End of World Note

Considering the world will end at 6 pm local time today, you should remember the South Park episode 'Probably', where everyone goes to hell. At one point the newcomers to Hell are being informed they were damned. One guy says 'hey, wait a minute, I shouldn't be here, I was a totally strict and devout Protestant, I thought we went to heaven?' The tour guide says 'you picked the wrong religion.' The correct group ... Mormons! I'm hoping that's not how it goes down, but we'll see soon enough.

Man Finds $45k in Attic

There's a nice story about a man who found $45k hidden in a house he bought from the family of an old man who recently died. He did the good thing, and gave the money to his family. Back in the 1970's, my family moved into a rather unique new house in a suburb of Cleveland Ohio. It was reputedly constructed by a mafia man, and had a fun rec room we called 'the ballroom' because it had floors for dancing with speakers and a bar with mirrors at one end. We bought it for $80k, which was slightly above market in my neighborhood, but nothing one would consider rich (not a prime residential neighborhood).

In any case, a couple years after we bought it, my dad was trimming the house, and found a $10 bill coming out of the molding connected to the roof. He went into the attic, looked in the floorboard near this $5, and found $5k in cash that were all dated from the 1950s. We didn't give it back, because it literally had blood on it, implying that its exposure might be unappreciated by the former homeowners. I remember how fun it was freshening up the old bills with a laundry iron. My mom's second career after raising me and my siblings was as an IRS agent, and she made me report my summer lawn mowing income, so this was her one little transgression against The Man.

Twitter Hedge Fund

The World's First Twitter-Based Hedge Fund:

This week, Derwent Capital Markets, a London investment firm, launched a $40 million hedge fund that will use Twitter to guide its investments. The world's first social media-based hedge fund will monitor a selection of tweets in real-time to feel out market sentiment before placing its bets...
The professors harvested tweets for key words and plugged them into an algorithm to determine the mood of the broader market. Using this mood index, the professors predicted the Dow's daily fluctuations in 2008 with an astounding 87 percent accuracy.

I remember smart people looking at keyword algorithms to predict asset fluctuations in the 1990's, and these projects invariably foundered. Thus, it's not a new idea, just a new medium, in this case Twitter. I'm skeptical.

Hedge Fund Return Timing Bias

It's well-known that there's a backfill and survivorship bias to many Hedge Fund indices. As most indices promote their product, this is understandible. Yet just as with the equity risk premium, the hedge fund bias usually neglects the adverse timing bias: that market inflows and outflows make the raw time series returns overestimate the return to an average investor. Thus, many funds with $100MM in assets have great return their first year, of say 50%, and then get on the cover of a big magazine, get $1B, and lose %20. Is the return on such a fund the average--geometric or arithmetic--of the 50% and -20% return, or should it weight the 20% loss more, reflecting the performance of the average investor in that fund?

I remember in 2004 or so when convertible bonds got rocked, convertible bond indices simply disappeared, merged into other indices within broader Fixed Income categories. But then, after a strong rebound, they returned as if nothing happened.

Ilia Dichev has a new paper out (with Gwen Yu) in the JFE documenting this bias is around 3-7% for hedge funds, just as he found this bias was around 3% for equity indices:

We use dollar-weighted returns (a form of IRR) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our main finding is that annualized dollar-weighted returns are on the magnitude of 3 to 7 percent lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the S&P 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.

Antti Ilmanen estimates a 3-5% survivorship bias, and a 1-3% backfill bias in Hedge Fund indices, so be sure to add to those. Here's something simple and valuable the new Consumer Financial Protection Bureau can do: monitor and disseminate accurate asset class performance data, eliminating the bias present in most indices that tend to inflate all of them.

Bank Stocks Still Stagnant

Above is the KBW bank index (extrapolated back to 1990 via another bank index). When I was working for a bank in the 1990, I remember we always had lots of unrecognized gains in our book of assets acquired from the S&L crisis. It seemed like a bottomless cookie jar that bailed us out whenever we needed it. As there were lots of banks, and bank assets, sold well below their value, it seeded the best decade of bank stock returns ever. But after the latest crisis, bank stocks have stagnated well below their prior peaks.

I think this time, we have a reverse cookie jar. Banks had a lot of mortgage assets, and not only have those prices fallen, but the rules have changed, so that the time to foreclosure has more than doubled. Thus, banks still have lots of unrecognized losses, and like Japan in the 1990s, hope to slowly write them off. I'm guessing. One thing I learned about banking is that unless you have some first hand knowledge that CFOs have, you don't really know.

New Econ Data Sites

I don't know why, but in the past week two new websites were introduced to me that consolidate economic data: Junar and Zanran. Junar is more into charts and exportable data, while Zanran has more pdfs with academic papers on the relevant topics.

So, for example, I pulled up this on Argentina, which is an interesting case study in Keynesian policies. From 1890 to 1939, the country's per capita income was similar to that of France, Germany and Canada, but then President Juan Perón took over and instituted a suite of progressive reforms: increased unionization, nationalization of major industries, more generous social welfare, increased public works investments, high tariffs and import restrictions. The big idea then was called developmentism, which is a national-socialist-fascist model that attempts to ameliorate the deficiencies of 'the market'. The result you can see below, as their income relative to other countries steadily declined from about 1946 onward (the center of the graph is 1946ish).

blog probs

so...blog was down for a day or so...came back missing last post...now back to normal...

I think it was someone in the Consumer Protection Financial Bureau...

The Perennial Hubris

Ariana Huffington makes the following lament:

"We do big things," President Obama said during his State of the Union speech in January. And, in fact, we do. Sometimes. Finding and dispatching Osama bin Laden certainly qualifies. "We are once again reminded," the president said after announcing the terrorist's death, "that America can do whatever we set our mind to." But if that's true, why are our leaders so accepting of a stagnant economy?

This kind of naive thinking is ubiquitious over time and space, the idea that collectives can do whatever they want because of examples like landing a man on the moon, winning World War 2, and now, killing Osama bin Laden (which given its cost, is hardly a great example of Federal success). The implication is that all we need is the will, and we can accomplish anything we set our minds to. Life teaches us that there’s only one corner of the universe you can be certain of improving, your own self, and even that does not imply you will be materially richer for it.

We have some affect on our family, less on friends, imperceptible on strangers. The idea that outsiders can materially improve an entire demographic--Gypsies, the unemployed, Haitians--via some federal job or income program involves a rather unempirical conceit about the ability of progressive policies to bend complex systems to our ends. To create real jobs in the public sector, jobs that provide benefits greater than their costs, is just as difficult as it is in the private economy without government. If it seems easy the result is merely consumption.

Stalin's five year plans, Nixon's War on Cancer, Johnson's War on Poverty, all shared a deep commitment from those up top. There are some things that can't be fixed merely by outsiders with good intentions, in part because they may be insoluble, in part because they may actually induces counterproductive incentives to lower level individual incentives. I remember when I worked with the CEO of KeyCorp, and can tell you he really really wanted our stock price and ROE to rise above its peers, but that didn't make it happen.

Hayek said it best in his Nobel speech:

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.

Federal do-gooders have ignored this advice, increased spending and regulations immensely over the past 4 years in order to create jobs. It has failed, and the predictable reaction by progressives is to double down. Real Federal outlays have increased 25% from 2008 to 2011, including a 40% increase in 'Income security', and a 23% increase in 'Education, Training, Employment and Social Services,' yet Ariana quotes economist Mark Thoma, who spouts the standard Keynesian belief that

We can't help to stimulate job growth if we don't try, and so far we aren't trying anywhere near hard enough.

