatile stocks. We know people are overconfident, where most of us think we are better drivers, leaders, etc., and one prominent mechanism is that the higher the volatility of the stocks, the greater the disagreement, the more these miscalibrated optimists overbuy, which pushes down stock returns. Thus, understanding why people are overconfident is important.

Overconfidence is puzzling in many dimensions of our lives, not just financial. Intellectually, it lacks the knowledge and honesty that comes with wisdom, where one recognizes we are neither as good as our mothers think, nor as bad as our enemies think. Thus, I've always been a little perplexed by the idea that people find confidence so sexually attractive. Confidence is something I was lacking as a young man, and generally I would need several beers to initiate various courting rituals. While I understood that confidence was sexy, something I wanted to be, I couldn't fake it because I couldn't understand why something was both ignorant and desirable.

Looking back, I had it all wrong, but it my defense, it flustered good people like Woody Allen and Allen Brooks too. Girls don't like overconfident boys merely because they miscalibrated. The key is the nature of one's overconfidence. People who are confident about the future continue trying, even when it's hard. They assume the good faith of others, which makes for good first impressions. People like optimists because they tend to be less defensive, less easy to offend, and so easier to be around. Optimism is related to positive reframing and a tendency to accept the situation's reality, because optimists see the silver lining to problems. Optimists are copers, and pessimists defeatists. It is not confidence in specifics, but in the future, their future, that makes people attractive, and this is a rational disposition. A confident person need not be miscalibrated, though they often are, but rather, their confidence is really simple optimistism about their life in general.

Thus, our instinct to be overconfident is a salutary disposition, suitably framed. We should see the future brightly because if we simply do the best we can things will work out as well as they can. To the extent things are out of our control and work against us, it doesn't help us to worry about such matters. Insecurity on the other hand leads to pettiness, which is why we find such characteristics so unappealing (eg, insecurity led Anakin Skywalker to The Dark Side, and presumably more genocides than 100 Hitlers--he blew up an entire planet to make an example!). Like any virtues optimism and confidence are useful only in thoughtful moderation, in the right context.

Eurozone Causing Greek AIDS

2011-11-23T09:06:00.011-06:00

A Greek economist notes that some Greeks are intentionally infecting themselves with HIV to qualify for benefits, the result of the Greek austerity forced on it by those nasty surplus countries currently funding their deficits. He mentions this, he says, to make dry statistics more real, to convey the true picture of what is going on in Greece. And another reason why anecdotes are usually tendentious crap. Here he is on Bloggingheads.tv:

Greece can either 1) leave the Euro and inflate their way out of their internal obligations, 2) stop running a deficit or 3) do what their lenders say to get their money. If they righteously declare the terms on the charity they demand, they shouldn't get all emo when it doesn't work and start cutting themselves in various ways.

Characteristics vs. Factors

2011-11-22T17:26:00.003-06:00

the Low Volatility ETF LVOL, put out by Russell-Axioma, tries to capture the low volatility goodness via a circuitous route. First, it takes into account beta, and momentum in some unspecified way, which makes it a really hard thing to nail down. What most amused me, was that it calculates the return to the lowest volatility third of the Russel1000 index. It then selects a portfolio of about 100 stocks that track this index. The idea is that you find the target portfolio, and then, instead of using that portfolio, you use stocks correlated with it.

Downloading their current holdings, the equal weighted beta is 0.91--low, but not by much. The average 90-day volatility of their holdings is 39%. In contrast, the SPLV low volatility ETF simply takes the 100 stocks from the S&P500 with the lowest volatility over the past 12 months. It has an average beta of 0.6, and an average volatility of 28%. The Russel 1000 itself has a 90-day of vol of 50%, and a beta slightly above 1. In short the SPLV ETF delivers 'low vol' more simply, and more efficiently, by focusing on the characteristic, not the factor.

The idea that there exist risk premiums based on covariances with unidentified stochastic discount factors that are like the S&P500 return, but orthogonal to it, will be in the trash heap of bad ideas. As no one can articulate what such a factor might be, it seems absurd that millions of people are implicitly valuing companies, currencies, and futures this way. But a more tangible problem created by this theory is thinking that to get a certain return stream you should target the asset with the requisite factor mimicking beta, as LVOL has done.

Daniel and Titman documented that it was the characteristic, rather than the factor, that generated the value and size effects. They did an ingenious study in that they took all the small stocks, and then separated them into those stocks that were correlated with the statistical size factor Fama and French constructed, and those that weren’t. That is, of all the small stocks, some were merely small, and weren’t correlated with the size factor of Fama-French, and the same is true for some high book-to-market stocks.

Remember, in risk it is only the covariance of a stock to some factor that counts. Daniel and Titman found that the pure characteristic of being small, or having a high book-to-market ratio, was sufficient to generate the return anomaly, independent of their loading on the factor proxy. In the APT or SDF, the covariance in the return with something is what makes it risky. In practice, it is the mere characteristic that generates the return lift.

Davis, Fama and French shot back that their approach did work better on the early, smaller sample, and more survivorship biased 1933-to-1960 period, but that implies at best that size and value seem the essence of characteristics, not factors, over the more recent and better documented 1963-to-2000 period. Data in favor of Daniel and Titman's characteristics approach was found in France by Souad Ajili, and in Japan by Daniel, Titman and Wei.

In a similar vein, Todd Houge and Tim Loughran (2006) find mutual funds with the highest loadings on the value factor reported no return premium over the same 1975-to-2002 period, even though the value factor generated a 6.2 percent average annual return over the same period. Loading on the factor, per se, did not generate a return premium.

The standard equity groupings of size, value/growth, and now volatility, are best done directly, and not via an exposure to factor-mimicking portfolios.

Facebook Followers Correlated with Stock Price

2011-11-21T19:03:00.007-06:00

A recent paper by Aurthur J. O'Connor and Famecount looked at 30 top brands from June 2010 through June 2011, and found that number of Facebook fans was correlated with the stock price. Looking at the charts below, I can see how it's pretty significant. You can't see these graphs very well, but the vertical axes are price, the horizontal are Facebook fans.

In my 1994 dissertation I found that if I counted up stories in Nexus, these stories counts explained the relative ownership percentage of mutual funds in regressions that included price, size, and volatility. That is, in the context of these other variables, stocks more frequently in the new tended to have larger mutual fund ownership. One could imagine fund being both more aware of these companies, and having an easier time explaining their ownership in these companies.

Contemporaneous correlations are one thing, predictions another. Stocks with higher volatility generate more news than less volatile firms. Such stocks are then ‘in play’, and so become relevant to the investor interested in deviating from the index. Further, they create a default value, in that once everyone seemed to have internet stock in their portfolio, or some exposure to residential real estate, it seemed prudent to also have some, especially if one were indifferent. Given short constraints and overconfidence, this increased focus on volatile stocks leads to lower future returns. I imagine this might be interesting to look at whether this is more useful as a short-term momentum indicator, or a longer-term mean-reverting signal. The trick for the longer term predictability, is that you need a survivorship bias free data set with historical data going back several years, so I doubt that Facebook or Twitter have enough data to test anything with a horizon greater than 1-week.

Are High Beta Stocks Like Call Options?

2011-11-20T12:07:00.009-06:00

Dave Cowan and Sam Wildeman at GMO have a new paper, Re-thinking Risk (check here or here if that doesn't work), that makes the argument that the poor performance of high beta stocks makes perfect sense. Their idea is that high beta stocks actually are leverage with a put option, because unlike a levered fund where you can lose 2 times your investment (200%), a beta=2 portfolio can only lose 100%. In their words:

The point here is that the form of leverage offered by high beta is different in an important way from explicit borrowing. Investors should prefer this kind of leverage, and, in an efficiently priced market, they will accept a lower return for it. As we will show, the performance of high beta is not a product of excessive demand, but rather a reasonable and rational consequence of the fact that it provides a convex payoff to the market.

Their analysis highlight the fact that 'risk' has two meanings. One is the risk people intuit, the other the technical metric in financial theory that generates a return premium. The risk that generates a risk premium is solely a function of expected covariance with some risk factor. Convexity just means the average expected risk in the future is nonlinear, but there's still a simple linear function of this expected covariance that should relate to the expected return. Convex payouts in options may seem less risky, and indeed are often sold via the pitch that they have 'limited downside.' If losing 100% is risk reduction for you, your broker probably has you on speed dial.

The key insight in Black-Scholes-Merton wasn't the basic formulation, which was well-known at that time among practitioners like Edward Thorpe, it was rather that one should use the 'risk free rate' to discount future payoffs. This was surprising, and though it was proved later much more simply by Cox and Rubinstein in their binomial pricing model, they figured it out first and deserve their accolades.

Convexity generates option value only because of its effect on expected values, not because of a 'risk premium' in the technical sense. That is, the 'option premium' above the 'intrinsic value' is purely a risk neutral expected value. The convexity in payoffs should show up in the expected returns, which should show in average returns over a large enough sample. As the authors note, high beta stocks under perform historically in the US and internationally, so it is implausible to say this is simple a 'peso problem' of having a small sample.

If a high beta stock is really like a portfolio with leverage plus a put option, the expected return is still a function of its expected beta. This is shown rather nicely by Joshua Coval and Tyler Shumway in their paper 'Expected Option Returns.'

Nevertheless, while it is true that Beta=2 equities can lose only 100% unlike being levered 2 times where you can lose 200%, in practice this convexity is quite small. Above is their empirical estimation of the convexity in high beta equities. While there is a little convexity, it is quite small, not significantly different than zero (ie, it's pretty linear). It's implausible to think this minor amount of curvature is practically important.

The authors then point out that betas for high-beta equities have lower betas in down markets than in up moves. True enough, but this highlights having a good conditional beta forecast that recognizes this. By now everyone should know that in highly volatile times like 2008, stocks tend to decline and correlations increase, compressing the cross-section of beta (lowering high betas and increasing low betas). In practice, you want a bayesian adjustment or shrinkage parameter to your beta estimation that recognizes this (more shrinkage in bull or declining volatility estimation periods).

In sum, I think the authors are confusing the intuitive risk with priced risk. The low return to high beta stocks is still a puzzle to standard theory because these stock returns include the convex payout, and this should show up in the average returns of stocks that implicitly include them. Not only is the convexity slight, high beta equities have lower than average returns historically.

Why Movie Reviewers Turn Into Op-Ed Writers

2011-11-18T17:40:00.004-06:00

I was reading Joe Morganstern's review of George Clooney's latest movie, and was struck by this line:

Mr. Clooney is a star at the peak of his powers, playing the sort of person we're seldom privileged to meet—a whole man, which is to say a flawed and foolish man who is basically good, and who gets a precious shot at being better.

There's a lot of profundity in that little snippet. I've notice several big think commentators today started or do movie reviews (Steve Sailer, Frank Rich, John Podhoretz, Michael Medved). The ability to articulately critique pop-fiction is deceptively deep, I guess.

Have US Federal Revenues Hit Their Laffer Curve Limit?

2011-11-16T13:31:00.018-06:00

I was listening to Jeffrey Hummel's recent talk (see here, scroll down to his picture). He argues the US federal default is inevitable, using the following reasoning.

Federal Tax revenues as a percent of GDP have consisntently been bumping up about 20% since 1951. Even in WW2, when federal taxes were highest as a percent of GDP, tax revenues never broke 25% of GDP.

Meanwhile, top marginal tax rates, corporate rates, and capital gains tax rates have basically declined, though bouncing about quite a bit.

This suggests the 20% barrier is some kind of structural barrier in the system: people adjust their effort and tax avoidance to generate basically the same percentage of GDP over a variety of tax rates.

Here are the projected Federal expenditures from the Congressional Budget Office

Thus, the projected 30% of GDP spending in the pipeline seems impossible to finance. While conceivably we could cut our spending, its likely this will only be cut when deficits are curtailed via an explicit or implicit default.

On the brighter side, it took Rome a good 200 years to totally implode after their peak, and there's the example of Argentina, which while not as relatively prosperous as it was 100 years ago, isn't a horrible place to live.

Gary Gorton on Hedge Fund Dilemma

2011-11-15T16:10:00.007-06:00

I found this little aside in Gary Gorton's 2010 Journal of Economic Literature review of 2008 financial crisis books--The Big Short and The Greatest Trade Ever--pretty funny:

Some of the most interesting material in the books concerns how hedge funds operate. Opening a hedge fund is problematic. The founder has a secret. Either the secret is that the founder has no new ideas. Or, the founder’s secret is a new idea. If the founder has no new idea, that cannot be revealed. If the founder has an original idea, he also can’t share it with investors because they might steal it. “Competitors might figure out the trade for themselves and buy the same insurance, driving up the cost. That made Paulson reluctant to provide details of his trade. It was a stance that made it more difficult to raise money” (Zuckerman, p. 127‐8). Indeed, Paulson’s friend Jeffrey Greene does steal the idea. Michael Burry has the same problem: “If I describe it enough it sounds compelling, and people think they can do it for themselves. . . If I don’t describe it enough, it sounds scary and binary and I can’t raise the capital” (Lewis, p. 58).

By the time I had capital to set up a low-vol strategy fund myself I was soon in litigation that exhausted my capital, but when I didn't have capital and was trying to convince others, a common reply was, 'why isn't everyone else doing it?' Now the problem is everyone is doing it (low vol investing).

A take away is that hedge funds are all fundamentally opaque. Another is that you can't start a hedge fund unless you or a very close associate, has at least a million or two to invest.

How to Spot Overfitting

2011-11-14T19:24:00.003-06:00

FRBSF Economic Letter: Probability of a Recession vs. Actual Recession Dates

You can teach statistics, but unfortunately, you can't teach people not to overfit data. The problem is that it is too tempting to look at some data, keep applying different inputs and functional forms, until you fit the data. In some sense, that's what a good model does, so the objective, maximizing the R2, is encouraged.

But there's no point fooling yourself, it just wastes time, and only the researcher really knows if they overfit the problem, because outsiders don't know how the ultimate functional form was chosen (iterating over a large set of inputs?). Macro forecasting is especially difficult, and anyone familiar with its history would do well to be modest (see here). The above graph from some San Francisco Fed researchers is clearly overfit because the base recession rate is about 16% since 1945, so the average forecast should be around 16%, not jumping from 0 to 100%. A forecast should cluster around the unconditional expectation, not the extremes. Only with hindsight do these kind of forecasts make sense.

Margin Call the Movie

2011-11-13T20:51:00.008-06:00

Margin Call was an excellent movie, in terms of its direction and acting. The nightime scenes were emphatically in the darkness of night, even though every time I've worked after dark, we simply turned on all the lights (for some reason they would have meeting in the dark with ominous screens lit around them). Life isn't as simple and clear as in movies, which is why I like them when they are good.

But, the key was in creating an event that provokes a crisis, one that engenders all sorts of soul searching, backstabbing, pain, and ultimately resurrection. The event in this case was that the fired risk manager, the always awesome Stanley Tucci, highlights that the value-at-risk is greater than the value of the firm. Now, they don't say what horizon this VAR was for, but that doesn't really matter. The key is, everyone supposedly knows 1) the value of their portfolio and 2) stress-test and value-at-risk numbers for that portfolio. Presumably, as best as I could make out, the really shocking VAR used current 'volatilities' as opposed to stale historical ones, which given the VIX was at 15 for a long time, then peaked at 80, could have been an issue.

