Re-Remics: Financial Folly?

The WSJ reports:

The popular deals are known as "re-remic," which stands for resecuritization of real-estate mortgage investment conduits. The way it works is that insurers and banks that hold battered securities on their books have Wall Street firms separate the good from the bad. The good mortgages are bundled together and create a security designed to get a higher rating. The weaker securities get low ratings.

Regulators are pushing back, saying the transactions don't have enough substance and stand to benefit bankers and ratings firms...U.S. Rep. Dennis Kucinich (D-Ohio) raised concerns about the mounting number of re-remics, saying, "The credit-rating agencies could be setting us up for problems all over again."

The process of securitization allows diversification: you can take a pool of assets, called collateral, and then assign various priority to the cash flows of these assets (which are basically bonds). Diversification is generally a good thing. The most senior is rated AAA, and when done appropriately, has an extremely low default rate. Then there are AA, A or BBB pieces, and sometimes a mezzanine piece rated BB or B (ie, junk). The least senior piece is simply equity, and the issuer generally retains an interest in the most junior set of residual cash flows. is mainly one of diversification.

Many firms specialize in holding AAA debt, and it often is efficient to move this from the loan issuers, to other institutions. Now we know everyone screwed up with rating mortgage AAA bonds, they assumed housing prices would not fall. It was not a subtle mistake only perceptible via reverse engineering a complex security or copula.

The continued resistance to anything similar to what blew up before highlights the adage about generals are always fighting the last war. Many people lost money on mortgages. Those mistakes will not happen again in that asset class for a generation. Yet, regulators and regulators are finely attuned to anything with mortgage securitization.

I remember when I worked at Moody's and someone was telling me that since the 1990 Commercial Real Estate debacle, defaults in this asset class were well below average across the board for the subsequent decade. In the aftermath of that crisis, newly issued Commercial Real Estate Asset Backed securities did very well, because everyone was especially cognizant of the risk factors involved: investors, ratings agencies, regulators, issuers, even borrowers. A similar thing happened in railroads after the Penn Central railroad defaulted in the early 1970s.

It would be wise to focus not on mortgages, which have enough skepticism, but rather the current 'low risk' investments. Things related to energy, or health care, seem highly risky because they have done relatively well, and regulations could drastically change profitability within those sectors. A good rule of thumb in debt is whatever sector did worst in the last recession, will perform above average in the next.

Why Capital Regulations did Not Cause the Mortgage Crisis

I still read many different takes on what caused the subprime housing bubble. The least compelling to me is the capital regulations. Mortgages were historically the lowest loss rates of any asset class, for the entire dataset anyone looked at. Think of a capital regulation as a rule enforced by government. If the rule is binding, this merely makes the activity more expensive, as when you amortize the cost of getting caught smoking pot (including potential career repercussions, which vary considerably by profession). Many rules we think are unnecessary are worked around, as for instance, ProShares has many stocks that allow you 3-to-1 leverage, which is technically illegal if done directly (it violates Reg-T for retail brokerage accounts). There are shares that allow you to be short, which for 401ks is otherwise illegal, but now legal.

Now, generally, the government allows you to do many things you can do, but shouldn't. Moderation in all things is a good rule, and what prevents most people from excess is discipline. People generally don't do things to excess because it causes various hangovers, real and metaphorical. So, if the government assigned a low capital ratio to mortgages, this did not cause banks to invest in mortgages in excess unless they also believed these were of low risk. It was a common mistake. So common, in fact, I think it strains credulity to think the regulation was extremely important. There were enough investors and companies not bound by US banking regulations involved to note this was bigger than them.

The fact that I can drink a bottle of Scotch every night is no reason to blame the government if I choose to do so.

Details Matter

Any successful policy needs both strategy and tactics. From an interview with MIT Economists Esther Duflo and Abhijit Banerjee in Philanthropy Action:

Q: When you read about where most private philanthropic dollars and official aid go, a lot of it goes into health, education and other areas that Oxford economist Paul Collier refers to as ‘photogenic subjects.’ Do you think the money going to these sectors is being used well?

Banerjee: The real issue is often in program design. Our endlessly repeated line is that details matter infinitely. The difference between successful programs and unsuccessful programs is not the sector, it is how you do it. Has the implementer thought completely about the reasons why a program might not work? In my experience, even when you talk to very competent, well-meaning organizations, that is the step where you see the biggest gap.

This is why macro is so sterile. Details matter. Looking at aggregates, the sine qua non of macroeconomics, like 'investment' or the 'interest rate' obscures so many important variables. To think there is a profound causal relation between some aggregate quantity like 'consumption' or 'the savings rate' and future growth, assumes that all the little details don't matter, but they matter a great deal.

The Latest Equity Factor Model

Lu Zhang and Long Chen have an article that seems to be making quite a stir: A Better Three-Factor Model that Explains More Anomalies. The current champion Three-Factor model is the Fama-French model that has three factors: size, value, and the market. The value factor is created by going long value stocks (high book-market, low P/E) and short growth stocks (low book-market, high P/E). The size factor is long small cap, and short large cap. Size and growth are cross tabbed in the Fama-French approach, to maximize their independence. The market factor is the value-weighted market return minus the risk free rate.

Now, Fama and French created this model to explain, well, itself. In 1992 they noted that value, and size, were outside the traditional CAPM, that had merely the market as a factor. So, adding a size and value factor, explained stocks sorted by value and size. If that seems like an anomaly explaining itself, welcome to Modern Finance, where return is a function of risk, which is a function of return. It's like explaining high productivity growth by saying a country has a high Solow residual. Anyway, these are the most prominent exceptions to the CAPM, around since around 1980, and observable in most countries. The value effect has remained strong since first discovered, while the size effect has subsequently been pretty small.

But there are new anomalies to this model. One anomaly is the capital issuance anomaly, where issuers of capital--debt or equity--tend to underperform, while those who buy it back tend to outperform. It seems either insiders are prescient, or outsiders are consistently poor market-timing investors, or companies tend to burn money when they ask for for new investments they can not, or are not willing, to finance themselves. Another anomaly is cash-flow/assets, first documented by Houge and Loughram: firms with high cash-flow/assets outperform, firms with low cash-flow/assets underperform. Another is momentum: firms with high past returns over the past 6-18 months tend to outperform over the next 6-18 months, the opposite for the low returning stocks. Also, firms with high asset growth tend to underperform, firms with low asset growth tend to outperform. A lot of this is the internet bubble, because firms that got a lot of assets through acquisitions, or issuing new shares, did worse than those that did not, and this is obviously related to the equity issuance anomaly. Lastly, firms with higher distress, as measured by a metric of default, do worse than firms with lower distress. Basically, outperforming firms tend to be firms one would think are good companies even if you did not know what the valuation was: high profits, low default rates.

Now, Zhang and Chen identify two new factors to replace value and size. The first is Investments-to-Assets. This is the change in Property, Plant and Equipment plus the change in inventories over assets. Firms with high I/A ratios have higher returns than those with low I/A ratios. Their other factor is Net Income minus Extraordinary Items divided by assets. Firms with higher ROAs do better than those with lower ROAs.

Clearly, their new factors are derived from the existing anomalies, as I/A and ROA are going to be correlated with distress metrics, asset growth, capita issuance, in straightforward ways. So in that sense, the fact this new approach can 'explain' those anomalies is rather unsurprising, in the same way that a value factor explaining the value anomaly is unsurprising. What is surprising is these factors do a better job at explaining the size and value portfolios than the value and size factors. Further, it does a better job explaining momentum portfolio returns.

Zhang and Chen argue this is a direct implication of Tobin's Q-theory, noting it is "potentially consistent with the risk hypothesis". Their basic argument is that firms that have high ROAs necessarily have higher discount rates, otherwise they would have more assets. Thus of course they have higher returns, because they have higher discount rates. If they had lower discount rates, they would issue more equity (because it would be cheap to issue), and increase their assets, lowering their ROA. One could also argue firms with higher momentum have higher returns because they have higher discount rates, and this is autocorrelated.

I argue the 'risk hypothesis' is demonstrably false, and present a theoretical argument why (see SSRN paper here, book there). The problem with their explanation is that it doesn't have the right covariances with intuitive metrics of aggregate welfare, things like 'the market', or GDP growth, etc. Risk is theoretically all about correlation to our Stochastic Discount Factor, and if only mere characteristics proxy risk, it seems highly dubious. One can argue, correlations and covariances are all backward looking, at characteristics like Inv/Assets and ROA are more forward looking, but when you form portfolios based on these characteristics and look at their correlations in real time over the past 80 years, the correlations still don't work.