The idea that good things can and will happen is we merely 'work together' or the rich pay more taxes is a popular belief, but it's still namby-pamby nonsense. It's unfortunate that even though the data have never shown that countries could spend and inflate their way to prosperity, one can cherry pick history to think this true. The War on Poverty, India's 'third way', the foreign aid disaster in Africa, Keynesian failures of the 1970's throughout Western Europe, affirmative action, and the positive results of market-centered solutions such as China's market oriented reforms, Adenauer's West Germany, the entire 19th century in the West, I think it's clear the best thing we can do is reduce the size and scope of government.

While many have rejected the comforting thought that an all-knowing God will reward and punish the living for their Earthly deeds, wishful thinking is still as prominent as ever. Theories like the Invisible Hand are seen as defeatist if not cruel, but most proverbs seem self-serving platitudes until you have personally experienced the truth of them.

We need some government, but given the current size of government, worry about anarchy is a bugaboo. Getting out of the way won't guarantee anything--especially equality--but it will certainly maximize liberty, is something we can afford, and is our best bet to maximize prosperity.

As laziness and self-pity are common vices, our greatest incentives are not positive but negative: the need to pay for essential expenditures. Our government is in an all out effort to eliminate this incentive via extending unemployment insurance from 13 to 99 weeks, making time since last payment to foreclosure going from 244 to 500 days, and creating make-work jobs in trendy areas like light-rail and ethanol production. Macro stagnation is the direct result of government encouraged micro stagnation, of people continuing to do things that make no economic sense for fear they won't appreciate the necessary transition. Remember that the initial reaction to the Exxon Valdez oil spill was to steam clean the rocks to get rid of the oil, which later was seen as more harmful than doing nothing; putting out little forest fires in Yellowstone created a huge backlog of kindling that created a horrible set of fires in 1988; AFDC created generations of people dependent on government without any job skills; paying people to destroy working cars increased the cost for those who did not already have cars. Complex systems are invariably made worse by outsiders trying to directly make things better.

Allowing people to fail incents them to make optimal decisions, no less so for Joe Sixpack than for Bear Stearns. It is a shame that large corporations are so cravenly dependent upon government for favors, but given the size of government and the capriciousness with which it can apply the law and create valuable favors, a corporation is like a college football program: it can't be big and not somewhat corrupt. Government can't increase our aggregate income any more than it can increase our aggregate happiness, and the sooner everyone realizes this the better off we all will be. At the rate we are on the path of all failed states where every bug needs a patch which needs another fix, all the while the size of city, county, state, and federal government keeps rising. If you look at failed states throughout the Third World you see this game does not correct itself, it simply creates a patronage system, and hypocrisy becomes a necessary tactic as bureaucrats spout populist rhetoric about how their parochial powers are in the best interests of the people.

Regal Risk Premium

The average homicide rate in America is about 6 per 100,000 people per year. Among certain areas and demographics, this is substantially higher: 42 for African American males, 40 for Detroit, Michigan, 154 for Honduras.

According to a paper by Manual Eisner, kings had a rather extreme violent death rate:

This paper examines the frequency of violent death and regicide amongst 1,513 monarchs in 45 monarchies across Europe between AD 600 and 1800. The analyses reveal that all types of violence combined account for about 22 per cent of all deaths. Murder is by far the most important violent cause of death, accounting for about 15 per cent of all deaths and corresponding to a homicide rate of about 1,000 per 100,000 ruler-years.

Further, there is 'positive autocorrelation' in murder rates, in that if you murder a King to take his spot, your probability of being killed is above trend. Thus, to commit regicide puts you in the rarefied air 10 times that of the most murderous environs on the planet.

One can see why the primary virtue of the nobility has always been physical courage, demonstrated most recently when young Prince Harry eagerly signed up for dangerous missions in Afghanistan, and has the benefit of merely being a function of will. Modern warfare and information technology has made such bravery as irrelevant and absurd as it should be for determining our class structure.

Obliquity Coda

John Kay's book, Obliquity, raises some very important points, but ultimately, his solution seems to lead at least him to nothing approaching wisdom, which is the ability to distinguish the good. Phillip Tetlock, whom Kay references, has a similar result. An expert in experts and their predictions, Tetlock surveys experts and their predictions, and categorizes them as either foxes (detail experts) or hedgehogs (big picture experts). He finds that foxes are usually right, but hedgehogs are occasionally right on the farthest out and important predictions. When asked if he is a fox or a hedgehog, Tetlock said he's a fox with a little hedgehog in him--isn't everyone? He notes this is the general pattern: foxes qualify their statements a lot, but are more correct--when you ignore the qualifications. I was left thinking he articulates some nice points, but ultimately is one of the archetypes he criticizes.

Kay notes the Iraqi invasion of 2003, and assumes without arguement it has been a failure. I agree on that, though the reason I have is probably different than for most commenters, and I think the why matters. Anyway, he notes he didn't know beforehand it was a failure, but:

I believe the right way to have formed an opinion would have been to say "I do not trust the judgment of the people [Bush and Cheney] who are making this decision or their ability to handle the consequences." That would have led to the right conclusion, and for the right reason.

As a 'right reason' it seems pure hindsight, because he gives absolutely no reason to not trust Bush and Cheney. He has other such practical examples of obliquity, which come off a lot like the derided objective to 'maximize shareholder value', an objective without much use because its easy ex post, but impossibly unspecific ex ante. Asking the right questions doesn't mean you are going to get good answers, which I guess highlights his main point, that good solutions are indirect.

Obliquity

Browsing at my local bookstore I picked up a copy of Obliquity by British economist John Kay (right), and was quickly taken in. It takes on a very profound subject with admirable brevity (200 pages). He notes the story of seeing three stone masons working on a medieval cathedral, and one says 'I am cutting stones to shape', one says 'I am building a great cathedral', and one says 'I am working for the glory of God.' These highlight that actions are guided by a hierarchy of objectives some short term, some long term, and some prove better guides than others.

Putting these various tactical and strategic objectives in harmony is tough work. Enjoying the journey and knowing you are on the right path removes the pressure and angst associated with an excessive focus on the end-goal, making that same goal more achievable. I think the key point he makes is to have all levels working for you, by adjusting all of them in light of feedback. An example is golf, a sport which for many is a 'game worth playing', making it worthy, and which benefits from practice and coaching, yet ultimately you can only swing well if you don't think when you are doing it.

Obliquity is his term for what someone called 'muddling through', and involves experiment and discovery in uncertain environments. Higher-level objectives, intermediate goals, and basic actions are constantly reassessed. The problem is that the big goals--a fulfilling life, maximizing shareholder value--are too imprecise to have any clear idea how to do them. As GE CEO Jack Welch noted, maximizing shareholder value is not a useful guide because it doesn't help you know what to do when you come to work.

It's a great book, though ultimately there is no clear answer, just another version of Feyerabend's 'Against Method': whatever works. Plans should be tentative and adjusted based on feedback from intermediate objectives, acknowledging our imperfect understanding of the solution, or even, the adequacy of our goal.

