Mortgage Follies Circa 1994

I was browsing the web and came across this video about NACA, an Acorn-type organization that seems manaically focused on lowering mortgage costs to poor people. Mission accomplished! Making houses 'affordable' created the no-doc, no-downpayment debacle, yet their take is clearly that anything that lowers the borrower cost of mortgages is good.

Yet even within their puff-piece video, they boast about fighting predatory lending by forcing a bank to allocate $8B towards 'affordable loans' back in 1994. They seem totally unaware this might have contributed to the problem (it's just a 12 second clip):



When these loans eventually couldn't be paid because the collateral value stopped rising, their solution was to get the banks to write down the mortgages. Now, it's only the government giving mortgages to such people, a solution that isn't helping the housing industry. The key to creating persistent dysfunctional redistribution plans is to make them so big alternative narratives for its inevitable failure are defensible.

How to Get High Returns From High Volatility Stocks

Rebalance daily! Turan Bali, Nobel Prize winner Robert Engle and Yi Yang, posted Dynamic Conditional Beta is Alive and Well in the Cross-Section of Daily Stock Returns over at the SSRN. It's an eerily similar title to Jagannathan and Wang's 1994 pub The CAPM is Alive and Well, which supposedly showed the same thing.  When people have to continually state something is 'Alive and Well,' you can be pretty sure it is 'Dead or Dying.'

Such research confirms my thinking that prejudices are more important than statistics when analyzing complex data, because people tend see what they believe rather than vice versa. Thus, developing good prejudices is more important than developing good econometric skills, reminding one of Oscar Wilde's dictum that 'Education is an admirable thing, but is well to remember from time to time that nothing that is worth knowing can be taught.'

In any case, they state:

Average return and alpha differences between stocks in the lowest and highest conditional beta deciles are about 8% per annum, implying a profitable zero-cost portfolio that goes long stocks in the highest conditional beta decile and shorts stocks in the lowest conditional beta decile.

  If higher beta stocks did have higher returns, many investors would hold their nose at the volatility and accept the price for a higher return.  Yet, the risk and return are both lousy, so such a fund has never been popular.  Consider that the low vol ETF SPLV trades about 1 million shares a day, while the high beta ETF SPHB trades about  50k shares per day.  SPLV is up since inception in 5/11, while the SPHB is down  (see below, click to enlarge).

It's a short sample to be sure, but one can ask Robeco or Arcadian how their low volatility funds have done, among many real-world examples (eg, I wasn't sued because low volatility didn't produce positive alpha).  Indeed, a glaring datapoint against the assertion that higher beta implies a higher return is the absence of a popular, explicitly high market beta fund, precisely because such stocks have had horrible returns. Consider there have been value and size portfolios even though these have high value and size risk, because they have higher-than-average returns.  As mentioned, if higher beta truly gave one a return premium, desperate investors like CalPERS would gladly take on the risk.  

The authors spend a lot of time on various subtle refinements of beta, making sure they are super fresh and estimated with the much more sophisticated Maximum Likelihood method, as opposed to some simple matrix inversion. They correctly note that the CAPM, and any of its derivatives (the APT, the SDF), are conditional, and so theoretically you need to update your beta estimates constantly as conditions change.

I've played around with beta calculations enough to know there isn't any real edge to doing something really tricky. Sure, you can do better than using the past 9 months of daily data using an exponential lag by adding some trickier refinements, but not much. The 36-month betas ubiquitous in the literature generate qualitatively similar outcomes for everything I've looked at, so that's not the key problem with the CAPM, any more than using the equal or value-weighted indices (also irrelevant). Indeed, their own paper shows their four different betas generate the same positive return to beta (a 4% annualized spread), only more so (8% annualized) if you update in more frequently than once a year.  So, their refinement doubles a return advantage that practitioners don't see.

In any case, this is irrelevant. The key is that they are using daily returns. Now, daily returns are problematic ever since the first estimate of the size effect was found to be overstated by 15% (annually) due to daily rebalancing effects (see Blume and Stambaugh).  Using monthly return data, since 1962, I find beta negatively correlated with returns, excluding the bottom dregs of penny stocks that add spurious precision but are untradeable (basically, I took the current $500MM cut-off, and applied that backwards in real terms). The data is over at www.betaarbitrage.com.

It would have been better to instead correct for the daily rebalancing bias rather than all that beta refinement so reminiscent of the 1980's focus on ever more sophisticated tests that produced nothing of lasting importance to anyone but a tenure-seeking finance professors.

But hey, lots of people worry about crowding into the low-volatility space, so I'm happy that the old guard doesn't have to change their mind about this if they don't want to. As Max Planck said, science progresses one funeral at a time. It's a mug's game trying to swat down all these statistical refinements that theoretically could matter, but don't. Much better to actually trade an idea and see if it works.  Too bad about finance students, however, spending valuable time learning a beautiful theory that is 180 degrees wrong, all for $50k/year.

The Naivete of Moderates

My local paper had a sequence of articles by Stephen Young, who presented caricatures of the left and right.  On the left, the Nanny State that gives us unlimited welfare rights and asks for nothing in return.  On the right, social darwinism, which ignores public goods and is indifferent to racism and child slavery.  He's part of the Caux Round Table, a group that wants a 'free, fair, and prosperous global society built on the twin pillars of moral capitalism and responsible government.' It's part of a long tradition of orphaned policy wonks. 

By setting up two indefensible poles as the planks for our two major political parties, he then suggests that his moderate solution is not merely reasonable, but optimal. I could say his ill-defined middle path is just like that articulated in Venezuela, India, or even Nazi Germany, with all sorts of corporate cronyism shielded by the state's monopoly on 'moral competition.'  I'm sure Young would reply, 'that's not what I meant.'  Perhaps, but the main problem with most political plans is not the intent but the result. Further, it is no less a caricature than what he does to the left and right's positions on politics.

I empathize with a desire to find common ground, especially among those who really don't have strong opinions on socialism or free markets, yet their arguments are pretty weak.  I'd rather they just say they, "I'm indifferent, let's make a deal," without any pretense that such a solution is anything but a temporary compromise.

The Non-Linearity of Leadership Competence

One of the more profound facts of life is nonlinearity.  From radiation to vitamins to things like politeness and honesty, optimality lies in some middle ground.  You can have too much or too little, which is what makes life non-trivial, because you always have to find that middle optimal point yourself, often by trial and error.  The optimal organization for a family is communist, but this doesn't generalize to large societies, a point that most leftists can't fathom.

The latest example is Sandy Weill, Jamie Dimon's mentor, stating that Glass-Steagall may be a good way to constrain the too-big-too-fail.  This regulation was totally irrevelant to the housing crisis, and the regulation was already impractical when it was repealed.  There was no difference between those banks with large investment banking operations and those without in the recent crisis, and in the quiet 1935-2005 period Europe had nothing like Glass-Steagall without adverse consequence.  It's a red herring.  The key is simply the size of financial institutions, which at a certain level become politicized.  Eliminating Glass-Steagall would just prevent efficient economies of scope.