Since when was a parameter like 'volatility' not presented with the results? In my experience, management isn't well versed on VAR details, but they are good on what makes a relevant stress test or assumed volatility, so I can't imagine this being as important as the movie implied (ie, they all got together for a 4 AM meeting and decided to cover their exposure the next day). The idea that someone updated VARs for current volatilities, and discovered their portfolios were too risky and had to be exited immediately, is pure Hollywood.

The risk, presumably, was merely from their pipeline of assets that they held in the process of creating various derivatives. If that was their total risk, they had an incredibly high leverage.

But, that's all sniping. I thought it was a pretty good movie. The problem is that if you discovered that mortgages were overpriced in 2008 by 20%, that wouldn't imply the amount of panic showed in the movie. You would have weeks, if not months, to exit positions, not the 'day' the movie used. Big mistakes like that are systematic errors that are not going to change overnight. Even Enron's stock took months to fall, so it's never the case you have to sell your entire portfolio of an asset overnight, especially for something correlated with so many highly liquid alternative assets.

dos Santos's Knock Out

2011-11-13T16:11:00.009-06:00

I'm a big fan of Mixed Martial Arts, and take classes where I punch pads and bags, which is very cathartic. I would never actually spar with someone, taking punches to the head, however, because I don't think the brain takes such punishment well. In last Saturday's prime time UFC battle, two heavyweights were involved, and only 60 seconds into t he fight Brazilian Junior dos Santos connected right behind Velasquez's left ear (see above). It didn't look like much, but this part of the brain controls your motion, and it clearly disrupted those circuits.

As Velasquez explained after the fight, he 'saw everything but his body wasn't reacting.' Thus, he was fully conscious but momentarily defenseless (not defending yourself is cause for stoppage). Most knockouts involve some momentary loss of consciousnesses, often when the head twists from a punch to the chin or jaw, so this was rather interesting.

MMA is less dangerous than boxing because in boxing concussed boxers are basically kept vertical via standing 8 counts and the nature of boxing where it isn't nearly as easy to finish someone; the result is a lot more brain punishment. In MMA a woozy fighter can dispatched many ways, often by tackling him and then applying a rear-naked choke that is pretty benign (not that I would want my sons doing this).

Mailer on Marx

2011-11-10T20:53:00.012-06:00

Norman Mailer was a famous American writer who died in 2007, who wrote with great forcefulness. People can still have interesting things to say (or in Mailer's case, say them in an interesting way), yet still be moon-bat crazy in many areas of their lives. So, listening to this video on Youtube, I was taken by this passage:

Marx's Das Kapital is utter bullcrap, and makes Joseph Smith's Book of Mormon seem like Euclid's Elements. It was before the marginalist revolution, so did not understand 'value', instead thinking all value came from labor. To note how stupid this is, think about someone spending 10 hours writing a paper--does this make it worth '10 hours' worth of 'steel'? Depends on what came out, and probably its worth is inversely correlated with the time spent on it. You can see a nice summary of its irrelevancy by going to the Wikipedia on volumes 1, 2 and 3, and note that the economic arguments are not even used by Marxist economists today (falling rate of profit? recessions becoming wider every time? Surplus value?).

They say sure, he got the details wrong, but he had great vision. Most of the book was very specific, and those little examples and arguments were all wrong. I guess by some cosmic analytic karma, if all your particulars are wrong the theme must be really profound. Literary types have always like it because it gives a scientific pretense to their statist and egalitarian instincts (based on hope alone, as all socialist enterprises turn out to labeled 'state capitalism' or some other oxymoron). Yet I like it when people like Mailer make such points, because it lays clear how hollow their base assumptions are, because it is simply impossible to 'think more clearly' after reading such a book.

What Happened to Momentum?

2011-11-09T17:17:00.011-06:00

The total return to Momentum was impressive for many decades. It's a simple strategy, basically going long past winners and short the losers, hoping they continue to win and lose. Interestingly, the past returns should go only up to the prior month, because there's slight mean-reversion at the one-month horizon, so most people use the returns from months t-12 through t-1. This highlights the non-fractal nature of stock returns, in that there's momentum in the data from 3-18 months, but mean-reversion at the shorter and longer frequencies.

Even after discovered by Jegadeesh and Titman in 1992, it seemed to work for another 8 years. Since 2000, however, it hasn't worked (see a decent paper on that here). Using Ken French's replication of this strategy, we see the total return pattern above. Note that while from 1932 through 1943 it stagnated, it seemed Madoff-like in its ascendance from the end of WW2 through 2000.

The big drawdowns in the momentum strategy occurred in the big stock rebounds of July-Aug 1932, and March-Sep 2009. These moves would generate losses of over 50%, which since it generated an 8% annual return, this would probably eliminate any particular portfolio manager--such losses are usually lethal.

Now, these long-term simulations tend to have a bunch of survivorship problem issues, and data prior to 1964 is to be taken with a grain of salt (the database was created then, so its much harder to correct errors when you don't remember how you collected data in real-time). Interestingly, while momentum is considered a real factor by some (eg, the Carhart 4-factor model is the Fama-French 3-factor model plus momentum), Fama has been conspicuously avoided treating momentum as a risk factor, nor trying to explain in theoretically in any way, and just looked at it quizzically. That was rather refreshing, in that it's tempting when you have the status he does to explain everything in your field, but instead he just shrugged.

Above are the December returns. These actually made sense because there was a real story here. The idea was that winners had taxable gains, and so not selling them until January would push off a liability; losers had losses that selling prior to January would lower one's taxes. Thus winners have this absence of selling, losers a greater amount of selling. Alas, since 2003, this pattern too has disappeared. In fact, I actually put the trade in December 2003 based on looking at this data, and got crushed. It was the worst return by far relative to my sample of 25 years that used a different universe than French but was basically the same pattern. I actually emailed Ken French at that time to ask if he had any insight, and he merely emailed back: 'it's risky.' My boss didn't think that was a good answer.

I think this highlights an important point. At any point in time your strategy is susceptible to a draw down that could cost you your client base. You can't just say 'hey, that's risk!' Investors see it as a failure, not a bad draw from the urn of chance. Returns over time are treated very differently than cross-sectional returns because cross sectional returns have covariances and volatilities amenable to statistical optimization; time-series returns are looked at more like datum in a broader strategy of eliminating all the 'losers' at any point in time. If you are in the bottom 10% at any time for any reason, your portfolio probably has hit an 'absorbing barrier.'

Aspiring Politicians Learn to Dissemble

2011-11-08T07:42:00.011-06:00

Hayek' Road to Serfdom argued that a major problem with socialism was that it encouraged the most ruthless and illiberal to rise to the top. As they find their plans untenable, they will be forced to apply force to achieve their aims, so those willing to apply such force will tend to be most successful in such systems. A problem with modern politics is that as only dissembling narcissists can succeed, politicians at all levels become such pathetic losers.

Recently my school board voted for busing to rectify the achievement gap that results from the new Somali immigrants who cluster at certain schools. This has made certain elementary schools have lower scores than others, and so their solution is to spread the Somalis around. That this only superficially rids one metric of inequality while not actually raising Somali scores (except through the theory of osmosis), and making my little guys take a longer bus ride across town, makes me almost want to run for the school board. Today's election in my little town consisted solely of school board elections, and it has polarized the town [note: we voted the busing advocates out].

I don't care about schools so much that I would allocate 15 hours a week to them, so I looked for someone being elected who shares my views. Unfortunately, reading their position statements, they all speak in platitudes similar to those spoken by senators and presidents, making statements that no one disagrees with.

Here's various takes on the softball question of how they would approach the School Board Governance Policy (which is never defined):

"the idea behind governance – clearly defining the roles of the superintendent and board – is a good one. If all parties commit to transparency and accountability, this model could work...."

"Board focus should be on achieving results and maintaining direct communications with stakeholders. Policies should state what should and shouldn’t be done..."

"Every group – like the Eden Prairie School Board – needs a set of rules, bylaws, or a governance policy..."

“I support coherent governance because it provides a comprehensive and systematic way for the Eden Prairie School Board to guide and monitor operations and results of the district..."

The rest of their vision statements are so vapid one might as well just know that first and foremost they all want to be liked by everyone, and think that being trite and vague are the best ways to that end. These aspiring politicians are afraid of saying anything that people might actually disagree with, but then if everyone agrees with you, you really aren't saying anything interesting. As George Orwell noted in his classic Politics and the English Language, the great enemy of clear language is insincerity. It's a dominant strategy. Remember Barack Obama's response to Rick Warren's question as to what he thinks about abortion: 'that's above my pay grade.' This was a stupid answer (he has an opinion and it would affect policy), but it probably worked out better for him than articulating his true beliefs. In a democracy the winner has to pander to a rabble--though there are better and worse among them.

This is a major reason why I prefer a smaller government, because at least businessmen pursues their own advantage more openly and honestly, whereas government workers pursue their self interest hypocritically and under false pretenses. Petty school board nominees are now aping our betters, and bringing the level of discourse down to a point where everyone is afraid of a Kinsley gaffe.

Cochrane on Alpha-Beta

2011-11-07T21:18:00.004-06:00

Quantivity glowing quotes John Cochrane:

I tried telling a hedge fund manager, “You don’t have alpha. I can replicate your returns with a value-growth, momentum, currency and term carry, and short-vol strategy.” He said, “‘Exotic beta’ is my alpha. I understand those systematic factors and know how to trade them. You don’t.” He has a point. How many investors have even thought through their exposures to carry-trade or short-volatility “systematic risks,” let alone have the ability to program computers to execute such strategies as “passive,” mechanical investments? To an investor who has not heard of it and holds the market index, a new factor is alpha. And that alpha has nothing to do with informational inefficiency.

Most active management and performance evaluation just is not well described by the alpha-beta, information-systematic, selection-style split anymore. There is no “alpha.” There is just beta you understand and beta you don’t understand, and beta you are positioned to buy vs. beta you are already exposed to and should sell.

I don't find this very profound. If the carry trade or shorting the VXX is a beta trade and makes a risk premium, investors should be indifferent to it. The risk premium is an even trade of premium for risk (or rebate for insurance). He's assuming that most people would love to earn the returns from the carry trade or shorting the VXX, and I suspect he's right, but that's because it's not a risk premium, rather, it's simply an opportunity.

Ever since the small cap effect was discovered, people have been attracted to it as an asset class because it offered higher returns. Dimensional Fund Advisors started with a small cap fund. Now, if the 'risk premium' story were true, it would be just as interesting for investors to take the other side, to buy insurance against whatever risk these things were providing a return premium for (these other factors tend to have medians of zero, not 1 as in the CAPM beta). Such opportunities are never sold that way, and investors don't want to pay for these things by shorting them.

Aristotle's Philosophical Conceit

2011-11-06T18:06:00.003-06:00

Aristotle wrote many years ago an anecdote that many erudite people take as gospel, that the thoughtful sages could be rich if they really wanted to. Here he recounts the story of Thales of Melitus (ie, the primordial philosopher 624-546 BC):

he knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year; so, having a little money, he gave deposits for the use of all the olive-presses in Chios and Miletus, which he hired at a low price because no one bid against him. When the harvest-time came, and many were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money.

Now, this is total bull because the stars don't predict weather. Reading chicken entrails and the like was popular back then and they had lots of other wacky beliefs, but the idea that they traded on them and prospered is clearly a self-serving lie. Today, we have active mutual fund managers who claim to outperform indices even though this has never been the case, so I guess every age has its own myths.

Lewin's Love of Physics

2011-11-02T19:11:00.021-05:00

Walter Lewin is an MIT physics professor, and wrote a pretty fun book entitled For the Love of Physics. It's a nice romp through fun facts of physics, such as why rainbows only appear when the sun is behind you. One of the more interesting parts concerns his investigation of Galileo's Square-Cube law.

Galileo's Dialogue Concerning Two New Sciences contained what he considered to be one of his most profound insights: the square-cube law. If two cubes are made of the same material then they will have the same density. Yet since the two cubes have different area to volume ratios they will likewise have different stress at the base of each cube. If too much stress is placed on an object then it will fail, or in this case a large cube has a much greater possibility of collapsing. This is why sandcastles can only be a few feet high.

Galileo applied this to animals, what we now call allometry, and noted that a this implies the diameter of bones should be proportional to their length so that length³=k•diameter², or diameter=k•length^1.5. The simple support required of bones implies limbs get thicker and thicker as animals get bigger, which is why rhinos and elephants are pretty thick. Bones comprise about 8% of the weight of a mouse, 14% of a goose or dog, and 18% of a man.

Also because of the Square-Cube Law, larger animals have less relative muscle strength than smaller animals. Both the muscle strength and bone strength are functions of the cross sectional area, while the weight of the animal is a function of volume. It is because of relative muscle strength that an ant can lift fifty times its weight while a human can lift an amount equal to its own weight, and an Asian elephant can only lift 25% of its own weight. The greater muscle to weight ratio of smaller animals is what allows them to jump higher than several times their own height, while at the other extreme an elephant can not even jump.

Back to Lewin, he actually looked at various animal bones from MIT's museum. Comparing a raccoon with a horse femur, he found the horse femur should be 6 times thicker than a raccoon's. It turned out 5 times thicker, which is close. Then he compared a horse to a mouse, and the thickness was only 70 times thicker, not the 250 times thicker as predicted by their lengths. The elephant femur was only 120 times thicker than a mouse's femur, not the 1000 times as predicted.

It appears that the structure of bones is different, bone chemistry changes along with its size. Thus, the fact that dinosaurs were the size of 12 bull elephants with leg bones of similar diameter, need not be explained by an expanding earth theory (the idea that the earth was smaller back then, so gravity wasn't as strong). So, Galileo's square-cube 'law' is really an approximation for the moderate spectrum of animal sizes, something that explains a lot but doesn't generalize like gravitation, which Newton used to explain the fall of an apple and the orbit of the moon.

Then again, perhaps even gravitation does not scale. Dark matter was introduced to explain the fact that galaxies rotate in a way very unlike our solar system. In our solar system the gravity vs. centripetal force generates the pattern where the period of a planet (T) and the mean distance from the sun (R) are related by a constant ratio for T²/R³, something observed by Kepler then proved by Newton 70 years later. Thus, Mercury has an orbit of 88 days, Neptune 165 years. Galaxies don't do that, with the outer regions moving almost as fast as the center stars. Dwarf galaxies are even worse, looking more like an evenly distributed swarm of bees, indifferent to clumping or spinning. The idea that the space is suffused with unobservable dark matter fixes this problem, but it's a fudge, because it 'appears' only as a solution to this problem. Perhaps gravitation doesn't scale at that dimension.

Chance, Effort, and Ability

2011-11-01T17:16:00.009-05:00

Here's my local paper's Sunday major opinion piece on wealth inequality, discussing a researcher's model of wealth distribution:

He began his research with a simple question: Can chance alone account for wealth concentration?...He assumed that all entrepreneurs began with equal wealth. Returns varied, solely by chance...I'll spare you the calculus, but according to Fargione's model, by the "inexorable effect of chance," and chance alone, "a small proportion of entrepreneurs come to possess essentially all of the wealth...According to Fargione, greater variation in rates of return hastened the concentration of wealth.