Robert Lucas as Anakin Skywalker

In a review of Robert Skidelski's new book arguing for a return to Keynesianism, Greg Mankiw gives Skidelski the common backhanded compliment: he is a great historian, but doesn't know squat about economics. DeLong gave Skidelski a similar review for a previous Skidelski book on Keynes, to which Skidelski took exception, and DeLong was peplexed: I said he wrote well, isn't that good? Ah, to be good at anecdotes, funny trivia, syntax, but 180 degrees wrong on substantive views about the economy, may sound like half-a-loaf to some, but anyone who writes this long and hard about a subject thinks his writing skills are for a greater good, not mere entertainment. That greater good is understanding the essence of how macroeconomies behave. So the standard praise for Skidelski is like the boss who sums up his secretary's career by highlighting she was really good at making coffee and keeping his schedule, and then is nonplussed at her reaction.

Mankiw notes Skidelski gives short shrift given to Keynesian critics:

Mr. Skidelsky fails to give Keynes's intellectual opponents their due. In academic circles, the most influential macroeconomist of the last quarter of the 20th century was Robert Lucas, of the University of Chicago, who won the Nobel Prize in 1995. His great contribution to the discipline was to analyze how government policies influence the economy in part through their effect on people's expectations—a lesson that Keynes would likely have appreciated but that early followers of Keynes often ignored.

Now, I'm no fan of Keynes, but Lucas has problems of his own. Lucas became important for developing a model that showed why the Phillips curve was only a short run phenomenon. That is, prior to 1970 or so, economists looked at the data, and found inflation and unemployment were inversely correlated. They came up with fancy models as to how this was so, in a Keynesian framework. Milton Friedman and Edmund Phillips noted this depended on people mainaining stale inflation expectations, and that in the long run, inflation would rise higher and higher without lowering unemployment. Indeed, after one puts so much inflation into the system, it necessitates a great recession to unwind this inflationary pressure.

Bob Lucas came along and formalized this reasoning. In his Lucas critique, he noted that the Keynesian model assumed that expectations were invariant for various interventions in fiscal and monetary policy. If expectations were rational, that is, if the actors in the economy knew as much as the modeler, their optimal response would neuter these interventions. In this way, money was neutralized, and in the stagflation era of the 1970's, this had a lot of resonance: in the short run inflaton was a clusterpuck, in the long run it could not augment growth. Lucas created a dynamic model where economic actors had foresight, and were maximizing their utility. Using a relatively simple mathematical construct this reasoning was very clear. Indeed, for analytical types who dislike the imprecision of words, much more compelling than anything Friedman and Phelps wrote.

Note that what Lucas did was clarify logic others had already presented. It was an intuitive idea, and all the causal relations in the Lucas Island Model are consistent with anything one might read in Friedman's work. The implications from the Lucas model were not novel, rather, clearer. Unfortunately, at this point Lucas turned to The Dark Side, and thought that since some mathematics was good, more was better. As his work got more and more mathematical, he got into measure theory, contraction mapping theorems, Liapounov Functions, Fixed Point theorems, etc. (see Recursive Methods in Economic Dynamics). None of this shed similar light on existing debates, nor did it discern interesting new ideas. It exemplifies the hope of method, based on the success in one area, and did not work. Macroeconomics has not become more fruitful because of this thread. It's all consistent, and clear, but I sense it's like constructing a mathematical model history or happiness. To see why this angle does not work one only need to look at Gary Gorton's interesting theory on how the 2008 crisis was a bank run on repo. It's a model, but it does not generalize to something that can be applied to the economy at all times in a dynamic model of GDP growth. It uses math, but only at an undergraduate level.

A major success, such as bringing so much light to an intuitive idea via a mathematical model, breeds great optimism. Alas, here's a case where economists made a meta-mistake, thinking the method was the innovation, as opposed to the simple idea the method articulated. Give a man a hammer, and everything's a nail. The macro hammer was not rational expectations, or mere consistency, but rather, formalism; complete general equilibrium models where you have production functions, utility functions, stochastic processes for parameters, dynamic utility maximization—no more 'comparative statics'. The Lucas critique of Keynes remains as valid as ever, but his oeuvre contains many mathematical curiousities that will be as well remembered as Patinkin's endless recitation of partial derivatives in his Money, Interest, and Prices (1956). Old economist remember cutting their teeth on the problem sets these tomes generated, and like to think they aren't totally irrelevant, but this is simply a romantic notion that the trials of our youth were all essential in building our character. There are lots of difficult exercises that are merely difficult.

It is useful to note that even though Lucas highlighted the inconsistency in the Keynesian system, many Keynesians still believed in it anyway. Lucas, and Friedman, still relied on assumptions, and in anything as complicated as a macroeconomy, one can object, or ignore the model wholesale. Many thought that inflation would rise when unemployment went below 6.0%, but then in the late 90's it went to 4.4%, and inflation did not rise, Keynesians were perplexed, but then merely shifted the Phillips Curve over to the left. Thus, even Lucas's crowning achievement did not end the debate, he just made Keynesianism less popular. Keynesians no longer dominated economics departments, but they have always been very prominent.

Finding Alpha Videos

Tyler Cowen was nice enough to review my book, and so I might have some newbies here. Note you can see a bunch of videos that outline some of my main arguments here, and an SSRN paper on the general theme is here. Below is an intro on the book.

Boxer Drinks Own Urine

For those not seeing tonight's UFC fights, which looks awesome, the Mayweather-Marquez matchup is interesting. An HBO special highlighted Marquez's unique training ritual; watch and enjoy.

Interesting to see he prefers it fresh (one would think it best like white wine, at 40 degrees Fahrenheit). Now, if you are on a life raft and dehydrated, you should drink your urine a couple times, after which the concentration of minerals and salts outweight the hydrating effect. If you drink your own urine (and know where you've been), the chances of bacterial infection are pretty slight, and it is sterile (unlike poop, which has thriving bacteria from the large intestine). Indeed, urophagia is a somewhat popular homeopathic remedy.

But, 'can' does not imply 'ought'. There are a lot of energy drinks out there that replace essential nutrients and taste great.

BTW, anyone who says there is no greater fighter than Mayweather, in terms of artistic talent and athleticism, has not seen Anderson Silva fight.

Macroeconomist Says Macroeconomics Really Successful

Narayana Kocherlakota writes a concise defense of modern macroeconomics, and basically says 'it's all good'.

I'm not so sure. I got my PhD in econ because I wanted to be a macroeconomist, but after a year of introductory macro, and having one quarter with models from a Keynesian, another quarter with models from a supply-sider (eg, Kydland & Prescott), it was clear to me they were overfitting the data, and reconciliation was not in the cards. They simply did not have enough business cycles to distinguish between very different theories, and it was too easy to fix models after every new decade's surprise.

For example, the main data is post World War 2 US data, and there have been about 10 recessions. There are hundreds of time series (consumption, consumption per capita, non-durable consumption per capita) where one can derive a model that explains things. Given the failure of economists to forsee the stagflation of the 1970s, the disinflation of the 1980s, the fall in velocity in the 1980s, the growth of the Asian Tigers, the relative productive power of capitalist economies (most thought the Soviet Union's savings rate would necessarily generate higher productivity in a generation circa 1960), it is difficult to see what what else is needed to be discouraged. I've made several strategic errors in my career; leaving macroeconomics was not one of them.

But, if you're a 50 year old macroeconomist, the cognitive dissonance in admitting this is too great. Thus, Kocherlakota notes:

The work of the people on this list is pretty technical. Most are very gifted intuitive economists. But intuition necessarily plays a limited role in macroeconomics. There are just too many things going on in a macroeconomic model of any interest to rely on intuition alone. ... The good news is that, thanks in part to the people on this list [top macroeconomists mentioned earlier], we’ve made enormous progress in the kind of realistic complications that we can usefully model.

An example would really help, because I'm at a loss. It reminds me of John Campbell's Asset Pricing at the Millenium, where he noted:

the period 1979 to 1999 has also been a highly productive one. Precisely because the conditions for the existence of a stochastic discount factor are so general, they place almost no restrictions on financial data

Yup. Progress is generalization, a la String Theory, because explaining things with complicated yet elegant mathematics is progress, right?

