Kurzweil on Creating a Mind

I just got done reading Ray Kurzweil's How to Create a Mind, his latest on how machines will soon (2030ish) pass the Turing test, and then basically become like robots envisaged in the 60's, with distinct personalities, acting as faithful butlers to our various needs.

And then, today over on The Edge, Bruce Sterling is saying that's all a pipe dream, computers are still pretty dumb.  As someone who works with computer algorithms all day, I too am rather unimpressed by a computer's intelligence, but Kurzweil made me a little more appreciative of what they can do.

He notes that IBM's Watson won a Jeopardy! contest by reading all of Wikipedia, a feat clearly beyond any human mind. Further, as Kurzweil notes, many humans are pretty simple, and so it's not inconceivable a computer can replicate your average human, if only average is pretty predictable. Sirri is already funnier than perhaps 10% of humans.

Human's have what machines currently don't have, which is emotions, and emotions are necessary for prioritizing, and a good prioritization is the essence of wisdom.  One can be a genius, but if you are focused solely on one thing you are autistic, and such people aren't called idiot-savants for nothing.

Just as objectivity is not the result of objective scientist, but an emergent result of the scientific community, consciousness may not be the result of a thoughtful individual, but a byproduct of a striving individual enmeshed in a community of other minds, each wishing to understand the other minds better so that they can rise above them. I see how you could program this drive into a computer, a deep parameter that gives points for how many times others call their app, perhaps.

Kurzwiel notes that among species of vole rats, those that have monogamous bonds have oxytocin and vasopressin receptors that give them a feeling of 'love', and those where dads are just sperm donors don't. Hard wired emotions dictate behavior.  Perhaps computers can have emotions, you can put in something for sadness when they aren't called by other programs or people, a desire to see users with physical correlates to fertility like smooth skin and tone bodies. But it's one thing to program an aversion to solitude, another to desire a truly independent will.

Proto humans presumably had the consciousness of dogs, so something in our striving created human consciousness incidentally. Schopenhauer said "we don't want a thing because we have found reasons for it, we find reasons for it because we want it." The intellect may at times to lead the will, but only as a guide leads the master. He saw the will to power, and fear of death, as being the essence of humanity.  Nietzsche noted similarly that "Happiness is the feeling that power increases."  I suppose one could try to put this into a program as a deep preference, but I'm not sure how, in that, what power to a computer could be analogous to power wielded by humans?

Kierkegaard thought the crux of human consciousness was anxiety, worrying about doing the right thing.  That is, consciousness is not merely having perceptions and thoughts, even self-referential thoughts, but doubt, anxiety about one's priorities and how well one is mastering them. We all have multiple priorities--self preservation, sensual pleasure, social status, meaning--and the higher we go the more doubtful we are about them. Having no doubt, like having no worries, isn't bliss, it's the end of consciousness.  That's what always bothers me about people who suggest we search for flow, because like good music or wine, it's nice occasionally like any other sensual pleasure, but only occasionally in the context of a life of perceived earned success.

Consider the Angler Fish. The smaller male is born with a huge olfactory system, and once he has developed some gonads, smells around for a gigantic female. When he finds her, he bites into her skin and releases an enzyme that digests the skin of his mouth and her body, fusing the pair down to the blood-vessel level. He is then fed by, and has his waste removed by, the female's blood supply, as the male is basically turned into a parasite. However, he is a welcomed parasite, because the female needs his sperm. What happens to a welcomed parasite? Other than his gonads, his organs simply disappear, because all that remains is all that is needed. No eyes, no jaw, no brain. He has achieved his purpose, has no worries, and could just chill in some Confucian calm, but instead just dissolves his brain entirely.

A computer needs pretty explicit goals because otherwise the state space of things it will do blows up, and one can end up figuratively calculating the 10^54th digit of pi--difficult to be sure, and not totally useless, but still pretty useless.  Without anxiety one could easily end up in an intellectual cul-de-sac and not care.  I don't see how a computer program with multiple goals would feel anxiety, because they don't have finite lives, so they can work continuously, forever, making it nonproblematic that one didn't achieve some goal by the time one's eggs ran out.  Our anxiety makes us satisfice, or find novel connections that do not what we originally wanted but do what's very useful nonetheless, and in the process helped increase our sense of meaning and status (often, by helping others).

Anxiety is what makes us worry we are at best maximizes an inferior local maximum, and so need to start over, and this helps us figure things out with minimal direction.  A program that does only what you tell it to do is pretty stupid compared to even stupid humans, any don't think for a second neural nets or hierarchical hidden markov models (HHMMs) can figure stuff out that isn't extremely well defined (like figuring out captchas, where Kurzweil thinks HHMMs show us something analogous to human thought).

Schopenhauer, Kierkegaard, and Nietzsche were all creative, deep thinkers about the essence of humanity, and they were all very lonely and depressed. When young they thought they were above simple romantic pair bonds, but all seemed to have deep regrets later, and I think this caused them to apply themselves more resolutely to abstract ideas (also, alas, women really like confidence in men, which leads to all sorts of interesting issues, including that their doubt hindered their ability to later find partners, and that perhaps women aren't fully conscious (beware troll!)). Humans have trade-offs, and we are always worrying if we are making the right ones, because no matter how smart you are, you can screw up a key decision and pay for it the rest of your life. We need fear, pride, shame, lust, depression and envy, in moderation, and I think you can probably get those into a computer.  But anxiety, doubt, I don't think can be programmed because logically a computer is always doing the very best it can in that's its only discretion is purely random, and so it perceives only risk and not uncertainty, and thus, no doubt.