The problem is basically how to know when you should think outside the box, how to use common sense. To always think outside the box is to ignore the great toolkit of algorithms and methods smart people have given us so we do not have to reinvent, say, ordinary least squares or t-statistics. Common sense may be a straight jacket, but letting every wacky idea into your mind leads to insufficient focus. Quantification is imperfect, and can lead to useless reification as with macroeconomics, but its still the ultimate benchmark, and indeed, allows us to know that macroeconomics does not work. I know success, happiness, justice, are impossible to objectively and uniquely quantify, but I think modest attempts to provide proxies are helpful.

I wish it were easier to know how to solve important problems, and more importantly, know what problem are important and soluble. I do know there isn't a simple cookbook, and Jacques Barzun's observation serves a cautionary warning:

Again and again, the bright thought has occurred, "if we can only define our terms, if we can only find the basic unit, if we can spot the right 'indicators', we can then measure and reason flawlessly, we shall have created one more science."

This has usually been a failure in the social sciences, including business, in part because of Goodhart's law: targeting a variable changes its meaning and significance. Yet, as a full-time quant that's what I do--measure, model--and often I find that simple rules dominate the vague, obfuscatory, self-serving, and disingenuous descriptions many workers apply to their tasks. It's a paradox that makes my life interesting.

Macro Aggregate Vacuousness

Brad DeLong had a post on Hayek, and at one point he buttresses his argument with this observation:

We start with our quantity theory of money, which tells us what nominal income PY is:

PY = MV(i)

Normally one would stabilize nominal income by boosting M. The problem is that the normal way the central bank boosts M is via open-market operations by which it buys safe savings vehicles for cash. Reduce the supply of safe savings vehicles and you raise their price--and thus lower the safe nominal interest rate i some more. Lowering i further reduces the opportunity cost of holding money and further reduces V. The net effect on PY is:

d(PY) = [V(i) + M(dV/di)(di/dM)]dM

Now, this all seems pretty scientific. Its logic is best exemplified by Don Patinkin’s Money, Interest and Prices (1957), which had page after page of such equations, and has been called the 'height of the IS/LM' theory. It appeared to be a very compelling theory, because it was consistent and logical at every step. All the partial derivatives made sense, but one had to hope that such simple models were sufficient to overcome all the variables and interactions not explicitly addressed, because in a complex economy there's an almost infinite number of relationships and omitted factors.

But what are theses variables and relationships that have such mathematical precision? Consider V, velocity. Velocity is the residual of the measurables nominal income and money. Thus, the derivative of V with respect to i (the interest rate) is really from the derivatives, and their correlations, of nominal income and money. Are either of these stable in any sense (d(PY)/di, dM/di)? No. They have no stable values and suggest they are no better than asserting a mathematical relationship between your body temperature and how much coffee you drank based on thermodynamics: there's a simple effect from the initial impact, but very shortly feedback effects that make the initial physical model worthless.

And so it goes with all these relationships. The economy is a complex, nonlinear, adaptive system where short run effects are often opposite of long run effects. Ultimately, people need to be involved in activities that generate more benefit than they they cost for they to be sustainable, and they must appear attractive to individuals given their other opportunities as they see them. A higher growth rate simply involves having more people near their unknown optimal--unknown because only rudimentary laborers know what the truly best use of their time is at any moment--and stagnation is caused when too many individuals lose their ability or willingness to actively search and make these choices. The more government puts in rules saying we can't drill in the Arctic because of potential effects of exhaust on a nearby village of 100 Eskimos, or that we can't cut hair without a state license, the lower our productivity. Economic freedom results in long term growth and so the key to macro policy is not from some chain rule but rather the wisdom of Smith, Bastiat, von Mises, Hayek, Friedman, Stigler, and the rest who found aggregate prosperity and economic freedom synonymous.

Increasing the money supply to fool employees into thinking they have more money than they do, hoping on a multiplier effect via such derivative compounding logic, is simply absurd. Currently, we are changing M to affect i, so the relationship should be di/dM, not dM/di, highlighting why the empirical relationship between i and M is so spastic. If countries could simply print and spend to increase GDP, the 1970's would have been an era of great growth, instead of the disaster it was, which is why the 1970s--increasing inflation, increased government spending--is such a profound empirical contradiction to the Keynesian model.

Thinking about aggregates this way is pure blather, like the way Marxist intellectuals talked about the laws of motion a century ago when their Oracle bloviated in Das Kapital that just 'as the heavenly bodies, once thrown into a certain definite motion, always repeat this, so it is with social production.' Yeah, just like celestial mechanics. I generally just ignore any argument based on or alluding to such pretentious, hopeful, willfully naive twaddle, but if for some reason someone accosted me at a Town Hall meeting and said such an equation implied we should do X, I would simply ask that they show me the regression results for it on a handful of developed countries in the modern era. The parameters would not be consistent over times or between countries.

Salt May Not be Unhealthy

Gary Taubes wrote What if It's All Been a Big Fat Lie? back in 2002 for the New York Times Magazine, which reinvigorated the Atkins/Southbeach/Paleo diets. He argues carbohydrates put us on an insulin treadmill, whereas proteins and fats satiate us. It seems the key effect is on your appetite via insulin regulation and the stability of going into fat burning mode, as opposed to some calories having different effects on your weight.

But he's a pretty interesting guy in general. His Blogginheads interview on last weekend's Science Saturday was pretty neat. He also wrote back in 1998 that the conventional wisdom on salt could be wrong too, with correlation not equaling causation. Indeed, there are a lot of bad correlations purported to be causations in medicine and biology, and it makes me skeptical of statins. Anyway, here's good news for salt lovers from a New York Times article on a study that included 3,681 middle-aged Europeans who did not have high blood pressure or cardiovascular disease and followed them for an average of 7.9 years.

A new study found that low-salt diets increase the risk of death from heart attacks and strokes and do not prevent high blood pressure, but the research’s limitations mean the debate over the effects of salt in the diet is far from over. In fact, officials at the Centers for Disease Control and Prevention felt so strongly that the study was flawed that they criticized it in an interview, something they normally do not do.

The investigators found that the less salt people ate, the more likely they were to die of heart disease – 50 people in the lowest third of salt consumption (2.5 grams of sodium per day) died during the study as compared with 24 in the medium group (3.9 grams of sodium per day) and 10 in the highest salt consumption group (6.0 grams of sodium per day). And while those eating the most salt had, on average, a slight increase in systolic blood pressure — a 1.71-millimeter increase in pressure for each 2.5-gram increase in sodium per day — they were no more likely to develop hypertension.

Limits to Growth

Martin Feldstein writes an op-ed in the WSJ where he asserts a 5.5% real equity growth rate. This is a common assumption, implying an expected 7.5% nominal equity growth rate going forward, just as CalPers and many other large funds assume.

Consider that profits are a pretty constant portion of GDP, around 10%:



Now, as Jeremy Siegal notes, you can have higher-than-GDP earnings per share growth in stocks if companies continually repurchase shares, but here's a graph from Barry Ritholz on the valuation of the market relative to our GDP over time: it's gone up, but it can't go up forever.


If valuations stay about the same portion of GDP, the average return to a dollar invested is capped by the growth rate of earnings. Remember that these profits are then used for dividends and buybacks.

Fama and French argued that the US 1950-2000 period that is so prominent in academic minds was truly anomalous:

the dividend-price and earnings-price ratios fall from 1950 to 2000: the cumulative percent capital gain for the period is more than three times the percent growth in divdends or earnings. All valuation models agree that the two price ratios are driven by expectations about future returns (discount rates) and expectations about dividend and earnings growth.