The main issues in economics are explaining

• what determines economic growth over long time horizons
• what determines business cycles
• what are the essential characteristics of an optimal fiscal policy
• that are the essential characteristics of an optimal monetary policy

I think to the degree we know anything about these key questions, we have learned via experience. In a productive scientific area, like solid state physics, experts are much better than non-experts at knowing essential truths, but macroeconomists are as divergent on the big issues as anyone. That is, they cannot explain, let alone predict, recessions, just like journalists. Look at the divergent explanations for 2008: the Fed, too much regulation, too little regulation. Which is it? Who knows. They are still arguing about the causes of the Great Depression, and why we got out of it. I have my beliefs, but I realize I can't prove them true.

The most successful macroeconomic policy is perhaps the the Taylor Rule (see here, page 202), which basically was derived by explaining how the actually Fed Funds rate related to inflation and GDP growth in the decade prior to its proposal in 1992. There are lots of dense books on theory that should have been helpful here, and one can retrospectively look in the macro literature to derive this rule, but lets be honest, high-brow theory was pretty irrelevant in the discovery of this useful rule.

Macroeconomics is the triumph of hope over experience, and has been no more successful than sociology. I think it's great that some people are working on this, but let's not kid ourselves that there has been any progress. It is easy to think that merely because a lot of intelligent people have published peer reviewed articles, knowledge must be increasing. The bottom line is the data, and real time experience with macroeconomic models has been horrible as always. It is nice that some of the bad models of the past are now known to be wrong, but the set of wrong models is infinite, so that does not imply we are getting closer to the correct model merely by excluding more bad ones.

Around 1840, Macaulay wrote a grand history of England, and noted that doctors had historically recounted their field’s successes with an obvious lack of detachment:

The history of our country during the last hundred and sixty years is eminently the history of physical, moral, and intellectual improvement. And this is the way the history of medicine used to be written, principally by doctors in their retirement, as a form of ancestor-worship (no doubt in the hope that they, too, would become ancestors worthy of worship). In this version, the history of medicine was that of the smooth and triumphant ascent of knowledge and technique, to our current state of unprecedented enlightenment. . . . [but] it is clear that for centuries it possessed no knowledge or skill that could have helped its patients, rather the reverse.

This was before anesthesia and the theory of germs, a time when visiting a medical doctor was about as useful as visiting a witch doctor.

Macro was created by John Maynard Keynes, before then it was just 'economics'. The simultaneous creation of a model that applied to aggregate variables (eg, aggregate demand) and national income accounting, created what Keynes thought would be the new era of the 'joy of statistics'. It hasn't turned out that way.

Paul Samuelson’s first paper in 1939 was to apply mathematics to the new theory of macroeconomic dynamics, in this case a second-order difference equation. Hyman Minsky's most prominent refereed journal article was a second order difference equation applied to the macroeconomy because that was top line macroeconomics in the 1960s. No one thinks those models work now, they were doomed. Do we really think today's tools are any less futile?

The key indicator of scientific progress is not the opinion of a seasoned practitioner (with their clear bias), but rather, do large financial institutions, who would really benefit from being able to forecast the economy, have thriving economics departments, with the best macroeconomists moving in and out as Chief Economist of Citigroup, to Harvard, and back? No.

In the 1980s, I worked with economists who worked for the Bank of America in the mid-1970s, and they talked of a whole floor of economists, forecasting at various industry and regional growth rates, the things one expects macroeconmists to know. When I got back into banking after graduate school around 1994, the large regional bank I worked for had over 10,000 employees and 1 economist, whose main job was public relations, not advising internal decision making, and this was a typical use for an economist. A few years later, they got rid of him. Macroeconomists are demonstrably not helpful to those institutions that could use economic expertise. Macroeconomists know a lot of stuff, just not anything useful.

Nonscientists Naive about Science

I like listening to journalists talk about science, as such fields have parochial tests and models that can take years of devoted study to fully appreciate. Some of these insiders, like Steven Pinker, are good at communicating to a general audience, but most of the translation to outsiders come from non-scientists simply because there are more of them, and some write very well.

Yet, I find many times, when these journalists digress from a specific subject to science in general they are extremely naive or duplicitous. If you go to The Skeptic's Guide to the Universe, you invariably hear a bunch of caricatures of those who disagree with conventional wisdom on science—most of which truly are quacks, but not always—and they pedantically emphasize how these alternative views are 'not science': they have beliefs that do not have peer-reviewed tests supporting a falsifiable hypothesis. Or listen to Chris Mooney, a journalist who thinks the masses are insufficiently scientific, and argues that Republicans hate or are ignorant of science. He argues we should have more 'pro-science' candidates, reflecting the 19th-century progressive notion that with education, most disagreements and bad policy disappears. Most importantly, if the masses knew more, he surely thinks then popular opinion would converge to his. This from a journalist, a clan whose scientific proficiency is similar to the athleticism of mathematicians.

When journalists talk about science, in general, this is usually a pretext for saying those who disagree with their favorite idea are wrong, because they are unscientific. Who can be against science? There isn't a formal anti-science movement because it's indefensible in principle. They then caricature their opponents, taking the most inarticulate advocates from the other side, and skewering their illogic. They then sit back and take inordinate pride in their scientific pretensions, as if their selective discussion was objective. The fact is, most 'big' scientific issues do not conform to the scientific method, where one puts out testable hypotheses, rejecting ones that are falsified.

Take finance, where the main potentially falsifiable theory is that there is a Stochastic Discount Factor 'like' the S&P500 index that one uses to generate 'risk', and thus the expected return, on every asset. This is a prerequisite for any rational portfolio allocation because you need the mean for a 'mean-variance optimization algorithm' for determining one's portfolio. What is this Stochastic Discount Factor? Well, not the S&P500, though that's what is still taught in Business School via the CAPM, because we are pretty sure these betas are not correlated with returns cross-sectionally anywhere. In Treasuries, it's a subset of forward rates. In equities, it's a size, value, and market factor (the Fama-French factors), or it could be consumption-to-wealth ratio, where consumption is measured as nondurable consumption, and wealth comes from the Survey of Households. Or it could be year-over-year consumption growth. Bill Sharpe, who won the Nobel prize for his one-factor model, also has a model with 12 factors. If it squiggles over time, it's a viable risk factor proxy. So, no one knows how to measure true risk, but presumably markets price it by aggregating everyone's preferences for this unidentified factor(s). Yet, as Andrew Lo states, "Finance is the only part of economics that works." Yikes!

To see how incredibly bizarre this situation is, consider the classic demonstration of group intelligence is the jelly-beans-in-the-jar experiment, in which the group's estimate is usually far superior to the vast majority of the individual guesses. When finance professor Jack Treynor ran the experiment in his class with a jar that held 850 beans, the group estimate was 871. Only one of the fifty-six people in the class made a better guess. So that's how risk and return work, the wisdom of crowds distills a precise truth out of our fuzzy uncertainty. Except here's the problem: no one knows what risk is. It like presenting people with a jar of jelly beans, a jar of rice, a jar of rocks, and a jar of bb's, and asking them 'How many are in THE jar'? The question does not make sense; there can be no aggregation. So with respect to risk, if no one knows what it is after 40 years of searching, why should we think people agree on it sufficiently to aggregate and distill priced risk premiums. Is it any wonder we can't measure them?

Yet, if you ask financial economists how scientific their field is, you can be sure the answer will be some variation on very. For example, derivatives pioneer Mark Rubinstein paid homage to Modern Portfolio Theory creator Harry Markowitz in 2002 and noted that:

Near the end of his reign in 14 AD, the Roman emperor Augustus could boast that he had found Rome a city of brick and left it a city of marble. Markowitz can boast that he found the field of finance awash in the imprecision of English and left it with the scientific precision and insight made possible only by mathematics.

This gives the impression finance is working on the third digit of fundamental constants in finance, as opposed to finding the right sign.

