Another Sign You are Getting Old

You think the potential Vice President is attractive. She's a year older than me.

I remember one comedian noting that he knew he was getting old when the moms on classic TV shows starting looking hot: June Cleaver, Shirley Partridge, Carol Brady.

Stiglitz Called Subprime Mortgage Problem

Joe Stiglitz adds his name to the list of those who called the recent financial crisis. I guess it's like the Crash of 1987, which immediately afterword, everyone seemed to have called. In his lecture at the Nobel Laureate Meetings in Lindau, he says that he was among several people who told markets the crisis was going to occur.

His critique is like Taleb's (he mentions unappreciated fat tails), but more consistent, because he has written down some models on this for decades. Much of his oeuvre is based on showing how specific information asymmetries lead to deviations from perfect markets assumptions, non-Pareto efficient outcomes (one can make someone better off, without making anyone worse off).

But the fact that the world is filled with imperfections, and is not Pareto efficient, does not imply government regulation is an improvement, especially because government has worse imperfections. Indeed, government was right in there, as the Government controlled Fannie and Freddie were reducing their underwriting criteria to increase home ownership, especially for historically disadvantaged communities. And of course, like so many of these critics, he did not call the crisis, he merely has been carping on market irrationality and inefficiently for decades.

Aumann on rule optmality vs act optimality

I was watching Robert Aumann give a talk on rule vs act rationality, and my first thought (after, 'I bet he's Jewish') is that it brought forth a profound point. A decision may make no sense as an act, but as part of a rule, and this makes sense.

The ultimatum game is an experimental economics game in which two players interact to decide how to divide a sum of money that is given to them. The first player proposes how to divide the sum between themselves, and the second player can either accept or reject this proposal. If the second player rejects, neither player receives anything. If the second player accepts, the money is split according to the proposal. The game is played only once, and anonymously, so that reciprocation is not an issue.

Most people reject an offer less than 20% of the pool. Aumann sees this as both irrational in the act, but rational in the general sense that one does not want to appear a chump. The rule overrides our act rationality because humans have evolved to follow rules.

I think a similar issue occurs in gambling, which is like investing, and so people have a rule, intuitively, that risk taking is good. Yet, applied to some domains, such as equities, this rule does not work, as the average individual investor pays too much in transactions, and suffers due to a lack of diversification. Risk taking is good, in general, but not in the stock market. So we see too much gambling.

This is an positive view, an idea about what is, rather than what should be.

Taleb Calls Fannie Mae

Portfolio.com has an interview with my favorite flaneur, Nassim Taleb. He notes that he called the Fannie Mae meltdown, citing a footnote on page 225 of the Black Swan that

Likewise, the government-sponsored institution Fannie Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry, their large staff of scientists deem these events 'unlikely.'"

He notes he wrote this in 2003, after talking with Alex Berenson about a NYTimes article on Fannie Mae's risk. But the article, and Nassim's comments in that article, are all about interest rate risk. Fannie Mae's current problem was adjusting the criteria of the underwriting--with the explicit goal of increasing home ownership of minorities--which increased their credit risk. For a guy who spends a lot of time discussing how fraudulent experts and forecasters are because of their hindsight bias, and lack of candor and honest evaluation, he seems to be speaking from first-hand knowledge. Being right for he wrong reason, is not trenchant. And being right when one makes many blanket statements, and calls multiple disasters, is not impressive, because it neglects all the disasters that did not happen: the general strategy of being a chicken little, buying out-of-the-money puts, is a bad general strategy, as Taleb discovered. You aren't evaluated on you best calls you are evaluated on your portfolio. Taleb basically said you might want to short these 50 stocks, and when 1 goes down 90%, says, 'told you so'! Sounds like a lot a brokers I know.

Priorities are essential when talking about risk, because simply listing all the things that can happen, or that 'you should check your assumptions', or that 'you could be wrong', gives one no sense of importance. If Taleb was hired by Fannie Mae to run their Risk Management in 2003, and they adjusted the interest rate risk management as a result, it would not have mattered. As one who criticized economists for not having been traders, he should be wary of criticizing risk management never having been a risk manager (except in the broad sense that everyone, at some level, is a risk manager). A risk manager has to do specific things: generate methods for monitoring risk, limits, reports. What, pray tell, would he do, just write 'shit happens--don't say I didn't tell you!', shut his door and browse the internet?