This means, the second half of the 20th century was abnormal, even with hindsight looking at dividends and earnings. Expecting greater than 3% real returns out of stocks relies on a lot of hope.

Then again, you can take the view of Jay Ritter, who notes very little correlation between equity returns and GDP growth cross-sectionally, looking at data from 16 countries over 100 years:



As an empirical matter, knowing a country's GDP growth is a pretty lame indicator of even its long run stock market return. Valuation (P/E fluctuations), the fraction of corporate profits paid out to shareholders, and the probability of catastrophic loss due to hyperinflation, revolution, war, are all very important in these 100 year samples.

But ultimately, a 3% top-line return seems the most reasonable equity premium estimate, and the return to shareholders will probably be below that due to transaction costs and adverse timing. The 5.5% return bandied about is a bias from a very biased sample--the US post WW2--not representative of general experience.

Macroeconomists Lament Sterile Methods

Brad DeLong argues that macro needs an overhaul:

We need more Eichengreens, Shillers, Akerlofs, Reinharts, and Rogoffs – not to mention a Kindleberger, Minsky, or Bagehot...perhaps economics will remain a discipline that forgets most of what it once knew and allows itself to be continually distracted, confused, and in denial.

Now, Rogoff has created some conventional macro models, but presumably is mentioned here because of his recent economic history book 'This Time It's Different' with Carmen Reinhart. Shiller's on the list presumably because he doesn't believe in the caricature of efficient markets, though no one believes in that caricature so I'm not sure what the alternative is. Akerloff's theory also highlights limits of efficient markets because of asymmetric information, though it should be mentioned that without the efficient markets benchmark, his result would be ambiguous, highlighting the usefulness of the benchmark.

It's easy to criticize straw men, but even one who tries to make money must realize the value of assuming that markets efficient is useful because otherwise it would be too easy to generate alpha, and any thoughtful person should recognize this is difficult, or at least, rare.

As to Kindleberger, Minsky, Bagehot, and Eichengreen, they tell stories. While these are very interesting, they aren't concise stories, and the older ones were especially vague and inconsistent. What is the essence of Bagehot's worldview? If these are the key writers, macro would have to admit it's best viewed like the field of history as opposed to physics.

Noahpinion makes a common complaint of macroeconomics:

When we learned [Real Business Cycle theory], we were told that the measure of its success in explaining the data was - get this - that if you tweaked the parameters just right, you could get the theory to produce economic fluctuations of about the same size as the ones we see in real life... The editors of Econometrica, the American Economic Review, the Quarterly Journal of Economics, and the other top journals are the ones who publish paper after paper on these subjects, who accept "moment matching" as a standard of empirical verification, who approve of pages upon pages of math that tells "stories" instead of making quantitative predictions

It would be interesting if macro moved away from its emphasis on Dynamic Stochastic General Equilibrium modeling. This toolset takes a major intellectual investment which makes one loathe to dismiss it, just as few who have read the Bible really carefully would admit it is insignificant, but clearly macro hasn't proved useful in explaining the big problems such as why Haiti is poor or what causes business cycles. After a couple decades I think it's fair to say this has been a dead end.

Robert Merton once wrote about finance that

As recently as a generation ago, finance theory was still little more than a collection of anecdotes, rules of thumb, and manipulation of accounting data...The subsequent evolution from this conceptual potpourri to a rigorous economic theory subjected to scientific empirical examination was, of course, the work of many, but most observers would agree that Arrow, Debreu, Lintner, Markowitz, Miller, Modigliani, Samuelson, Sharpe and Tobin were the early pioneers in this transformation.'

And this is the way the history of any field is written, principally by esteemed academics as a form of ancestor-worship, no doubt in the hope that they, too, will become ancestors worthy of worship. In this version, the history of finance, or macro, is that of the smooth and triumphant ascent of knowledge and technique, to our current state of unprecedented enlightenment. Yet it is clear that the big issues of macro and finance, which are closely related, have generated little knowledge or skill that could have helped practitioners about expected returns and economic growth relative to that acquired by economic historians.

The essence of Macro was to leave the methodological individualism that is the essence of economics, and look instead at macro aggregates following laws of motion loosely motivated to look like supply and demand curves. One of the best decisions I ever made was to leave this field, because like being a learned Marxist or sociologist (same thing?), this may get you tenure, but you still don't understand anything.

It's important to know when a paradigm is not working, and clearly macro is just as unhelpful today as it was in the Great Depression in terms of focusing the debate, eliminating irrelevant distractions. The same arguments are being made for more or less government. I don't have the answers, but I do know that full-time macroeconomists are like active mutual fund managers: articulate, hard working, and basically worthless.

Front Kick Wins Again

For the second time in two months, a front kick to the face ended a major UFC fight. This time, it was Lyoto Machida delivering to Randy Couture, whereas previously it was Anderson Silva delivering on Vito Belfort. Machida and Silva are good friends, and both gave credit to action film star Steven Seagal, so I guess he truly deserves credit. It's pretty devastating because the defender is watching his opponents hands, and the kick comes straight up between one's hands. A good shot to the chin is like hitting the power switch on your computer.

Good Riff from Krugman

Paull Krugman is now a joke(see this town hall meeting), but he's clearly a smart guy. I think he just decided that he could do more good shilling for Democrats by any means necessary, and if his intermediate target is helping Democrats, being more evenhanded, or even courteous, may or may not be optimal, it is too early to evaluate. In the long run, I think it hurts his intermediate objective, and more importantly think his long run objective is wrong so he's doomed anyway (in the same way I think those who believe in false Gods are wrong, they won't go where they think they are going).

Here he is in better days. This address he gave to the European Association for Evolutionary Political Economy in 1996 still reads pretty well:

Economics and evolutionary theory are surprisingly similar. It is often asserted that economic theory draws its inspiration from physics, and that it should become more like biology. If that's what you think, you should do two things. First, read a text on evoluationary theory, like John Maynard Smith's Evolutionary Genetics. You will be startled at how much it looks like a textbook on microeconomics. Second, try to explain a simple economic concept, like supply and demand, to a physicist. You will discover that our whole style of thinking, of building up aggregative stories from individual decisions, is not at all the way they think.

So there is a close affinity in method and indeed of intellectual style between economics and evolution. But there is another interesting parallel: both economics and evolution are model-oriented, algebra-heavy subjects that are the subject of intense interest from people who cannot stand algebra. And as a result in each case it is very important to distinguish between the field as it is perceived by outsiders (and portrayed in popular books) and what it is really like. We all know that economics is a field in which the most famous authors are often people who are regarded, with good reason, as not even worth arguing with by almost everyone in the profession. Do you remember that global best-seller The Coming Great Depression of 1990 by Ravi Batra? And I guess it is no secret that even John Kenneth Galbraith, still the public's idea of a great economist, looks to most serious economists like an intellectual dilettante who lacks the patience for hard thinking. Well, the same is true in evolution.

He makes a profound point, that evolutionists dismiss the small-step process of evolution and rather focus on the result. Local maxima are dismissed as simply a lack of imagination.