The key, as Minsky always told me, was uncertainty, true uncertainty as discussed by Keynes and Knight.  If it is truly non-quantifiable, then a computer can not understand it, and they will never empathize with us correctly, never accurately have a 'theory of mind' that comes naturally for humans.  After all, without uncertainty, there really isn't doubt, which Schopenhauer said was the essence of consciousness. So, the search for AI, and a model of 'real risk', seemed joined at the hip. 

Is Broker-Dealer Leverage the Elusive SDF?

Every year thousands of young people attend elite schools to learn about business. One of the core courses is Corporate Finance, and one of the key principles they learn is about risk and reward, and the standard theory is framework--not a model--that holds that the expected return of a financial asset is a function of risk, where you are paid to endure this unpleasant, irreducible characteristic. The quantity of risk is measured by a covariance with priced risk factors which are as-yet unidentified time series like the stock market, and there’s a linear relationship between this risk metric and expected returns. Risk measures the 'how much', and the price you receive for this is from risk premiums. Thus, expected returns are determined by this crucial, objective characteristic (Cliff Asness nicely describes the expected return as dominating the variance in the forward to Antti Ilmanen's Expected Returns, accurate because if you ever do a mean-variance optimization, those assumptions really drive the end result, but alas they have much greater uncertainty).

Yet as Mark Rubinstein said about the CAPM and its extensions, “More empirical effort may have been put into testing the CAPM equation than any other result in finance. The results are quite mixed and in many ways discouraging.” Eugene Fama and Kenneth French called the CAPM “empirically vacuous,” and APT creator Stephen Ross noted that “having a low, middle or high beta does not matter; the expected return is the same.” These are all major proponents of this approach, so I think it's fair to say that the standard model is a theory in search of validation. As the elusive risk factor is clearly not 'the market', but something like the market, new factors are proposed all the time.

Remember the CAPM, with its simple single factor model,

E(R_i)=R_f+bE(R_m-R_f)

Supposedly, this worked great, but then, Fama and French showed that when you pre-sort data by size, there's no relationship with beta.  Thus, they created the new 3-factor Fama-French portfolio

E(R_i)=R_f+bE(R_m-R_f)+b_size(R_small-R_big)+b_value(R_value-R_growth)

At this point, all bets were off. There were two ways to theoretically rationalize a factor. One could simply assert it as being intuitively risk, as Fama and French did, which via Arbitrage Pricing Theory logic should be priced.  Alternatively, one could write down a Stochastic Discount Function, as Harvey and Siddique did in (2000) with their co-skewness paper:

Or as Jacobs and Wang did in their 2001 consumption growth volatility paper:

'm' is sort of like super-string's M-theory: it can be whatever you want it to be, and the great elders of rigor have proven these are all kosher, so, once written down as above, you can simply append the resulting 'betas' to the above 3-factor Fama-French model and not explain exactly how they work together given one's earlier motivation that contained no value or growth factor (It reminds me of how Marx's totally wrong but complicated and rigorous Das Kapital allowed generations of theorists to talk about the Hegelian dialectic as if it were real, because nonbelievers simply didn't want to waste time on it, and insiders could all point to thoughtful people who believed and extended the great work).

Researchers Tobias Adrian of the Federal Reserve Bank of New York, Erkko Etula of the Federal Reserve Bank of New York (now at Goldman Sachs), and Tyler Muir of Northwestern University have a hot paper that is the latest best hope for the elusive risk factor that explains asset returns (Financial Intermediaries and the Cross-Section of Asset Returns). They argue that the key is broker-dealers, specifically, their leverage constraint. The nice thing is that one has data on their leverage going back to 1968 or so with quarterly data, so you can throw it against the wall, and guess what, "Our single-factor model prices size, book-to-market, momentum, and bond portfolios with an R2 of 77 percent and an average annual pricing error of 1 percent." That is, 25 size-value sorted portfolios, plus a momentum portfolio, and some US Tbond portfolios.

Considering that CAPM betas can't explain anything, how does this work?  I'm not sure, but I suppose a lot of it is overfitting: there are only 25 portfolios targeted, and there are lots of potential SDFs (eg, consumption-labor-wealth VARs, consumption growth, Tobin's Q in various forms).  As usual, they stress the deep theoretical roots to their metric:

Guided by theory, we use shocks to the leverage of securities broker-dealers to construct an intermediate SDF.  

How does theory guide this?  Well, remember, 'm' is the Stochastic Discount Factor,so, if you simply assert that

Where LevFac is the seasonally adjusted change in Broker/Dealer leverage, there you go. As Frazzini and Pedersen's Betting Against Beta framework also included the market return with their leverage constraint, I'm not sure how they dropped that given their similar intuition.

I took their proxy of the SDF, and graph it next to the S&P for the past 10 years.  You can see its correlated about 30% but catches the really big moves as in 2008 and 1987 (not pictured here).

note: the BD factor is derived from a factor-mimicking portfolio from the 6 F-F size-value portfolios and the momentum portfolio as given in their paper

What I suspect, though I haven't done the experiment, is that if you regress individual stocks against this factor there will be a zero correlation with returns. That's the result of overfitting. You fit the target, in this case, some portfolios from Ken French's website, and you have a pub, especially if you write down an SDF, but it's just the flavor of the month, the latest potential solution to a perennial problem.