That's not a model, that's an assumption. He assumed individual wealth varies randomly, and found the net inequality will be due to randomness. I understand that assumptions drive models, but the step between assumption and result has to be a little subtle or non-obvious. Here, he assumed everyone varied by randomness, and after doing this in Excel (really), it implied variation by chance is really random.

While it's important to remember that assumptions aren't models, they are perhaps more important, because as Darwin said,

False facts are highly injurious to the progress of science, for they often long endure; but false views, if supported by some evidence, do little harm, as every one takes a salutary pleasure in proving their falseness.

People who get excited about wealth being explained solely by effort or chance are making an important assumption about navigating one's life. Success is the result of randomness, effort, and ability. If you omit one of these, you will be miserable. A lot of growing up is about finding what you like that you are good at, and usually you like things you are relatively good at. Then practice that skill until you become excellent at it. The rest you can't really worry about even though that too is important, especially in explaining things like why certain people are really rich, which is often being in the right place at the right time. This should make us content because it's all we can control.

Anxiety should be not be ignored, but seen as what incents us to do our best--to observe the Serenity Prayer--because we worry all the time if we are doing our best given an uncertain future (in the end, it's the doers that prosper). For the existentialists Kierkegaard and Heidegger, this anxiety is the essence of consciousness (or sein), because we exist in time and are always thinking about an uncertain future in a way animals do not. They had very different solutions to this problem, and while I tend to find Heidegger's solution more fruitful, it clearly has more potential downside (Kierkegaard chose faith in God, Heidegger became an enthusiastic Nazi).

It's sad that some people see the disparities in income, and think this is all effort or all luck. In any case, this is a more damaging belief for their own self-actualization than any silly tax policy they envisage.

Real Investors Lag Indices by 6%

2011-10-31T20:32:00.005-05:00

I recently discovered there is considerable amount of data documenting how much investors underperform indices, and it's being ignored. In the 2008 Journal of Pension Benefits, N. Scott Pritchard documented that that individual investors have done much worse than the indices that everyone assumes reflect investor returns. He looked at data from 401(k) plans, and found that from 1988 through 2007, while the S&P 500 returned 11.81 percent annually and Treasury bills returned 4.53 percent, the average investor achieved a return of only 4.48 percent.

Pritchard relied on the annual Dalbar study, which consolidates data from the Investment Company Institute, and is availble for investment advisers as a way to show them what the 'conventional wisdom' is on asset allocation and investor performance. More recent data found that over the twenty years ending in 12/31/2010, the average annual equity return for investors was only 3.27%, while the S&P500 was 9.14%.

So, this 6% investor underperformance you would think would be very interesting news, because the risk premium is one of the most important facts in all of economics, being the subject of thousands of research pieces, but instead it has had about zero impact. No one finds it interesting because it is not useful to academics or investment companies.

To put this into perspective, one of the most important research findings in twentieth century finance was when two professors at the University of Chicago, James H. Lorie and Lawrence Fisher, created what has become the preeminent database on stocks in the United States, what is now known as the Center for Research on Security Prices (CRSP) database.

The front page of the New York Times financial section heralded the pair’s findings, and their Journal of Business article reported the average of the rates of return on common stocks listed on the NYSE was 9 percent for the NYSE from January 30, 1926, to through 1960. Included in the NYT article was a flattering picture of them in a room with a big computer, emphasizing that this was very scientific. Interestingly, if you read their paper, you will see how academics bury their lede by noting that this final result is not conspicuous, highlighting that academics like to emphasize their technique, not the results.

Now, this was 3% higher than the average annual return on the Dow Jones index, but with dividends added, about the same, so why the big deal? It was important because while this old data probably still contains large amounts of survivorship bias, it meticulously corrected for all sorts of other issues and therefore added the patina of academic rigor to a fundamental financial constant: the equity risk premium.

This result stood for decades, and led to many to think the equity risk premium was on the order of 6-8% up to the internet bubble of 2001. It validated the new 'risk premium' paradigm that was being created in the early 1960s, where risk, properly measured, generates an observable return premium over time, because without higher expected returns no one would invest in risky assets. When combined with a stock's beta, it generated the expected return for each asset, making a seemingly qualitative problem one amenable to linear programming.

Much has happened since then, most importantly, the poor returns since 2000, which have reduced most estimates of the equity risk premium to around 3.5%. This excludes transaction costs, and adverse timing, which are captured in the Dalbar data. And of course this excludes taxes.

Happy Halloween!

2011-10-31T19:37:00.003-05:00

Everyone likes to mock people who dress up their pets, but my daughter has been saying 'doggy Batman' over and over for the past few days, in pure delight over the sublime ridiculousness of combining a dog, a bat, and a man. Worth every penny. Boys have grown out of Star Wars, and are now 'scary/gross.'

Investors Underperform Indices

2011-10-31T15:10:00.011-05:00

mistake (see above)

Shorting Leveraged ETF Pairs

2011-10-30T13:40:00.004-05:00

ProShares offers a wildly successful array of Exchange Traded Funds (ETFs) that allows people to easily gain leverage and short targeted subsets of stocks. They trade a lot, and so clearly are satisfying consumer preferences, but probably the more delusional part of investor beliefs. Their explicit goal of targeting a daily benchmark return correlation leaves the secondary consideration less important: maximizing long term return. Thus, they tend to underperform their benchmark over longer durations, and this adds up. I suspect they end up burning money trading so much in a way that traders can anticipate and game.

If the Proshares are underperforming, there's a simple arbitrage here. Take the 'Ultras', which offer 2x leverage, and the 'UltraShorts', which offer the opposite, -2x exposure. Going short both stocks generates a very low-risk portfolio pair, because on a daily basis when one goes up 1% the other will almost surely go down about 1% by design; the positions will offset each other. But the drift for both is negative, as they burn money. Since ProShares has been very busy adding ETFs, this simulated strategy started with 23 pairs in 2008, and is now up to 45. Below is a graph of the total return to going short all the Ultra and UltraShort pairs offered by Proshares since 2008. I rebalanced every week. The annual return was 14%, and the annualized standard deviation was 12%.

Now, I am ignoring the short rebate, which for these may have been highly negative for some of these, but on average these have pretty meager short rates. As the S&P500 has a prospective Sharpe of 0.3 (excess return of 5% and standard deviation of 15%), this is a very dominant strategy. Notice that while the annualized vol is 12%, this really overestimates the risk here because most of this volatility is 'good': sometimes returns are much higher than average. It's a rather Madoff looking strategy

Another way to shade this is to notice that it works best during periods of high volatility, and among those pairs with the highest volatility. Notice that the October 2008 to March 2009 was a great time for this strategy, and so was August 2011, when markets were reeling.

Below are the returns to the various pairs I used, annualized. You can also use these pairs to simulate them yourself. Over time, I suppose these ETFs should start trading at a discount to their net asset value, but until then, it's a pretty simple strategy that seems to work.

Total Return to Short Pairs
pair1	pair2	AnnRet
AGQ	ZSL	31.8%
BIB	BIS	3.7%
DDM	DXD	9.0%
DIG	DUG	18.8%
EET	EEV	7.7%
EFO	EFU	8.0%
EZJ	EWV	6.6%
LTL	TLL	16.2%
MVV	MZZ	8.5%
QLD	QID	10.2%
ROM	REW	7.9%
RXL	RXD	5.2%
SAA	SDD	10.4%
SSO	SDS	9.6%
TQQQ	SQQQ	3.0%
UBR	BZQ	1.1%
UBT	TBT	4.8%
UCC	SCC	7.3%
UCD	CMD	6.5%
UCO	SCO	5.7%
UDOW	SDOW	5.3%
UGE	SZK	5.6%
UGL	GLL	8.1%
UKF	SFK	7.6%
UKK	SKK	12.8%
UKW	SDK	7.9%
UMDD	SMDD	5.9%
UMX	SMK	5.8%
UPRO	SPXU	4.5%
UPV	EPV	17.0%
UPW	SDP	13.8%
URE	SRS	51.8%
URTY	SRTY	13.9%
USD	SSG	10.2%
UST	PST	3.8%
UVG	SJF	10.7%
UVT	SJH	14.7%
UVU	SJL	20.1%
UWC	TWQ	2.5%
UWM	TWM	12.6%
UXI	SIJ	5.9%
UXJ	JPX	4.7%
UYG	SKF	30.8%
UYM	SMN	11.0%
XPP	FXP	7.1%

DailyKos on Good Intentions

2011-10-29T21:28:00.003-05:00

I found this funny:

While Communists are certainly responsible for more deaths and misery than the Nazis could ever dream of, at least their intentions were good, so I'll give them a pass.

The entire article was filled with such observations, making me wonder whether the website was hacked. So, if you cause more death and misery than the Nazis, but have good intentions...it's ok? [I'm now told it was an attempt at sarcasm. If so, it's stupid sarcasm.]

Calomiris on Underwriting Problems

2011-10-27T15:24:00.002-05:00

Charles Calomiris taught me Money and Banking in graduate school, and I thought then he was very wise. Here he is in today's WSJ:

In a painstaking forensic analysis of the sources of increased mortgage risk during the 2000s, "The Failure of Models that Predict Failure," Uday Rajan of the University of Michigan, Amit Seru of the University of Chicago and Vikrant Vig of London Business School show that more than half of the mortgage losses that occurred in excess of the rosy forecasts of expected loss at the time of mortgage origination reflected the predictable consequences of low-doc and no-doc lending. In other words, if the mortgage-underwriting standards at Fannie and Freddie circa 2003 had remained in place, nothing like the magnitude of the subprime crisis would have occurred.

Good Ideas Become Clearer over Time

2011-10-25T12:54:00.019-05:00

Kant is known for his theory that there is a single moral obligation, which he called the "Categorical Imperative", and is derived from the concept of duty. Moral acts are those done in good will, which are done for the sake of duty. Duty is the necessity of acting out of reverence for universal law, something that you would want everyone in a situation to do.

Now, I find this reasoning rather flawed,* but my opinion on that isn't my point. In the Groundwork for the Metaphysics, of Morals Kant states that what he is saying is not the same as the Golden Rule; that the Golden Rule is derived from the categorical imperative with many important limitations. Many agree with Kant, such as radical egalitarians like Jurgen Habermas (see here), or John Rawls (see here). On the other hand, many argue that the Categorical Imperative is the same as The Golden Rule. Biologist and economist Peter Corning and game theorist Ken Binmore suggests that Kant's objection notwithstanding, the Golden rule is basically Kant's Categorical Imperative.

This seems like one of those ideas that is infinitely malleable, merely useful to give false authority to one's current pet idea. Habermas and Rawls did not want to engage in a debate on the practical issues of radical egalitarianism (its usefulness to tyrants, its impossibility, its assault on liberty), they preferred to simply defer to some famous philosopher's statement that is not evaluated merely by its consequences.

A good idea becomes clearer and more useful over time, while bad ideas become more subtle. Black-Scholes and Feynman diagrams are useful tools, taught to every beginner in finance and physics, because they explain things very parsimoniously, and because they are so clear can be extended or modified, which is the goal of every active mind. The invisible hand, the idea that inflation is ultimately a monetary phenomenon, that free markets decentralize knowledge and incentives, all simple, powerful, ideas. An idea's objective and quick decipherment enables us to avoid the systematic errors which invariably arise from prolonged entanglement. The longer we look at something vague and well-known, the more we qualify it to make it more sympatico with our prejudices.

In finance the risk premium started as volatility, became beta (covariance with the stock market divided by the variance of the market), and is now a covariance with some undefined set of proxies for our happiness (too be uncovered by powerful econometric techniques really soon). The 'risk premium' is a bad idea. Taleb's 'Black Swan' applies to anything unexpected, and as every specific outcome is in some sense unexpected, it applies to everything (except finance, says Taleb, which is ironic because presumably his 'buying cheap options' strategy supposedly reflects the profundity of his approach). He now says 'Ideas come and go, stories stay,' which makes about as much sense as anything else he says.

* I agree with Nietzsche that duty is not obvious, and often some self-serving platitude for some powerful interest, so it isn't helpful to state that something that is a duty is best. Further, it makes no sense to ignore context when applying a universal law, as when you should lie to keep Nazis from finding Jews in your basement, or when you kill a dangerous burglar, and so universal law is not obvious. Lastly, as Ayn Rand noted, ignoring the consequences of actions, and just focusing on the duty, is irrational, because we act to make things in a real world that we might as well believe really is real. Finally, I should note it is rather circular in practice, because in the end the 'universal law' is defended on utilitarian grounds anyway (eg, it will make society happier).

Haidt on the Moral Foundations of Occupy Wall Street

2011-10-25T12:35:00.007-05:00

Happiness author Jonathan Haidt on the Occupy Wall Street/Tea Party difference:

We really hate cheaters, slackers, and exploiters. By far the most common message I saw at OWS was that the rich (“the 1 percent”) got rich by taking without giving. They cheated and exploited their way to the top. As if that wasn’t bad enough, we the taxpayers then had to bail them out after they crashed the economy, and so now they really owe us for saving their necks. It’s high time that they started giving back, paying what they owe.

As a point of comparison, a similar look at signs found at the Tea Party rallies suggests that protesters there are also chiefly concerned with fairness. The key to understanding Tea Partiers' morality, though, is that they want to restore the law of karma. They want laziness and cheating to be punished, and they see liberalism and liberal government as an assault on that project. The liberal fairness of OWS diverges from conservative and libertarian fairness in that liberals often think that equality of outcomes is evidence of fairness.

Those who think the market is generally fair and rewards virtue, who think that unequal ability is primarily from effort, discipline, and finding one's niche, believe in markets; those who think the market is generally a rigged game that rewards vice, that people are basically equal and become unequal mainly through forces beyond their control, believe in greater government control. Equality of outcomes is justice in one case, injustice in the other. Given these different assumptions are responsible for the most pressing political disagreements we have, and these are rather factual statements, the nice thing is that someday there may be more agreement on politics.

Bank Lending Dilemma

2011-10-24T14:57:00.006-05:00

In the Financial Times, Larry Summers argues lenders should pay more for past bad loans, and also make more now:

First, and perhaps most fundamentally, credit standards for those seeking to buy homes are too high and rigorous.
...
Surely there is a strong case for experimentation with principal reduction strategies at the local level.
...
Fifth, there were substantial abuses by financial institutions and almost everyone in the mortgage industry during the bubble. Just compensation to the victims is a legitimate objective of public policy. But allowing negotiation over the past to dominate present policy creates overhangs of uncertainty that impose huge costs on the financial system and inhibits lending.
...
Bank regulators could facilitate inevitable restructuring of underwater mortgages by requiring banks to treat second mortgages and home equity loans in realistic ways.

Summers seems to recognize that punishing banks hurts new lending, but he also thinks some form of bank punishment would be just. Until they get over this and let the banks alone, lending will remain weak because banks are wary of the lookback option being giving to borrowers who 'bought' houses without the means or willingness to pay it back. In the US, loans are already 'non-recourse', meaning borrowers can walk away and let the lender eat most of the loss, but people want 'just compensation', which is a code word for an expropriation from banks to NINJA borrowers.

Until regulators, legislators, and the experts that advise them stop hounding banks for their old home loans, new home loans won't be forthcoming. It's all good and well to say we should just nationalize home lending, but if public housing is any guide that's a disastrous endgame.