Meritocracy Undemocratic

Atlas Shrugged seems to be getting the same reception that the 500th anniversary of Columbus discovering America got back in 1992. Timing is important, and currently egalitarianism dominates individualism in the world of ideas. Over at Bloggingheads, Noah Millman articulates the belief that meritocracy is horrible because it is antidemocratic. Millman seems to think that just because merit can't be measured infallibly it should be ignored. Further, he seems to think society is currently 'run' by an elite chosen by some Star Chamber according to some merit metric; I tend to think many leaders are simply popular people who learn how to navigate reverse dominance hierarchies, and these leaders are pretty widely distributed--politicians at many levels, businessmen who compete against each other.

Aristotle noted in his Politics Book 3 that justice is in one sense simple, equality. What makes justice hard politically is, equality of what? I much prefer an imperfect meritocracy to a society where merit is considered meaningless.

Housing CPI Bizarre

This picture shows the housing component of inflation (blue line), compared to house price changes (red line). As housing prices went through their bubble, the effect on CPI didn't budge much from 3%, whereas the recent crash brought it down to zero. See Dr.HousingBubble for more.

Things like oil, corn, and gold have skyrocket recently, but I'm told that things like clothing, 'food away from home' and 'shelter' are keeping inflation low. Perhaps. But I'm with Bill Gross, who highlights the gov't dilemma given its true debt-to-GDP ratio is 500%:

Unless entitlements are substantially reformed, I am confident that this country will default on its debt; not in conventional ways, but by picking the pocket of savers via a combination of less observable, yet historically verifiable policies--inflation, currency devaluation and low to negative real interest rates.

Social Security a Tax?

Krugman let slip a little semantic misconception 75 years in the making:

And while the income tax is quite progressive, the payroll tax — the other major federal tax — isn’t; and state and local taxes are strongly regressive.

For generations it was sold as a pension, not a tax. The 12.4% of our compensation (up to $106k) given to the government under the rubric of Old-Age, Survivors, and Disability Insurance (OASDI) [insurance?], is clearly not an investment in our future government pension, unless by 'our' one means 'the Borg collective', not the individual saver.

I suppose soon people are going to start noticing there is nothing in the Social Security trust fund. Here's a funny description of the trust fund over at 'Just Facts':

Bonds that represent the debt that the U.S. government owes to Social Security are located in a file cabinet at the Bureau of Public Debt in Parkersburg, West Virginia. Below is a photo of President George W. Bush inspecting the documents along with Susan Chapman of the Office of Public Debt Accounting.

MorningStar Measures Adverse Timing

That investors have different average returns than the assets they invest in, is the least appreciated return bias. Ilia Dichev (2005) looked at a variety of indices, and equity net inflows, and found this adjustment reduces returns by 1.3% for NYSE/AMEX for the period 1926-2002, 5.3% for Nasdaq from 1973-2002, and 1.5% for 19 major international stock exchanges from 1973-2004. These are big numbers, and almost universally an ignored by those studying the equity 'risk' premium. You can be sure that if this adjustment could be made consistent with some risk story it would be taken seriously, but what we see is influenced by what we believe and so we don't see this effect. To be precise, we don't see it as 'interesting' or anything other than random noise, because it does not fit into any big paradigm, and killing the equity risk premium would destroy the primary empirical point for asset pricing theory.

Morningstar is now measuring this for fund categories, which is very helpful. They note that due to adverse timing (!), recent attempts by investors to 'chase' market returns have hurt them:

In 2010, the average domestic fund earned a return of 18.7% compared with 16.7% for the average fund investor, making for a gap of 200 basis points. For the trailing three years, that gap was 128 basis points. For the past five years, it was 98 basis points, and for the past 10, it was 47 basis points.

Interestingly, their studies all show a large bias that gets smaller as one goes backward over time. I'm skeptical adverse timing is primarily a recent issue because the 2001 internet bubble, as John Cochrane emphasizes, is the poster-child for adverse timing. Perhaps there's a straightforward bias to their metric, because it seems strange that it attenuates for every asset class at the same rate.

Further, as Antti Ilmanen notes in his new book Expected Returns, 'momentum' in strategies is statistically significant, it is there, and suggests a 'Mathew Effect' for allocating capital. I wonder how the adverse timing, which implies average investors are buying more prior to declines than prior to increases, relates the momentum in asset strategy returns.

hat tip: Tadas Viskanta

Easter Show

This South Park special on Easter has the following scene that made me spit milk out my nose:

Jesus: we have no choice Kyle, you're going to have to kill me
Kyle:what?
Jesus: Stab me with this, if I die I can resurrect outside the bars
Kyle: Dude, you don't understand, I'm a Jew, I have a few hangups about killing Jesus.
Jesus: Make it quick, through the neck
Kyle: Eric Cartman can never know about this

IQ and Stock Market Participation

A forthcoming JoF piece from Grinblatt et al report

Stock market participation is monotonically related to IQ...High-IQ investors are more likely to hold mutual funds and larger numbers of stocks, experience lower risk, and earn higher Sharpe ratios. We discuss implications for policy and finance research.

I interpret that to mean, you need some intelligence to have the confidence to take some risk, but the smarter you are, the more you realize this game is played best at the standard CAPM level: low fees, high diversification. That is, I agree with the CAPM as a normative theory, just not a positive one; I'm just not so naive to extrapolate my very minority preferences and interpretations to 'all investors.'

Shane Frederick observed a related finding in a JEL piece where he noted that smarter people preferred greater expected choices when framed probabilistically.

I think the IQ and stock market participation finding makes sense only in the context that the stock market exists in the context of many investments with similar 'risk'. Smarter people understand you can gain an equity premium ... but only applying indices, or as an insider! Sure you can get big return otherwise--especially as a middleman--but the basic risk return payoff here is decidedly contextual.

Junk Bond Returns 43% or 20% Since 2007

Above is a total return graph for JPC, Nuveen's High yield convert ETF, from 2007 (ie, 1/1/2007) to present. Note the return is basically zero. I pulled 39 High Yield ETFs, and their average return from 2007 to present has been about 21%, and is the same whether I equal-weight or value weight them, and note these have a survivorship bias in them, in that I am not using all extant funds from 2007. The JPC benchmark, the Bloomberg Active Index for Corporate Preferred funds generates a similar 20% return over that period.

In contrast, the Merrill High Yield Master II shows a whopping 43% return over this period, twice what bonds with that moniker actually generated. The Merrill index is not tradeable, which is very important. The bid-ask spreads in junk bonds are very high, often 5 points, and indices don't internalize these. Also, if you are big, there's trade impact. Academics might look at the Merrill index to estimate the return to junk bonds, but there's a 22% difference here, and that excludes all the survivorship biases in my comparison to actual funds.

Caplan's Selfish Reasons to Have More Kids

Back in 2008 when I was blogging under a pseudonym at Mahanolobis, I posted on the birth of my girl Izzie under the title Increasing my Carbon Footprint. I mentioned this was all due to a 2005 blog post, The Selfish Reason to Have More Kids, by Bryan Caplan, which he turned into a book of the same name. Of course, while it might have been a necessary condition so were many other variables, so I don't want to oversell this, but he made a compelling point (I discussed this in an earlier post). My wife admits she was quite content (overwhelmed?) with two children, I persisted, and she's now infinitely grateful. I just got the book last Friday, and its cheap, good, quick read. Maybe it will change your life!