I shouldn't be too hard on it, it is intellectually honest work, very clear.  Yet, these pop up all the time as one would expect with thousands of potential SDFs out there and the ease at which they can be rationalized.  If one ever explained the cross-section of stock returns, I'd rethink my skepticism.

Bob Haugen RIP

Bob Haugen passed away last Sunday. My favorite Haugen articles are really two.  In Commonalities in  the Determinants of Expected Stock Returns (1995, with Nardin Baker), he basically showed that there's lots of stange things going on in the stock market. He looked at 40 or so specific metrics related to liquidity, price ratios, prior returns, growth, and risk, and found many of them significantly related to future returns in the US, Germany, France, and the UK.

The paper was important because at that time Fama and French came out with their influential paper showing the value and size anomalies, and reconciled this within a risk model that they said must have some orthogonal value and size related factors.  Lakonishok, Shliefer, and Vishny, meanwhile were arguing these were due to inefficiencies, investor over and under-reactions. Haugen favored the inefficiency explanation, and more importantly highlighted there were a lot more than the value and size anomalies.

Most importantly to me, in my dissertation I remember highlighting his The efficient market inefficiency of capitalization-weighted stock portfolios (1991, with Nardin Baker). This paper highlighted that a very fundamental portfolio, the Minimum Variance Portfolio that is at the extreme left of a convex hull created via Markowitzian diversification in mean-variance space, actually had a slightly higher than average return.  Haugen focused on the inefficiency of the market portfolio, but I used it to support my contention that low volatility stocks actually had slightly higher than average returns.  Most low volatility funds reference this paper in presentations of their approach, as it was the first paper to highlight the dominance of this special portfolio.

He was an independent spirit, and will be greatly missed.

Hubbard on Relative Risk

Glenn Hubbard was a major academic bank researcher when I was in graduate school, and later he became a Republican stalwart and dean of Columbia's business school. In connection with the lawsuit of monoline insurer MBIA against Bank of America and Countrywide, he recently gave this interesting deposition.

The plaintiffs are trying to prove Countrywide was negligent or even fraudulent in dealing with customers and investors. Hubbard is trying to support the proposition Countrywide did nothing wrong.  I'm kind of torn because on one hand, Countrywide was pushing the envelope of no-income/no down payment loans that made the bubble much greater than it would have been with mere monetary easing; on the other hand, Countrywide bragged about this for years, and their CEO Angelo Mozillo received many honors for expanding the home ownership to minority communities (eg, he won the American Banker's Lifetime Achievement Award in 2006).  What they did was stupid, but it wasn't a secret, and when it was happening it was encouraged by regulators, legislators, academics, community activists, borrowers, and yes, investors.

The key problem was not something really complicated in the copulas or a misplaced confidence on correlations, it was the assumption that housing prices, nationally, would not fall in nominal value, significantly. This outcome basically was assigned a zero probability, why the correlation assumption was allowed to stand. So, it wasn't really that subtle, but it was pervasive, and as we all now know, terribly wrong.

Anyway, Hubbard's post-mortem defense is that as Countrwide's portfolio did about as well as other lenders, they didn't do anything wrong.  He gets very testy, just as he did in the Movie Inside Job:

Q. You understand your obligation is to answer my questions to the best of your ability, including as the questions change, as they will throughout the course of the day?
 A. I promise to be as nonlinear as you would like me to be.

Around page 48 of the deposition, the plaintiff lawyers try to get Hubbard to admit that all he did was compare Countrywide to other mortgage originators, so if fraud or misrepresentation was pervasive it wouldn't show up in his benchmark comparison of Countrywide performance relative to its peers.  Hubbard tries to have it both ways, saying at various times he didn't analyze underwriting, that he had no knowledge of what other lenders were doing, but also that Countrywide wasn't doing anything wrong because Countrywide's mortgages did as poorly as everyone else's. 

The analysis Hubbard does is pretty straightforward. That he gets paid hundreds of thousands of dollars by many large corporations highlights that they are all paying for his brand name, because his knowledge of mortgage risk is pretty meager. The problem, however, is that everyone who really understands this market is clearly biased, but then, Hubbard is obviously biased too, so in a sense this is all a sham (get a big name to do pedestrian work that is purportedly objective).

Alas, this brings to mind the famous John Maynard Keynes quote, 'worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally', or perhaps Schopenhauer's, "in a herd, we are free from the standards of an individual." Both are lamentable but true.  If everyone's doing it, it's hard to call this fraud or negligence, criminally defined.  Singling out bankers would be arbitrary, as these guys were not doing this outside the Matrix (Fannie Mae's DeskTop Underwriter front-end greatly expedited ninja loan underwriting, and they are a product of the Federal Government). So, while I think shaming should go all around, I don't see the point in criminalizing it because then you either fine/jail everyone, or arbitrarily scapegoat some minority group (here, bankers).

The bottom line is that Hubbard's correct in that there is less risk doing what everyone else does, regardless of how good or bad it is, precisely because it is impossible to punish everyone. That's why it's essential to have a Bill of Rights, so majorities can't steamroll unpopular minorities.

In any case, risk, in practice, is relative, the theme of my book, The Missing Risk Premium, which curiously implies a zero risk premium in general and a persistent negative premium to assets desired for reasons outside of standard models.

Relative risk means pervasive benchmarking and the importance of tracking error. It can lead to sunspot equilibria when everyone is going crazy like the in the internet bubble. Now, it's easy to say, you should not benchmark, you should target a Sharpe ratio, not an Information Ratio, but most people don't. I think it highlights that there's an easy way to beat the benchmark, avoiding the crowd any sticking with boring investments, but the key is you need sufficient reputation or capital to be able to do this without losing your job, so it's not so easy to do even if you want to.