Trivially, everything is possible, and so we cannot insulate against everything, but you have to do something, and this is based on probabilities and payoffs. Simply listing 50 things or companies that can blow up because anything can happen, and then when one of them blows up, saying 'aha!', highlights the depth of Taleb's understanding of risk, because this vague statement was not actionable. What about all those companies or scenarios that did not happen, what would have happened if you retreated there as well. You can't mention lots of disasters, in no particular order, with no specifics about nature of the risks, and then when something happens claim one was prescient. Further, logically certain statements like 'something unexpected and important will happen' are incapable of being wrong and therefore meaningless. It's like saying, there will be a humanitarian crisis in the Third World next year unless we act now! Of course, we won't, because one needs to be more specific, and something will go wrong, it always does.

The Talebs and David Smicks and Kevin Phillips of the world are all very loud, certain they know something really really important, viz, the world is complicated, and many things can go wrong, or right, in unpredictable ways, and it is getting more so. Now, except for the latter point, this is all indubitibly true, but that observation is not useful to anyone, nor interesting to me.

Housing Bubble in Vegas

These things are so obvious with hindsight. But at the very least, it looks like we are getting very close to the old long-run trendline.

John Maynard Keynes Song

OK, if you really take pride in your inner geek, you can buy a CD of songs about science and famous scientists. Listen to this rockin' little tribute to John Maynard Keynes.

John Maynard Keynes, he was tall and had a lot of brains

chorus: he was one of the giants of the dismal science

John Maynard Keynes, read his books each and every time it rains

chorus: you'll get lots of knowledge you can use in college

John Maynard Keynes, he instructs, even as he entertains,
if your fond of the comics, your gonna love economics

John Maynard Keynes, favorite author of travelers of planes

chorus: you will find no fun way, to pass the time, on a runway

John Maynard Keynes, sing it often the verses and refrains

You can't help being cheery with Employment Theory
coursing through your veins,
like John Maynard Keynes

Error in Excel

I noted that 9*508697815467511(aka 9*5.08697815467511E14)=4578280339207599
but in Excel, it says 4578280339207600.

I want a refund!

The World is Curved

I got this note in my email about this book The World is Curved by David Smick. I did not think much of it, but it said it was blurbed by Greenspan, Barton Biggs, Laurence Summers, Jean-Claude Trichet, and others. Then I find it was praised by about 50 of these types of guys, as if Davos had a session on writing blurbs for David Smick. See the quotes here.

So, I wondered around the site, and read the first two chapters. Something about how we are all interconnected, and the Chinese are going to have a lot of investing power, the market has been fluctuating a lot recently, financial instruments are complicated (things called 'collateralized debt obligations'). Most importantly, though Thomas Friedman's book the World is Flat is GREAT, he says, the world is actually curved (who knew?), because things change unexpectedly (hey, Taleb, he stole your idea!). Lastly, the author talks to all sorts of smart, powerful people ("Friend of mine at the Fed say...").

This book riffs on so many cliches (we are at a tipping point) in a way that just mentions current trends ad nauseum, as if listing the trends and facts of financial markets somehow awes me into an appreciation that this collection of observations has a point, other than, the world is complicated, and though it may get better, it may get worse. Like many of these types of books, he seems to think he clarifies things by mentioning lots of varied facts, or some banal observations are really profound (eg, capital flows: important). He did not get to his point in the two first chapters of his book, perhaps its at the end ('plastics', or something).

But the list of advanced praise highlights a bad equilibrium in book blurbing. I can't imagine these people read the book and felt the way they did. Did Lawrence Summers really say "He writes in a way that makes giving close attention a pleasure."? Did Stan Druckemiller really write "It's a 'must read'"? If you think stock analysts were in cahoots with the investment banks, then the book blurbing industry is that situation raised to the google power. And if this is a 'must read' according to the Davos crowd, it clearly highlights the champagne was flowing, and its scary to think these guys are making the key decisions at the Fed, White House, etc.