Market Mimicry and Panics

A bunch of physicists (Harmon, de Aguiar, Chinellato, Braha, Epstein, Bar-Yam) have an intriguing paper about cascades. They call it 'mimicry', but Ivo Welch really mined this field for a while, and while I think he gave it a good try, it didn't yield much. We know that in bubbles there's a lot of people doing what everyone else is doing on the way up and down. Correlations go up. It's interesting to model this as a rational outcome, as a situation in which every subsequent actor, based on the observations of others, makes the same choice independent of his private signal. In an information cascades everyone is individually acting rationally. Even if all participants as a collective have overwhelming information in favor of the correct action, each and every participant may take the wrong action. Even though a million people may have chosen one action, seemingly little information can induce the next million people to choose the opposite action. Fragility is an integral component of the Informational cascades theory.

The bottom line is that a theory should be able to not merely explain the past, that's hindsight, not science. It should predict. And these models haven't been successful here, so that thread has kind of dried up.

So, here's some physicists trying again. They generate the simple time series graph above. The top graph is a measure of dispersion, so a high number means that stocks are pretty uncorrelated, the lower number means stocks are highly correlated. They find that 1) stocks have become a lot more correlated over the past 15 years and 2) the change in this metric over the past year is a significant predictor of future crises. The bottom time series shows that prior to big moves like the 1987 crash, LTCM crash, 2001 crash, and 2008 crash, this measure moved relatively downward prior to them all. It's not perfect, but I like the unpretentious way they framed the problem and presented their results. It's not overfit.

Cochrane Excited by 'Expected Return' Data

John Cochrane is one of the top finance academics in the world, and I think he's very thoughtful. He's also swallowed the risk premium story so much, he's like a Keynesian who thinks the 1970's highlight the relevance of the Keynesian model.

Here's his latest survey:

We thought returns were uncorrelated over time, so variation in price-dividend ratios was due to variation in expected cashflows. Now it seems all price-dividend variation corresponds to discount-rate variation. We thought that the cross-section of expected returns came from the CAPM. Now we have a zoo of new factors.

Later:

In the beginning, there was chaos; practitioners thought one only needed to be clever to earn high returns. Then came the CAPM. Every clever strategy to deliver high average returns ended up delivering high market betas as well. Then anomalies erupted, and there was chaos again. The “value effect” was the most prominent anomaly.

Fama and French (1993), (1996) brought order once again with size and value factors.

Explaining the value and size effect using value and size portfolios does work if you don't mind circular explanations. We have, as Fama stated in 1991, given a fishing license for factors, where every exception to the standard model is now a potential factor. It's a bit like the effects of Global Warming, except here you can say these are the one thousand things caused by variations in risk premiums.

New Book on Coach's Proverbs

Pat Williams, the GM of an NBA fanchise, has a book that riffs on UCLA basketball coach John Wooden's Seven Point Creed, given to him by his father Joshua upon his graduation from grammar school. He kept these rules in his wallet throughout his life:

• Be true to yourself.
• Make each day your masterpiece.
• Help others.
• Drink deeply from good books, especially the Bible.
• Make friendship a fine art.
• Build a shelter against a rainy day.
• Pray for guidance and give thanks for your blessings every day.

These are pretty vague rules, hardly sufficient for a good life in my opinion (what about courage, discipline, gratitude, or prudence?). Yet Wooden was a highly successful man, living for 99 healthy years, producing many championship teams, positively impacting many young men. It reminds me of the editor of the Great Books series, Mortimer J. Adler, who's Synopticon is a very intriguing though flawed philosophy of life, yet, Adler himself was quite successful, and his influence was positive, influencing the Great Books emphasis at the University of Chicago.

Suboptimal hypotheses, rightly worked from, have produced more useful results than unguided observations. I think the key is to be intelligent, start from a decent set of assumptions, and work every day towards becoming a better man. If you use reality as a filter, you will do OK.

Alas, I think more often then not such maxims from famous people are used as signals as opposed to principles. I remember one NYT story about how these junk bond investors were all acolytes of the great Ed Altman, yet I have never met a junk bond investor who thinks highly of such models, and Altman's model is pretty lame, about as powerful as rank-ordering firms by Net Income/Assets. They wanted to project gravitas, so they paid lip service to the old man. Similarly, people highlight their idea is derivative from some esteemed source, but that's merely posturing.

Happy Tax Day!

This year I had to write a check because I rolled my 401(k) into a Roth IRA, generating a lot of taxable income that had no withholding. To give an example, say I put $5k into my IRA each year for the past 20 years. Say it grew to $200k. By rolling it into a Roth IRA, I am taking that $200k in taxable income for 2010, and so have to pay state and federal taxes on that, but then it will increase, hopefully, tax free. I'm basically betting on rising taxes for investments, as this makes sense if you think tax rates will be higher in the future than currently. Of course, I'm also betting the government won't reneg on the Roth IRA terms and tax me again. Interestingly, I'm finding that my state tax payment is about 1/3 my federal. Then I have property taxes of about 2% of my assessed house value for my city, which basically rigs the rate vs. assessment so that my payment is constant.

Beware the Dark Side

From the July issue of the Journal of Personality and Social Psychology, an interesting finding:

The researchers found a person's tendency to describe others in positive terms is an important indicator of the positivity of the person's own personality traits. They discovered particularly strong associations between positively judging others and how enthusiastic, happy, kind-hearted, courteous, emotionally stable and capable the person describes oneself and is described by others.

"Seeing others positively reveals our own positive traits," Wood says.

The study also found that how positively you see other people shows how satisfied you are with your own life, and how much you are liked by others.

I think this is true. When I'm in a funk I am really critical of others, and perhaps a good way to change is not so much to focus on being more positive about myself, but rather focus on the positive aspects of others.

Summers Highlights Dilemma

At the Bretton Woods conference over the weekend, sponsored by the Institute for New Economic Thinking, Larry Summers had this little nugget on regulators:

Speaking at length about the competing ideologies surrounding regulation, Summers distinguished between one side worrying that regulators will become "co-opted" by a conflict of interest, and the other afraid regulators are simply "ignorant" of the institutions they are charged with controlling. "There is hardly anyone," Summers said, "that is both knowledgeable and [sic] unco-opted."

It's an insoluble problem in the public sector because anyone really knowledgeable is more valuable within one of the firms he regulates rather than outside it, creating a constant brain drain. There are exceptions to be sure, but the talent will always disproportionately on the inside. Financial entities make money in very complex ways, making an outsider's job very difficult even if able and motivated. When I have seen regulators, invariably they are focusing on some check list developed in Washington that is so irrelevant.

The key to managing government this century has been to remove individual authority. The abuses of the spoils system of a century ago are far more vivid in the modern mind than the bureaucratic inertia that slowly drains our national vitality. Bureaucrats have discovered one best way to avoid blame: by creating systems in which no one has the ability to do anything not in a rulebook created years ago by bureaucrats who haven't been on the front line.

Effective regulators, when they exist, are free to make the countless judgments needed to make something good happen, as when an analyst decides that a bank is a 'sell'. Yet this now only happens to firms so weak they are already almost dead, protecting us only after the damage has been done.

For over a hundred years we have been erecting regulatory systems designed to add licensing and other criteria that supposedly make things safe. But no system of licensing, nor any regulatory system, no matter how brilliantly conceived, will function as intended unless humans have primacy over ultimate judgments ant every level of responsibility. When people focus on compliance instead of making sense of the situation, you get irrelevancy.