Dimensional's Latest on Low-Vol

Ronnie Shah has a new piece on low volatility investing (Residual Volatility and Average Returns, Dec 2012), and as he works for Dimensional Fund Advisors, I presume his take is consistent with that of the Dimensional management.  As this would include Eugene Fama, Ken French, Robert Merton, Roger Ibbotson, Myron Scholes, and George Constantinides, I think it represents conventional academic financial wisdom about as well as any firm can.

The old guard continues to think nothing's wrong with the standard theory, a 3-factor model include a value and size proxies (ie, long high book-market/low cap, short low book-market/high cap) as well as the market (as in the traditional Capital Asset Pricing Model). The market factor does not work within equities, but 'explains' the relative premium in equity indices over bonds; the size and value factors explain, well, themselves (the size and value anomaly). That is, all factors are chosen to explain themselves! While the market factor has some theoretical justification, value and size proxy some factor we still, after about 30 years, haven't identified. That this is considered a logical, rigorous, theory highlights to me that smart people are willing to accept a lot of rationalization to keep their paradigm alive.

In any case, Shah's argument is that Low Volatility is not an anomaly because if you sort by residual volatility, among the high cap/value stocks, there's an insignificant difference between the low and high volatility stocks.

Methinks he's conveniently ignoring a lot of arguments, instead focusing on a simple statistic that, while logically correct, is rather selective.  That is, minimum volatility portfolios taken within the SP500, since 1998, generate a large 3.9% difference in annual returns with the SP500 (this is just multiplying the monthly returns by 12).  Look at the results below (data are from here).  That's statistically insignificant, however, given standard t-stats, and if things continue, will become significant around 2050. Such is the nature of financial time series.

I haven't broken out a low 'residual volatility' portfolio because I think it's really total volatility that is the key, and so using residual volatility handicaps the results. Note that there's no beta premium, and so from a return perspective this doesn't hurt, and lower systematic volatility (ie, beta) is also a good thing for a portfolio.

More importantly, even if there's no low volatility premium, the fact you can generate the same return for one-third the beta, or total volatility, then anyone who believes in mean-variance optimization (as the Dimensional Star Chamber does) should love low volatility investing much more than value or small cap investing.

Lastly, just because high volatility stocks tend to be small cap, and have high spreads, does not mean they aren't good data points. It's true that you can't really arbitrage the poor returns on high volatility stocks because they are often illiquid, but note that lots of people own these stocks, and they seem strictly dominated in the sense of Rothschild and Stiglitz  (Increasing Risk I, 1970).  The fact you can't short them efficiently, still doesn't explain why anyone would own these as they do. Further, given their high transaction costs, the holding period should be long, and what really kills these stocks is the compounding, as their volatility is about 40%, which generates an 8% drag on geometric returns (Geometric Return=arithmetic Return-variance/2). That people buy these lottery tickets is impossible to reconcile with the model where people are maximizing a standard utility function.

This will be an example of Max Planck's dictum that science increases funeral by funeral, because these guys aren't about to give their standard model the root canal I think it deserves.  As shown above, you can have meaningfully large opportunities that won't look statistically significant for 50 years, so, if you have a strong prior, there's no logical reason you have to give it up in this life. 

Buy AAPL

With the VIX at lows, and central banks across the globe printing money at breakneck pace, it seems a great time to be long equities. Not that I think this is good for the long run, but for at least a couple years this should be great for equities.

Specifically, Apple has decline 25% from its peak in September, probably due to investors with large gains taking their capital gains before 2013 when such capital gains rates will go up.

Given so many interest groups have an interest in asset prices rising, and the central banks across the world have this as their priority, I think once bank get some of their final legacy lawsuits off their backs they will start lending again, M2 will explode, and prices will rise. First in assets. 

Some Classic Economics Articles

Here are some of my favorite economic articles.  You might enjoy them.

Bruce Yandle on Bootleggers and Baptists. I think this is a really deep theory, in that it applies not simply to economic regulation, but almost all political divisions. That is, contra Marx, the Hegelian dialectic is not between those in power and those not, the rich and the poor, but rather, each side in any revolution contains some of both. There simply aren't enough rich to beat 'the poor', and these classes are very heterogeneous, each with various divisions (I remember how the Mexicans and Central Americans used to fight when I lived near MacArthur Park in Los Angeles). Think Emperor Claudius, the Praetorian Guard and the mob, vs the Senators and patricians after the assassination of Caligula, with high-minded rhetoric about Rome leading the PR battle. Henry Manne's Parable of the Parking Lots is a good example of these coalitions applied to economic regulation.

Frederick Bastiat on The Seen and Unseen.

There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

Most stimulus and redistribution is simply the seen, so shame on economists for generally supporting these boondoggles, usually as a Keynesian pretext for their less defensible, but still understandable, egalitarian ends (the theme of my book The Missing Risk Premium is that this is precisely our dominant instinct, envy over greed).

Mark Skousen on Samuelson's Economics Textbook. This book really reflected conventional Macroeconomic wisdom for 50 years, and its tendencies are worth examining. Samuelson highlights the uselessness of Tetlock's Hedgehog and Fox dichotomy, because 1) Samuelson was clearly both, and 2) Tetlock described himself as both. Who isn't both?

R.A. Radford on the Economics of a P.O.W. camp.  Notice the politics of economics even in these situations.  Hyman Minsky used to tell me markets are good at distributing goods that already exist, like care packages in a POW camp, but not investment, which being subject to Keynesian uncertainty, is too irrational. He ceded the Radford anecdote, yet dismissed its generality.