But, finance should be congratulated because its errors are more conspicuous than other fields, which have similar problems. Take String Theory. Invariably any researcher is working on one aspect of the theory, and cannot comment on the theory as a whole. Alas, the main problem is they have 10^500 potential solutions and prominent theorists saying that these actually all exist now. One of them matches our universe, but with quint-google universes this is unsurprising. Throw in the anthropic principle, which states we necessarily live in a universe hospitable to human life, and there we are, numbers match to a T. It does not predict, it explains, but in a meager way because it merely tries to match parameters generated from a small set of separate models using a much more complex but unified model. Complex mathematics necessarily has more degrees of freedom, so this is all pretty unsurprising, and without some novel testable hypothesis, rather pointless.

Or take astrophysics. Their theories of the early universe also tell us which atoms should have been forged in the first 5 minutes after the big bang, and the existing amounts of hydrogen and helium match theory so well that cosmologists claim this is the best evidence we have for the big bang. Yet what about the next element, lithium? There, they are off by a factor of three. They don't like to talk about that. Or background of the universe, which seems perfectly flat...except for this mystery pattern in the middle called the 'axis of evil' that does not make any sense.

But the best example of science putting lipstick on a pig is dark matter. Vera Rubin, together with Kent Ford, announced at a 1975 meeting of the American Astronomical Society the astonishing discovery that most stars in spiral galaxies orbit at roughly the same speed, which implied that their mass densities were uniform well beyond the locations with most of the stars (the galactic bulge). This result suggests that either Newtonian gravity does not apply universally (can't be!) or that most of the mass of galaxies was contained in the relatively dark galactic halo. Met with skepticism, it is now conventional wisdom. But what is dark matter? The stuff needed to make Newtonian physics match galaxy reality. It's like saying X=7, but when you measure X=9, you simply say there is an extra '2' of 'dark X'. They've tried to find it, building big swimming pools underground, hoping to find evidence of the leading candidate for dark matter (WIMPS), but thus far have been no more successful than SETI.


Or take our solar system, where every planet except Jupiter is assumed to have a huge, fortuitous asteroid giving it its singular properties of spin, moon, and composition. It seems like it is more common than not to fix a flawed empirical prediction with a nonfalsifiable adjustment.

Lastly, take Darwinian evolution, the idea that all life on earth descended from a common ancestor. Now, if you define evolution as the natural processes of heredity, chance, mutation, and natural selection, I believe 100% in evolution. That is, methodological naturalism excludes any other possibility. If you don't believe in the supernatural, evolution is a tautology because whatever exists descended from something else that was both lucky and successful, statistically, and also different from but related to its ancestors. The real theory in evolution is the mechanism, which is on much shakier ground, similar to economists' understanding of business cycles.

Take the 'evidence' for evolution, which has been assumed overwhelming by conventional scientific opinion for over a century, and see how tendentious it is. Darwin thought his best evidence was Haeckel's drawings that suggested ontogeny recapitulates phylogeny, that species closer to our uber-ancestors look more like early embryos, species higher in the evolutionary tree-like late embryos. We know those drawings were frauds, and this line of reasoning is a dead end. Karl Popper gave as an example of the analytical power of evolution the existence of darker moths in industrial environments, and this example was prominent in textbooks for decades. But the signature pictures of the dark moth on the pollution-darkened tree were invariably stuck there with a pin, and not relevant to speciation. Or Darwin's famous finch beaks, that were longer when there was less food--these turned out to be a temporary phenomenon, and there is no trend in finch beaks that suggests this phenomenon leads to speciation.

Darwin anticipated finding all sorts of intermediate forms in evolution, but these are the exception, not the rule. Indeed, Gould's punctuated equilibrium theory was first seen as untrue, but then, a minor change in emphasis that Darwin's theory allowed all the time. There is much effort to show Darwin did not reject sudden changes, but clearly, the Origin of Species emphasized the smaller steps. One can argue that 'sudden' in geological time is long in generations, but nonetheless, it's a major change in emphasis. The scientists like to whitewash these debates because they are scared to death of looking uncertain to Bible thumpers.

Or take Richard Dawkins, whose Selfish Gene argued evolution takes place almost entirely at the gene level (ergo, selfish gene, not selfish organism), not the organism or the population. Over the past 15 years, this view is now very much in doubt, as evolution at multiple levels appears equally important, with no special prominence to the gene level. Emphasis is everything because science is about probabilities, not possibilities, and so Dawkins was wrong, though he has never admitted to anything but being right all along.

The smoking gun for evolution from common descent is speciation, not local adaptation and differentiation of populations. There is no smoking gun. The mechanism of evolution is still a mystery unless one is happy merely knowing that it's 'not God', which given methodological naturalism, is true by assumption. Nonetheless, none of these setbacks has affected believers in the theory of evolution, which even in its very incomplete state of explanation is considered perhaps the greatest scientific theory of all time. In sum, there is no debate about the tautologous portion of evolutionary theory, but mass mystery on the 'scientific' part, though they are loath to admit it.

In all these cases, science mainly is about explanation, not prediction, and practitioners exhibit much more precision and confidence than is objectively warranted. Even in cases where there is prediction, like Global Warming, this is not a falsifiable prediction. There are not unambiguous Global Warming forecasts with standard errors, such that in one's lifetime any Global Warming advocate could be proven wrong. If the world shows no trend in temperatures, it will simply be seen as temporary. There are no definitive tests in major scientific debates.

So, when some journalists talks about how horrible it is that politicians, or voters, do not understand science, which their rigorous falsification of hypotheses, I say, gimme a break. The biggest scientific debates are not about testing a definitive hypothesis, they are more often about coming up with more evidence for a meta-view about some bigger truth, hardly much different than our quaint medieval ancestors. The big ideas are fun to think about, and I have opinions on them, but I'm not naive enough to think these debates are subject to the ideals of THE scientific method, where only objective, rational empiricism is involved. Tests that don't go our way are dismissed, tests that favor our predisposition are emphasized.

If you don't think that is true, think about how many Keynesian economists became supply-siders over their career or supply-siders who became Keynesians. Think about the market efficiency debate, where irrationalists (eg, Thaler, Shleifer, Stiglitz) are against those who see the markets as rational (eg, Fama, Cochrane, and French). I would estimate less than 5% of economists change sides over their working lives. Yet, they are all scientists, use logic, examine data, publish in peer-reviewed journals, understand statistics, and generally think they have good faith trying to understand the world as it is. The data seem rather unconvincing to diametric views on the big ideas within any field.

God is dead, but faith did not disappear. Rather, people always have faith in whatever they think is really important. With God out, now what is important is some big cause that, when fixed, will create a better world. As Eric Hoffer noted in The True Believer, 'all mass movements are interchangeable', meaning nationalistic, religious, social, political movements have the same true believers. Western civilization has tossed off nationalism and religion, but we are just as ideological as ever, only now we pride ourselves that our beliefs in social or ecological justice as the result of truth, divined through science. If only.

It is good to have the facts on your side because it makes it a lot easier to argue your case, but in real-time any big debate necessarily will have ambiguous facts for the simple reason that if the data were definitive there would not be a debate. Further, important matters necessarily have a debate, because there if there's no debate one takes it for granted, as opposed to seeing it as something noble to fight for. In this cynical view of the world, it is best to have common sense, which Einstein said 'is nothing more than a deposit of prejudices laid down in the mind before you reach eighteen.'

Science as a practical matter is about applying logic to data piecemeal. Isaac Newton made huge contributions to optics, and created calculus so he could prove the laws of motion. He also had bat-shiat crazy ideas about alchemy and Biblically based numerology, and thought his greatest achievement was dying a virgin. And that's as good as it gets.

Minsky a Keynesian Sockpuppet

A Boston Globe article tries to rehabilitate Minsky, as if his work proves Keynes had it right all along. To the extent Minsky believed markets were endogenously unstable, inevitably generating financial crises, I think this is a profound truth about capitalist systems. But that's a rather general point. It does not identify the mechanism, it just says don't think business cycles and panics are history, because success breeds overconfidence, too much leverage, and eventual collapse.

I was Minsky's TA while a senior at Washington University in St.Louis in 1987, and took a couple of his advanced classes, which regardless of the official name, were all just classes in Minskyism. He was a maverick, but perhaps a bit too much, being a little too dismissive of others, as he hated the traditional Samuelson/Solow Keynesians as much as the Friedmanite Monetarists. He always thought a market collapse was just around the corner. The S&P was 250 when I took his course, it went to 1500 in 2007 and then back to 735 in 2009. Does that prove he was right all along?