Holding people and companies responsible for their actions is the most important way of enforcing genuine ethical and efficient behavior, and I don't see how government regulators can do this. Remember, the best regulator ever invented is competition, which involves breaking down barriers to entry, and expediting the failure process that is an essential part of competition (including defaults with loss of principal, foreclosures), is the exact opposite of what most regulations actually do.

It's naive to think a checklist in Washington will be effective, as any explicit process invites its circumvention. After all, for years Washington wanted more housing loans, and when the hucksters started gaming the system with NINJA loans, it was Fannie Mae software that really institutionalized it, and then they acted shocked that such loans were commonplace.

CFO vs. CEO Insider Buying

I'm kind of skeptical of 'insider buying' signals, because I remember executives being totally clueless about our stock return, basically believing that after a big fall the price would rise and vice versa. Share issuance, meanwhile, has a pretty strong literature and I have found it valuable (yet another factor my old boss argued was not usable by me going forward because it would be covered under his interpretation of our confidentiality agreement). It seems this plays out in looking at CFO vs. CEO purchase, from a new paper by Wang, Shin and Frances:

We find that CFOs earn statistically and economically higher abnormal returns following their purchases of company shares than CEOs. During 1992-2002, CFOs earned an average 12-month excess return that is 5% higher than that by CEOs.

What Happened to Hedge Fund Replication?

I remember when Harry Kat was getting a lot of play in 2006/7 for his idea you can replicate various hedge funds via futures. I was skeptical because while any fund with 5 years of monthly returns will generate a nice in-sample fit with something, such data are not really 60 independent observations because their will be a handful of big bets that were correlated with some sector. In my experience working at hedge funds you could point to a few key strategic moves that explained most of the returns, and as people changed, or the strategy died, it was hardly an internal factor loading, just a coincidence. I got a couple calls from industry magazines doing pieces on Kat, and both declined to incorporate any of my criticisms.

I haven't heard much about it since. Some algorithms seemed to do very poorly in 2008 with most strategies, but presumably Kat says not his. This highlight a major problem in finance, that so many fund managers are encouraged to keep their records private, because then they can use the fawning press to imply huge returns while never actually saying so, and so everyone else seems to be beating the market (just as most people who go to Las Vegas say they were either 'flat' or 'up big'). So how have they done? In Antti Ilmanen's Expected Returns, he has a couple cryptic pages (238-9), where he states 'the in-sample fit to HF index and HF sector index returns can often be surprisingly good, but out-of-sample results less so.'

End of Month Anomaly

Calendar effects in stock returns have been prominent in the finance literature since the 1970s. It's easy to pull in a time series and look at things like January, Monday, or beginning of month. Josef Lakonishok and Robert Haugen wrote a book, The Incredible January Effect, in 1988. Alas, most of this effect was in smaller stocks that were hard to trade, and while it may have existed, it no longer does.

I used to think these calendar effects were gone, but the end-of-the-month effect seems to live on. Lakonishok and Smidt (1988) reported a turn-of-the month seasonal in equity returns wherein the turn-of-the-month is defined as beginning with the last trading day of the month and ending with the third trading day of the following month. Using the Dow Jones Industrial Average, they find that on average the four days at the turn-of-the-month account for all of the positive return to the DJIA over the period of 1897-1986. More specifically, over this 90-year period, the average cumulative return over the four-day turn-of-the-month is 0.47% whereas the average cumulative return over the full month is 0.35%, indicating that returns were, on average, negative over the remaining days of the month.

So I downloaded the S&P data from 1950, and was surprised to see it actually works! Data are averages of log returns, and days are trading days from the beginning of the month, where -1 is the day immediately before the end of the month. See the top graph. But then I looked at the past 10 years, and the results seem not so good. Looks like another example of failed or extinct calendar effects.

Ilmanen's Expected Returns

If you are in the investment industry, you should read this book. You should know the facts across different asset classes.  These are essential facts.

 I just got Antti Ilmanen's Expected Returns, and think it's a great reference for any investment professional. Like my book, it's published by Wiley, which mean you can always buy it for half the list price on Amazon vs. going directly to Wiley (how this makes sense I have no idea). He describes the theory and data behind all the major investment strategies (eg, value, carry trade, selling volatility) and asset classes (eg, stocks, bonds, FX, real estate). At 594 pages, and given the failure of risk models and the parochial nature of various behavioral explanations, it is not a focused book, more like a compendium of what the 'state of the art' thinking is on the theory and data, as opposed to a strong theme. Indeed, there are many bullet points for the summary chapters and for the subsections, and each seem pretty independent. Yet, if you want to invest in the carry trade, or value stocks, it's a great place to go to understand the conventional wisdom on these investments.

I've been a fan of Ilmanen since he wrote several clear and concise white papers on yield curve investing back in the 1990s (here's a zipped set). At one point he states 'My preferred approach to stuydying return consistency across subperiods is to plot cumulative returns over time. Careful eyeballing of such praphs reveals performance for any subperiod of interest, especially if he graphs are in log scale.' This kind of straightforward approach I find refreshing, because given the failure of any risk metric to generalize within or across asset classes, I find the abstruse models that claim some fundamental relation to a utility function, then proven econometrically but unamenable to a simple graph, highlights the rigor of modern finance is primarily a convenient way to hide for dopey ideas the way post-modernists hide their stupidity behind incomprehensibility.

As Cliff Asness note in the forward to this book, 'the first moment laughs at and taunts the second moment', meaning basically that means are much less certain than variances and covariances, and ultimately we want to know what the 'average return' has been for various assets and strategies. This is not obvious, because you can have periods like 1960 to 1982, where bond returns were strictly decreasing in duration as rates rose, and then the opposite from 1982-2008 when rates went the other way. But Ilmanen highlights the cases such as these where combining historical data with forward looking metrics like yields to highlight what a good expectation in these cases might be.

Now, I've corresponded a bit with Antti over the years, he's about my age, graduating about the same time. I respect him a lot. Thus, when I think about conventional wisdom in academic finance I think it's good to think about Antti, someone I think is thoughtful, smart, sincere, but also wrong about some very important points, most prominently, that this is consistent with some as-yet-undiscovered risk model.

He's a little too charitable towards various esteemed citations, as he presents the various explanations for asset/strategy returns, often inconsistent. For example, in the chapter on the premium to selling puts, he references Taleb's Black Swan, which basically argues that gamma is underpriced because people prefer negative skew (ie, people lose money selling volatility because they love the positive modal return). He references DeBondt and Thaler's 'mean reversion' findings, though they have not stood up well: they were driven by untradeable stocks, which is why they were not replicated--the ultimate rejection. Ilmanen speaks well of Peter Bernstein, who wrote incredibly popular and interesting books that have been exposed as being totally wrong (ie, the Modern Portfolio Theory lionized in Capital Ideas or Against the Gods is now admitted to be empirically vacuous--I think that matters). I guess as Malcom Gladwell, Steve Levitt, or Michael Lewis have shown, a good yarn just needs the facts to be plausible at that time, whether or not they were subsequently shown totally wrong seems irrelevant. He also states that Robert Shiller called the housing bubble, which is true only if you count the statement that the previous rise from 2000-2005 would probably not extend, and some cities may experience declines, as the same thing as predicting a wholesale decline in housing prices. A paper is not true or profound merely because it is popular. Indeed, many papers are more popular the more flawed they are because they present an easy straw man to best (as a default modeler, one always references Altman (1967), because it is popular and a really inferior model).

