Tuesday, September 24, 2013


I've got a new job with Pine River, and I want my new colleagues to know I'm not going to blab about anything that comes up, so blogging is now really over.  Of course, if you bump into me you can always buy me drinks and try to get me spill the beans (about non-proprietary matters) but I should warn you, I can drink a lot of beer. Best.

Tuesday, September 17, 2013

Historical CBO Budget Projection Highlights Bias

Recently the CBO issued its annual budget projection, and it's pretty benign for the next decade, then climbs at a pretty measured pace.

Yet, note that in the last recession our debt relative to GDP doubled.  Given that economists still don't have a good model for predicting business cycles let alone avoiding recessions, we can expect more of them. I think the odds that we elect a modern-day Calvin Coolidge next term are much smaller than the odds the deficit will increase dramatically when the next recession hits.

Consider that in 2007, before anyone saw any hint of the 2008 crisis, the debt was actually projected to fall, but we know how that turned out (black are actual historicals).  That is, they never anticipate recessions, though we all know they haven't been abolished.  I pulled these numbers out of the 2007 'wayback machine' which is a great way to hold large institutions accountable, because for some reason the CBO doesn't keep their historical forecasts on their current site (maybe the NSA can get Google to scrape them away?).  Liberals who happen to be economists  (eg, Brad DeLong) think the latest objective projections prove we have no budget worries.  I guess some people really do think This Time It's Different.

Sunday, September 08, 2013

MSCI Quality Index

I was unaware MSCI had beaten AQR to the punch by producing a boatload of quality indices last spring.  These are applied worldwide, so they are necessarily more parsimonious than AQRs...but jeez, these are really barebones:

1) Net Income/Book Equity
2) Debt/Book Equity
3) Earnings volatility over 5 years

Instructively, they Winsorize the data, which everyone should do to financial ratios (ie, truncate extremums).  But, book equity in the denominator?  Earnings volatility over 5 years? Those seem like bad choices, and AQR's quality index will be superior.

I have a feeling MSCI is a bit confused, as they have another tab noting their 'Risk Premia Indexing', which they note
An accumulating body of empirical research has found positive gross excess returns from exposure to factors (or risk premia) such as Value, Momentum, Low Size (small firms), and Low Volatility stocks. The studies show that these factors historically have improved return-to-risk ratios. Today, interest in risk premia (also known as smart beta or alternative beta) has been widespread across the institutional investor community.
In other words, risk premia are really return premiums, because predictable returns only come from risk (in theory). But then, they also 'improve return-to-risk ratios', because, as we all know, these factors aren't risk in any obvious way, so strangely they all have 'excess return' premia. Indeed, 'value and size were initially thought to be due to distress risk, which would show up only episodically.  Alas, 'quality' is basically an metric of anti-distress, and this generates a return premium, which MSCI occasionally calls a 'risk premium'...so basically whatever asset outperforms over the next 20 year period will ex post be declared risky.  

The risk-begets-return model of economics is clearly nonfalsifiable amongst current financial academics and their coterie.  They still say interesting things on occasion, so it doesn't render them useless, but it definitely impairs their ability to see and interpret reality.

Wednesday, September 04, 2013

de Botton on Status Anxiety

I find Alain de Botton's approach to philosophy rather refreshing, because one senses his genuine lack of certainty, and appreciation of discovering, in his works.  He's interested in applying virtue for daily betterment, and the search for meaning, two very important goals in my life.  Interestingly he was insightfully quoted in a NYT review of Sophie Fontanel's self-indulgent book on her self-induced celibacy, which highlighted his breadth and profundity (de Botton's quip was basically that 'sex is messy, get over it'). 

Anyway, here's de Botton on status anxiety. He argues that status anxiety is worse than ever because now we believe we are less constrained by our birth, more responsible for our fate. Paul Krugman agrees with this view of life, but like most economists, can't take this to it's ultimate implication, that this this leads to a zero risk premium, which when combined with the various attractions of sexy stocks, leads to high risk assets have lower-than-average returns (see my book The Missing Risk Premium).


Sunday, September 01, 2013

How to Maximize Lottery Revenue

As a proponent of the idea that people are oriented towards their relative success, not absolute wealth, I think this lottery idea is fiendishly clever.  Here's a description from TheWeek of a clever way to capitalize on this instinct:
A salient example is the "Postcode Lottery" in the Netherlands. Weekly it awards a "Street Prize" to one postal code, the Dutch equivalent of a zip code, chosen at random. When a postal code (usually about 25 houses on a street) is drawn, everybody who played the lottery in that code wins about $12,500 or more. Those living there who neglected to buy a ticket win nothing — except the chance to watch their neighbors celebrate. 
In a 2003 study, researchers in the Netherlands noted that fear of regret played a significantly larger role in the Postcode Lottery than in a regular lottery. It was not the chance of winning that drove the players to buy tickets, the researchers found, it was the idea that they might be forced to sit on the sidelines contemplating missed opportunity. 

The Boring Premium

Todd Mitton and Keith Vorkink from (boring) BYU published Why Do Firms With Diversification Discounts Have Higher Expected Returns? Their answer: no skew. People will pay up for lottery tickets, but if you take those dreams away, it becomes an asset that is neglected. They find diversified firms offers less skew, and diversification discounts are significantly greater when the diversified firm offers less skewness than typical focused firms in similar business segments. They suggest a substantial proportion of the excess returns received on discount firms relative to premium firms can be explained by differences in exposure to skewness.

The implication is clear: people pay a premium for volatile stocks that have stories and potential. Conditional upon playing in a risky game, such as equities, there's not a return premium for risk, there's a premium for boring.