He believed all microeconomics was 'apologetics', because in these models you get an equilibrium, and the essence of his economics was macro, and macro had a necessary time dimension. With time, you get uncertainty, Keynesian uncertainty, the kind that cannot be measured. And with this kind of environment, it does not take long for people to become overconfident, and move from standard finance (paying principle and interest with cash flow), to levered finance (paying only interest with cash flow), to ponzi finance (paying only with increases in collateral value). The latter is a bubble, and when it breaks, it can cause collateral damage via The Multiplier leading to a Great Depression. [I remember when he got all worked up by reading someone saying his 'Ponzi' finance term was an Italian smear. The kind of things academics fight about...].

The problem, however, is that his top-down theory is rejected by the data. Aggregate leverage ratios do not closely correspond to business cycles. If Minsky took microeconomics more seriously he could have made his theory more relevant, by noting that crises tend to occur in specific subsets in the economy: in 1990, hotels and Commercial real estate, in 2001, high tech, in 2008, mortgages. The mistake is not one made in aggregate, but in different sectors each recession. By noting these areas, but not the aggregate economy, had too much leverage, and depended on expected future increases in collateral value, he might have been more successful proselytizing his colleagues. But he was a traditional Keynesian, who liked to look at aggregate equations, like Profits=Investment + Deficits + Net Imports.

Most articles celebrating Minsky have a strong subtext, kind of like Krugman's wistful remembrance of his undergraduate macro based on the General Theory, that if we only go back to the days when Nixon famously said 'we are all Keynesians now', we would have more faith in government top-down solutions. That was when Federal spending was 30% of GDP. Now it's 40%. Economists did not abandon Keynesianism because they are capitalist dupes, rather, it was inconsistent, generated poor models of economic growth, and it neglected the micro economic factors that make all the difference between a North Korea and South Korea: free markets, property rights, decentralized incentives. A Keynesian thought he could steer the economy via two controls, the budget deficit and the Fed Funds rate, and indeed in the short run these are very powerful tools, but in the longer run, rather unimportant.

What's Right about Intelligent Design

There's an interesting set of videos over at The Science Network on the Origins Symposium that goes over issues in physics and evolution. In the panel on Origin and Evolution of Life and Phenotypic Innovations, highlights many interesting issues. At the end, Richard Dawkins steps up, and says (around 51:00):

I just want to enter a protest against the recurrence of the suggestion that there is something odd going on in the Cambrian and very early times, that we only got new phyla then and we only get new classes and orders today. That obviously has got to be true. I've compared it before to a gardener going into a garden, looking at an old oak tree and saying isn't it strange nowadays we only have little twigs sprouting from this tree, we don't see any great big boughs [trunks] anymore.

The panelists dismiss him:

It's not true with plants...Another way to see this is we can measure morphological disparity, and what we see very early maximal disparity, later on filling in this space...disparity should increase over time...that's patently the opposite of what is predicted.

In other words, Dawkins sees the Cambrian explosion as no big puzzle, while these researchers are saying it is a big puzzle. These are not creationists, they are Darwinists (ie, they are naturalists, and believe in only genetic heredity, random mutation, and selection). In Dawkins's view a phylum is defined with hindsight, and so needs time to be developed, so the fact they are all really old is necessary in the same sense that tree trunks are thicker than twigs. But the panel members state no, this is not what is predicted by standard Darwinian theory, as what was expected was more phyla to be created over time, which is what we see for the plant kindom, and can be measured molecularly and morphologically. It seems that development gets more precise over time, preventing the development of new phyla, so how did all these phyla arise? These are actual researchers published in peer-reviewed journals, something Dawkins does not do.

The lecture mentions other interesting puzzles. For example, the common ancestor for humans and fruit flies need a heart gene, a stomach gene, an eye gene, and each of these has been found in both humans and fruit flies. From a developmental standpoint, what makes a fruit fly gene express itself so differently than a human being is still a mystery given so many similar genes we share. And it's even more bizarre than that, as these eye and heart genes have also been found in jellyfish (which does not have a heart or eye). A hydra is a very simple organism, but has about the same looking DNA as a human, with 20k protein coding genes for things like hearts, eyes, etc. How does this happen?

Dawkins does not see what many cutting edge researchers see as a puzzle, because he is so focused on demonstrating that Darwinian evolution works against Creationists: there are no significant puzzles to the paradigm! However, if you want to make progress, you have to accurately identify what is preventing it, and the Creationists are basically not affecting scientific research at major universities. If you go to the popular biology section at the bookstore you see several large popular tomes arguing against creationism (discussed here). Now, the percentage of journal editors in this field preaching creationism is zero, while the majority of the great unwashed do not believe Darwinian evolution is the complete answer. So, it's strange to focus one's attack on a contigent that is large to be sure, but rather irrelevant in the day-to-day discussion of ideas with colleagues. It's a bit like going to a wine tasting and talking about how unsophisticated beer drinkers are: in some sense you have a sympathetic audience, but they are interested in wine intricacies and so should you be.

I find evolution very interesting because Stephen Jay Gould is correct to highlight that most of the big changes in life on this planet appear without any really good theory at the molecular level. In his theory of 'punctated equilibrium' species appear and remain virtually unchanged, then disappear, over say 5 million year periods. The extinctions you can explain via asteroids and large climate changes, but the origination seems to demand more than the mere extrapolation from processes we can observe in local populations (like human having different skin color based on sun exposure, or lactose tolerance based on the importance of dairy farming). The creation of new helpful functionality, via adding information to the genome, is a lot more difficult than anticipated.

For example, biologists have been tracking E. Coli for over 40k generations, and almost all of the beneficial mutations identified from the studies so far seem to have been degradative ones, where functioning genes are knocked out or rendered less active. Random mutation much more easily breaks genes than builds them, even when it helps an organism to survive. That’s a very important point. A process which breaks genes so easily is not one that is going to build up complex coherent molecular systems of many proteins, which fill the cell. You can actually do the math, and the standard Darwinian mutations do not extrapolate from simple single celled organism to human in a mere 800MM years. 10^800MM, sure, but that's not where we are.

In contrast Dawkins emphasizes that evolution of new organisms is merely the gradual evolution of little mutations in the DNA, the climb up mount improbable is merely counterintuitive because of the numbers involved (millions of years, organisms).

I've read a lot of Michael Behe, whose recent Bloggingheads TV piece was recently delinked, then reposted (with a long apology by Robert Wright about how this happened), and find his arguments very interesting. Not because I believe in God (I don't), but because they highlight how, at the molecular level, the creation of different tissues is much more improbable than Dawkins examples imply. I don't think saying 'God did it' is a better theory, but I do think Behe highlights a major flaw in the convention mechanism of evolution. We haven't identified that in my opinion, as Dawkins' handwaving about slight modifications is as deficient as Gould argued [Gould had a very different endgame, but it's the same puzzle]. That's fascinating to me, and while the ID crowd isn't on to a fruitful new path, they are highlighting key problems to the conventional wisdom, one that highlights we need a new big idea in this area, as opposed to hand-waving about how it's just an extrapolation of how dogs breeds developed.

Perhaps one reason I find this so interesting is that I feel a lot like an Intelligent Design researcher, being dismissed because I'm outside the paradigm. Not that I'm totally outside the box, arguing for some kind of Spaghetti Monster, or Taleb's vague anti-formalism. I have tried to send academic version of my SSRN paper, or arguments in my book Finding Alpha, to journals, or academics, and I don't even get a response. I get responses like: "this is not of interest to the general readers of the Journal of Finance". Now, I could be wrong, in which case of course my hypothesis is uninteresting, but if I'm right I think the idea that risk premiums generally don't exist because of relative utility functions would be of interest, so clearly, he just sees me as a kook and dismisses me. Yet, they don't even want to discuss it.

This has been going on my whole life. My 1994 PhD job-market paper emphasized the negative relation to risk and return, and it was considered so silly I got zero fly-outs, because it implied an arbitrage (see dissertation here). Now everyone agrees that my fact is indeed correct (high volatility or beta loadings is negatively correlated with returns), but supposedly the Stochastic Discount Factor is negatively correlated with these primitive metrics, if we can only find it. Around 2000, when I introduced the idea that equity returns are negatively correlated with Agency Ratings (lower for B and C rated companies), this was also considered factually wrong, I must have made a mistake. Now it is considered right, but again, merely reflects the profound subtlety of the SDF.