How could Weill be so clueless on something so fundamental?  He was a dealmaker.  His specialty was simply buying other companies.  His knowledge of how various regulations affect the macroeconomy, or how they affect a company's risk, is at the level of your average fortune 500 CEO: banal.

Leaders of small groups tend to be highly competent, able to do almost everything better than everyone in the group.  Yet for large groups, leaders are quite clueless.  I remember working for executives at KeyCorp, and the big joke was always how to dumb down things for our CEO and the management committee.  They were hopelessly clueless about the most basic relationships between interest rates and our basic business, or risk factors on our book.  Consider that Bob Rubin was on the management committee at CitiCorp, and after pulling in $115MM, noted that he had no idea they were exposed to the mortgage debacle.  I'm sure he was telling the truth.

Needless to say, the policies of Bill Clinton and George Bush were extremely important in the mortgage fiasco, and they too are so oblivious they rarely even bother to comment upon it.  They were merely for more home ownership, which given enough cognitive dissonance is totally unrelated to the eventual result that no money down mortgages were being given to people without income documentation.

In my experience, CEOs and politicians with tens of thousands of subjects are much less competent than leaders of organizations with 10 to 100 people.  The big leaders are very good at politics and public relations, necessary skills, but ones I personally don't find very interesting or admirable, mainly because platitudes and insincerity are so common in that realm.    

Economists Idea Bag Seems Empty

BigThink asked some great young economists about big ideas in economics. I'm not very sanguine about any of these guys finding something important very soon. It starts with Paul Krugman, lamenting that

the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Krugman got his Nobel Prize for a mathematically elegant model of international trade. There was no new, true and important insight of that model, it was merely an elegant rationalization of some stylized facts that has zero predictive power and is 99% orthogonal to anything he himself actually discusses about economics. I glad to see he sees the pointlessness of such parochial models. Will he give back his Nobel Prize?

 Here are some great insights or projected intellectual trends, from young star economists.

 NICHOLAS BLOOM:

people in developing countries are poor because wages are low, and wages are low because firms are very unproductive, and firms seem to be unproductive in large part because of bad management.

RAJ CHETTY:

[We need to] identify the determinants of intergenerational mobility, with an eye towards finding policies that increase equality of opportunity. Should we be focusing on increasing access to higher education? Changing the structure of elementary schooling? Revamping the tax code?

GAUTI EGGERTSSON:

[We will see] the study of traditional questions, such as how to use monetary and fiscal policy to eliminate unemployment and control inflation.

XAVIER GABAIX:

The modeling of agents with bounded rationality will help us build economic models (in particular, macroeconomic and financial models) and institutions that better take into account the limitations of human reason

GITA GOPINATH:

In an increasingly globalized world, the search for answers will necessarily require a much deeper understanding of three areas that interest me. One, we need a better understanding of the interlinkages across countries in trade, finance, and macroeconomic policy.

I stopped, but it continues in this way. If BigThink asked me, I would say:

I see a big payback to integrating psychology, anthropology, and history into economics more directly, using real-world data to understand how prices, output, and inequality relate to institutions, norms, education, and taxes. And vice versa.

Of course I'm being a bit snide because I find these answers as vapid and trite as any politician's platitudes.

Primate Status Battles

Robert Sapolsky's book Why Zebra's Don't Get Ulcers focuses on how stress increases serum glucocorticoids (eg, cortisol) and these lead to higher mortality from many dimensions, but primarily arterial sclerosis. He did original work examining baboon troops and found glucocorticoid levels inversely correlated with status, mainly because when you are low status you are often randomly slapped by a higher ranking baboon venting frustration, or have your hard earned meals swiped.

Interestingly, if you are navigating a baboon hierarchy, it actually is good therapy to take out a recent slight by smacking some random lower ranking baboon, as he measured their stress levels before and after (Sapolsky notes that, with some exceptions, he doesn't really like baboons; they're mean). Further, another thing that raises stress is fighting for position in the hierarchy, so when a new alpha male comes into the troop and everyone has to compete again for position, this is stressful. Think of a baboon leadership change as a recession, in that the creative destruction from new leadership may help the troop in the long run, but in the short run everyone feels worse.

This stress-hormone-mortality connection has a direct analogue in humans, as evidenced by the famous Whitehall study, which did a lengthy longitudinal study and found that a British civil servant's level was inversely correlated with mortality rates, primarily from stress-related arterial sclerosis.

Yet, Sapolsky's explanation of why status matters to humans is rather weak. He argues that, like low status baboons, poor Americans are physically hungry, and pushed around by their betters (eg, no bathroom breaks for factor workers). In fact, the lowest SES individuals are both fatter and commit more assaults than those in higher socioeconomic status levels. Stress isn’t mainly caused by objective insults, but rather subjective ones, primarily feeling under appreciated. This is highlighted by Sapolsky's own work, which noted that human subjects glucocorticoid levels increased when faced with stressful social evaluations, not when faced with merely difficult logic puzzles. He can't escape his Marxist instincts and goes for dialectical materialism, where the structure of production implies classes, alienation, and angst.  I see it more like in Aaron Beck's cognitive therapy, where dysfunctional thinking, behavior, and emotional responses lead to lower income and poor appreciation from others in general.

If you like science and lean libertarian as I do, you have to get used to gratuitous asides about how inequality or ignorance is merely a choice of an indifferent society, and that obviously if we wanted to, we could spend more on the poor and look just like Sweden. After spending trillions of dollars on Third World aid, and on the War on Poverty here in America, this is clearly not true. Americans have not chosen more inequality out of indifference to the poor, rather, it's an emergent response to our naive attempts to directly rectify these inequalities: SES indicators of all sorts stopped improving right around the time welfare and civil rights started exploding in the 1960s.

It is somewhat sad to think that so many humans suffer angst thinking about things like mortgage payments or how our children will fare, while Zebras are pretty stress-free as long as lions or dominant males are not messing with them.  Thus, they don't get ulcers because if the stressor isn't right in front of them, it isn't there.  It gets back to Socrates' question as to whether you would prefer being a happy pig or an unhappy human.  Surely, once you've take the blue pill you can't go back, but it's not obvious to me that many unhappy humans would have had a better life as a happy pig.

Prop 13 Isn't Choking California

My brother is a standard progressive liberal living in California, and he plans to move to Oregon soon. As California is run by Liberal principles, in large part, I asked him why California is so poorly managed. His answer: prop 13. But he's not a lunatic, Nobel prize winning economist Paul Krugman has made the same argument.

 Prop 13 was a state law enacted in 1978 that prevented property taxes from rising much as long as you owned the property. When you sell it, it resets. While the hope was this would help little old ladies from getting pushed out of their houses, and keep government spending in check, the net result is that with inflation you now have many places where people are living in million dollar homes and paying taxes as if it were only a $100 home. Looking at it differently, they are spending 10x as much as their neighbor on taxes.