Tullock and Buchanan on the Calculus of Consent, why collectives choose policies that are suboptimal. Markets can be suboptimal, but giving power to a regulatory body has even greater problems. That is, it's simply not correct to assume a regulator will implement the optimal policy, or anything close to it.

Gun and Bank Regulations

Recently, David Gregory brandished a 30-round magazine on his Sunday TV show as a prop. He knowingly violated a local law that prohibits those clips existing in the district, presumably because he knew he wasn't a real danger to anyone (as opposed to registered gun owners).  They were still talking about it today on the Sunday shows, and I found it amusing that the TV people seemed to think the issue was absurd.  Alas, life is often absurd, especially when tragic.

While it's true that this celebrity was not endangering anyone, to presume that makes a difference highlights the power of laws that often don't make much sense for particular cases. Little laws that entrap those who don't fall under the spirit of the legislation happens all the time. I was pulled into costly litigation that started out by arguing to the court that anything I did related to volatility, cash flow, and mean-variance optimization was verboten via a confidentiality agreement. This was preposterous, but to the court they were tenable accusations, and so started an unconstrained discovery process that was sure to find something (why privacy is important even if you aren't a criminal or prude: give enough data to a motivated adversary and they will find you guilty of something).

Every law, no matter how stupid when applied to something like Gregory's transgression, is based on a principle that can be bandied about, and equality before the law is one such principle. For example in my litigation the judge asked my adversary at various points "what is it you want?" referring to a specific strategy, concept, or algorithm that they might feel is their property. All they had to say was, "We want to protect our intellectual property!" and the judge let it go at that. If you want to use the law to hammer someone, the fact that there's nothing important in the specific application is irrelevant because you can always fall back on some high-minded principle, and you probably won't be challenged on it.  

So, the letter of the law matters quite a bit because most people aren't rich or famous.  There are so many laws regulating your average business that at any time one is probably being broken. This puts everyone at the mercy of their regulator's goodwill, because like David Gregory you will probably get off if the right people are on your side. If they are indifferent you are at the mercy of the mob, government, or wealthy antagonist.  

I'm sure a large complex financial organization like Citigroup is violating some laws all the time given 260k employees operating across the globe working in a highly regulated environment. That's why large financial companies hire people like Bob Rubin, Peter Orszag, or Bill Daley, because they need someone who can get access to those people who can squash an investigation.  

If you have a business worth a decent amount of money the most important priority you have is to get powerful friends and avoid powerful enemies.  The massive number of laws and regulations permits a hook for many to hurt you if they want to.  A better policy solution is to shrink the avenues of injustice by making the law more constrained, giving jerks fewer opportunities to hide small-minded motives behind some grand principle.  A larger set of rules, especially vague ones (eg, Obamacare) simply makes the system more corrupt, because simple things like 'outlawing 20 cartridge magazines' or "mandating more (or less) lending to poor people" creates a situation where people are at the whim of politicians.  

Bad things happen all the time because of vice, which I think is all based in ignorance and an absence of empathy (evil is always some combination of the two). When we try to eliminate bad things via more laws and top-down policies, it just creates a more capricious and unjust world. The solution is not more laws, but fewer.  

Samuelson on Keynes

I couldn't find this Samuelson essay online anywhere, so I'm posting it here. It's rather enlightening portrait from one of Keynes's main popularizers on the cusp of a career that never wavered in its Keynesian enthusiasm. I think it pretty clearly highlights that The General Theory was, as von Mises said, a 'tract for the times,' because it rationalized greater governmental involvement in the economy and is pretty inscrutable (Samuelson compares it to that great scientific treatise, Finnegan's Wake). It's a classic non-falsifiable book, because as Samuelson notes, it's obscure.

it bears repeating that the General Theory is an obscure book, so that would be anti-Keynesians must assume their position largely on credit unless they are willing to put in a great deal of work and run the risk of seduction in the process.

In other words, the GT is a giant spread argument where one can't pull out a single testable equation; the essence is a gestalt. Keynes didn't even understand it, according to Samuelson, so good luck convincing a true believer you know what the GT means and it is wrong--you just don't know what it means!  Further, it contains the old theory as a special case, so it's not incompatible with any of those assumptions, logically.

It should also be noted that when William Wordsworth wrote Samuelson's quote below ('bliss...') it was about the French Revolution, and the post-revolutionary terror was a recent memory, the Napoleonic wars were still raging. This poem was an ironic comment on the naiveté of youth. The French Revolution was the first modern revolution driven intellectually by the Rights of Man, a theory. While Wordsworth was initially a big supporter of the French revolution, like Orwell in Spain 150 years later, he became appalled by the increasing violence and fanaticism, and the resulting military officer taking charge to restore order. Like Edmond Burke, Wordsworth saw that ideologies are lethal abbreviations of thought. While the Keynesian revolution wasn't that destructive, it was, to my mind, a similar abbreviation of thought towards an ideology, a larger state, justified via 'aggregate demand' in Keynes's General Theory.

The Impact Of The General Theory.
Econometrica, July 1946.

by Paul A. Samuelson

I have always considered it a priceless advantage to have been born as an economist prior to1936 and to have received a thorough grounding in classical economics. It is quite impossible for modern students to realize the full effect of what has been advisably called "The Keynesian Revolution" upon those of us brought up in the orthodox tradition. What beginners today often regard as trite and obvious was to us puzzling, novel, and heretical. To have been born as an economist before 1936 was a boon—yes. But not to have been born too long before! 