I see the anomalies to the standard theory as actually the rule, not the exception. One sees risk aversion in explicit hypotheticals, or fire insurance, where there is no chance for alpha, or hope, but when alpha can exist everything changes. Across and within asset classes, and over time, intuitive measures of risk are not positively correlated with actual returns. This is the consequence of a the assumption about how people evaluate their wealth, via benchmarking, as opposed to comparing themselves to zero wealth. Exploring this path is more fruitful than building branches on a framework that after 40 years, does not explain the data at 30,000 feet.

Forensic Risk Management

Sometimes, when a catastrophic system failure happens, a reconstruction of the risks is rather unnecessary. For example, with the most unsurprising headline in major newspapers, World Oldest Person Dies, we see a case of mystery and intrigue:

LOS ANGELES - Gertrude Baines, who lived to be the world's oldest person on a steady diet of crispy bacon, fried chicken and ice cream, died Friday at a nursing home. She was 115.

The centenarian likely suffered a heart attack, said her longtime physician, Dr. Charles Witt. An autopsy was scheduled to determine the cause of death.

An autopsy? Here's a guess: she's 115 years old!

Madoff Intimidates Regulators and Risk Managers

The SEC released transcripts from phone conversations between Madoff and various risk managers and SEC personell. It reminds me how most powerful trading desk head treats regulators and risk managers, whith duplicity and contempt. Not at this level, and not that everyone is a fraud like Madoff, but truly independent risk managers are considered lightweights, and eager to join those they are policing. In UBS's Report to Shareholders, they noted their Internal Audit group did 250 reviews a year. With that many reviews, the analysis is pretty superficial. It's a mismatch.

Clearly, he understood phone calls are best. People who meticulously avoid email should not be trusted, because it is simply too calculating, as if they know they are regularly committing crimes. A phone conversation can always be disavowed, you just say you were talking about last weekend's bar mitzvah.

Obviously, first of all, this conversation never took place.

Madoff's strategy was to keep the underling in the dark, a classic spy novel tactic, because then neither creates a liability for the other:

"The less you know about how we execute," he tells the chief risk officer of one of his feeder funds, "the better you are."

Confidence and reputation can answer most anything:

"You [...] say, listen, Madoff has been in business for 45 years, you know, he executes, you know, a huge percentage of the industry's orders [...] We make the assumption that he's -- he's doing everything properly... You don't want them to think you're concerned about anything. You're best off, you just be casual."

Madoff dismissed an SEC investigation as a fishing expedition, which it probably was--see if they get any bites, if not, move on. He reminded the risk manager that SEC personnel were young guys looking to get jobs at hedge funds as compliance officers, making them eager to accept anything they said.

The Politics of Insincerity

A major problem in politics is that it is not optimal for any party to say what they mean. People pound the table as to how innocuous a certain policy is, and how 'crazy' anyone must be to be against it. Others highlight a different endgame, a principle, or the insincerity of the policy. This is why Michael Kinsley famously said a 'gaffe' is when a politician accidentally says the truth. Ignorance, and bad faith, make truth-telling a dominated strategy.

It is important to distinguish between private and public sphere here, as in my private life I can adopt a truth-telling strategy because when I encounter the ignorant and those of bad faith, I can simply avoid those neighbors and friends going forward. In contrast, one must build coalitions in public, and one cannot simply abstain from interacting with such parties. Thus, insincerity is needed much more in public contacts than private contacts [one still needs some insincerity in private, like saying 'your butt doesn't look big in that' to your spouse].

Ignorant people will misinterpret your assertions or plans. The idea that getting rid of the minimum wage helps the poor or that giving people money to destroy old cars is a waste of money, is a complex assertion that takes an equilibrium argument, and is primarily theoretical. The benefits are seen and the costs are unseen. Alternatively, the idea that it is optimal for governments to have 5-year plans for industrial production at one time seemed obvious, based on the fact one plans before building a bridge. In this case, the error is not in undercounting the unseen, but a flawed analogy.

Then there are those with bad faith. Often these aren't people out to get you, but rather, see your immediate aim as not in the best interest of their overall plan, and so want to stop it at all costs. Your failure is not their direct aim, but rather, consistent with their objective. Their opposition can be direct ('no new taxes!), but it can also be indirect, helping the ignorant develop antipathy by clever caricature ('he wants to hurt small businesses!').

Thus, people often speak in metaphors based on principles no one is against. For example, in litigation, when asked 'what is your endgame?', an honest response would state one's direct claim against the defendant. This would be a specific demand, but that presents a problem. Perhaps your endgame is something that an ignorant person would find highly dubious or self-serving if discovered. For example, you could merely want to effect a noncompete agreement, stifling a new competitor. Perhaps your endgame is costing your ex-employee a lot of money to signal to current employees the futility of trying to negotiate for more within the firm. Clearly, these are not sympathetic aims, even if your plan for crushing some plebes is part of a greater good via using your ultimate booty to fund a charity in Africa. So instead of saying something specific you say 'to protect our intellectual property and enforce valid contracts'. You start broad, and when pressed, get less broad, but always keep at a level where any Sunday school teacher would agree with your goals.

In health care, I think the bottom line is that most people see this as a foot in the door to greater government control of a large segment of our economy, one that will be used for more egalitarian, and politicized, allocation of resources. Democrats in this country like egalitarian redistributions, and 'politicized' is just a pejorative for 'democratized'. Republicans emphasize the inefficiencies of egalitarian distributions, the violations of liberty. As health care is expensive and already highly regulated, it's sort of like the Balkans of historical Europe, a good place to start a fight on this more fundamental issue.

As Greg Mankiw has noted:

To judge whether my conjecture [that this is not mainly about health care] is correct, ask your favorite pundit of the left the following: What health reform would you favor if the reform were required to be distribution-neutral?

Intentions, people's end games, are very important, because if you know what someone wants, that makes what they say mean something very different. I think all people understand this at a deep level, which is why old people suffering from dementia have prominent paranoid beliefs about people wanting to 'get' them. They know that the intentions of people are very important, and this knowledge is deep in the cranium, not at the edge.

In observing the public debate, one has to arrange one's argument in a way that makes it more likely the ignorant will be on your side because they are always a decisive block in any policy debate. As Keynes said, right policies are invariably chosen for the wrong reasons, so one must anticipate that. This makes a lot of discussion on these issues confusing, because some people are commenting on statements as if they were not part of a broader context.

Market Timing Using a Moving Average

Mebane (me-bany? mee-ban?) Faber has a well-read paper on the SSRN concerning market timing (A Quantitative Approach to Tactical Asset Allocation). I think this because the article is pretty simple, and it seems to work. It's incredibly easy to understand, accessible to anyone who uses Excel. He took the 10 month moving average rule proposed by Robert Siegel in his 2008 edition of Stocks for the Long Run, and found it worked in a variety of markets. I've seen a lot of market timing rules and find most stink, so I looked at the data myself, expecting it not to work.


I used the monthly data from Ken French's website. I went long the market if the index was above its 10 month moving average, went to T-bills otherwise, where 'the market' is the value-weighted US composite. The arithmetic return was slightly higher simply always being long (10.7% vs. 10.0%), but given the volatility of the long-only rule was 50% higher, its geometric return was about the same (9.3% vs. 9.2%). The Sharpe ratio using this index data suggests the market timing rule significantly helps one's investment, taking it from 0.30 to 0.46 in this 1926-2008 period.

US 1927-2008
Long vs. Market Timing Based on 10-Month Moving Avg.

	Regular	Timing
GeoRet	9.3%	9.2%
ArithRet	10.7%	10.0%
StDev	19.0%	12.2%
Sharpe	0.30	0.46

The result is pretty robust, in that it does not drop off dramatically using a 6-month moving average, or an 18-month moving average.

You can see that the main periods of outperformance were from the 4 big bear markets: 29-33, 73-75, 2000-02, and 2007-08. Perhaps in a simple moving average rule is a wise investment strategy. I would want to look at international data to become more certain, but it's interesting.

Are Expected Returns Unmeasurable?

Aaron Brown writes over at Willmott Forum (need to register):

I treasure the perfection in the Capital Asset Pricing Model, a necessary advance, even if expected return is nonmeasurable so the model cannot be tested.