 This would fit the narrative that bad things happen mainly because people don't care enough to spend government money on them. That point was made yesterday by the writer John Scalzi, who claimed he owed his success to government in this piece, and noted:

From kindergarten through the eighth grade, I had a public school education, which at the time in California was very good, because the cuts that would come to education through the good graces of Proposition 13 had not yet trickled down to affect me.

But then, per capita spending in California on schooling is higher than anywhere else in the US (see here), and per capita spending has been above inflation plus population growth for the past 20 years (see here). Californians still pay 22% of their income in state and local taxes, compared to 14% for Texas (cite). The beast is not starved. I agree that prop 13 is a rather ham-handed way to implement constraints on spending, and now it's a mess because it creates a very powerful lock-in effect on current property owners. But it has little to do with California's downward spiral, a state that used to be the most educated, prosperous, and beautiful place on the planet, is now near the bottom of state achievement, and their public places (airports, beach bathrooms) are poorly maintained, like the bankrupt state they are.

Some Quant Screwed Up

Last Thursday, a very non-typical hourly saw-tooth pattern emerged in several stocks. By the time we saw this mid-day, we were intrigued, with some message boards noting it. I don't know the provenance of this pattern, but suspect it was a poorly designed algorithm that was trying to buy some fixed amount at the hour until completion, and did this repetitively over the day in some newfangled VWAP attempt. It looks like it shot out stupid buy orders for the first 30 minutes of each hour.

Clearly someone screwed up, because after the second time this happens you should stop your stupid program and tweak it.

Here's IBM, Coca-Cola, and McDonald's price movements over that day. This isn't random.

IBM

Coca-Cola

McDonald's

James Watson on Modern Marxists

In this interview, James Watson comments on those opposed to genetically modified food. He makes this observation on how Marxism got aligned with environmentalism:

And then, you know, the usual leftist, Marxist, communists who, when they can't fight for communism, became environmentalists, because, you know, as an environmentalist the chief evil was the rapacious corporation, which is going to destroy the air, the soil, the oceans, etc. So it was, you know, Marxists need bogey enemies.

I think one good way to divide the left and right as commonly understood are those who fear power concentrated in government versus those who fear power concentrated in corporations. He's a pretty funny guy. When asked if he would want to live forever, he says:

You mean, stay at 50? Uh, I'd freeze women at 35 ... Right now I haven't met a 100 year old person I want to look at.

Low Vol Momentum

So, I was in Boston talking about low volatility to a couple of groups. I met a couple of current practitioners and it is very interesting to hear about the different approaches these guys take. They tend to have very different takes on what is going on, and what investors really care about, and these subtle differences lead to very different portfolios if you are talking about choosing 100 stocks out of 2000 possible.

 More cynically, each firm selling these approaches needs to differentiate itself, because simply trying to be better than a competitor is risky: there's at least a 50% chance of failure, and possibly higher because it might degrade into a simple price war that leads to no prices (Bertrand competition). There's no need to be so cynical here because everyone comes to low vol from such a different approach (eg, flat or negative Security Market Line?).

 At my Qwafafew talk (during which, I quaffed a few--beer and finance are complements), there was a true believer in the audience defending the conventional wisdom, which was actually quite refreshing. I like actually engaging with them because they generally don't argue with me, adopting the debating tactic of hoping an embarrassing criticism will go away if you ignore it. They have been doing that to me for years. Anyway, he insisted that beta was positively correlated with average returns, you merely had to measure beta correctly. I can't prove it can't be done, but I haven't seen it, and I'm pretty certain any journal would publish such a result asap, so I'm skeptical.

I'm even more skeptical because when I asked him if he would agree that beta is positively correlated with total variance, he said, 'not necessarily!' as if this was some great gotcha point. Correlations refer to statistical relationships, meaning, there are some datapoints off the linear relationship. Clearly, some stocks will have high variance and low beta or vice versa, but all discussions about risk and return are about averages and tendencies; the distinction about there being exceptions to financial generalizations is not like saying there are exceptions to gravity. I thought he was really reaching if that's the kind of counterargument to my assertion that risk and return aren't correlated in general.

 He did bring up the point that I tended to put up data on geometric averages, and that arithmetic averages would generally be more consistent with the theory because the arithmetic returns are greater than their geometric averages by a variance term. That's a valid point, but only geometric averages uniquely correspond to total period returns, and so the geometric average is to my mind a better statistic of a portfolio's performance. Further, this is why the scope of my findings are so important: across many asset classes, the average returns are generally flat. Average returns are unbiased estimates of future total returns, but then sometimes one should see massive outperformance by these high volatility portfolios, which we do not. It's a complicated issue, and I can't treat it sufficiently in this point, but I should mention that while I think this is one of the best arguments by the risk-begets-return crowd, it still fails empirically.

 Then there's the issue of overcrowding that always seems to come up. I find this rather amusing, because when I was trying to sell this idea in the 1990's, before anyone thought it would work, a common argument was that 'what if everyone did it?' It's like when you show someone something that has worked well for 50 years, and they say, 'sure, but now it can't work because I'm sure everyone sees it.' Well, if everyone invests by maximizing Sharpe ratios, then we are in the CAPM world that creates the positive sloping security market line, but we've been telling MBAs to do this for decades to no avail. Considering all the money in value and small cap funds, I don't think the modest allocation to low volatility has changed things.

 In fact, there are two good pieces of research put out on this point recently. One by Pim van Vliet at Robeco (download here) documents a metric of value for low vol portfolios back to 1930. He finds low vol has gotten more expensive over the past 5 years, but looking at it in context it is not so scary (it has been here before). Nevertheless, he argues this is why you need his secret sauce. Self serving, but rightfully so. Another (here), by quants at Deutsche Bank, found that low vol is not overcrowded primarily using pairwise correlation data. That's an interesting way to view crowding.

 One thing I found interesting is that in institutional asset management, finance and econ PhDs are common. That's quite different than in my day-to-day field where physics and computer science PhDs are more common, where we aren't interested in soliciting client money. I'm on the fence as to whether this means financial theory is useful for investing large amounts of assets in broad asset classes...or that it merely is more helpful in selling one's services to institutions.

I'm Speaking Tuesday in Boston

I'm speaking Tuesday the 17th at 6 pm at the Quantitative Work Alliance for Applied Finance, Education, and Wisdom (aka QWAFAFEW, really). It's at the Tennis & Racquet Club, 939 Boylston Street. Walk-ins are accepted, space permitting, but see here for info to see if that's feasible. I have a new book coming out soon, The Missing Risk Premium: Why Low Volatility Investing Works, which I estimate will be available in a month, and will have an inexpensive paperback and an e-book version.

It's Useful to Actually Plan

Charles' Murray's Losing Ground was that most incentives in life are negative, in that if you don't do X you will starve or freeze or whatever. Thus, you learn to be thrifty, nice, and hard working to simply get by. The most common complaint by businesses as to why they fail is that their  banker stopped lending or seized their collateral; if they just had more time things would have turned around.