Obama's latest housing effort seems like the last iterations (Hope Now, Hope for Homeowners, the Home Affordable Mortgage Program, the Home Affordable Refinancing Program, the Hardest Hit Funds), but until things like the Department of Justice's lawsuit against banks gets cleared up, banks won't consider homelending anything but toxic.

Short Powerful CEOs

2011-10-23T18:16:00.005-05:00

A recently published article in the Journal of Finance by Morse, Nanda, and Seru argues that if you generate a metric of CEO overreach, their stocks underperform. They define CEO malfeasoance using the example of Home Depot CEO Robert Nardelli, who in 2005 changed his incentive pay to be based on average diluted earnings per share, from the tota return to shareholders over the prior 3-years compared to their peers. This was very convenient to Nardelli, because he did much better on the new comparison over the old, and it abrogated the prior performance contract; a lookback option, as it were. Nardelli presided over a 6-year period (2001-07) where the S&P500 was up 12%, Home Depot lost 17%, and Nardelli pocketed a $240MM for his stewardship.

The researchers construct three different metrics of CEO power. One is whether he is also President or Chairman of the Board. Secondly,they uses insider ownership, the amount of stock owned by the directors. Lastly they capture the percent of the board appointed by the CEO. They use regression analysis to find that firms with high CEO power face a 4.8% decrease in firm value going forward.

It would have been nice if they put this into a long-short portfolio and showed the portfolio return characteristics. As the data covered the infamous tech bubble (1992-2003), a lot could be explained by the rather singular 2001-2 tech bubble, which while interesting, is much less interesting than if this result was more persistent across time periods. In any case, another reason to read proxy statement footnotes, and hopefully people will invest on this information which would be the best way to regulate it. Home Depot got what they deserved, those responsible, shareholders, suffered most.

.

Aggregate Supply and Demand Nonsense

2011-10-20T08:45:00.006-05:00

One characteristic of Keynesian thinking is to think the problem currently is with inadequate Aggregate Demand, as if this is some simple analytical construct that is just as meaningful as the demand for apples. This is nonsense. Aggregate Demand and Aggregate Supply are incoherent constructs that require heroic assumptions. You might as well talk about the current law of motion on the Hegelian Dialectic, which for decades was discussed as if it were real. Things exist before people know they exist (eg, nations, atoms), and things also don't exist even when many are certain they do (eg, anthropomorphic God, aether, phlogiston). About what one can not speak, one should remain silent, and you can't talk about something that is as logically vacuous as aggregate supply and demand.

In partial equilibrium, a good exists and its price represents its output relative to innumerable other consumer wants. This is why the demand curve slopes downward, because the more it costs, the more you have to forgo of other stuff. Demand curves are driven by consumer utility (which decreases as one consumes more of a specific good), and income (which shifts it about). For supply curves, the correlate to utility curves are cost curves. One generally produces where marginal cost equals price, and so marginal cost is increasing (if it were decreasing, you could increase supply and lower costs for a 'given' price). Thus, you only raise your output if the price rises.

You can assume demand and supply move separately, as when seasonal harvests of perishable goods arise in supply, or demand for cranberries increases before Thanksgiving. The logic of supply and demand curves in markets is firmly based on utility and cost functions, and is a very useful way to think about things.

Now consider Aggregate Demand. Here the 'price' on the vertical axis is not a relative price, but rather an absolute price level, which by itself is meaningless. If there was only one good in any economy people cared about, what would its 'price' even mean? So, right off the bat, something's fishy. Supposedly, in normal times the AD curve slopes down, we think, because other things equal a higher price level increases the demand for money, which drives up interest rates, which reduces investment and spending. But how does one increase the price level and leave 'other things equal?' One can imagine doing this in partial equilibrium, but it's a strange thing to contemplate over all goods. Further, at interest rate levels like today, it's not as if lowering interest rates is having any effect on investment (the liquidity trap, which is occurs always in real time for Keynesians, who always say this is why government spending is necessary now).

Then there's the 'Pigou's wealth effect', which affects wealth by changing people's real balances, because presumably their cash levels are constant but magically prices move, affecting real wealth, CashValue/Price. However, offsetting that is the 'Fisher real balance effect', where one's debts change in real value. These debt effects are generally thought of as more important, and why most macroeconomists believe a little inflation would be good right now, and perhaps always: it reduces the legacy debt in real terms.

Lastly there are Mundell-Fleming effects, which operate though capital inflows caused by changes in real rates from changing the price level. Supposedly lower interest rates lead to capital account deficit, which a trade surplus, which implies higher GDP. The data on this are mixed, but generally international trade is the tail, not the dog, for large countries like the USA.

Now consider aggregate supply, which classically is horizontal, and then in the Keynesian world vertical. It supposedly becomes positively sloped because 'prices' refers to outputs, not inputs. Why prices supposedly effect finished goods rather than wages or intermediate goods is strictly ad hoc.

This is why general equilibrium models, like those of Edward Prescott and Finn Kydland, whose Nobel Prize winning research emphasized shocks to utility or production functions, because one has to put in some ad hoc structure to get these aggregate demand and supply curves to work in the Keynesian paradigm. Now, I don't think Prescott/Kydland models work either, but most policy debates aren't predicated on these models (I don't know anyone to really believe our problems are currently a technology shock, or preferences for more leisure).

The result of this flawed paradigm is to continually assert that simply spending more on X increases aggregate demand via their spending, because one becomes inured to extrapolating partial equilibrium analysis into general equilibrium results. Consider this AFL-CIO press release, which conflates more spending on union jobs with greater prosperity. If only everyone worked for a government protected industry with market power, presumably, we could all work 9-4 with negotiated, predictable wage increases.

So, like discussions in Marxist economics, which often involves very learned, earnest, and prolix researchers, it's best just not to go there, because it's gibberish. Don't say Aggregate Demand, say, subsidies to investment of some kind, or more government spending, because that's more meaningful, and then ask, should we be subsidizing these investments, or having more government spending? The indirect effects are so speculative you might as well ignore them, and just ask if the direct effects are worthwhile.

Do Academics Overfit?

2011-10-19T09:46:00.016-05:00

Yes. Academics are just as susceptible to this bias as anyone else. On one hand they have extra discipline from having to put their ideas out there, while on the other hand they often don't pay the price for creating overfit models in the way a poorly performing asset manager would. The big difference between academic overfitting and that from your average quant is that when academics do it they are much better at rationalizing such models.

I've worked with finance professors on consulting projects, and cherry-picking data recent data and pointing to something 'out of sample' when it is used iteratively is quite common. An important postulate to remember is that there are no true out-of-sample backtests, just tests of subsample stability. Invariably researchers know about the entire dataset in question, so out-of-sample results are really models that when fit on a subsample and applied to its complement generate the best fit. That is, quants try models sequentially until they find one that works well 'out of sample,' which means the data is not really out of sample.

That's not to say out-of-sample tests are meaningless, just that it takes a lot of self-discipline because a lot of this is done outside the box, and the easiest person to fool is often oneself because it's very tempting to believe things when they imply many self-serving benefits. This is why integrity is a virtue, because it's hard, uncommon, and helpful. It's tempting to over-promote your own pet idea as tendentious advocacy can seem necessary in the real world where 'everybody does it.' But, the biggest problem knowledge-workers make is not making a logical error or not being able to solve a complicated problem, but working on something that is a dead-end, because that implies you've just wasted a large part of your career: an expert on input-output models, Keynesian macro models, dynamic programming isn't valuable for making decisions. Fooling yourself into believing in a false model simply wastes your time.

Consider John Cochrane and Monika Piazzesi's Bond Risk Premia paper that purports a model that forecasts one year bond excess returns with a 44% R2. Both are competent academics who I generally respect, as I think they are smart, careful and do research with good faith. Their model suggests that if you look at the current forward rates from the US Treasury yield curve, the first five forwards predict year-ahead bond returns very well (to be precise, these are 'excess' returns, so they subtract the 1-year bond yields).

What is this model? Basically, if you run an ordinary least squares of the 10yr bond return over the next year (minus the 1yr yield), on the forwards. They looked at the 1964-2004 period, which has 467 monthly datapoints, but because these are year-ahead returns, we really only have 39 totally independent datapoints, which is not a very large sample (most year-ahead returns being highly correlated because they share much of the same data). So the basic pattern they found was

year ahead 10yrBondReturn-1yr Bond Yield=a+b1*f1+b2*f2+b3*f3+b4*f4+b5*f5

*here f1-f5 are the 1 through 5 year forwards.

You can download his data here. Now, the first problem I found is that his bond data is a bit fishy. He used bond data from CRSP, and 2 and 4 year USTreasury datapoints are pretty uncommon. His 4 and 5 year forwards yield changes have a suspiciously low correlation. In anycase, I took the H15 data using their 1, 3 and 5 year monthly bond yields, and generated pretty much the same result: tent-shaped set of coefficients on the forwards (approximately equal and negative for 1 and 5 year forwards, positive and larger for the 3 year forward), and my R2 for the 1964-03 period was a large 31%. My results look like this for the same sample period Cochran and Piazzesi use:

The coefficients suggest that there are higher returns the more concave the forwards are, and lower returns the more convex. This doesn't really make any sense, in that there's no intuition as to why this 'tent-structure' of coefficients is related to risk, or utility, it just comes out of a best fit of the data.

If we look at the subsequent 7 years, that same set of coefficients that worked so well in-sample for 64-03, don't work at all for 2004-2010 (last datapoint was for the return from 9/2010 through 9/2011). See below.

So, it seems a classic overfitting of the data. Sure, the pattern could have just stopped, but given the model had no intuition, no causal mechanism, just some unlikely set of coefficients, it almost surely was an overfit. Such results, prior to Freakonomics and Behavioral Finance, were considered rubbish for a while, as the development of CRSP into a data source led to a lot of stupid correlation papers in the 1980s and 70s, but the success of other atheoretical findings (momentum) has unleashed non-intutive correlations into top tier journals.

As an academic, this will always be a plus on Cochrane and Piazzesi's vitas because it made a top tier journal (AEA 2005), but as a practioner this would have gotten them fired. Thus for academics, overfit theories that generate publications have little downside compared to a practioner.

Zero-Sum Game

2011-10-18T20:12:00.004-05:00

A while back I got a copy of Zero-Sum Game by Erika Olson. She worked for the CBOT when there was a merger battle with CME and the ICE exchanges, so it's basically a lot of inside baseball on the corporate politics of acquisitions. It sat on my bookshelf hidden for a while, because it didn't really leap up at me. But eventually I found time to read it, and it reminded me of the old saw that everyone has a story to tell.

What's most telling is that any large institutional realignment involves a lot of little issues, and various stakeholders all have different interests and power, and making them all happy involves a lot of politics that is difficult to do publicly. The idea that merely passing a law will change things is pretty naive because any explicit, complicated process invites its circumvention. You need to align incentives, and in the private market this is by giving various people carefully delineated property rights (shares, seats), often via having them buy-in explicitly in some way. When you involve 'stakeholders' who don't have any investment in the process, they just have some vague sense of a better structure, these people just create more anachronisms and complexities that lower transparency and help insiders.

One of the more telling anecdotes was about how when Amaranth Advisers was still alive, it was breaking various position limits in energy on the NYMEX, and the CFTC which regulates the NYMEX took 7 months to actually enforce these rules. Yet Amaranth merely moved its positions to another exchange, the ICE, whose natural gas swaps were not subject to position limits at that time. One should anticipate that any regulation that mandates certain positions must be in a certain contract on a particular set of exchanges, will simply move to highly correlated positions in different venues.

Partying with Actuaries

2011-10-17T21:43:00.007-05:00

As they say, what happens at the Society of Actuaries annual meeting, stays there. It was a pretty good conference, one with literally a dozen streams, so it's pretty easy to find some talk that's interesting at any time (it's actually continuing until Thursday). My talk (see pdf of presentation here), was pretty well received. That is, I had a lot of people telling me it's interesting, thoughtful questions, etc. This is in contrast to academics, who either tell me I'm stupid or crazy, though usually just ignoring me. I have not met an active finance professor who thinks my 'no risk premium due to relative status' is interesting, let alone true.

As mentioned, some professors have even been quite defensive, which is understandable. It doesn't bother me because it's fun to have the facts on your side. They'll come around, as they did on the low return to high volatility stocks and distressed stocks.

Bernie Sanders Clueless on the Fed

2011-10-13T16:31:00.004-05:00

Patron saint of Liberal radio and websites, Socialist senator Bernie Sanders, questioned Bernanke this week, and he asked one reasonable question, namely, why not break up the top 6 banks if they are all 'too-big-to-fail'. Bernanke said he thought incentives in Dodd-Frank would better address the incentive problems. I'm not so sure. I would prefer the simplicity of having a maximum asset size than the open-ended regulatory gibberish in Dodd-Frank.

Then Sanders asked why the Fed does not provide low-interest loans to small businesses, to help kick-start the economy (see video here). He even threw out a number, $15 Trillion. Bernanke noted that the Fed has no structure to underwrite or service general loans to businesses. Sanders thought that this would be no different than offering back-stop liquidity to banks, oblivious to the insanely large amount of infrastructure needed for that to work.

That's just insanely ignorant, and highlights how the socialist mindset fails to appreciate the reasons why markets, and the firms that comprise them, are more efficient than government. It reminds me of Lenin's assumption that nationalizing industry would be trivial because business was strictly accounting, or more recently, the faith in shovel-ready projects. There are many stupid Republicans, but this really sets a new bar.

We are the 99%!

2011-10-12T17:01:00.006-05:00

Egalitarians may be a majority, but they aren't close to 99%. This reminds me of the False Consensus Effect, which states that individuals view their own preferences, behaviours and judgements as being typical, normal and common within a broader context; it also suggests we find alternative characteristics as being more deviant and atypical than they actually are.

The blogger Psycasm did a survey, and asked them about their phobias, and compared them to what they supposed the percent of people shared these specific phobias, and got these results:

So, people who are afraid of spiders, dogs, and heights, vastly overestimate the prevalence of their specific phobia. Sort of like how economists, who have no alpha and are inclined to statistical optimization, assume all investors would invest as they would: presuming no alpha, optimizing mean-variance preferences. It's not a problem limited to proles.

I feel pretty calibrated, in that I'm pretty aware of my many beliefs that are a distinct minority. It doesn't bother me too much because I believe in meritocracy, which is inherently elitist. This not only is a minority view (at least in public), but it by definition considers 'common' to mean 'crappy' in most cases. As Aristotle noted, just because people are equal in some respects does not imply they are equal all respects; men are equally free, but not absolutely equal

We are a democracy, which means majorities elect the lawmakers, so it is important to have a majority opinion, especially if you want to pass laws that make people do what they would otherwise not (eg, pay more to strangers in Washington, not marry their partner, not own a gun). But there's no reason to brag about it, because it's merely a sign you can be a bully, not that you are somehow more enlightened:

The fact that an opinion is widely held is no evidence whatever that it is not utterly absurd; indeed in view of the silliness of the majority of mankind, a widespread belief is more likely to be foolish than sensible.
~Bertrand Russel

To disagree with three-fourths of the British public is one of the first requisites of sanity.
~Oscar Wilde

Interest Rates, Risk, and Macro Foundations

2011-10-11T18:24:00.015-05:00

Tom Sargent, recent Nobel laureate, reminds us of the asset pricing-macro connection:

To put it technically, the “new Keynesian IS [investment-savings] curve” is an asset pricing equation, one of a form very close to those exposed as empirically deficient by Hansen and Singleton. Efforts to repair the asset pricing theory are part and parcel of the important project of building an econometric model suitable for providing quantitative guidance to monetary and fiscal policymakers.