Bliss was it in that dawn to be alive, But to be young was very heaven!

The General Theory caught most economists under the age of 35 with the unexpected virulence of a disease first attacking and decimating an isolated tribe of south sea islanders. Economists beyond 50 turned out to be quite immune to the ailment. With time, most economists in between began to run the fever, often without knowing or admitting their condition.

I must confess that my own first reaction to the General Theory was not at all like that of Keats on first looking into Chapman's Homer. No silent watcher, I, upon a peak in Darien. My rebellion against its pretensions would have been complete. Except for an uneasy realization that I did not at all understand what it was about. And I think I am giving away no secrets when I solemnly aver— upon the basis of vivid personal recollection—that no one else in Cambridge, Massachusetts, really knew what it was about for some twelve to eighteen months after its publication. Indeed. until the appearance of the mathematical models of Meade, Lange. Hicks, and Harrod, there is reason to believe that Keynes himself did not truly understand his own analysis. 

Fashion always plays an important role in economic science: new concepts become the 'mode and then are passe. A cynic might even be tempted to speculate as to whether academic discussion is itself equilibrating: whether assertion, reply, and rejoinder do not represent an oscillating divergent series, in which—to quote Frank Knight's characterization of sociology—"bad talk drives out good." 

In this case, gradually and against heavy resistance, the realization grew that the new analysis of effective demand associated with the General Theory was not to prove such a passing fad, that here indeed was part of "the wave of the future." This impression was confirmed by the rapidity with which English economists, other than those at Cambridge, took up the new Gospel: e.g., Harrod, Meade, and others, at Oxford: and, still more surprisingly, the young blades at the London School, like Kaldor. Lerner. and Hicks, who threw off their Hayekian garments and joined in the swim. 

In this country it was pretty much the same story. Obviously, exactly the same words cannot be used to describe the analysis of income determination of, say, Lange, Hart, Harris, Ellis, Hansen, Bissell, Haberler, Slichter, J.M. Clark, or myself. And yet the Keynesian taint is unmistakably there upon every one of us. 

Instead of burning out like a fad the General Theory is still gaining adherents and appears to be in business to stay. Many economists who are most vehement in criticism of the specific Keynesian policies—which must always be carefully distinguished from the scientific analysis associated with his name—will never again be the same after passing through his hands. It has been wisely said that only in terms of a modern theory of effective demand can one understand and defend the so called "classical" theory of unemployment. It is perhaps not without additional significance. in appraising the long-run prospects of the Keynesian theories, that no individual, having once embraced the modern analysis, has—as far as I am aware—later returned to the older theories. And in universities where graduate students are exposed to the old and new income analyses. I am told that it is often only too clear which way the wind blows. 

Finally, and perhaps most important from the long-run standpoint, the Keynesian analysis has begun to filter down into the elementary textbooks; and, as everybody knows, once an idea gets into these, however bad it may be, it becomes practically immortal.

Thus far, I have been discussing the new doctrines without regard to their content or merits, as if they were a religion and nothing else. True, we find a Gospel, a Scriptures, a Prophet, Disciples, Apostles. Epigoni, and even a Duality: and if there is no Apostolic Succession, there is at least an Apostolic Benediction. But by now the joke has worn thin, and it is in any case irrelevant. 

The modern saving-investment theory of income determination did not directly displace the old latent belief in Say's Law of Markets (according to which only "frictions" could give rise to unemployment and over-production). Events of the years following 1929 destroyed the previous economic synthesis. The economists' belief in the orthodox synthesis was not overthrown, but had simply atrophied: it was not as though one's soul had faced a showdown as to the existence of the Deity and that faith was unthroned, or even that one had awakened in the morning to find that belief had flown away in the night: rather it was realized with a sense of belated recognition that one no longer had faith, that one had been living without faith for a long time, and that what, after all, was the difference? The nature of the world did not suddenly change on a black October day in 1929 so that a new theory became mandatory. Even in their day, the older theories were incomplete and inadequate: in 1815, in 1844, 1893, and 1920. I venture to believe that the eighteenth and nineteenth centuries take on a new aspect when looked back upon from the modern perspective, that a new dimension has been added to the rereading of the Mercantilists, Thornton, Malthus, Ricardo, Tooke, David Wels, Marshall, and Wicksell. 

Of course, the great depression of the thirties was not the first to reveal the untenability of the classical synthesis. The classical philosophy always had its ups and downs along with the great swings of business activity. Each time it had come back. But now for the first time, it was confronted by a competing system—a well-reasoned body of thought containing among other things as many equations as unknowns; in short, like itself, a synthesis: and one which could swallow the classical system as a special case. 

A new system, that is what requires emphasis. Classical economics could withstand isolated criticism. Theorists can always resist facts: for facts are hard to establish and are always changing anyway, and ceteris paribus can be made to absorb a good deal of punishment. Inevitably, at the earliest opportunity, the mind slips back into the old grooves of thought, since analysis Is utterly impossible without a frame of reference, a way of thinking about things, or, in short, a theory. 

Herein lies the secret of the General Theory. It is a badly written book, poorly organized; any layman who, beguiled by the author's previous reputation. bought the book was cheated of his five shillings. It is not well suited for classroom use. It is arrogant, bad-tempered. polemical, and not overly generous in its acknowledgments. It abounds in mares' nests or confusions. In it the Keynesian system stands out indistinctly, as if the author were hardly aware of its existence or cognizant of its properties; and certainly he is at his worst when expounding its relations to its predecessors. Flashes of insight and intuition intersperse tedious algebra. An awkward definition suddenly gives way to an unforgettable cadenza. When finally mastered, its analysis is found to be obvious and at the same time new. In short, it is a work of genius. 