In some asset classes, like Hedge Funds, he notes that average top-line returns of 14% are turned to 7% when a couple of obvious adjustments are made for survivorship biases, and admits even then that since data are supplied voluntarily, this is incomplete. Yet such issues also occur in something as simple as equities, where he totally ignores transaction costs, taxes, adverse timing (market inflows). He notes investing in 'art' has had a pretty large positive real return, somewhere betveen 1 and 5%. As Felix Salmon has noted, these art indices exclude most art because if it is bought and never sold--usually because it cannot be sold--it simply disappears from the index, severely biasing such indices. Further, transaction costs selling art are considerable and not included in art indices. This highlights that estimating the first moment (mean returns) is quite subtle not merely because limited number of business cycles, but the data we have are often biased and so do not reflect a 'return to an average investor' (eg, buying a mutual fund in the 1960's had an 8.5% load right off the top). These are not small adjustments, and highlights the important adjustments are not sophisticated statistics, but rather yeoman's work.

As to the 'expected returns' distinction, this I find really gets into scholasticism. Theoretically, there's only a relation between expected risk and expected returns, what actually happens involves random chance. As expected returns change over time, and one only observes average returns, one can argue that expected returns are quite different than what was experienced, or not. He notes that 'periods of high realized returns and rsing asset valuations--think stock markets in the 1990s--are often associated with falling forward-looking returns.' ORLY? If people in 2000 expected to experience the next decade of negative returns and also massive volatility, stockholders were making the stupidest financial decision since Esau traded his inheritance for a bowl of soup. Sharpe and Amromin (2009) surveyed investors and found they basically were inversely related to subsequent returns, reaching a peak at the top of the internet bubble at the end of the 1990s. So were expected returns higher then, as suggested by what investors said, or lower, as suggested by the returns the realized (and ex-post measures of valuations implied)? This conflation of average and expected returns is used selectively by academics all the time, where 'sample average' is synonymous with 'expected' sometimes, and sometimes not, depending on the author's objective. It makes one wonder if the 10^500 universes of string theory is more falsifiable than asset pricing theory.

The main strategic take-aways I would pull would be the following:

1) Simple valuation metrics like P/Es in stocks, the current roll in futures, or yield spreads between currencies, help predict returns. They are easy to measure so try to have them on your side. It does not seem like any 'risk' premium, but rather a free lunch (or, the same thing, a risk premium so convoluted no one understands it and it does not generalize).

2) Momentum, chasing past returns, is not a bad strategy. That is, invest more in asset classes and strategies that have been working over the past year. Again, it seems like a risk-free, easy way, to improve returns.

Bottom line is that if you are presenting a case for some major asset allocation, you should be familiar with the data and arguments noted in this book.

This is Big News?

I chuckled when I read this:

FAA Administrator Randy Babbitt told a congressional hearing that the controller was "found intentionally sleeping" in the radar room during a midnight shift on February 19 in Knoxville, Tennessee. Babbitt said the agency is seeking to have the person, who was not named, fired. The sleeping controller was found asleep with cushions and a blanket.

'Was seeking?' Sleeping on the job is pretty common, but usually the results are straightforward and not worthy of comment. I suppose, like not paying your mortgage, that means in 438 days or so.

I'm in Disney World!

Gotta love Spring Break. Get to visit the in-laws, whose internet connectivity consists of a AOL LAN connection! Mother-in-law says she doesn't use it much, but I imagine she might if it didn't take so long to load pages.

I love seeing all the cows on the side of the highways here, part of a tax scam where you get a different assessment if your land is 'agricultural', about 1/100 the otherwise rate (it's called greenbelting, preserving the agriculture). Thus, a dozen random cows in property ready for redevelopment, rented for the minimum time needed for the zoning.

Strangely, I note that everywhere I go there's the option for 'debit' when you ring a transaction that does not work on my debit/credit card so you have to push 'credit'. But then, why the choice? This little bug has been persistent in my Minnesota Home Depot for 10 years, and seems a nationwide issue.

Anyway, vacation reminds me that the happiness available to any man is available to everyman, as really all one needs are G-forces and water, and those are pretty accessible anywhere. But...the princesses here are a surreal treat for my 3-yr old Isabel, whose conception of reality has now been pushed back a couple years. experience.

Capital Requirement Probably no Good

David Henderson noted that capital cushions are not cushions at all, highlighting a perverse effect of these requirements. One of the more interesting puzzles in banking is the absence of any clear leverage-risk nexus in the statistical data. I know everyone thinks the past recession proved leverage is an obvious and soluble problem, but that's anecdotal, and I doubt that Bear, Fannie, or AIG would have survived with twice their capital. Hyman Minsky's financial instability hypothesis remained obscure until after his death precisely because there wasn't clear evidence between leverage and business cycles (as an acolyte, I would have loved proving the big man right...alas, he missed a lot).

When I was head of capital allocations at a bank, every week I would be in a meeting or presentation where the logic of our mission was that higher 'risk' required a greater 'cushion' for bad times, a greater equity charge. I still think this is a good idea (no better alternative), but the whole 'cushion' idea simply doesn't generalize. We (consultants, regulators, advocates) looked cross-sectionally at banks, but could not see a clear cost-of-funning and leverage connection, and it would have helped me immensely to have such a finding. Also, one of the big goals in modeling default risk would be to create a financial firm model, because many banks and finance companies do not have agency ratings. Again, I worked at an institution that would have loved demonstrating this, but there is almost zero correlation between leverage and default rates.

Given the financial sector has been in aggregate insolvent in 1975, 1981, 1990, and 2008, I would say it is generally undercapitalized by a factor of two. Yet, proposals to require a capital amount of, say, 8% of assets counterproductive. This is because a good portion of a firm's value is its franchise value, the present value of its brand, and all the myriad regulatory contrivances that keep competition at bay. Now, if a firm's capital amount is 8.01%, as a debtor I realize this firm is a coin flip away from losing that franchise value, and then I might have a principal loss on my debt. The "capital cushion" becomes simply a new trigger value, as opposed to resource to tap in tough times.

The bottom line is, as long as the private sector anticipates little or no risk, it will skate close to the edge, which will be the regulatory minimum, not zero (either spell death, and thus a liquidation of sorts). Perhaps, given the politics of closing failing banks, there should be a bank asset size limit because we can anticipate a Goldman simply having too many connections to ever let it fail, whereas ten firms each with one tenth the size wouldn't have such pull. I can be convinced of that. As per the private sector underestimating risk, I agree this happens, but only after a couple generations. The safety of the 1950s was not due to regulation, it was because these bankers had experienced failure first hand and such lessons leave a mark (did any actually read the SEC act of 1933 and 34? It simply has brokers sign statements saying they won't rob you blind, an oath administered by Joe P. Kennedy). Just look at how Commercial Real Estate has done subsequent to its 1990 crisis (lower-than-average defaults), or how tech firms did after their 2001 debacle, to see that while the public is fooled again and again it's not the same generation on the same products.

So, bankers and everyone else believed there was too little risk in mortgage lending. Currently mortgage debt needs 50% down payments to get securitized in the private market, so they don't need top-down reminders that this is risky. Indeed, the government is lending at 3.5% down (FHA), so I would say they aren't exactly leading by example.

Punked by Google

For about 10 seconds I thought they were serious, which makes it all the funnier...see Google's new 'Motion' app.



Also, jobs for autocompleters...background in spellchecking a plus!