 Promising large pensions is one of those things that keeps increasing future liabilities, and if you simply plan based on cash flow--including borrowing--you will hit your constraint with probability=1. Bankruptcy seems to be the only realistic constraint.

 Here's a now bankrupt city mayor explaining a minor lacunae in her management style:

Stockton Mayor Ann Johnston voted for these expensive measures when she served on the city council. 'We didn't have projections into the future what the costs might be…I learned that you don't make decisions without looking into the future'… 'Nobody gave thought to how it was eventually going to be paid for,' says Mr. Deis, the city manager.

Who knew?

How do the 1% Win in a Democracy?

The 99% seem to be pathetic at asserting their self interest. They have a huge majority, but are totally incompetent or unwilling to assert their preferences. What's the matter with Kansas? Here's a simple theory, where I will assume there's pretty much a 50-50 split currently among the electorate as to the preferred direction for tax rates, regulation, etc. Those who succeed in the marketplace favor allocation by markets, not governments. Those who do not succeed in markets favor government.

Now, people tend to get happiness not so much about what they currently consume, but rather an expected consumption of the future. Robert Sapolsky has some neat data on monkeys and finds that monkeys and humans commonly generate the highest levels of dopamine when pleasure is anticipated, not when pleasure is actually experienced. See the graph above for a picture of how dopamine spikes upward not when the monkey gets the reward, but rather when it anticipates getting the reward; the actual reward is anticlimactic.

 So, having the highest present value, not current value or one-time gimmick, is what drives people's political regime preferences. A person's preference for more government over less would involve whether one's relative competence is greater in the private or public sphere. Increasing government through more taxes and regulation is good for those with a comparative advantage in politics, not good for those good in the private sector. If the economy contains only the private sector and government, this means increasing marginal tax rates is only good for those who are relatively good at government.

 This rationalizes the Bryan Caplan puzzle that people tend to not merely vote for the direct self-interest of their income level, but are rather 'groupish', or altruistic towards their group whatever it may be (humanity for some, a tribe for most). In the long run moving to a larger or smaller relative private sector affects one's future with a different sign depending on one's 'skills'.

 Every month or so I get a letter from some class action lawsuit that gives me $2 if I fill it out, all for some vague corporate crime. Such class action suits aren't interesting to me because  they are not worth my hourly wage and more importantly they don't raise my status, rather redistribute money from some unknown corporate exec to some unknown lawyer plus everyone.  Similarly, bonking all the George Soroses on the head, taking their money, and giving to all Americans would be pretty pointless: it wouldn't raise the relative status of anyone other than the chief prosecutor. If I think this money won't merely be redistributed, but rather, reallocated towards a different sector, I have to ask myself: which sector do I want to see succeed? An increase in tax rates or government benefits implies a relatively larger governmental sector.

 Diversity consultants, union reps, etc., want the size of government to grow because it helps their status; those good a solving problems for a profit maximizers would relatively lose, and prefer the opposite. This is why the issue of tax rates is usually a toss-up even though, from a simple perspective given the lognormal distribution of wealth this seems counter-productive. Those good at markets want the non-governmental sector to thrive, even if that means the superstars become billionaires. It's not anticipating a higher income for everyone via trickle down economics, it's anticipating higher status for them as their preferred sector grows.

 Everyone, no matter how incompetent, has a comparative advantage. Half of us have a comparative advantage in the private sector and so want it to succeed, relatively.

Obviously, it's more complicated than that, but as a 30k foot view, I think it explains why so many making below $250k/year don't want taxes raised on those with such incomes.

Happy Independence Day!

Vacation: g-forces, water ... weddings!

CFPB Not Doing Anything

A Wall Street Journal article notes that the supposedly independent Consumer Financial Protection Bureau has had many meetings with the Executive branch (ie, Obama). They are spending $340MM this year, with only 1000 employees. Research and development, I guess. I really hope Obama wins so we can see this agency flourish, because only conspicuous failure changes things.

Our Green Government

When you don't have a bottom line, rather a mish-mash of objectives, massive inefficiencies can be tolerated. Here's a bit on our new green navy:

The USNS Henry J. Kaiser carried nearly 900,000 gallons of biofuel blended with petroleum to power the cruisers, destroyers and fighter jets of what the Navy has taken to calling the "Great Green Fleet," the first carrier strike group to be powered largely by alternative fuels...Some Republican lawmakers have seized on the fuel's $26-a-gallon price, compared to $3.60 for conventional fuel.

In addition to the rather large extra expense we have an increase in crony capitalism, those bureaucrats from both sides of the aisle will be cashing in:

The Pentagon paid Solazyme Inc $8.5 million in 2009 for 20,055 gallons of biofuel based on algae oil, or $424 a gallon. Solazyme's strategic advisers, according to its website, include T.J. Glauthier, who served on Obama's White House Transition team and dealt with energy issues, but also former CIA director R. James Woolsey, a conservative national security official.

The bigger the size and scope of government, the more of such winners, who then pay for candidates who continue their subsidies, why we have had a quota on sugar imports since 1934. But I'm sure the Keynesians will note that a dollar spent by government otherwise would have been destroyed via private thrift, so it's all good.

Mandates are Taxes

Perhaps the reasoning that 'mandate are taxes' in Judge Robert's decision for Obamacare will make it more accepted that taxes are a radical understatement for the size of government. Clearly, it is easier to proxy the size of government with things like number of employees, or total revenue or spending, but that doesn't mean this is a sufficient statistic, just an easy one.

 A friend of mine is a CFO for a large company, and says they are not expanding into California because of the excessive amount of regulations in that state, making the total cost of development much higher than any simple metric of property values or wages. Currently the Equal Employment Opportunity Commission mandates that things like disparate impact among historically disadvantaged minorities, using criminal records in employment, or firing alcoholics, can be illegal. Home Depot's founder says that he could never have built up his company today with all the environmental and employment regulations. And then there's the Hoover Dam, which many like to show what government can do, but now could never be built because of current regulations.

Obama was pretty adamant that a mandate is not a tax, and this was a common argument. Now that this bill was salvaged via the argument that mandates are a tax, I at least hope there's a concession that a mandate is a tax.  Cliff Asness has an article on this point, presciently written days before the decision.   

Happy Tau Day

One of the more tragic path dependencies is that years ago someone defined π (aka pi) as ratio of the circumference of a circle to its diameter, as opposed to its radius. If you define τ(tau)=2π, it's like a presbyopic putting on reading glasses for the first time. It turns out, switching from π to τ makes a lot of other corollaries less convoluted, including the 'world's most beautiful formula' e^iπ=-1, which would be e^iτ=1.

 

The Envelope Theorem, Group Selection, and Cynical Framing

I'm rather fascinated by the concept of group selection, which seems rather important in explaining human behavior. I don't think it explains everything, but a lot. Steven Pinker just wrote an Edge piece criticizing it, and it is pretty good. His basic point is that unlike ants, human soldiers need a lot of prodding to kill themselves for the commonweal. Kin selection and reciprocal altruism, for Pinker, are sufficient to explain the superficial altruism one sees in society  In the comments section Herb Gintis replies, and he's an economist with a long interest in this debate; he favors the importance of group selection.