Clever vs. Useful

I remember going to a job market presentation around 1993 by a finance PhD from MIT. Jiang Wang went through a presentation to a full set of finance faculty, and at the end, asked if there were any questions. There were none. I thought, boy, this guy bombed. How wrong I was. He was the top guy on the market that year, having solved a complicated problem involving comparing individuals with different utility functions. Previously it was thought you could only explain the heterogeneity by having different coefficients in their functional form, but this guy compared a consumer/investor with a square root utility, to that of a consumer with logarithmic utility. I failed to see the significance, but then I realized that professors love this kind of thing. It was difficult math, and he derived a closed form solution!

So I'm reading Rubinstein's History of the Theory of Investments, which for PhD finance type is a great book. He also notes the spectacular nature of this achievement, saying:

he shows that for certain other specific combinations of powers, closed-form results are possible. He then asks how the results are qualitatively different from an economy with a CRRA representative agent.

Gee, 10 years later, and that's all he can say. Clearly, there weren't any really interesting differences found, or they would have been mentioned. I would call that a dead end. He just got a closed form, and everyone clapped. It reminds me of articles that show 'a rich class of models', as if interesting applications are left as an exercise for the reader.

Why was I born with such contemporaries?

Retail Traders Burn Money

From The Extent of Individual Investory Trading Losses by Fong, Gallagher, and Lee over at New South Wales:

This paper investigates the trading performance of retail brokerage investors on the Australian Securities Exchange (ASX) from 1990 to 2005. We document average losses per day, before transaction costs, of USD$120,000 (AUD$190,000) or 27 basis points per day from individual investors buying (selling) higher (lower) than the closing price on the day. This loss is robust across calendar years, stock size, order type, time of day and broker service offerings. Net of this loss, individual buy trades are statistically indistinguishable to sells at a 254-day/1 year window.

It seems this documents two important points. First, the average investor pays a bid-ask spread, independent of his commission. He also is no better than throwing darts.

My only issues is I wish they would have compared the fill price to the open, because by comparing it to the close that day, or the VWAP (value weight average price) that day, you ignore how much you actually move the price. This 'trade impact' is often large, especially for big trades. There's a tradeoff, such that really small traders with little trade impact tend to pay the highest in bid ask spread, and commissions, while the big guys have fancy trading algorithms to minimize the effect of the bid-ask spread (buy, say, having a program that patiently buys at the bid), but their trade impact is significant. By comparing the fill price to the prior day's close, you capture trade impact.

I remember brokers touting their VWAP algorithms, noting by how little it 'misses' the value-weighted average price. But they ignored the fact that if you move the VWAP upward significantly, equalling the VWAP doesn't mean it was a good fill.

Ouch

Freestyle Bronze medalist George Gogshelidze of Georgia.

Pyndick and Homoskedasticity

Greg Mankiw's blog notes an interview with Bob Pyndick on energy prices. I was a TA for an intermediate micro course, and Pyndick and Rubinfeld was our text. Lots of titters from the class, mainly male, about that guy's name (it's pronounced pin-dick), as they all simultaneously discovered an insanely funny pun. Teaching undergrads, one has to be aware of these things. Ever introduce the term 'homoskedasticity' to a group of non-quants? Immediately lots of funny glances between classmates. I know a 60 year old ex-CEO of a fortune 500 company, and he said he still giggles in his mind when he sees the number "69". Can't help it. Ever listen to an IT guy ask for the female or male end of some electronic wire? Ask if you mounted his hard drive? I can't help but go into the sewer. The 12 year old boy lives in all of us.

Super String: Vortex Theory?

In the 19th-century the was something called the vortex theory of atoms. It maintained that atoms are not pointlike but are incredibly tiny loops of energy that vibrate at different frequencies. They are minute whirlpools in the ether, a rigid, frictionless substance then believed to permeate all space. The atoms have the structure of knots and links, their shapes and vibrations generating the properties of all the elements.

Eminent physicists, including Lord Kelvin and James Clerk Maxwell, suggested that vortex theory was far too beautiful not to be true. Papers on the topic proliferated, books about it were published. Scottish mathematician Peter Tait's work on vortex atoms led to advances in knot theory. Tait predicted it would take several generations to develop the theory's mathematical foundations. Beautiful though it seemed, the vortex theory proved to be a glorious road that led nowhere.