I don't think this approach will work because I don't think standard asset pricing theory is near correct, and I'm not a fan of Keynesian macro models either. But here's an asset class that highlights why macro is in such a futz, why such different macro views can be held simultaneous by smart researchers: you can't reject their different priors.

Interest rates are probably the oldest and most liquid prices we have, and there are several facts associated with the basic risk-free yield curve:

The real term structure is fairly flat, but rises and peaks at around a 3-year maturity
Real rates are much more variable at the short than long end of the curve.
The nominal yield curve was flat prior to abandoning the gold standard in the 1930s
Inflation expectations explain the majority of nominal rate fluctuations
Interest rates have been pretty stationary over the past 100 years.

This latter point is especially important, because it seems the short term real rates is small (<1% and positive), over the past 100 years, though it varies quite a bit decade to decade. Most researchers think this series is not trending. This is inconsistent with any utility function other than those with 'constant relative risk aversion', a special set of preferences that imply 10% risk to one's wealth feels the same regardless of wealth. As real gdp per capita in the US rose 760% since 1900 through 2011, this seems the only logical conclusion. The most important thing to understand with yield curves is that the high quality of US bond data since 1953 makes this sample very prominent in research, and it has a very particular pattern, rising up to 1980, then falling, in concert with inflation.

US Interest Rates and Inflation: 1953-11

As bond returns are a function of their current yield, and the price appreciation from changes in market rates, the rising interest rate environment had low bond returns, the falling had rising ones. This leaves a tale of two regimes, and it isn’t clear whether the low real returns by maturity prior to 1980, and subsequent reversal subsequently, was an ‘expected’ return, or both period were unexpected.

Total Return Regimes to US Treasury Yield Curve: 1954-2011

Economists were just as surprised by the movements in yields over the past 40 years as anyone. I worked in a bank economics department from 1987-9, and can tell you we had no clue we were in a period of secular interest rate reduction, and that those same economists lamented their poor forecasts throughout the 1960’s and 70’s. In the 1990’s, 10-year inflation-indexed yields average about 3.5% in te UK, and exceeded 4% in the US around2000, and declined until a spike in 2008, and currently (2011) are below 1%. These movements are, in the words of Campbell, Shiller, and Vaciera (2009, Understanding Inflation-Indexed Bond Markets), a puzzle.

Keynes’s (1930, Treatise on Money) argued that the yield curve should rise due to a risk premium, Modigliani and Sutch (1966, Innovations in Interest Rate Policy) argue that there’s a habitat preference for interest rate investors, so that some prefer longer bonds, but most shorter durations. With the development of the stochastic discount rate factor, risk premium were supposed to be a function of covariances.

To test the yield curve then, we can look and see if we can explain the pattern across maturities or time, of the real return (the nominal return being trivially higher in higher inflation environments). The standard covariance factors are consumption, and the stock market. Consider the following 'betas' with the S&P500 and Real Consumption Growth range from -0.1 to 0.1, with an average of 0.05, depending on what periods (53-80 vs. 81-11), time horizon (daily vs. 60 month investment horizons), real vs. nominal returns, whether we are regressing against consumption vs. S&P500 returns. The point is, the data here are too noisy to confidently say that short, or long term Treasuries are 'risky': there's always a different view that says something different.

Looking at this over time perhaps shows the problem more clearly:

10 year US Treasury Slope with S&P500 vs. 10 year Total Return

Slope from rolling 85 month monthly returns

The lower returning early period, and the higher returning later period, do not show a clear distinction in the bond's S&P500 factor loading, and so it is with all the various permutations of these data.

The bottom line is that inflationary periods have lower bond returns than disinflationary periods, though it is not clear whether these are expected, and thus true risk premium. There is no obvious risk premium explanation of the 'default free' spectrum of bonds across maturities or time, and any statistical analysis that purports to say it all makes complete sense is clearly torturing the data (eg, see Bansal's 'long run risks' model that adds a bunch of parameters to explain more datapoints).

This is especially relevant to macroeconomics because in the standard New Keynesian models, a representative agent’s Euler equation that links a one-period real interest rate to the consumption growth rate is the IS curve central to the policy transmission mechanism. A long list of empirical failures come from applying the stochastic discount factor implied by that Euler equation. Until someone succeeds in getting some kind of consumption-based asset pricing model that works well, the New Keynesian IS curve is empirically vacuous.

The Brain's Permanent Income Hypothesis

2011-10-10T18:30:00.004-05:00

The Keynesian consumption function assumes consumption is entirely based on current income, and is the basis for the multiplier, which magically translates investment in alien defense systems into greater prosperity. Milton Friedman's permanent income hypothesis is a theory of consumption whereby consumption is determined not by current income but by one's longer-term income expectations. The key conclusion of this theory is that transitory, short-term changes in income have little effect on consumer spending behavior. Federal stimulus plans, for example, are intrinsically temporary.

It seems are brains are intrinsically forward looking, more focused on anticipation of rewards than the rewards themselves. In studies with monkeys, where the monkey sees the light, pushes the button, and gets a treat, very quickly the monkey figures it out. Interestingly, the dopamine response fires not when he eats or receives the treat, but rather when he sees the light. The brain present values the stimulus, so that by the time the treat is tasted it has already been figuratively consumed. A short video on the dopamine effect is here.

It's a lot harder for the government to redistribute wealth than income, because wealth is primarily ability as opposed to cash. If you have a niche, a role where you feel valued, you are wealthy. The government can create only so many post-office jobs that grant sinecures arbitrarily, and all those temporary job incentives are seen as the transitory, ephemeral things that they are. To create real wealth, which is what really matters, you need to allow individuals to find their niches, which is best done indirectly.

Sims and Sargent

2011-10-10T08:37:00.009-05:00

Minnesota Rules (that's where I live)! My favorite Sargent paper shows a model where even when inflation is a strictly monetary phenomenon, inflation it is really, in the long run, a fiscal phenomenon.

Chris Sims--who I've mentioned several times on this blog--is here. He basically destroyed interest in large-scale-macro-models, at least for anyone graduating subsequent to his seminal papers.

They will certainly help increase the Nobel Laureate signal/noise ratio, which currently is on par with those 'anarchists for big government' protesters. Though Sargent is, fundamentally, a macroeconomist, which means he says many silly things.

Another Reason to Dislike Habermas

2011-10-08T17:32:00.002-05:00

I'm no fan of abstruse Marxist philosopher/sociologists, so I found this point rather amusing:

I remember reading a response by Habermas to a critic, limited to the statement that he refused to discuss with an individual who quoted Hegel from a secondary source.

I remember seeing a documentary on Jacques Derrida, and he was asked what one question he would like to ask Ludwig Wittgenstein if he were alive, and he said he would ask him about his sex life. Philosophers are pretty loony.

Dying Thoughts

2011-10-07T12:23:00.005-05:00

Steve Jobs, a true mensch, left an estate worth around $6.5B. Nevertheless:

“Steve made choices,” Dr. Ornish said. “I once asked him if he was glad that he had kids, and he said, ‘It’s 10,000 times better than anything I’ve ever done.’ ”

I think those of us who love our kids are better off than childless billionaires. More importantly, the value of our children is 10,000 times more important than any financial fortune.

Taleb's Latest BB Riff

2011-10-07T08:06:00.006-05:00

People often email me Nassim Taleb rants because I've written on him previously (see Black Swan review, Bed of Procrustes review), and I must say I enjoyed his latest. From the latest Bloomberg article on Spitznagel and Taleb, Spitz comes off as an incredibly fun guy, whereas I think this Taleb quote only got in the because the writer knew it was over the top:

“I’m not interested in money; I’m not interested in finance,” Taleb says. “I’m comfortable enough as it is. I don’t need it. Finance should be a footnote in my bio, not a central component. Why should I waste time in finance when my influence as an intellectual is so high?”

I hope someday he gets stuck in an elevator with Tom Friedman, and then after a couple hours one might realize that if there exist at least one bloviating best-seller, perhaps there exist more than one.

Elsewhere in the article someone notes that Universa’s clients lost about 4 percent in both 2009 and 2010. I'm skeptical that represents his average investor loss, as opposed to some cherry-picked account, and I'll write a check for $1000 to a charity of Taleb/Spitznagel's choice if that's true (just send the audited consolidated returns for Universa). Allowing random people to spout data like that allows funds to intimate performance without taking responsibility for such statements, highlighting another regulation that is worse than nothing (by law hedge funds aren't allowed to mention their record in general media, but if you say something and they don't comment, who's to say?).

English Fun Facts

2011-10-06T21:40:00.002-05:00

A psycholinguist wrote a book on language, and this was funny:

Mr. Pennebaker shows, for example, that someone is more likely to be lying if he says "Let me state clearly and without qualification" and more likely to be giving an opinion if he says: "There is absolutely no doubt that . . . ."

Another linguist comments on English, and argues

The advantage of the huge vocabulary of English, of course, is that it makes English a superb literary and scientific language, able to express fine and precise shades of meaning far more easily than other tongues. This is no small part of the reason English has become the near universal language of science. It also makes English more efficient. The English version of a lengthy text is always substantially shorter than versions in other languages.

English's verbs are simpler than, say, French and German, and nouns don't have gender. English isn't perfect, but it could be worse.

IS-LM Is Ignored for a Reason

2011-10-05T19:47:00.007-05:00

Lots of talk by Tyler Cowen and Scott Sumner arguing against the IS-LM framework, and Brad DeLong and Paul Krugman defending it. I remember how important it was as an ungraduate, and then when I was a TA for undergrads at Northwestern, found it odd that macro emphasized this framework that was totally ignored in graduate school.

The IS-LM framework was an intellectual dead end. It started with all sorts of optimism about how it could generate useful predictions and guidance on how to steer the economy, but basically deflected focus from the little things that make an economy work: property rights, good incentives. When the economy underperformed, the answer was always more goverment spending. When the economy was working well, they presumed it would keep on working no matter what, so we increased all sorts of social programs that hurt families and created an ever-larger patronage portion of the economy.

Then, the 70's. Empirically we had stagflation, which shouldn't happen. The model was internally inconsistent as the Lucas Critique showed the IS-LM implied the modeler knew about different relationships than the economic agents in the models, which is always attractive to those in the vanguard (thus, the popularity of Behavioral economics, based on correcting the biases of others). When Chris Sims showed that an atheoretical, simple, vector autoregression outperformed the fancy macro models built upon IS-LM logic, the ghost was up. No one wrote dissertations extending the IS-LM framework anymore. When I was in grad school it simply was never discussed except when working on undergraduate expositions.

Here's Krugman describing his situation having to teach graduate macro a few years ago:

This spring I have a new assignment: to teach Macroeconomics I for graduate students. Ordinarily this course is taught by someone who specializes in macroeconomics; and whatever topics my popular writings may cover, my professional specialties are international trade and finance, not general macroeconomic theory. However, MIT has a temporary staffing problem, which is itself revealing of the current state of macro, and I have been called in to fill the gap.

Here's the problem: Macro I is a quarter course, which is supposed to cover the "workhorse" models of the field - the standard approaches that everyone is supposed to know, the models that underlie discussion at, say, the Fed, Treasury, and the IMF. In particular, it is supposed to provide an overview of such items as the IS-LM model of monetary and fiscal policy, the AS-AD approach to short-run versus long-run analysis, and so on. By the standards of modern macro theory, this is crude and simplistic stuff, so you might think that any trained macroeconomist could teach it. But it turns out that that isn't true.

You see, younger macroeconomists - say, those under 40 or so - by and large don't know this stuff. Their teachers regarded such constructs as the IS-LM model as too ad hoc, too simplistic, even to be worth teaching - after all, they could not serve as the basis for a dissertation. Now our younger macro people are certainly very smart, and could learn the material in order to teach it - but they would find it strange, even repugnant.

So, he admits 1) he knows as much about macro as a cardiologist knows about cancer, and 2) no younger economists care to know about the IS-LM model. Of course his conclusion is that this is a travesty, not the more reasonable inference that his prejudices have probably led him to like the IS-LM model more than warranted.

Here's a tip. When a new paradigm is introduced, and it generates many honors, books, and large-scale-collaberative models, and then after 40 years is found uninteresting by young graduate students who don't have a dog in the fight, this is a sign it has been a good-faith mistake. Best to move on. All the IS-LM model predicts is that with massive fiscal or monetary stimulus there will be a short run effect, but you don't need the IS-LM for that (eg, WW3 will increase output). And like any short run stimulus, that shouldn't be the focus of economists, any more than a psychologist should recommend drinking beer to get over your problems (you'll feel better in an hour!).

LVOL vs. SPLV

2011-10-04T17:09:00.012-05:00

There are two low vol ETFs out there, and there's one main difference. LVOL is Russell-Axioma US Large Cap Low Volatility Index, and is drawn from the Russell 1000. SPLV is the PowerShares S&P500 Low Volatility Fund, and is drawn from the S&P. Thus, SPLV is more large cap, LVOL more small cap.

If we look at the time series since they both have been available (7/1/11), we see the SPLV has done much better than the LVOL, just as the S&P500 did better than the Russell 1000 over this period.

Looking at my own indices, I too see that my US Minimum Variance Portfolio drawn from the S&P500 has outperformed my Beta 0.5 portfolio that is drawn from the Russell 1000, again primarily reflecting the higher cap bias on the MVP portfolio.

This highlights that there are many factors and these often explain short-term performance independent of any alpha. I think size is something to account for, so it's very important to know your benchmark, whether it is large cap or small cap, when implementing a low volatility strategy.

Envy Solves The Allais Paradox

2011-10-03T17:06:00.027-05:00

Maurice Allais won the Nobel prize for stuff that is never really read anymore, but his curious Allais paradox has endured because it's both simple and baffling.

It arises when comparing participants' choices in two different experiments, each of which consists of a choice between two gambles, A and B. The payoffs for each gamble in each experiment are as follows:

Experiment 1				Experiment 2
Gamble 1A		Gamble 1B		Gamble 2A		Gamble 2B
Winnings	Chance	Winnings	Chance	Winnings	Chance	Winnings	Chance
$1 million	100%	$1 million	89%	Nothing	89%	Nothing	90%
		Nothing	1%	$1 million	11%
		$5 million	10%			$5 million	10%

Several studies involving hypothetical and small monetary payoffs, and recently involving health outcomes, have supported the assertion that when presented with a choice between 1A and 1B, most people would choose 1A. Likewise, when presented with a choice between 2A and 2B, most people would choose 2B. Personally, I would make those choices too, and haven't met anyone who wouldn't.

This is inconsistent with expected utility theory. According to expected utility theory, the person should choose either (1A and 2A) or (1B and 2B).