 I think a lot of this gets down to the envelope theorem, because if self and group selection mechanisms are operating, you will find something optimal for the self given the optimal group behavior, will also be optimal for the group given the optimal selfish behavior.  That is, take y* to be the optimal output, and x* to be the optimal value of x for any value of a.  Then

 

So, as with economics, it is often difficult to find easy tests.  That is, I'm sure for most instincts, one can rationalize them with selfish and groupish incentives.  I think a key proof would involve showing  that if you are competing with other individuals, it is not an equilibrium for there to be no coalitions; a coalition would outperform those not acting in concert, the way a collusion in Texas hold 'em can dominate non-colluding players.  Thus, it should be hard wired to collude because it is a dominant strategy if no one else is doing it, and perhaps even if everyone is doing it.  

In a tenuously related observation, Dan Dennet responded with an especially cynical focus.  First, he says to drop the 'group' prefix because it seems to support some 'vague and misguided ideas' that Dennet does not like.  As Jonathan Haidt emphasizes patriotism and religiosity of group selection, one can presume that's what Dennet is afraid of there.  He then suggests adding the word 'design'  into the selfish selection mechanism because the 'intelligent design' community has stumbled upon a good description of how biologic systems appear (ie, like they are designed, as admitted by Dawkins and Pinker), and he hates 'Intelligent Design'.

This is what reading George Lakoff does to people's thinking, gets them to focus on manipulating metaphors and focusing on higher truths as opposed to discussing ideas at hand, and that is a path to cynicism and nihilism. I agree that the big picture matters and very occasionally one has to be insincere or misleading to help a higher goal (eg, not overly criticizing your leaders when fighting Nazis and the battle is in doubt).  But  if you make them your primary focus you have simply become a shill for whatever big idea you chose years ago.

Consider the genius Lakoff's idea to rebrand taxes as community dues, an idea that didn't work because while we don't mind paying dues for clubs, unlike taxes, dues are voluntary. But because he's is so partisan he doesn't see the stupidity of his suggestion, and it has gone nowhere. Lakoff's latest riff on branding the health care fight, is especially funny because this master of language writes the following, which I could not decipher:

There is another metaphor trying to get onstage -- that the individual mandate levies a health care tax on all citizens, with exemptions for those with health care. The mandate wasn't called a tax, but because money is fungible, it is economically equivalent to a tax, and so it could be metaphorically considered a tax -- but only if the Supreme Decided 

Where the first metaphor would effectively kill the Affordable Care Act, the second could save it.

As George Orwell noted, the enemy of clear language is insincerity, and here he does want a mandate and all it implies, but does not want to say so.

Simple Theory on the College Premium

I'm sure a Yale economist could formalize this with set theory, but the idea is pretty straightforward. This is from Steve Postrel:

My hypothesis is that it is precisely the dumbing down of U.S. education over the last decades that explains the increase in willingness to pay for education. The mechanism is diminishing marginal returns to education.

 Typical graduate business school education has indeed become less rigorous over time, as has typical college education. But typical high school education has declined in quality just as much. As a result, the human capital difference between a college and high-school graduate has increased, because the first increments of education are more valuable on the job market than the later ones. It used to be that everybody could read and understand something like Orwell’s Animal Farm, but the typical college graduates could also understand Milton or Spencer. Now, nobody grasps Milton but only the college grads can process Animal Farm, and for employers the See Spot Run–>Animal Farm jump is more valuable than the Animal Farm–>Milton jump.

 So the value of a college education has increased even as its rigor has declined, because willingness to pay for quality is really willingness to pay for incremental quality.

I have a feeling that with the increased importance of programming, and the fact that programming skill is verifiable, smart kids will start arbing the skills premium, taking the $150k otherwise spent on college to start a business or buy a condo, and avoid those $50k/year schools that offer little.

Investors Like Large Spreads, Says Broker

Here's a good example of someone who has learned to rationalize his self-interest so well he does not recognize when he is saying something absurd, from the WSJ:

"If you could set your tick size [minimum bid-ask spread] much wider, market participants will react," said Jeffrey Solomon, chief executive of banking firm Cowen and Co. LLC, speaking to lawmakers at the hearing Wednesday. "Investors like round numbers--nickels, dimes and quarters."

... Moving to broader pricing increments could be a boon to providers of equity research, which have been forced to focus on heavily traded, brand-name stocks after the move to pennies, according to Patrick Healy, Chief Executive of Issuer Advisory Group, a consultant to companies on exchange matters.

Brokerage firms often can't afford to spend money developing reports on thinly traded companies because firms are less likely to make back that money through commissions linked to trades in such securities, said Healy. With less research available on small-cap companies, mutual funds and other institutions may not be inclined to invest in such stocks, he said.

A higher tick size raises the cost for your average retail trader who crosses spreads to transact.  If you give the brokerage a greater franchise value, they will spend more on research fluff, but any mutual fund relying on these reports should be restricted to paper trading.

 If people really like round numbers, why not apply this to everything. I hate coins, and feel I give more to the take-a-penny-give-a-penny tray than most. No more $2.09 coffee at Starbucks, generating 91 cents of change.

 Of course, a firm wishing to increase its relative bad-ask spread it can always push its price down to below $10 via a split share, and some clearly do that.

   

 The chart above is taken from data over the past year, and shows a strong increase in the relative magnitude of the spread over the share price as the price goes below $15, so issuers can target this themselves. A Washington solution clearly would favor industry insiders, like Jefferey Solomon of Cowen and Co. LLC. 

The Fantastic Keynesian Endgame

I really dislike fawning Keynesians because I used to be one when I was a TA for Hyman Minsky back in college (he was a Post-Keynesian). As such I was enamored with Keynes, and read many biographies about him. There's no greater ire than that of early infatuations, in part because we feel tricked, and these objects remind us of a naive earlier self that wasted part of our precious finite life on a wrong road. Anyway, I can't can read the familiar Keynesian tropes (eg, 'Keynes wanted to save capitalism') without rolling my eyes.

 A good indicator of a failed vision is a fanciful endgame.  If that endgame is clearly wrong the vision is wrong.  Marxists and their ilk thought the rate of profit would continually fall, until the proletariate took over and the state withered away.  In the 1940's economists thought that while capitalism offered greater liberty, the higher productivity of socialism would overtake capitalism.  And then there's Keynes' famous 1930 essay The Economic Possibilities of our Grandchildren, in which he imagined that in 100 years or so, the greatest problem would be how to spend our leisure.  Note that Frank Knight, Ludwig von Mises, and Freiderich Hayek never considered this possibility, highlighting their more accurate understanding of human nature.

Anyway, the latest Keynesian thumbsucker to take on this essay is biographer Robert Skidelski and son:

The irony, however, is that now that we have at last achieved abundance, the habits bred into us by capitalism have left us incapable of enjoying it properly. The Devil, it seems, has claimed his reward... The point to keep in mind is that we know, prior to anything scientists or statisticians can tell us, that the unending pursuit of wealth is madness. The first defect is moral. The banking crisis has shown yet again that the present system relies on motives of greed and acquisitiveness, which are morally repugnant.