Clearly there's an analogue with string theory, but I think lots of economics gets a pass because it is beautiful, meaning it is full of results that are surprisingly consistent and rigorous. I'm thinking Debreu's Theory of Value, Continuous time finance, Bellman's equations, Value functions. These fields take a lot of time to get really up to speed, but I don't see any results here that can't be found using simpler methods, and they mainly just confirmed intuitions, as opposed to generating results that are now used elsewhere. Many think such results can only indicate there's a deep truth there, because these things don't happen by accident. But I think a bunch of really smart people, given a set of things to explain, can invent a set of assumptions that generate these things a lot more easily than they imagine. This is why it's essential to have some experimental results that corroborate these forays, otherwise, it's can be like vortex theory.

Dr. Fox Effect

There's a lot of talk that Obama's great speaking ability will bring this nation together, inspire kids, especially kids of color. Clearly, having hope is important, and a leader who can inspire kids is an attractive quality by itself, even if its all based on smarmy quotes from Successories.

The bias of presentation is rather unsettling when it comes to leaders who aren't merely figureheads, but making important decisions. The famous account of Nixon winning his debate with Kennedy according to radio listeners, but losing just as much according to TV viewers, highlights the importance of nonverbal communication.

This reminds me of the famous "Dr. Fox effect", a fun stunt performed 35 years ago:

In 1973 a group of academics noticed that student ratings of teachers often seemed to depend more on personality than educational content. They wanted to find out how far this effect could be stretched: what if you had an impressive, charismatic and witty lecturer, who knew nothing at all about the subject on which they were lecturing? Could plausibility alone make an audience feel satisfied that they had learned something, even if the information delivered was deliberately inconsistent, irrelevant, and even meaningless?

They hired a guy who “looked distinguished and sounded authoritative”. They called him “Dr Myron L Fox” and he was given a long, impressive, and fictitious CV. Dr Fox was an authority on the application of mathematics to human behavior.

They slipped Dr Fox on to the program at an academic conference on medical education. His audience was made up of psychologics, psychiatrists, mental health educators, and graduate students. The title of his lecture was Mathematical Game Theory as Applied to Physician Education. Dr Fox filled his lecture and his question and answer session with double talk, jargon, dubious neologisms, non sequiturs, and contradictory statements. This was interspersed with humor and 'meaningless references to unrelated topics'.

The doctors, healthcare workers, and students all gave it a thumbs up. As the study of this little stunt summed:

The study serves as an example to educators that their effectiveness must be evaluated beyond the satisfaction with which students view them and raises the possibility of training actors to give "legitimate" lectures as an innovative approach toward effective education. The authors conclude by emphasizing that student satisfaction with learning may represent little more than the illusion of having learned.

All very depressing. One reason why student performance ratings of teachers is highly overrated. And democracy is about giving the people what they vote for ... good and hard.

Women's Wrestling

I watch a lot of amateur wrestling, coaching my kids and all, and there's always a handful of girls in these events in grade school. Usually, they are the sisters of wrestling brothers, and the dad was a wrestler. Some are really good, but then puberty hits, and the boys separate, and there is perhaps one female wrestler among every 20 teams.

While I appreciate their effort, one must recognize it is a very unpopular female sport. So when looking for wrestling, I was surprised to see so much women's wrestling. I guess if I want my daughter to make the Olympics, this is probably one of the easier paths, just because there are so few competitors.

On the other hand, there are tons of cheerleaders, and to be a cheerleader at the college level means you bested many many other girls. That should be a varsity sport. Sure, it's not competitive like football, but it is competitive nonetheless, and given the interest of the girls, I think saying you were a cheerleader at a division 1 school is more impressive than saying you played softball or lacrosse. Plus, it would alleviate a lot of Title IX problems that are decimating wrestling programs in college.

20-20 investing

Paul Scanlon, at Putnam High Yield, was interviewed over at the Wall Street Journal. It's pretty funny. He notes he likes the energy sector, companies with transparent assets, bearish on financials and autos. Talk about window dressing.