The problem comes from basic utility theory, because if you plug in a utility function like

U(x)=-exp(-aW) or W^(1-a)/(1-a)

Where W is your wealth and 'a' is your relative risk aversion coefficient, it never works; that is, they can't generate the preferences for 1A and 2B. The Wikipedia page on this outlines the simple proof, which is irrefutable. Something is wrong, and there have been several solutions, all ad hoc. For example, Kahneman and Tversky's Prospect theory allows one to weight outcomes arbitrarily, and so can accomodate this, but the weightings that solve one paradox imply nonsensical other outcomes, such as the simultaneous desire to prefer gambling and insurance, which was the initial motivation for prospect theory (see here).

Allais highlighted that the problem was probably with the independence axiom of von Neumann-Morgenstern utility functions, which basically is the one that implies we don't care about our peers, just our own wealth. For fun, I tried applying a relative utility function to the gambles in the Allais paradox (back to the envy meme). The key is that decision makers imagine the gamble in a world where their neighbor is presented with the same option, so you have to imagine them having been given this absurdly generous gamble as well, and contemplating the relative squalor or richness in the various states. Basically, applying U(x/y), where y is your neighbor's wealth (who is offered the same gamble), as opposed to U(x), where your utility is independent of your neighbor.

If you assume you and your neighbor start with $100k in wealth, then at a certain level of risk aversion (>3.02), with exponential utility, your preferences are for 1A and 2B! This applies to either averaging the two states, or a 'maximin' approach that maximizes the minimum utility among all the states. At really low risk aversion, you prefer the higher expected value choice 'B' in both gambles, and with sufficiently large risk aversion you prefer choice 'A' in both gambles.

It's not really important what the precise numbers are, but it's useful to understand this paradox has a solution within relative utility that is not as ad hoc as prospect theory. Exponential utility is very common because the expected utility for normally distributed wealth has a closed form solution, and this is very convenient, an innocuous simplification for exposition in many applications. However, as it implies 'constant absolute risk aversion', where everyone treats $1 of wealth variance the same, this is not desirable, because then the rich and poor would allocate the same dollar amount to risky assets, which we don't find realistic. Thus, most researchers like to use 'constant relative risk aversion utility functions' like x^(1-a)/(1-a), and there the trick does not work--same paradox as before.

So, it's not as if relative utility neatly provides an insanely robust solution to a prominent game-theoretic paradox, but it does provide a reasonable solution. The exponential utility function is pretty common, and I suspect this result holds across many other specifications. Further, it highlights Maurice Allais's initial intuition was correct, that the wrong assumption was that utility is independent of what others have.

You can download my Excel sheet with the example worked out here.

Learning to Accept Envy

2011-10-02T18:19:00.018-05:00

Economists are pretty comfortable with simple self-interest, where individuals maximize their own wealth. It's part of what makes them flint-eyed realists as opposed to naive social philosophers who think the world can be made better by convincing men to be selfless. That is, after being beaten up by utopians who envisaged a society ruled by thinking about society instead of themselves, most now see how selfishness is consistent with a growing economy (the invisible hand, Adam Smith), being nice (reciprocal altruism, see Robert Axelrod or Robert Trivers), and is an efficient way to incent people with relevant information to get them to do the right thing (Friedrich Hayek's work). Just consider that ants, who sacrifice themselves without pause for the group and work tirelessly for the tribe, are also genocidal maniacs. Our selfishness, paradoxically, makes us wealthy and nice.

Unfortunately, after having reconciled with greed, envy seems still outside acceptable behavior. Envy is one of the Seven Deadly Sins, and is rather prominent in the Ten Commandments (coveting neighbor's goods, God's envy of other gods). So, compared to simple greed, it has a similar pedigree, even if we think it worse than greed.

Several econ bloggers commented on Brad DeLong's remark that the rich gain utility from their relative consumption, and so the optimality of more progressive taxation. Alex Tabarrok remarked that we should not encourage envy by the lower-income people; Greg Mankiw sees envy as economically destructive, and arbitrary (stopping at our borders); Megan McArdle sees inequality in much more than income, which leads to absurdities if we tried to apply this to looks. All seem pretty intent on keeping envy out of their assumptions about human behavior, a vice more like pettiness than greed.

It's hard to avoid envy when a colleague gets a great new job, but that's not society's problem, just mine. Luck is a big part of life, and it's actually not pretty to envisage a world where payoffs are not so random. Consider that in competitive chess players have much less random outcomes than in other sports, and they are rather depressive bunch (see Tyler Cowen on this here, and he was a good young chess player). Randomness in life allows us all a little excessive optimism, and such optimism makes us happier and more successful.

Rober Frank's book on Social Darwinism, reviewed here in Slate, argues that because of conspicuous consumption driven by attempts to increase our relative status, we engage in lots of wasteful consumption analogous to elks with large antlers: we'd all be better off with smaller antlers (houses), but individually we all benefit from larger antlers (houses). He then thinks, why not tax consumption progressively, to the benefit of all? No fancy watches, cars, and grills, for anyone, will benefit everyone.

It's heartening to see so many taking up the envy paradigm--even if to say it's all wrong--because as I've argued, if we are primarily envious as opposed to greedy, that would explain the lack of a risk premium. I'm also OK with envy, in that we just started trying to figure out its implications, and it may turn out to be as innocuous, even beneficial, as with greed. For example, envy allows us to empathize with others who still don't need our money to survive, which describes virtually all of the poor in America; it's nice that we are charitable towards the poor today even though they are wealthy beyond anyone's dreams prior to the 20th century. As envy is rather hard-wired it would be odd if it were completely dysfunctional to our species, and so I suspect it is essential in moderate doses because every instinct we have has some base benefit (greed, lust, pride). In any case, it can still be important even if it makes us all worse off.

As to discouraging antler growth, the size of elephant seals, or Patek Phillipe watches, this seems to ignore the fact that almost all of the amenities of modern life are unanticipated benefits from someone who was probably partially driven by his desire to have the best car among his social circle. The great technology, art, and philosophy we enjoy is a by-product of selfish, and envious, individuals. Were we to prevent conspicuous consumption, how much less would we have? That's a hypothetical, but consider that many technologies started as baubles for the idle rich, and then became extremely useful for more mundane uses (no one anticipated computers or cars becoming essential household products).

Envy is ubiquitous, one of the Human Universals found in every culture at every time. It's not a societal problem, but a personal one, one that deserves moderation like so many of our instincts. Economists would do well to start taking seriously the implications of envy over greed, its effects show up in all sorts of unexpected, important places (eg, asset pricing theory).

Low Vol Investing in The News

2011-10-01T19:33:00.003-05:00

See Barron's here, and WSJ here. I'm mentioned in both articles, so obviously they got their facts straight.

As Eddy Elfenbein noted, this was probably all instigated by his post last week on the subject.

Letting Greece Go

2011-09-28T20:28:00.002-05:00

John Cochrane makes a good point about Greece: if you don't let it default within the Euro framework, the Euro is doomed.

Europe's deepest problem is bad ideas. Unpleasant price movements represent "illiquidity," "speculators," "market manipulation," "lack of confidence" and "contagion," not the hard reality of looming default. The point of policy is to "calm markets" and "provide confidence"—not to solve financial problems.
...
The worst idea of all is that Europe's admirable economic free trade zone and currency union cannot survive a sovereign default. It is precisely allowing sovereign default, and isolating the central bank from sovereign default, that is the only way to keep the union together. That is, after all, how the euro was set up in the first place. It's almost too late. But not quite.

Another Reason to Worry

2011-09-27T21:00:00.002-05:00

Over at the AEI, Andrew Biggs asks an important question:

Public pensions report that over the 25-year period from 1985 through 2011 they have achieved a median investment return of 8.8 percent, exceeding the 8 percent returns they project for the future, and have earned these returns without taking undue risks. Given this, they say, why shouldn’t we assume they can keep on doing so into the future?

The answer, of course, is that that period had a reduction in rates from 10% to 3%. The raised the sample return to an average bond portfolio by about 3% annually. If long term interest rates went to zero, the benefit would only be about 2.1% annually. Most likely, rates will rise, because that is what the Fed wants them to do! Thus, instead of a 3% tailwind, there will be something like a 1-2% wind in our faces over the next 25 years.

I hope there are lots of Doug Edwards's out their, eager to pay more taxes.

Why Ambiguity Aversion is Rational

2011-09-27T04:39:00.013-05:00

Kierkegaard noted that 'Life is to be understood backwards, but it is lived forwards,' which is kind of sad--as is much existentialism--because it emphasizes how much time we spend on things we can't affect. Leave it to the government to make this an economic policy.

The SEC gave a Wells notice to S&P for their dealings with a 2007 AAA rated CDO that subsequently went into junk status. The smoking gun is that while the deal was done with an assumed collateral issue that would be investment grade, by early 2007 the market was already tanking, and the issuer had subprime collateral. An email documents S&P was aware of this.

This was a mistake, one that was probably made many times previously but they got away with it because AAA securities tend to have multiple levels of redundancy, belts and suspenders. Securitization became very complicated over the years, with many different tranches and waterfalls, and alas any explicit, complicated process invites its circumvention, so issuers and borrowers eventually figured out the mortgage-CDO game and pushed weaker and weaker collateral into them until they finally imploded. Those screaming warnings while it was happening were ignored (Stan Liebowitz), those who said these effects were innocuous, even morally righteous, were rewarded (eg, Richard Syron, Alicia Munnell). When this house of cards collapsed, everyone points to those with the deepest pockets, though no one seems to be going after Jamie Gorelick.

This was probably the last big mortgage deal to go through as if things were business as usual. As Bernanke noted, the mortgage market shut down in mid 2007 because issuers could not get the ratings needed. Market players make mistakes, but at least they stopped their idiocy 4 years ago, unlike our government, which even today issues mortgages with 3.5% down though private lenders are back to demanding 20% down.

This case highlights the importance of ambiguity aversion, as opposed to risk aversion. If a bad outcome results from a prospect about which an agent had, with the benefit of hindsight, made a mistake, he looks not just unlucky, but incompetent or malicious. In experiments, a lottery ticket is worth a lot less after the drawing for most people even if they don't know what the true number is, and seemingly the seller does not either. People shy away from processes about which they think they have insufficient, as opposed to probabilistic, information, even if framed identically (eg, both with a 50% chance). This is ambiguity aversion.

A bad outcome resulting from a pure risky prospect, on the other hand, cannot be attributed to poor judgment. If all possible information about a risky prospect was known, failure can only be bad luck. The key is, ex post, can you look like a sucker or just unlucky? Investment managers can live with bad luck, but their reputation is essential and they can't be seen a fool.

This aversion to 'incomplete information' games is related to, but different from, classical risk aversion, and probably explains why lenders are now so afraid to lend: if they make a mistake now, it won't be merely a bad investment, but a crime. Life is a lot more like a game of incomplete information than a roulette wheel.

AAA ratings on securities that subsequently suffered generated big losses to investors, the people who ultimately should be monitoring the credit agencies. Their incentives are already aligned. The rating agencies themselves have suffered credibility shocks for this, and so now we have DBRS and Kroll jumping into the previously unpenetrable field. Jumping onto the battlefield and court-marshalling the wounded is a poor tactic for improving morale or future performance, rather, it will just encourage all sorts of tentative, butt-covering behavior that precludes the dynamism a growing economy needs.

Risk-Return Duality

2011-09-25T19:29:00.011-05:00

If the standard asset pricing model is correct, we estimate expected returns from risk premiums and their factor loadings (eg, beta*equity return premium), and we can infer the risk loadings and risk premiums from an expected return. Given we don't observe expected returns, but assume that with large samples, average returns estimate expected returns, this is why the small cap risk factor is supposed to exist, because it tautologically explains the higher return to small cap stocks over large cap stocks. In this way there should be a risk-return duality from expected return to risk.

There has been a long tradition in Western thought of trying to develop a set of beliefs that are objectively true and rational. This usually involved some basic assumptions and then logic, as in dialectical materialism, or Russell and Whitehead's Principia Mathematica. It is very comforting to think that important beliefs are can be rationally justified, in contrast to beliefs based on faith or aesthetic preferences. When finance created asset pricing theory in the 50's and 60's, this kind of rational reductionism was dominant, and it seemed obvious that applying the logic would render previously intractable, qualitative problems into unambiguous solutions within linear programming or dynamic programming. Expected returns in this framework have a rational, objective grounding, a la Logical Positivism. Alas, out investment beliefs is just like our other beliefs, and it is futile to try and make them apodictic.

ProShares has revolutionized trading with their plethora of levered funds that provide 2 times the daily return of some target index, such as the SSO ETF which replicates a strategy that generates 200% return of the S&P500 index over a single day. These ETFs are very popular, and obviously have the precise doubling or tripling of the covariance as the targeted index. Yet, due to trading costs and compounding, the returns over longer periods are significantly lower than 2 times the return on the index. Of the 24 ETFs that promise a 200% daily return of the index, where the index has risen since the end of 2009 through August 2011, the average Ultra ETF has returned about 10% less than 2 times the index. If returns are a function of covariances, investors are being shortchanged here, and the ETF should trade at a discount to net asset value, but they don't.

Imagine a world where expected returns are solely a function of covariances, as standard theory implies. Then if you create assets with specific covariances, the market should give them specific expected returns. Everything should be consistent. People should expect risk and return to be positively correlated.
Instead, Sharpe and Amromin find that people expect volatility and returns to be inversely correlated: when they are bullish they expect low volatility, and when they are bearish they expect high volatility. This is counter to standard theory, where basically expected equity returns should be a linear function of market variance. Given the inverse correlation between returns and volatilities, where increases in stock prices correspond to decreases in implied volatilities and vice versa, this makes sense. People are clearly assuming a specific return, and then deriving the volatility consistent with that scenario.

For buyers this means they expect volatility to decrease as the price rises, as it does in practice (and is implicit in the volatility skew in equity options). It is not possible to expect a really large expected return without assuming a large amount of risk, merely because it necessarily follows that if you expect, say, a 20% return on an asset, it must be capable of generating a fluctuation that high, which unfortunately also implies it could fall by 20%. The conditional volatility on an asset where a relatively large return is significantly probable must be larger than for an asset where a relatively large return is less common. Expected returns are a function of expected volatility (higher volatility assets have higher conceivable returns), but they are collectively wrong, which is why future returns are decreasing as a function of volatility.

Investors understand that stocks prices fluctuate randomly, but just as 'no conqueror believes in chance,' no active investor believes in chance either when they take risk. People are thinking about the collapse of the wave function, as opposed to the wave, because it’s more common for investors to think about outcomes as opposed to probability distributions. They understand they can be wrong, and experience much anxiety about their investments, but that's different than thinking that expected returns are random, and very few investors base their expected return on risk factors and their loadings, as opposed to some specific outcome.

There is a duality, but it involves two sets of expected returns. If people invest based on the delusion that their expected returns are single outcomes, they are constantly evaluating value. Many investors are making this work, investing by applying some discounted cash flow logic. They are sufficiently right that a stock price is a decent estimate of its future profitability, but sufficiently wrong so that the stocks with the greatest expected variances, which necessarily include those stocks with the greatest expected returns among its investors, tend to be most 'over-bought', and thus have the lowest returns. Expected returns, derived from a model that empirically estimates expected returns from historical returns, as opposed to canvassing investor opinion, are negatively related to risk. Low volatility investing is truly outside-the-box, an expectation that comes from noting the emergent pattern caused by investor beliefs, which contain a systematic bias.