Alas, I see often in responses to my critique of the standard theory that I am only using historical returns, not expected returns, so my take is invalid. Now, it is one things to say expected returns are difficult to measure, quite another to say they are unmeasurable. If large sample averages are not vaguely correlated with population averages, what does 'expected return' mean? It must mean one rationally expects randomness, making such a theory rather trivial. If a theory is by definition untestable, that is not merely 'imperfection', but rather, a bad theory (like asserting there are unmeasurable ghosts in my garage).

Nobel Prize Winner William Sharpe mentioned that expected returns are much more difficult to measure than anticipated in the 1960s, and I will admit these early tests contained several errors that needed fixing. For example, there's the 'two pass' sort, an adjustment for the 'errors in variables' such that high betas tend to be overestimated and low betas underestimated. But it has been 40 years, and we have data in the US back to 1927, and broader data, and only a small, ungeneralizabe fraction of it generates an intuitive scatter plot where some metric of risk is positively correlated with average returns. At what point does one say, this theory isn't untestable, it's wrong?

Currently, in empirical finance we know that size, value and momentum are related to returns, but it's not clear why. In the nineties most thought value reflected distress risk, but when measured financial distress actually is inversely related to future returns. One thing that is clear is beta and volatility are not positively correlated with returns. To say that financial theory is successful while the main facts were discovered via simple sorts, and sophisticated tests like GMM have uncovered nothing interesting to an investor, suggests current theory is pretty and consistent to be sure, yet I would only call a theory beautiful if it's true, because it in non-empirical, it's simply mathematical masturbation.

Physicists 'Solve' Two-Envelopes Paradox

I was reading about a new solution to the two-envelope problem over at some science/physics website:

Researchers from Australia have taken a step toward resolving a seemingly simple yet unsolved paradox known as the "two-envelope" problem. They’ve worked out a new strategy that can enable a player to beat the game in terms of increasing their payoff. The strategy could have applications in optimizing gains in investments and other areas...The researchers explained that the strategy emerges from recent advances in two-state switching phenomena that are emerging in the fields of physics, engineering, and economics.

Hmmm. Everyone can be make better off in a two-person, zero sum exchange? Please tell. I think the paradox comes from not looking at the true state space. It is funny to think these guys think they figured out how to get blood out of stone via 'emerging fields of physics, engineering and economics'. Asserting the solution they do is like asserting a mixed strategy is dominant for the Monty Hall problem. I think they get results via jerry-rigged simulations with particular a priori payoff distributions.

The problem is simple to state:

In the two-envelope paradox, a player must choose between two envelopes, one of which contains twice as much money as the other. The player can open the envelope they choose, and then they have the option of switching envelopes. The other envelope, of course, has either twice the money or half the money as the first envelope, but the player does not know which

It may seem that given an amount $X in your envelope, switching generates 0.5*2*X+0.5*0.5*X=1.25*X, which is 0.25 times more than the $X you have. But if they both apply such logic, how can that be rational, they both have the same expected, positive return in a zero-sum game (one's gain is the other's loss)?

There are many known solutions to this problem, some of which are inconsistent, but I think the simplest is as follows.

You might think you have $X in your envelope, and can trade to $2X or $0.5*X, giving you a gain of New Envelope minus value of Current Envelope, or 0.5*($2X+$0.5X)-$X, or +$0.25X. However, you must consider, symmetrically, you are the 'other guy', and so your envelope contains the $2X or the $0.5X. In that case, your expected gain is the opposite, trading gives you a new envelope with $X, giving up the random 0.5*($2X+$0.5X), generating an expected loss of $X-0.5*($2X+$0.5X), or -$0.25X. As you are either in the first or second case with equal probability, the expected value is zero, 0.5*(+$0.25X-$0.25*X).

The seeming paradox comes from thinking you have the envelop with the $X that is either doubled or halved, ignoring the chance you could be the one who starts out with $2X or $0.5X. If one player has $X, you have a 50% chance of being that guy, a 25% chance of having 0.5*X and a 25% chance of having the 2X. When you look in your envelope, and see $10, you can't assume X=$10. It could be that X=$20 or $5, conditional upon seeing $10 in your envelope. Weighting everything probabilistically leads to no increase in value from exchange.

Ratings Agencies Lose 'Free Speech' Immunity

From the WSJ, an important ruling affecting the backlog of lawsuits against Moody's, S&P, and Fitch:

U.S. District Judge Shira Scheindlin ruled on Wednesday in a 68-page opinion that the ratings of certain securities -- those that were distributed to a limited number of investors -- don't deserve the same free-speech protection as more general ratings of corporate bonds that were widely disseminated.

In other words, you can see the rating of IBM in Google Finance, or other free websites. It's on IBM's investor relations page. In contrast, some special investment vehicles have a rating known to a relatively small number of investors. It's not illegal to mention the rating, but really, who cares about such parochial funds. The example given was for a $1B fund, but there are about $400B of such funds.

I am very sympathetic to the Rating Agencies because I know that in general Moody's is filled with thoughtful, sincere people, who because of their culture, have better ethics than your average investment banker. That is, very few people who work at Ratings agencies make the kind of money prominent investment bankers do, and their steady, salaried work generates more far-sighted thinking. Nonetheless, they got caught up like everyone else in assuming that in aggregate, US houses can not decline in value, an assumption that drove all the insanity.

I am not sympathetic to the 'free speech' gambit, because that seems a bit strained. As the judge noted, it's not like they wrote a newspaper article on their opinion, but rather, they were paid by a small group of people to deliver a rating delivered to a small group of investors. Potentially, there is negligence and bad faith involved. If I were the rating agencies, I would argue this was merely a good faith error, and highlight how conventional their opinions were by referencing contemporaneous statements by academics, regulators, investors, legislators, bankers, even Robert Shiller (the famous 'housing bear' whose meek warning highlights how common the insanity was). I don't think it is reasonable to legally punish someone for holding conventional views, because incorrect conventional views are so common, if such errors were actionable we should just turn over corporate revenues to the trial lawyers right now. As a practical matter, the scope of damages is too large given the historical stupidity of conventional wisdom (busing, new math, socialism).

One thing I wish the Agencies were pressed on, is presenting the performance of their ratings in a standardized way. Currently, the agencies get to present their opinion on their opinions, and this cannot be anything but biased. For example, from 1993-2007 (the latest data available), Moody's cumulative 5-year 'impairment' rate on Residential Mortgage Backed Securities is 0%; for corporate ratings, the 5-year 'default' rate 0.09%. As they said in The Princess Bride, I don't think those words mean what you think they mean.

The problem is the universe of things to rate is very complicated. As a practical matter, you do not want to include Municipal bonds, with sovereign ratings, corporate, and structured finance. Even within structured finance, you want to disaggregate credit cards from commercial real estate. This is because the criteria, the model, the data, one applies to these areas is very different, so the relevance of a AAA for the IBMs of the world, is very different than the AAA applied to Structured Investment Vehicles. One might say, an AAA should mean the same thing, and they do attempt to mean the same thing. But they are very different problems, like estimating the probability Democrats with the presidency in 2016 vs. the probability global temperatures rise by 1 degree Celsius over the next 50 years. AAA targeted default rates are so low, you can't calibrate these empirically, you just make your best estimate in very different domains.

The net result is that when the agencies present their data they exclude various securities that are not obvious, leading to selection biases that are parochial and difficult to tease out. The exclusions are invariably favorable to the rating agencies reputations. I'm sure that, under some definition, the AAA default rate for structured securities is 0%. I'm sure using another, it is much higher. One thing regulators could do is to define for the agencies how this is calculated. Indeed, they should get all ratings data, and performance data, and generate a timely report card. That would be something useful and straightforward for our legions of regulators to do, and given the special status accorded to ratings agencies by the government, not an unreasonable intrusion.

There are many lawsuits in the pipeline, more than the value of the rating agencies. It would not be best for the economy to kill Moody's, Fitch, and S&P, because new firms would have the same analytical problem they face today, only with less institutional experience with a failure that is helpful to have internalized. These institutions are very helpful, because without them there would be much less liquidity in these obligations, and liquidity helps increase intermediation, and getting savings to companies efficiently makes our economy work better.