This pompous blowhard grew up part of Britain's upper class (he's a Baron, whatever that means), and watching one's status fall stings.  Now he wishes money, and the market skill generally associated with it, weren't so important for determining one's social status anymore (though it was fine when gramps made the family fortune that bought his peerage).

 He asserts that because Westerners got rich because we are intrinsically greedy, we now are rich but do not enjoy it because we are greedy: a Faustian bargain indeed! Yet, looking at hunter gatherers or hippies, both anti-materialists, I hardly see a more cultured, meaningful, or higher levels of existence.  Mark Zuckerberg, meanwhile, seems centered, nice, intelligent, and interesting.

 As per greed being repugnant, I don't see what is intrinsically wrong with greed if such people are not hurting me. Minding my business under the rubric of safety or fairness, in contrast, is a much more common sort of intrusion in my life, and extremely unwelcome. Greedy people who pay for themselves by creating things of great value to others are both more fun and virtuous than do-gooders who spend all day thinking about new ways to force other people to work for other people.  Of course, there's a lot of luck and skulduggery involved in any market economy too, but it's more fair than anything else I've seen.

Skidelski assumes that we should be egalitarians, and so, anyone wealthier than me hurts me via my now lower relative wealth, regardless of what he does with the wealth. That's not society's problem, that's his problem.

He imagines the standard Marxian utopia of people engaged in thoughtful, productive, artistic activities, and notes we don't seem geared that way right now:

The pleasures of urban populations have become mainly passive: seeing cinemas, watching football matches, listening to the radio, and so on. This results from the fact that their active energies are fully taken up with work; if they had more leisure, they would again enjoy pleasures in which they took an active part.

So, he advocates we all become artisans of some sort, making homebrew, tending gardens, writing poetry.  Yet he notes people like to relax by just watching a movie.  If they didn't have a job, would they then more actively partake in their leisure?  I doubt it.  As Henry Ford said, I can think of nothing less pleasurable than a life devoted to pleasure.

People get most of their pleasure, and meaning, being useful to others, which includes inspiring the admiration or happiness of others by one's actions. Every time I make my daughter squeal with delight makes me thankful to be alive, because I know she really loves me, and I work to provide her with things and habits that will make her prosper, and hope that at some point after I'm gone she will remember me with sincere gratitude. A healthy wage is a strong correlate with one's usefulness to non-family members, especially if you work in field without a lot of regulation.

Our valuations are not just internal, which is why in Robert Nozick's famous experience machine thought experiment where one is asked if they could spend their life in some sort of holodeck that offered incredible but fake experiences,  most people don't want the fantasy life. This is because living in a morphine high of solipsistic pleasure isn't estimable, but rather, pathetic. A satisfying life affects other people in a positive way, which is why those 'flow' advocates really don't understand what they are talking about--it's not the flow, its the feeling that one's focused actions are banking esteem in some communal credit bank, even if it is in some future world.   It's paradoxical that those focused on mandating altruism seem to think satisfaction can and should come purely from within.   

In contrast to the Keynesian vision of us all trying to figure out how to spend our endless vacation, there's Eric Hoffer, the enigmatic philosopher who appeared out of nowhere around 1934 in California at age 34, and claimed to be an autodidact longshoreman. I suspect he was a German immigrant who at one point was a rabbinical student, and wanted to avoid immigration restrictions so he made up some story about growing up in Brooklyn.  

Tom Bethell's recent biography of Hoffer notes   his vision of the future was prescient, not fanciful, highlighting a much greater profundity.  Hoffer himself didn't take much to make him happy: a well-written book to read, and evidence someone thought well of him.  He thought intellectuals found free societies a threat because such societies didn't need mandarins directing them, and if not flattered would help incite the masses to some sort of revolution.  A man is likely to mind his own business when it is worth minding, and so those unhappy with their own meaningless affairs will focus on minding other people's business. Hoffer noted one must not merely provide for those without meaning in their lives, but provide against them, because in a democracy and market economy their preferences will have power. Those who see their lives as inferior and wasted crave equality and fraternity more than they do freedom, and this can cause a Republic to fall to a democracy, and ultimately a tyranny.

In other words, Hoffer describes the essence of the Liberal desire to micromanage society into perfect equality at the expense of liberty. A coalition of intellectuals and the underclass, both of whom feel unappreciated.  We haven't figured out a good outlet for these do-gooders, or a good way for those without a purpose to find life rewarding, so they continue to plague us with their plans and angst. That's a realistic vision of society, a future problem that is real yet potentially soluble. 

Dark Pools: Good Book, Bad Title

Scott Patterson's new book Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System suggests a Rolling Stone type expose of vampire squids sucking the vital fluids out of widows and orphans. In contrast, most of the book was about the development of electronic exchanges from 1990 through 2007, especially focused on the firms Archapelego and Island. It reminds me of Justin Fox's Myth of the Rational Market which suggested a rather slanted and damning hatchet job but then did nothing of the sort. I suppose the marginal business book buyer is on the way to an Occupy rally.

 I work on tactics related to these tactics and technologies, so found it very enjoyable. The real hero of this book, rightly, is Joshua Levine, who started Island. He pioneered paying for flow, where one pays those making markets, and charges those crossing the spread. He was on the bleeding edge in cloud computing, creating more robust infrastructure with a fraction of the budget than his big-time competitors. I know people who dealt with him, and they highlight how thoughtful he was about sharing information back in the day on order strategies, technical stuff that others might guard in a paranoid fashion. Levine thought if his customers could make more money, they would trade more, and this would breed even more liquidity. In other words, a classic business mensch.

 There are lots of numbers thrown around, but it's good to remember that  electrons move about 1 foot per nanosecond, so there's a basic limit to how fast these things can get.  It is true that humans generally take  a couple hundred milliseconds to process information and push a button, so clearly computers that can turn around info in a couple milliseconds beat humans in any whack-a-mole game.  But all that pico-stuff is pretty silly.  Consider the S&P minis futures contracts trades 400k times a day, so every 60 milliseconds (thousandth of a second) represents the highest frequency relevant for any contract. Stocks like IBM trade about once a second. Thus, all that super speed below a millisecond is not for trading so much as 'lining the book', market makers playing games in the queue to provide liquidity.  Your average trader should think about this as much as they think about what's going on underground at Disney World.   

There's a theme that originally the innovators wanted to cut out the middlemen, but then discovered there were new middlemen. Meet the new boss, as The Who would say. The bottom line is that spreads on big stocks like MSFT and ORCL used to be ¼ in the good old days before ECNs, which allowed lots of traders to make a fortune via their monopoly access to customer flow and the various barriers to competitors. That these specialists are now unemployed should be considered classic creative destruction.  I knew several of them; they were lucky while it lasted, and it lasted too long.