UBS Staffed by Idiots

2011-09-22T14:20:00.012-05:00

Perhaps the aristocratic heritage of Swiss banking has generated their version of Charles II of Spain. That's the poor, misshapen sap to the right with only 2 great-great-great-great grandparents, a family tree that converges.

I wrote a rather fawning post complimenting UBS on their candor and perception when the wrote up their 2008 debacle. They seemed to have identified key errors in judgment, and were refreshingly detailed in the origin of their write-down (I never saw anything similar among US banks). Everyone slips up now and then, and so I figured that was a sign of a healthy organization that merely made a singular mistake.

However, 2 strikes and you are out. Reading snippets about their $2B loss via some low-level trader makes me think the bank is thoroughly incompetent. This 'Delta One' desk had a $7B rogue trader loss only a couple years ago, so they should have been keenly aware of the potential risks (this was at Soc Gen--the businesses have the same Delta One name for some reason). To generate that kind of loss implies several levels of fail within risk management, the trading desk itself, and the back office. It's easy to think a couple people screwed up, but this must have involved at least a dozen important people who apparently got paid to surf the web all day.

When I worked for a large bank there were many senior executives who were good at playing the game, but ultimately ignorant of how banks made money. These include those who were good at glad-handling the various political bodies that were essential to many of our strategic efforts, such as what businesses we could enter, and keeping competitors out under the pretext of protecting the consumer. Unfortunately, as $115MM Citigroup executive Bob Rubin showed, such skill doesn't translate in an ability or even interest in nitty gritty issues like what's on the balance sheet. A smart banker avoids positions unrelated to the core business of originating and distributing loans and deposits and other financial instruments. For example, it does not make sense to trade corn futures if you have no business with futures exchanges or corn growers.

I used to think the Swiss financial types were smart, with their solid currency and all. Perhaps they merely avoided both World Wars, which could have been due to savvy strategy, but also chance. They seem to have good general competence (thus the nice mea culpa on their 2008 write-down), but are too aloof or naive for the realities of modern banking. They should stick to chocolate.

Credit Suisse Arb Index Fishy

2011-09-21T15:53:00.008-05:00

Credit Suisse has an 'Arbitrage US Index' (CSIARBUS Index), that presumably reflects the return on 10 stat arb strategies. The total return since inception in Jan 2002 is above. It's a Sharpe of about 2.4, Madoff-like. If it's real, everyone should put most of their money in such strategies asap.

I'm rather skeptical of such indices. Where's the infamous August 2007 draw down? The index was first made available on Bloomberg in February 2011, and just this August this index had its worst draw-down ever. I have a feeling it is filled with innumerable back-fill biases, a typical naive backtest quants present all the time, oblivious to their selection biases. I looked on the internet for some kind of description, and found nothing.

The world doesn't need more institutions presenting implausible returns. It sure doesn't help their credibility.

Keynesian Anecdote

2011-09-20T10:36:00.009-05:00

From Ron Suskin's book on Obama:

By the estimates of [Christina Romer's] Council of Economic Advisers, at a cost of $100,000 per job, $100 billion would mean one million new jobs. "A million people is a lot of people."

Obama was unenthusiastic. Romer, in meeting after meeting, came back with new plans, new ways either to locate $100 billion or pitch it to Congress. Her appeals were passionate. She said they were falling into a "The perfect is the enemy of the good" trap. It's about doing something, anything."

The focus on jobs irrespective of whether they pass a cost-benefit test, highlights the worldview of Keynesians, where spending on anything when unemployment is high, is a good thing via the magic of the multiplier. Further, spending $100k per job is good because it's a million jobs. One wonders if there's a price at which it would not be attractive.

Obama to Lower Interest Expense by $430B?

2011-09-19T19:44:00.003-05:00

I saw this number in various news summaries, but no details (eg, here and here). I suppose if you use future values instead of present values, when you lower the deficit by a dollar in some future year--say 2014--you generate an almost infinite amount of interest savings on our perpetual debt.

Is Low Vol Investing a Value Play?

2011-09-18T19:31:00.009-05:00

Dimensional Fund Advisors, the embodiment of conventional wisdom for rational academics, has a paper out--Understanding Low Volatility Strategies: Minimum Variance, by Ronnie R. Shah--arguing that low volatility funds are basically value and industry plays in disguise (I can't find it on the web, so I won't post it, but it seems like a standard white paper for public consumption). It's really a spin on Berd Scherer's white paper from last year, inspired by Dan DiBartolomeo's 2007 PowerPoint, that the value stocks are driving low volatility's seeming alpha. Both of these papers devolve into convoluted arguments certain to rationalize the CAPM framework, but instead are just squid ink. DiBartolomeo states that the value premium is primarily just a return to negative skew, which investors dislike and thus demand a premium.

The skew explanation for anomalies is plausible at 30,000 feet, but find this line of reasoning rather unserious, as when Nassim Taleb pals around with Danny Kahneman, one arguing that we are primarily prefer positive skew (Kahneman), the other negative skew (Taleb), and they happily consider themselves brothers in arms. It's like anarchists and fascists united against the status quo, which would excusable if they were not also happily convinced they are more alike than different.

The negative skew premium may exist, but then one would have to then explain why equities are generally thought to have higher returns than corporate bonds, even though clearly bonds have much greater negative skew than equities. And just look at the histogram of monthly returns for the market, size and value factors (from Ken French's website). I don't see how value is considered to have negative skew.

Lastly, Post and van Vliet (2006) showed that if you actually look at utility functions where investors care about variance AND skew, the maximum skew premium is a fraction of the 'variance premium', about one-fifth as large. This is because investors still must be globally risk averse, and since skew and variance are positively correlated, there are limits on how large the skew aversion can be relative to the variance aversion.

Scherer notes that if you construct a minimum variance portfolio a certain way, and regress it against the 3 Fama-French factors (market, size, and value), as well as long-short portfolios formed on betas and residual variance, much of the MVP's performance is 'explained'. Now, given MVPs load up on low beta and low residual risk stocks, it's obvious that a long-short portfolio formed on CAPM betas and residual variances would explain the MVP return relative to the broader index, but that's really not interesting. It's a bit like saying the book/market effect explains the price/earnings effect.

The DFA's Ronnie Shah, meanwhile, is much clearer, but makes the same point. He notes that the return premium to value and the market is about 4% for both. As the market beta on his MVP portfolio is about 0.75, and his beta on value is about 0.25, it seems like a swap of market exposure for value exposure.

It could be, but I'm skeptical for two reasons. First, as Daniel and Titman 1997 noted, the return to 'value' is more a function of it's characteristic, low book/market, than its 'factor loading', which in the case of value is merely a loading on itself. Houge and Loughran found that mutual funds with high value loading, independent of whether or not it was a 'value fund', had no explanatory power. The value risk factor is really just the value anomaly rebranded as a risk factor, because it isn't obviously 'risky' in any sense. Originally it was thought value was related to financial distress, but then when we look at distress directly, such as using agency ratings or metrics of default based on income statements and balance sheets, distressed firms actually have lower-than-average returns. So I'm skeptical value is anything but a characteristic-based anomaly, not a 'risk factor'.

Secondly, when I look at the Minimum Variance and Low Beta portfolios I have created, I do not see a consistent value loading. Looking at the MVP, which I have data from 1998 to 2011, it estimates value beta of 0.34 using monthly data. Using daily data from July 2000 through July 2011, the value beta is 0.24. These are around what Shah gets. Yet it floats around like an incidental symptom, not something fundamental. Here's the data for my MVP and Beta 0.5 portfolios using daily data (value beta being a loading on the Fama-French HML value factor proxy):

Here it is using the longer monthly time series:

While on average, the value beta may be around 0.3, it doesn't seem consistent enough to be fundamental.

Now, Shah does note that low vol portfolios tend to have a lot of utility loading, and little technology. True. But I've never seen someone argue that various industries have higher risk than others. Looking at industry relative returns, one three-year period over the prior, there is no pattern. That is, past winners do not repeat consistently, as they would if there were an industry risk premium. So, to say this is picking up the 'utility' risk premium, and avoiding the 'tech' insurance premium, does not make sense. Of course, the higher-weighted utility industry has much lower volatility than the lower weighted tech industry, and so if there was a risk story here, it would take some special pleading.

Dimensional's reluctance to embrace low volatility investing is good news to low volatility investors. As long as people generally keep doing what they have done, the opportunity remains to simply improve one's index returns by focusing on the low volatility subset of stocks, lowering volatility and increasing the return. It's the easiest, large-scale way to better institutional returns since the invention of the index fund.

The Big Lie

2011-09-16T09:37:00.006-05:00

The KIPP education group has been trying to sell some character values to its students:

What appealed to Levin about the list of character strengths that Seligman and Peterson compiled was that it was presented not as a finger-wagging guilt trip about good values and appropriate behavior but as a recipe for a successful and happy life. He was wary of the idea that KIPP’s aim was to instill in its students “middle-class values,” as though well-off kids had some depth of character that low-income students lacked. “The thing that I think is great about the character-strength approach,” he told me, “is it is fundamentally devoid of value judgment.”

Now, if on average the poor possess an equivalent amount of most virtues--discipline, generosity, prudence, etc.--then there's a massive and subtle conspiracy of DaVinci code proportions going on. Virtues by definition make us prosperous, statistically. The idea that the poor are so insecure that they have to be told an obvious untruth to maintain their self-esteem merely creates more resentment against society, which they are told again and again is fundamentally unfair in a really subtle pervasive way. The truth, or something close to it, is necessary for finding the good, and that means telling kids they need bourgeois values. If someone points out that such values are more like 'middle class values' than 'public housing values', the kinder might actually appreciate the connection between these abstract concepts and concrete results.

Bogle's Beginnings

2011-09-14T16:27:00.010-05:00

John Bogle is one of the founders of index investing, a very valuable tool still underutilized by investors. Bogle writes over at the WSJ:

The idea that passive equity management could outpace active management—then the mutual fund industry's universal strategy—was derogated and ridiculed. The fund, now called the Vanguard 500 Index Fund, was referred to as "Bogle's Folly." Yet today indexing has come to dominate the field. Over the past five years, index funds have accounted for 100% of all equity funds' cash flows, with assets now totaling $2 trillion, one-fourth of all equity fund assets.

The story is a good one. In 1951, the anecdotal evidence John Bogle--a mediocre student at Princeton--assembled in his senior thesis on the then-minuscule mutual fund industry led him to write that mutual funds “can make no claim to superiority to the market averages.”

In 1975 Vanguard was a shareholder-owned mutual fund group—the company was owned by the mutual fund investors—so low-cost fund administration was not taking money from owners, it was giving money to them. In contrast, the idea of an index fund would have hardly appealed to a high-cost fund complex whose very revenue depended on the conviction that active management did add value, at least, in their particular case.

In his pitch to the Vanguard board for starting an index fund, he brought some of his own data on the performance of mutual fund managers, suggesting that they underperformed by about the same amount as their expenses, and some references to recent articles by Paul A. Samuelson and Charles Ellis. So, blessed with some good intuition from Bogle, the rising popularity of the idea in the academy, timing, and good incentives from Vanguard, they had both the opportunity and the motive to create the first retail index fund, which is now the largest index fund in the world, and Vanguard, the second-largest fund family. By the next summer, the fund was launched with about $11 million.

While Bogle seemingly had the idea right all along, it should be noted that there were several missteps among the index founding fathers. John McQuown and David Booth at Wells Fargo, and Rex Sinquefield at American National Bank in Chicago, both established the first passive Index Funds in 1973. These were portfolios targeted at institutions. The Wells Fargo fund was initially an equal-weighted fund on all the stocks on the NYSE, which, given the large number of small stocks, and the fact that a price decline meant you should buy more, and at a price increase sell more, proved to be an implementation nightmare.

It was replaced with a value-weighted index fund of the S&P500 in 1976, which eliminates this problem. Another misstep was clearly not targeting the retail investor early, which turned out to be where the real money was. Rex Sinquefeld and David Booth started Dimensional Fund Advisors in 1981, in part to address this deficiency. Sinquefeld was also hooked into the University of Chicago, which had Eugene Fama as its head of research. As the size effect was the hot thing at that time, DFA had a small cap portfolio at the outset to take advantage of this anomaly. Unfortunately, the size effect disappeared in the 1980s, but Dimensional was able to survive this setback admirably. Thus, even a great, simple idea like an index fund, has a learning curve in practice.

Even good ideas like index funds are not straightforward, and take some interested care to make work. Further, as John Bogle showed, it was not until he was the CEO of a fund complex that he could implement his idea for a retail index fund, and even then he dealt with a skeptical board, and relied heavily on authority figures like Paul Samuelson (Sinquefeld and McQuown were also well-connected). Imagine if he were a bright-eyed young kid with merely a PowerPoint presentation and his own data. It is essential to have the right connections when you have a good idea, more so the bigger the idea.

Why Government Spending is So Impotent

2011-09-13T08:46:00.013-05:00

We have a proposed Southwest Light Rail Transit line, a high frequency train that would connect downtown Minneapolis to my town of Eden Prairie. funding for capital costs will come from four sources: the transit sales tax in the metro area (30 percent), the County (10 percent), the State (10 percent), and the Federal Transit Administration (up 50 percent). Every month there's a new cost added to the currently estimated $1.25 billion project.

Ridership is projected to be 24,000 to 30,000 rides per day by year 2030, which would be a large increase from the 2000 rides a day generated via the buses that run from Eden Prairie to downtown. Currently, very cushy buses with large comfortable seats carry a handful of people downtown all day on each trip. Revenue, meanwhile, is falling, reflect low demand. Riders pay an average of $2.5 per trip, even though it costs $8 to cover marginal costs. The proposed project has many stops as planners hate express routes that travel nonstop node-to-node because this just encourages riders to live outside the city! The wishful thinking is basically designed to fail, not that anyone cares because they are all spending not just someone else's money, but each agency feels like the other agencies are subsidizing them, as if it doesn't all come from taxpayers in the end.

Spending money on such boondoggles to create jobs relies on a faith in the fiscal multiplier, and the magic of spending to reduce debt. Bush II spent like a drunken sailor (wars, medicare) and this ended with a disaster even though it should have been no worse than the alien invasion expenditures suggested by Keynesian economists. It should be remembered that after independence India focused on jobs and the poor, as opposed to free trade and property rights, and they stagnated for decades. If governments could boost the economy spending on big top-down projects, countries like India would have done much better than countries that were less hands-on in their management.

Good Take on Dodd-Frank

2011-09-12T15:45:00.005-05:00

I agree with Ross Levine (from BloggingHeads):

Stock Returns by Debt Rating

2011-09-11T19:15:00.012-05:00

Above are annual returns for portfolios formed every July 1, based on the Senior rating of the company. I only used non-financial companies because financial companies tend to be only with investment grade, and they are very different from a debt rating perspective (when I modeled default at Moody's, there was a clear non-financial focus because financial companies are very different).