Macro Guy Says No Recession

Other than housing, the market seems quite unlike a recession, which jibes with what I'm seeing anecdotally, as business outside of housing seems at full speed. Ed Leamer notes that three indices — payroll employment, the unemployment rate and industrial production — “nearly perfectly reproduce the NBER official peak and trough dates.” and that "things have to get much worse to pass the recession threshold.”...

Leamers model includes the following thresholds:
falling industrial production for six months at a rate of at least 6% per year;
declining payroll employment for six months at a minimum 1% rate per year;
and a six-month rise in the unemployment rate of at least 0.8 percentage point.

“Every recession since World War II has included months that satisfied all three of these limits. And there has never been a time in the expansions during which all three of these limits were satisfied.”

This would be very reassuring, but we must remember he is a macroeconomist.

I remember the Stock-Watson model that was to replace the old Leading Economic Indicators. While highly rigorous--it used a Kalman filter, just like real rocket scientists--the model failed to predict the 1990-1991 recession, and an updated version of the model then failed to predict the 2001 recession. Stock and Watson (download here) discuss, with admirable honesty and clarity, this failure and argue that it is hard to predict recessions because each is caused by a unique set of factors. For instance, housing and durable goods consumption was strong proceeding and throughout the 2001 recession, as the decline was focused on IT manufacturing. By contrast, in the 1990-1991 recessions, housing and durable goods spending slowed considerably. As Stock and Watson say, "without knowing these shocks in advance, it is unclear how a forecaster would have decided in 1999 which of the many promising leading indicators would perform well over the next few years and which would not". Indeed.

I remember asking Watson about what he learned about macro from this venture, as he also does lots of pure theory, and he said, 'stick to seasonals' (ie, you can predict unadjusted monthly output).

Implied Volatility vs. Next Year's S&P Return

You can download the VIX index, daily, from 1986. I took all these datapoints, and grouped them into deciles. I then looked at the average 12 month ahead returns within those deciles. The results are in the graph above, and show that there is no clear relationship between volatility and future index returns, at least over the past 20 years.

It's standard in theory to assume that higher anticipated systematic volatility increases the expected return. Many researchers have documented this is not so (eg, Glosten, Nelson), but Christian Lundblad took the innovative approach of going back to 1836 and showing that under certain assumptions, you could not reject the hypothesis that return is positively related to volatility. Clearly, he tortured the data into talking. If the effect is this subtle, it is meaningless for driving behavior. I reminds William Sharpe's interview, where he notes that they were incredibly naive to think returns would be the same as expected returns, as if the failure of beta is due to a small sample variation in the CRSP data--an anomalous 80 year draw.

hollow point bullets

I'm hanging out with a fellow parent at some kid thing, talking to an ex-army guy. He tells me that hollow point bullets are illegal via some convention. That is, these bullets generate so much damage in the body, they are immoral, and so illegal (whatever that means in international law). Whenever you shoot at someone, in theory, you are OK with killing them. So instead of hollow point bullets, we just have bigger caliber bullets? Do these people understand that bullets kill people, and getting rid of hollow points just invites compensating adjustments?

It reminds me a little of the torture debate. Torture is never acceptable to many people, because it makes us no better than 'them'. But, even the biggest lefty recognizes the right to use lethal force in certain circumstances, which is why our armed services and police have guns with bullets. Clearly, killing is one thing, but torture is much much worse, though I would much rather my children be tortured than murdered. It's all about being able to rationalize one's moral supremacy. I think such people need to understand that arsonists and firefighters deal with fire, and they are very different people.

Best Journal Title

Massively Confused Investors Making Conspicuously Ignorant Choices (MCI-MCIC) , by Michael Rashes (Journal of Finance, Oct 2001). The author notes that many investors in the 1990s confused MCI corp, the big phone company that is now dead. It had the ticker MCIC. So when news hit MCI, as would often happen, poor little MCI, which is totally different, would move, and then move back. A good exogenous experiment with stock supply curves.

Another example of a stock that moved for no real reason was Aksys (ticker ESPR, now dead), which rose steadily in 2003 because some idiot inadvertently bought lots of stock every day for a few months. It rose from 7 to about 19 in 2003, when the error was discovered, and this guy owned 67% of the company by accident. with MCI