 The book is a bit light on actual tactics, making some strategies sound a lot more effective than they are. For example, Patterson describes a strategy he calls "0+", that supposedly makes money with zero risk. In fact, this strategy does have risk, because it presumes that you can always exit your position before the queue behind disappears.   Often a level gets 'taken out' by an order and so the queue behind you is gone within any possible time to place new order and get out at scratch (pre-fees, I should add). Indeed, the trader plying this strategy is presented later pathetically fishing for 10 minute stock predictors like thousands of other punters, highlighting this was no money pump.

A lot of the conspiracy talk around algorithms presumes a market price reflects 'true value', like the mass of something, and that algorithms are keeping others from it. Market prices approximate value, but a price is really an aggregate compromise, one that almost everyone disagrees with.  If you want to buy more, now, you will pay a higher price because you need to convince more people to take the other side. Jehova shouldn't care because 'true value' is unaffected by such concerns, but the market does, and so comparing prices to some assumed point estimate of 'true value' just leads to meaningless disquisitions.  If you want to think about such issues just remember all those theologians who wrote about the 'just price' for about one thousand years and whose work is now totally ignored for good reason, to give you a sense of your futility.  

The bottom line is that those buyers and sellers with big orders have always moved markets from their 'last price', and in the old days this was all done via a coalition of partners over a phone, but now algorithms sniff out these orders by noting a higher-than-usual buy crossing rate, or sense a really big iceberg limit order, and so basically have expropriated the front-running revenue from the traditional recipient of this value. A large order will move prices so it's going to be exploited, and this is better done competitively via electronic markets than by a specialist with monopoly access to the flow.

 There's some funny other stuff in there, like how regulator are pretty irrelevant to all the innovations. Indeed, the regulators appear more interested in protecting the status quo, as George Stigler noted 50 years prior in his work on the industry capture of regulators. Mary Schapiro gets her standard uncritical mention, as she is always presented as the righteous regulator who would have prevented the 2008 crisis if it weren't for Lawrence Summers and his cabal. Her big idea after the flash crash was 'circuit breakers', aka limit price moves. This doesn't help much, as decades of experience with these in futures has shown, though it does 'work' if you merely want to prevent prices from moving more than 5% a day (why not solve the Greek budget deficit by not reporting it?).

The Flash Crash of May 6 2010 included an order to buy 75000 contracts when your average price level had only 5000 contracts there, so it pushed the 'market price' into uncharted territory. Its understandable these things happen, it's a new technology, lots of users, and lots of new emergent properties, most coming down to problems related to idiots placing large 'market orders' that wipe out several 'levels' of prices. I bet the exchanges will figure out a governor in spite of what the SEC does, but such issues are really irrelevant to what caused the crisis of 2008 or the 'Global Financial System.'

Part of a popular work on technical issues seems to involve building up the major players as geniuses, going over their rocket science background. In this case it's like pointing out how every professional football player was an outstanding high school athlete--financial innovators tend to have done well in math and science, so that whole physicist turned financier story isn't rare or intellectually sexy. I suppose that's how to get your hooks into the masses, because people like to read about geniuses.

In spite of the scary title, it's simply a good story of how innovators destroy the old guard. If you are worried about high frequency traders you almost surely trade too much, and would be better focused on asset markets built on things that are truly unsustainable.  High frequency traders are very sensitive to cash flow (note Trading Machines shut down pretty quickly after not finding a niche), so they aren't building palaces based on unrealistic expectations like, say, California or or NYU journalism majors.  

Is Spitznagel an Apostate?

Mark Spitznagel, former employee of Nassim Taleb, has run the Universa Hedge fund for a while and seems to be doing quite well for himself (he bought Jennifer Lopez and Marc Anthony's old home in Bel Air). What his returns have been I don't know, but they are always reported second-hand when vol spikes (as usual regulation is the opposite of helpful here, discouraging hedge fund reporting that would allow investors to more accurately estimate returns for various strategies).

Anyway, Taleb's Black Swan investment advice seemed to be a barbell strategy with a lot of something really safe balanced by radical risky investments. Because people don't appreciate the magnitude or frequency of infrequent events, these low-probability but large impact events offer good returns. In this white paper, Austrians of a Feather, Spitznagel seems to be saying that doesn't work. He seems enamored by Austrian business cycle theory, and an unfortunate side effect of which is to abjure clarity and concision. Thus I'm not sure what he's trying to say, but it seems he is saying that tail risk, out-of-the-money options and their ilk, are fairly priced if not overpriced. The real market opportunity is in predicting specific Black Swans. In other words, speculating on rare events, as opposed to presuming rare events are under appreciated in general.

 Taleb is listed rather prominently on the Universa Website and Spitznagel graciously credits Taleb in the paper, but Taleb and/or Spitznagel have put a fork in the archetypal Black Swan theory (and yet, Taleb has never been really consistent, so one can say he meant this all along at some level). I have no doubt some people can predict infrequent events, and perhaps Spitznagel is one of them. Yet it's pretty hard to validate objectively, and in my experienced is best done via observing all the little good investments someone has made for 10 years, something that is impossible to do in scale. The idea that if you can predict infrequent events you can do very well for yourself is true enough, but that's a lot less useful to know than if rare events are unappreciated in general, which turns out not be be true.

Truth and Loyalty

Norman Finklestein, the go-to academic for the Jewish anti-Zionist take on Middle East events, was interviewed recently. I found this precious:

NF: Because Chomsky’s biggest virtue, you know what it is? Aside from his staggering intellect and absolute faithfulness, Professor Chomsky never betrayed a friend. He will defend them even though inside he knows that they’re completely wrong.

Q: But don’t those virtues of friendship and faithfulness come into conflict with the truth?

NF: I know that! I see that! But he cares very deeply about the facts. Let me tell you a story...

 Jonathan Haidt highlights that loyalty is an important virtue to conservatives that liberals tend to not value. That is, loyalty is seen by liberals as blind obedience, something peculiar to Authoritarian Personality types, an unalloyed vice. Yet that's in abstract. Loyalty is always prized at some level, even the liberal fringe like Chomsky and Finkelstein. Myrmecologist and sociobiologist E.O. Wilson argues that the essence of most of what is publicly esteemed as virtue relates to actions that help the group: patriotism, selfless giving, etc.

I have come to appreciate loyalty more, as like Haidt's liberal personality type, I used to think loyalty was simply not a virtue (that I don't fit the liberal archetype is besides the point). However, unlike Finkelstein I am under no illusion that loyalty is totally consistent with the truth, rather that there are trade-offs and sometimes a lie is worthwhile if it helps one in a relationship. All the virtues involve trade-offs as when one is too honest to be polite or too polite to be honest; moderation in all things. If you think you never lie then you are really self-deceived because as Michael Gazzaniga has demonstrated, our left, narrative, brain confabulates all the time when interpreting and reconciling data it receives from the right brain and peripherals.