It is not unlikely that future historians of economic thought will conclude that the very obscurity and polemical character of the General Theory ultimately served to maximize its long-run influence. Possibly such an analyst will place it in the first rank of theoretical classics, along with the work of Smith. Cournot, and Walras. Certainly. these four books together encompass most of what is vital in the field of economic theory: and only the first is by any standards easy reading or even accessible to the intelligent layman. 

In any case, it bears repeating that the General Theory is an obscure book, so that would be anti-Keynesians must assume their position largely on credit unless they are willing to put in a great deal of work and run the risk of seduction in the process. The General Theory seems the random notes over a period of years of a gifted man who in his youth gained the whip hand over his publishers by virtue of the acclaim and fortune resulting from the success of his Economic Consequences of the Peace. 

Like Joyce's Finnegan's Wake, the General Theory is much in need of a companion volume providing a "skeleton key" and guide to its contents: warning the young and innocent away from Book I (especially the difficult Chapter 3) and on to Books II, IV and VI. Certainly in its present state, the book does; not get itself read from one year to another even by the sympathetic teacher and scholar. 

Too much regret should not be attached to the fact that all hope must now be abandoned of an improved second edition, since it is the first edition which would in any case have assumed the stature of a classic. We may still paste into our copies of the General Theory certain subsequent Keynesian additions, most particularly the famous chapter in How to Pay for the War which first outlined the modern theory of the inflationary process. 

This last item helps to dispose of the fallacious belief that Keynesian economics is good "depression economics" and only that. Actually, the Keynesian system is indispensable to an understanding of conditions of over-effective demand and secular exhilaration; so much so that one anti-Keynesian has argued in print that only in times of a great war boom do such concepts as the marginal propensity to consume have validity. Perhaps, therefore, it would be more nearly correct to aver the reverse: that certain economists are Keynesian fellow-travelers only in boom times, falling off the band wagon in depression. If time permitted. it would be instructive to contrast the analysis of inflation during the Napoleonic and first World War periods with that of the recent War and correlate this with Keynes' influence. Thus, the "inflationary gap" concept, recently so popular. seems to have been first used around the Spring of 1941 in a speech by the British Chancellor of the Exchequer, a speech thought to have been the product of Keynes himself. 

No author can complete a survey of Keynesian economics without indulging in that favorite in-door guessing game: wherein lies the essential contribution of the General Theory and its distinguishing characteristic from the classical writings? Some consider its novelty to lie in the treatment of the demand for money, in its liquidity preference emphasis. Others single out the treatment of expectations. 

I cannot agree. According to recent trends of thought. the interest rate is less important than Keynes himself believed…As for expectations, the General Theory is brilliant in calling attention to their importance and in suggesting many of the central features of uncertainty and speculation. It paves the way for a theory of expectations, but it hardly provides one. I myself believe the broad significance of the General Theory to be in the fact that it provides a relatively realistic, complete system for analyzing the level of effective demand and its fluctuations. More narrowly. I conceive the heart of its contribution to be in that subset of its equations which relate to the propensity to consume and to saving in relation to offsets-to-saving. In addition to linking saving explicitly to income, there is an equally important denial of the implicit "classical" axiom that motivated investment is indefinitely expansible or contractible, so that whatever people try to save will always be fully invested. It is not important whether we deny this by reason of expectations, interest rate rigidity, investment inelasticity with respect to overall price changes and the interest rate, capital or investment satiation, secular factors of a technological and political nature of what have you. But it is vital for business-cycle analysis that we do assume definite amounts of investment which are highly variable over time in response to a myriad of exogenous and endogenous factors, and which are not automatically equilibrated to full. Discussion employment saving levels by any internal efficacious economic process.

With respect to the level of total purchasing power and employment, Keynes denies that there is an invisible hand channeling the self-centered action of each individual to the social optimum. This is the sum and substance of his heresy. Again and again through his writings there is to be found the figure of speech that what is needed are certain "rules of the road" and governmental actions, which will benefit everybody, but which nobody by himself is motivated to establish or follow. Left to themselves during depression, people will try to save and only end up lowering society's level of capital formation and saving; during an inflation, apparent self-interest leads everyone to action which only aggravates the malignant upward spiral

Ben Graham: Relative Utility Investor

One of my themes in The Missing Risk Premium is that people i people are benchmarking--aka relative utility investors--then they only deviate from the benchmark of what everyone else is doing  when they feel they have an edge. There's no other reason to do so. As many people falsely believe they have an edge in highly risky (antifragile?) stocks, this causes these securities to have lower-than-average returns within bonds, stocks, options, horses, and lotteries.

It's important to recognize this is the reason people take concentrated bets. The Wall Street Journal has an article on an old colleague of classic value investor Benjamin Graham, and notes the 107 year old's guiding principle:

His abiding goal, he told me, is "to know much more about the stock I'm buying than the man who's selling does."

That's a good rule, often noted by Graham. It's obviously impossible, in aggregate, but I think it's not only descriptive, but good normative advice. If you know that's the game you are playing, it should create greater caution, more sober risk-taking. The alternative is that you can take big risks and these generate return premiums via their risk premium, but alas the risk premium is usually negative, so that theory seems falsified via conventional empiricism.