People Lie About Alpha

This year's hot investment strategies are related to distressed debt, as reflected by a lots of inflows, and this highlights that anything that worked well recently are considered smart. They took 'good risks'. When one loses money, they simply were foolish, such as going long mortgages in 2007. If you went long these in early 2009 you weren't lucky, you were smart. Risk taking seems only to apply to past trades that worked out well, those that did not work are just dumb. This creates a lot of confusion as to the true nature of risk.

Last Friday, the WSJ had a long article on the meticulous risk management at Graham Capital Management, a hedge fund that had one of the best performances over the past 12 months. Nassim Taleb's 'long gamma' strategy is hailed as genius in November 2008, at the top tic of a long put strategy (funny, no update after the market rally and the VIX has come down from 80 to 25). 12 months is a very short time frame to evaluate any strategy, but for a journalist highlighting business geniuses, it's a lifetime.

One should remember that Enron was the subject of Harvard Business School case studies in 'best practices' management, they emphasized their 'risk management' and received plaudits there. (I think there's a strategy in going short any company who's senior risk officer wins 'risk manager of the year' from GARP or RISK Magazine). Golden West Financial won an award as 'best mortgage lender' from Forbes before its portfolio took down otherwise prudent Wachovia.

So after a disastrous 2007 and 2008 in distressed, a good 2009 leads to new lemmings. One can imagine the sales presentations to investors, as management highlights how their meticulous deal-by-deal analysis enabled them to score big gains this year. That is, they make a beta bet (long distressed securities) look like pure alpha. This is easy to do in distressed because invariably the benchmark is not as obvious as it is for a diversified US equity portfolio.

In my book Finding Alpha I describe these strategies, as they are built on the fact that alpha is a residual return, a risk-adjusted return, and as 'risk' is not definable, this gives people a lot of degrees of freedom. Further, it has long been the case that successful people are good at doing one thing while saying they are doing another. Augustus Ceasar was successful because unlike Julius Ceasar he appeased the senators by making it seem like he restored the Republic (where the senate is in charge), when in practice he had probably more power than Julius Ceasar. When unions are successful they promote their agenda by appealing to how they are helping their customers, assiduously maintaining quality via their exclusionary rules. Affirmative Action was successful because proponents said it definitely does not imply quotas. The key is that many large strategies involve duplicity.

And so it is that most asset managers say they are doing alpha X when actually doing a beta bet on Y. I was talking to someone recently who noted a mutual friend was making a lot of money 'day trading spiders'. I don't think anyone can make a lot of money day trading spiders, but hope springs eternal and lots of people like to believe that anyone who made money recently, made such money via alpha, not a dumb bet. It's a better story than the truth, something like being long mortgages, because we all know how risky that bet was.

Below are some other examples of alpha deception, from my videos:

Arithmetic Returns For Junk Biased

I noted in my book Finding Alpha that junk bonds have not outperformed investment grade bonds since data on junk bonds really became available, around 1987. This is the real corporate bond puzzle, in direct contrast to the corporate bond puzzle most academics address, which is the anomalously high return premium between BBB and AAA bonds (around 100 basis points annually).

Academics seem to consistently miss the big picture in corporate bonds, which to me is the lame returns on patently riskier junk bonds over the business cycle. For example, Steve Cecchetti’s textbook Money, Banking, and Financial Markets, immediately presents the seemingly straightforward example of how bonds with higher default rates have higher yields: Risk and return rise together. Yet, this is purely an anticipation of the default rates, and so is not risk in the sense of something priced. BBB bonds have, over time, about the same total return as B-rated bonds. One must subtract the expected defaults and the resulting losses from a stated yield regardless of one’s risk tolerance.

The successful and ubiquitous usage of one flavor of 'risk'—the mere statistical volatility and loss estimation—does not imply the second flavor of 'risk' relating to a priced factor affecting future returns as also ubiquitous and essential. The distinction between or default risk by itself and priced risk (a covariance with some systemic metric of aggregate happiness, such as GDP, the S&P500, or unemployment) is a fundamental distinction in modern risk-return theory, yet prominent professors conflate risks when useful for selling the old bromide that risk and return go together like shoes and socks. Financial professionals have a strong, perhaps unconscious, bias toward the big idea: Risk begets average returns.

In addition to stated yield vs. actual returns, or survivorship biases, there is the simple fact of the difference between an annual average, and a cumulative return. Basically, the difference between a geometric mean and an arithmetic mean. In bonds this is huge. As mentioned yesterday, bond returns were down 26% in 2008, but up 40% in 2009. Does that mean they have a 14% total return? No. Think (1-.26)*(1+.40) and you get an 3.6% total return. But remember, those numbers are from Merrill Lynch indices using a collection of highly illiquid bonds closing prices. Actual bond fund returns from the beginning of 2008 have been -1%. See below for a collection of returns from the subperiods, and note how they compare to the entire period.

Below are data through August 2009 for a collection of High Yield bond funds:

		2008 Ret	2009 Ret	2008-9 Ret
BLACK-HI INC SHS	HIS	-37	56	-2
NEW AMER HI INC	HYB	-40	94	17
HIGH YLD PLUS FD	HYP	-28	59	14
MORGAN ST HI YLD	MSY	-27	45	6
VAN KAMP HI INC2	VLT	-45	59	-12
MFS INTERMEDIATE	CIF	-40	56	-6
PUTNAM MGD MUNI	PMM	-23	33	3
MFS HIGH INC MUN	CXE	-43	74	0
DWS HIGH INCOME	KHI	-30	39	-3
MFS HIGH YIELD M	CMU	-38	62	1
BLACKROCK-COR HY	COY	-39	76	8
BLACKROCK-SR HIG	ARK	-49	42	-28
WESTERN ASSET IN	SBI	-9	22	11
PACHOLDER H/Y FD	PHF	-48	84	-4
FRANKLIN UNIVERS	FT	-41	45	-14
HIGH YLD INC FND	HYI	-26	40	3
MFS MUNI INC TST	MFM	-36	68	8
WESTERN ASSET MU	MHF	-5	16	10
MORGAN ST MU IN3	OIC	-28	33	4
DWS STR MUN INCM	KSM	-20	49	19
MORGAN ST MU IN	OIA	-31	37	-6
BLACKROCK-APEX M	APX	-27	36	-1
FEDERATED I MUNI	FPT	-17	45	21
MORGAN ST MU IN2	OIB	-33	35	10
Average		-32	50	-1

Things Never Change

From the NYTimes: Some Analysts See an End to Market Rally.

Really? Some do. Some don't. I guess there's always sufficient noobs to make such a headline interesting.

There are many clichés extant as to why times are tough: greed, inequality, hubris. In general, these are bad things, and they always exist they remain perenial causes of bad things. As if Gilian Tett's ridiculous Fool's Gold, which also blames the drive for perpetual innovation--really blew the lid on greed and hubris. Arnold Kling mentions this book as one of the 10 he would use in an economics course, probably because it highlights securitization as a key driver. I'd put that up there with sunspots and El Nino, because the home ownership craze was multifaceted, with hardly any bottlenecks singularly affecting it. CDO's were an enabler, but investors would have put money into homes other ways too, especially with the GSE's guaranteeing so much of it. After that great bit of investigative journalism, we should decide as a society to identify all self-interesting, overconfident people put them on an ice-flow and send them to a watery grave (excepting the good guys who know the good and true, e.g., authors). Good riddance.

I am reading an interesting book on the Roman Empire, and it's really depressing. All the dysfunctional diagnoses and remedies, leading to decline. You get the feeling society's optimal sphere of military control was greater than its optimal governance size, making most of its last 5 centuries a disequilibria of waxing and waning coalitions and dynasties. I don't think our politics is much better. Certainly, the best of the Romans are better than most modern politicians, but bit by bit they misunderstood what was sustainable, how to balance authority with sustainable power. Eventually it was no longer Holy, Roman, or an Empire.

What was most interesting was the part on how Romans needed to raise money, but had to resort to debasing the currency by decreasing the amount of silver in their money, which really took off in the third century AD. As prices rose they were totally flummoxed as to the cause, and blamed this on 'greed', a common enough political response in the twentieth century to excessive money growth. But fundamentally, there was no solution because the size of the Empire was larger than could be sustained, and monetizing the debt was a symptom of this problem. No politician gets power saying we should do less, the assumption is always that a state can achieve whatever it wants if it tries really really hard. Blaming symptoms we don't like, such as greed and hubris, is a constant refrain. Some things never change.