Beta Factor Proxy Portfolios

I just discovered some new long/short beta ETFs: BTAH and BTAL.  One goes long high beta, short low beta, equal dollar weighted, equal sector weighted; the other is the opposite.  That is, they both are 'factor mimicking' portfolios on  beta, one the inverse of the other.   They use the top 1000 stocks in the Dow Jones US index as their universe, and pick the extremum 200 as their holdings for longs and shorts.  They don't trade much (~20k shares per day), and they might have some technical issues trying to target the top 200 each month, but I wish them well.

As per sector neutrality, I think that's overkill, but I know lots of people like it.  That is, you miss a lot of the essence of the beta factor by neutralizing sector weightings.

If these existed for twenty years we wouldn't have any doubt about the shape of the Security Market Line.

Levered ETFs Highlights Volatility Demand

PowerShares rolled out a pair of ETNs offering inverse exposure to Japanese government bonds, the 3x Japanese Government Bond Futures ETN (JGBT), and the 3x Inverse Japanese Government Bond Futures ETN (JGBD). Government bonds are typically considered low risk, but to generate sufficient demand, it appears you need to lever them so they have high enough risk to warrant interest.  I suspect that in 10 years, everything will have a 2x and 3x derivative that's tradable on liquid exchanges.

Now, one reason for the demand is that accounts like 401ks discourage leverage, so the leverage is implicit in the ETF, and not explicit.  This is a big problem with leverage limits because leverage can always be gamed in this way, and there is no simple solution.

But I suspect the main reason is more fundamental: people like volatility, and so demand increases with higher volatility.  Now, in most formulations, risky asset demand is determined something like this.

First, maximize the weight on the risky asset, where w is a proportion of the investor's portfolio allocated to the risky asset:


 

By definition, the risky asset has a Gaussian distribution, and the risk-free asset is some constant.



Taking the derivative with respect to w and setting equal to zero gives us the familiar risky asset demand.



This says it is linearly related to the expected return, and inversely related to its variance.  Increasing leverage increases the return (numerator) by X, and the variance (denominator) by X², so the ratio changes by 1/x.  Optimal demand, in this theory, goes down parri passu with the leverage; leverage should not affect actual $ demand because it washes out.

Yet, in practice that's not what happens.  I'm not sure what's going on, but I think part of it is a quantum effect, where investors are not interested in something until it can generate a sufficient threshold return.  That is, most investors basically have 'null' for their Japanese bond exposure.  A significant number of investors would put down $1000 if they had a chance to make $200, but many fewer are interested in putting down $1000 to make $100.  Sure, they could always lever positions themselves but that's another level of complication, creating all sorts of operational risk such as issues about taxation and margin calls.  

Poor Volatility Buyers

The VXX and TVIX target the VIX futures index, a metric of forward-looking volatility, and trade well over 40 million shares a day. As the VIX went up from 20 to 80 in 2008, which I guess makes a lot of people think this is a smart trade. With all the tumult this year, the VIX has remained about the same since the beginning of the year, but the VXX and TVIX are down 41% and 72%, respectively.

Since inception (Jan 2009), the VXX is down about 95%, and since Jan 2008, the SPVXSTR index (which matches the VXX pretty well) is down about 88%, so it's not like over time this strategy has a positive return. I bet a large fraction of these buyers have a copy of The Black Swan on their bookshelf.  The best way to play the volatility game is not to buy it, but to avoid relatively high volatility assets.  People overpay for stuff with large positive skew, like lotteries, and volatility.

Banks Key to Recovery

With news of a possible bailout in Spain, bank bailouts are in the news again.  I'm a big believer that banks are key to this recovery, but I'm skeptical that bailouts are actually helpful.  That is, the best way to add a lack of focus to a bank is to make it even more beholden to 'the public'. A restructuring or default would be preferred, because then the pain is allocated to investors, and so new owners can start over without any baggage from prior favors from politicians and just maximize profits (there's a good reason to think this is what banks should be doing, but I understand many find that argument incomprehensible).

Anyway, I think one of my better ideas was in a post I wrote last year on Barrier Options and Business Cycles.  The basic idea there was that if you looked at banks as not an option on a firm like in a Merton model, but as a barrier option on a firm, the vega actually becomes negative when the firm value is sufficiently low.  This would mean banks go from taking on new projects to maximize equity value, to shedding projects.

Bank stocks are still well off their historical highs, and I think this has some relevance to our rather unusually soft recovery.



Monthly bank index data from Ken French's website

Meta Bias

in Cognitive Sophistication Does Not Attenuate the Bias Blind Spot just published in the Journal of Personality and Social Psychology, the authors note :

As opposed to the social emphasis in past work on the bias blind spot, we examined bias blind spots connected to some of the most well-known effects from the heuristics and biases literature: outcome bias, base-rate neglect, framing bias, conjunction fallacy, anchoring bias, and myside bias. We found that none of these bias blind spot effects displayed a negative correlation with measures of cognitive ability (SAT total, CRT) or with measures of thinking dispositions (need for cognition, actively open-minded thinking). If anything, the correlations went in the other direction...More intelligent people were not actually less biased—a finding that would have justified their displaying a larger bias blind spot.

I put this in with evidence that IQ is positively correlated with not just deception, but self-deception. This is why stupid sons don’t ruin a family, the clever ones do. Remember this the next time someone tells you their strategy is based on heuristics and biases, because it isn't obvious people aware of biases are less biased.

Hat tip: Robin Hanson

CAPM Never Confirmed?

I was looking at a 2004 JEP paper from Fama and French on the history of the CAPM.  Interestingly, they mention all the papers that showed the slope on CAPM betas was too low, and it included just about every important empirical paper on this subject.  It got me thinking: was there ever a paper that didn't estimate the security market line was 'too low?'

Recall that, in cross-section regressions, the Sharpe–Lintner model predicts that the intercept is the riskfree rate and the coefficient on beta is the expected market return in excess of the risk-free rate, E(RM) - Rf. The regressions consistently find that the intercept is greater than the average risk-free rate (typically proxied as the return on a one-month Treasury bill), and the coefficient on beta is less than the average excess market return (proxied as the average return on a portfolio of U.S. common stocks minus the Treasury bill rate). This is true in the early tests, such as Douglas (1968), Black, Jensen and Scholes (1972), Miller and Scholes (1972), Blume and Friend (1973), and Fama and MacBeth (1973), as well as in more recent cross-section regression tests, like Fama and French (1992).

The evidence that the relation between beta and average return is too flat is confirmed in time series tests, such as Friend and Blume (1970), Black, Jensen, and Scholes (1972), and Stambaugh (1982). The intercepts in time series regressions of excess asset returns on the excess market return are positive for assets with low betas and negative for assets with high betas.

When I was in grad school, this was not conventional wisdom, though with hindsight it supposedly was.  Rather, we emphasized that you could not reject the CAPM if you threw the kitchen sink of uncertainties and refinements in there. This kind of historical revisionism, common among stock prognosticators and consultants, is really misleading because it makes it seem that a bunch of really smart experts are never really wrong about something right in the middle of their bailiwick.