The annual data are as follows for this period (Jul1975-Jun2011):

	StockReturns(%)	beta	Volatility(%)
AAA	12.4	0.78	17.1
AA	13.9	0.81	16.1
A	14.3	0.81	16.5
BBB	14.2	0.82	17.9
BB	15.0	1.04	23.4
B	8.6	1.43	32.0
C	-12.7	1.18	44.9

It appears there's a reasonable story one could tell about returns from AAA to BB: higher returns, and higher intuitive measures of risk: beta, volatility. But for B and C rated stocks, the returns make no sense to standard asset pricing theory, because these are obviously risky stocks. I remember presenting this chart to an NBER conference around 2000, and the esteemed audience told me I was wrong; my data had to be incorrect. I was working at Moody's, so my ratings data was as good as it got. Anyway, I wrote it up and sent it to Journal of Portfolio Management, and the editor, Peter Bernstein, wrote back they weren't accepting submissions at that time. I thought that was an odd response. This avenue wasn't part of my day job, so I let it go, but I keep updating my data for fun.

The result is really corroborated by Campbell, Hilscher and Szilagyi (2005), who found distress risk to be negatively correlated with stock returns, which makes sense because volatility and leverage is inversely correlated with future returns, and cash-flow is positively correlated with future returns, so those are the main drivers of default risk.

Reality is that which, when you don't believe it, doesn't go away, so I don't really mind when people tell me I'm wrong on facts like this.

This is not Our Day

2011-09-10T17:48:00.022-05:00

On September 11 2001, there were many individual acts of unambiguous courage, a primal virtue. As the instigators had no reasonable end to rationalize their means, the moral calculus was very simple that day. Everyone dying stoically or risking death to save others was a courageous person, and other than the terrorists all those who died were innocent victims.

I knew one person who died that day, Brit Oliver Bennett, a real mensch, but as I worked at Moody's and took the daily stop at the World Trade Center to get to work, when I see the documentaries it really makes me tear up thinking about the horrible ending to people so 'close' to me.

Physical courage is admirable, but in modern society it simply isn't as important as it was when philosophy developed 2500 years ago. Intellectual courage, the readiness to risk humiliation, is much harder, precisely because it is more ambiguous. Only with the virtue of hindsight of generations do we see intellectually courageous stands for what they were, what distinguishes the Churchills from the Maos, the Galileos from the Lysenkos. It is courage combined with prudence, not mere zealotry.

Having something terrible happen to you generates instant sympathy. Our culture has moved from from celebrating accomplishment (Eisenhower) to suffering (McCain), where suffering has been expanded to include the indignity of growing up a non-asian minority. Thus, Obama's rather cushy Hawaiian life was transformed in his autobiography into something subtly oppressive because his biological father was African.

I think it's fine to remember that many people were virtuous on that day, but statistically it occurs among millions of people who get up day after day, without complaining, and suffer indignities and physical inconvenience doing a job they are overqualified for, primarily to provide for their families. Let's not make random victimization the new template for heroes and holidays.

Unions of Peace

2011-09-09T08:08:00.004-05:00

Joe Biden, Labor Day:

"We've been through a lot of fights, but this is a different kind of fight," he told an annual Labor Day gathering of the Cincinnati AFL-CIO. "This is a fight for the heart and soul of the labor movement. This is a fight literally for our right to exist. Don't misunderstand what this is. … You are the only folks keeping the barbarians from the gates."

From the NYT yesterday:

About 500 longshoremen stormed the new $200 million terminal in Longview before sunrise Thursday, carrying baseball bats, smashing windows, damaging rail cars and dumping tons of grain from the cars, police and company officials said.

von Mises noted that unions were based on coercion and monopoly, sources of inefficiency and simple injustice in most scenarios, but, they're populist, so it's always tempting to rationalize them in some way.

Why I'm Pessimistic

2011-09-08T22:09:00.005-05:00

Last month, a big deal was made about a deal to raise the debt ceiling, which involved a major concession by Obama: $917 billion in spending cuts over 10 years. A special committee of lawmakers would be charged with finding another $1.5 trillion in deficit reduction, which could come through a tax overhaul and changes to safety-net programs. That included only $22B in fiscal 2012.

Tonight, Obama just added about $100B in spending for FY2012, as well as tax cuts and more spending in future years. Next time there's a debt ceiling stalemate, Obama should promise to cut spending by $10 trillion in future decades.

Risk and Return: Knowledge is Dangerous

2011-09-07T16:42:00.036-05:00

From Yoav Ganzach, Judging Risk and Return of Financial Assets (2001).

According to this model, unfamiliar assets are unidimensionally perceived on a continuum ranging from “good” to “bad.” Judgments of risk and return are derived from this unidimensional attitudinal continuum. If an asset is perceived as good, it will be judged to have both high return and low risk, whereas if it is perceived as bad, it will be judged to have both low return and high risk.

[for familiar assets the results are] similar to the standard economic model of the risk and return of financial assets (e.g., the Capital Assets Pricing Model; see, for example, Sharpe, 1981).

So, when judging familiar stocks, analysts' judgments of risks and returns were positively correlated, as conventionally predicted. But when judging unfamiliar stocks, analysts tended to judge the stocks as if they were generally good or generally bad - low risk and high returns, or high risk and low returns. Ganzach presents some surveys, testing a bunch of MBAs familiar with the CAPM. He basically argues that when people really understand an asset, they then apply the standard CAPM reasoning (expected return inversely related to risk), and worked backward from the intitial 'good asset' to 'low return' (or from 'bad' to 'high'), using their theoretical training. The author assumed without much note the CAPM theory as correct. I see it as applying a theory that is severely contradicted by the data, solely because it is so well believed by conventional wisdom.

These students would have been better off in a state of ignorance. Empirically we know that high cashflow and low volatility are correlated with higher-than-average returns, but there's no dominant theory for that.

Ganzach's 'unfamiliar asset' finding is what Sharpe and Amromnin found in general surveys of American investors that when they believed times were propitious for stocks, they would have high returns and low risk. Forecasting the overall market is something difficult for anyone, so individuals would likely behave as if this were an 'unfamiliar' asset play.

But with some knowledge of the situation, one sees the particulars which are invariably mixed: everything has pros and cons. To see a pattern within this overload of data requires a theory, and the dominant one in this case is that a 'good' company is not risky (eg, high profits, low volatility), so its return therefore should be low.

People apply the halo effect because it's generally true, in this case to company risk and returns. The 'halo effect' theory is certainly not true all the time, but the key is it just has to be true most of the time to be a useful generalization, because it then saves one time thinking about things.

When we have a lot of data, however, we override this generalization, because we figure more knowledge should increase our understanding of whatever we are examining. This too, as a generalization, is true. All theories are wrong, some are useful, so the hope is that your theory is of the latter sort. In these cases, the more one knows, the more one is lured into applying their theoretical knowledge, and then the issue is whether or not their underlying theory is either irrelevant or has a sign error. Unfortunately, a lot of conventional theories are profoundly wrong.

Consider that in earlier days, people thought eating fat made you fat, boys secretly desired to have sex with their mothers, and that people learned solely through operant conditioning. Consider that today, people with education degrees tend to emphasize credentialism even though they are in the best position to understand how wrong this is, or most macroeconomists think that when unemployment is high the government should spend ever more money regardless of how it is spent; experts are less wise than laypersons in their very own fields.

When you know a lot of facts you can rationalize your opinions very well, but it does not converge one's beliefs onto better theories, more so the bigger the theory. Consider how psychologists are not happier than average, political scientists never seem attractive politicians, economists are generally not good economics advisers .

When William Blake noted that 'To generalize is to be an idiot. To particularize alone is a distinction of merit', I am sympathetic. People are bad at generalizing in general. Humans are pretty good at picking up social cues, sensing when their dog is hungry, but the more abstract the worse it gets. Our wet neural nets simply weren't optimized for this kind of thing, which is why common sense among experts is less frequent than what one thinks greater learning should bring. We are often led astray by theories that tend to tell comforting stories, or that contain bad analogies, faulty extrapolations, or omitted variables biases. We can't avoid generalizing at some level, just as we can't look at data and see anything without some kind of theory. But it's a useful generalization that when your source is an academic theory, caveat emptor.

US MVP Year to Date

2011-09-06T19:24:00.004-05:00

I have my own set of MVP and low volatility indices over at betaarbitrage.com. Here's the MVP drawn from the S&P500, compared to the S&P500 this year. It had a very good August, primarily because it has only 50 stocks from within the S&P and one of them was Motorola (that generated 1.5% to the index in August). So, it's up 13% more than the S&P for this year, whereas prior to that, from 1998 through 2010, it outperformed only by 4.8% annually. An it has about a 0.5 beta, and about 18% less volatility. Basically, it outperformed because of standard tracking error, being a subset of 50 stocks, so I don't read too much into one month.

I'd like to find the other MVPs and see how they compare, as I bet over short periods like 8 months they vary a lot. One distinction of mine is that I totally ignore industry concentration, and just take the 50 stocks that generate the lowest portfolio variance (estimated on 3 latent factors using the prior 252 business days). A lot of people add industry limits, but I find that double counting. It is not as if any industries have an obvious 'size' or 'value' effect, and to the extent they are correlated that should be addressed in my algorithm. So, que sera sera, industry-wise. I think it might be my special sauce relative to all these newcomers.

California to Regulate 2-hour Babysitter Shifts

2011-09-05T19:39:00.002-05:00

Regulation in this country is out of control. Anyone who has met with 'regulators' knows how incredibly ignorant they are about what they are trying to manage, as when a boss 4 levels above you comes in and tries to make your daily tasks more efficient. They are often good people, just doing their job, but it's rather pitiful watching them come in, you explain what you do, and they make some silly reporting requirements. The latest turns the regulator knob to 11:

Under AB 889, household “employers” (aka “parents”) who hire a babysitter on a Friday night will be legally obligated to pay at least minimum wage to any sitter over the age of 18 (unless it is a family member), provide a substitute caregiver every two hours to cover rest and meal breaks, in addition to workers’ compensation coverage, overtime pay, and a meticulously calculated timecard/paycheck.

Betting on Banks

2011-09-05T18:43:00.004-05:00

Warren Buffett made a big investment in Bank of America a couple weeks ago. The PE based on estimates of next year's earnings is about 4, which suggests it is really cheap. Unfortunately, there's a catch.

Our government is going after the banks, suing them for losses on loans guaranteed by Fannie and Freddie. As Dick Bove notes, this would be the tip of the iceberg:

The price tag is unlimited. Basically, we can look at Fannie Mae and Freddie Mac and say they've lost $33 billion, supposedly, as a result of buying these bad mortgages, and therefore, those losses should be put back to the banking system. But in essence, if we establish the precedent that anyone can sue a bank if they get a mortgage that doesn't work out, and there were $5 trillion of mortgages that were securitized through this Fannie-Freddie system over the past number of years. I have no idea how many people would sue, nor how much the courts are willing to give back to these companies and take away from the banks. It's a very, very negative development.

So, if the government wins this case, it would establish a fact that other investors could use, and given the size of the mortgage market, basically wipe the banks out. Meanwhile, Obama has been castigating 'fat cat bankers' for not lending more. Bove thinks banks are a good buy because the government will realize it is making a mistake: ruining the banking sector would not help the economy, we don't have enough money to recapitalize it after giving it to the trial lawyers.

The government is basically behaving like a child, wanting inconsistent things. That's understandible, because the government is not a unified whole, rather, a collective with many parochial interests. The rumored call for selective stimulus through targeted tax breaks for 'innovative' businesses, and the constant demand for closing corporate loopholes, is inconsistent. Today's loophole is yesterday's targeted tax break. So is the idea that for labor, temporarily reducing payroll taxes is a good idea, but that same administration has pushed for increasing the minimum wage.

Bove is betting that the FHA will have the wisdom to drop the lawsuit because winning would be a tragedy for the economy, and I bet Buffett also has this kind of faith. It's an interesting gamble.

Personally, I think the quicker bad ideas fail the better. Obamacare is really poisonous because it kicks in slowly and front loads revenues, so by the time everyone notices it is a bad idea and very expensive (say 2014), it will be impossible to prove what provisions and who is at fault (the new President, or Congress, will be to blame). Let the FHA win its lawsuit asap, crash the economy, and then our legislators may understand that without a vibrant business sector, they have no taxes to distribute.

In practice, Correlation Implies Causation

2011-09-01T08:00:00.007-05:00

Of course, everyone knows the cliche that correlation does not imply causation, but in practice any correlation that fits into a narrative is seen as evidence of that theory. This NBER paper by Currie and Tekin argues foreclosures lead to a variety of bad health outcomes--sort of like the symptoms of chronic fatigue syndrome. It's a joke, but sure got a lot of play over the past few days because it's so darn helpful to some people. See the attached graph, which underlies their findings. The NBER, like the American Economic Association, is a pretty official, bureaucratic, PC trade institution that wants to be relevant and respected.

This is the same group condemned The Bell Curve for producing arguments directly to a public that could not understand statistics as well as trained economists, an absurd proclamation that would eliminate all working papers and books. Econometric technique is much less important than one's biases, which is why we should have 'free-market', 'Marxist', and 'Keynesian' econometricians, just like we have Republican and Democratic pollsters. It's not like a lifetime Keynesian/supply-sider, at age 50, will suddenly publish a paper documenting that fiscal multipliers are exactly opposite to their preconceptions. It's the meta-decisions of what to look at, what to control for, that fall outside any formal statistics that determine most interesting conclusions, not some asymptotic distribution on moment restrictions.

How to Double Productivity

2011-08-30T10:43:00.012-05:00

Macroeconomists focus on things like increasing education, tax breaks for trendy investments, even space aliens and hurricanes (more jobs!), but the best way to increase productivity is to deregulate. A lot of this overbearing regulation is from union-related work rules. In this Ed Prescott video he mentions this case study of how the Minnesota mining productivity soared after being exposed to new competition from international markets. Output fell about 50% from 1979-82. This study is from James Schmitz an the Minneapolis Fed:

In response to the crisis, these iron-ore industries dramatically changed how they produced iron-ore, in the process doubling their labor productivity and pushing foreign competition out of the Great Lakes.

...I begin my analysis of productivity in Section 3 by describing the work rules that prevailed before the crisis. These placed restrictions on the tasks individuals could perform at mines, particularly repair work. First, machine operators were not permitted to perform even the simplest repair work on their machines. Second, repair staﬀ had restrictions on their work. In particular, there were a very large number of repair job classiﬁcations, close to thirty. A person with a given classiﬁcation was permitted to complete repair jobs assigned to this classiﬁcation but not others. In response to the crisis, work rules were changed to allow machine operators to conduct simple repairs and which reduced the number of repair job classes... a growth accounting exercise would show this growth (from changes in work rules) was “accounted” for by increases in total factor productivity, and in the capital-labor and materials-labor ratios.

Over the next five years, productivity doubled.

The increase in regulations is difficult to quantify, but consider that just last week the proposed TransCanada pipeline, known as Keystone XL, has had dozens of public meetings, hundreds of thousands of comments, and extensive consultations with the EPA, DOT, USDA, DOI, DOE as well as several other federal and state agencies. A recent abortion kerfuffle occurred when Virginia's Department of Health proposed regulations for abortion clinics that are consistent with the construction of new hospitals, and all the sudden liberals realized how insanely onerous these regulations are. The bottom line is that regulations are very costly, and they are growing, as Obama is pushing for more EPA regulations based on fanciful savings to health care costs.

Unfortunately, for Keynesians there's no interest in the effects of regulations on aggregate demand.