The High Price of Low Delta Options

Antti Ilmanen and Frazzini and Pedersen have papers highlighting the poor returns to low delta options. This highlights the power of prediction markets, in that since Alpert and Raiffa (the working paper is dated 1969) we have know that people over estimate their confidence for 1 and 99% probabilities:  these are more like 10 and 90%, respectively. Yet, these are surveys. When people put money down on these improbably (or highly probable) events, the estimates are actually too timid.

Consider the imminent apocalypse.  The End of the World is given a meager 1000:1 odds:

Paddy Power is also offering a fairly skimpy 1/1000 that the sun will rise on the 22nd.

Other betting sites offer only 500:1 odds. So, when someone says 'everyone thought' or 'no one thought', don't think this implies there was easy money. Even if the odds are as great as the absence of an apocalypse, you'll get something more like 500:1 with real money. Needless to say, this materially affects the expected value.

Another Crank

As critic of modern economics, I am often contacted by other critics, or fans of other critics. Alas, I often find them not even wrong, as in

2 + zebra ÷ glockenspiel = homeopathy works!

 Steve Keen was recommended, and I looked him up. Interestingly he's a huge Minsky fan. I admire Minsky, because he was intellectually honest and curious, and had some really good insights. If you read his books you'll learn a lot about US macro history from a financial perspective. However, he wasn't perfect. He dismissed microeconomics as apologetics, and so basically ceded that whole field as irrelevant. He didn't try to convince his colleagues, rather, he would dismiss them as fools, and so they would dismiss him. He was forever anticipating another 1929 crash, and would get very excited if the Dow was down a lot intraday (alas, back in the 1980's it would always bounce back). His macro model he failed to concisely formulate, not just in a model, but even in words.

 Minsky should have said his theory was based on endogenous instability from excessive leverage, and then one could have tested it, and found it doesn't work: aggregate leverage is not a great leading economic indicator. I too believe the economy is endogenously unstable. That is, unlike Friedman and other free-marketers who believe recessions are caused by government, I think it usually happens simply via systematic errors among private investors. But unlike Minsky, I think it's more micro-based, happening idiosyncratically in a different subsector of the economy. It's more like an eco-system of Batesian mimicry, where over time mimics fester and create a phase shift in the system as predators learn that, eg, all those poisonous snakes are actually non-poisonous, and a havoc occurs until equilibrium is restored.

The key is that the excesses occur in different industries, using different metrics, every cycle. Off the top of my head, here are the focal points for some big recessions; railroads (1893), conglomerates (1969), oil and real estate (1990), internet (2002), residential real estate (2008). What's consistent is that they are all different. Every cycle is predicated on some new 'new thing' that survived the prior two or more recessions, and thus to most participants is their entire working life.

 Like Minsky, Keen was predicting a crash, and so when one happened, he took credit, just like others (Roubini) with a vague, persistent prediction of a crash whose reputations were burnished by the 2008 crisis.  It makes me think that if something unpredictable happens, like the Mayans really do come back this Friday, those who predicted it won't be prescient, but rather, cranks.  In an case, reading Keen I see he picks up Minsky's dismissal of modern economics. However, Keen takes this to the next level by saying that economics is based on a math error. Now, economists I think have made a mistake, but they are pretty good at working from assumptions to conclusions, that's brute force logic, and there are lots of really smart economists who can solve logic puzzles.

He seems fixated on the market power of firms that are small, not infinitesimal  He thinks they act like monopolists, showing a math error at the root of Samuelsonian neo-classical economics. It reminds me of that guy who thinks fat tails or stochastic parameters invalidates financial theory.  This is simply wrong, but as a rhetorical device I think it convinces a lot of people that he's proved the existing theory is wrong, thus in some way proved his alternative is correct (not that this is logical, just it seems to work on many readers).  He then builds up a pretty standard 1970's macro model to show how money is endogenous and whips us through cycles, as if this wasn't tried for a generation and failed. These models have so many equations and parameters one can't prove them wrong, but then, they don't have unambiguous predictions, just fit the past really well. Thousands have wasted their lives on these approaches. A good way to judge a jumble is to look at the results: what to do? His solution to current problems is to simply print money and pay off everyone's debt. Such a solution doesn't deserve much consideration, because when I have time to think of wacky theories, I prefer Ancient Alien Astronauts or stories of the Mayan Apocalypse.

Like other successful cranks, Keen does seem intelligent, and makes some very good points. But net net, his Weltanschauung has more flaws than what he's criticizing. It's easy to note that existing theory is deficient, much harder to present a coherent, more attractive alternative.  It reminds me of a high school class I took where we all got to give a speech criticizing some great thinker of the past, like Socrates, Nietzsche, or Kant. We all did great. Then, we had to present our own new theory on something important, and it was pretty humiliating. Lesson learned.

I hasten to add I  don't hate all macro critics. For example, I really enjoyed Peter Schiff's The Real Crash. And of course, I think I have a rather pointed criticism of finance that doesn't throw the baby out with the bathwater, and has clear empirical implications. But, I realize I am lumped in with the numerous other critics, and that's kind of depressing.

Cult of the Presidency

Watching the media's anticipation of Obama's press conference after the tragic school shooting in Connecticut, I was reminded of the great book The Cult of the Presidency by Gene Healy, where he notes the president is now expected to be, among many other things, the Consoler in Chief, our national chaplain in times of great tragedies. The President originally was someone who would simply officiate the congress, which was the main body for enacting legislation. Just as the senate in the Roman Republic ruled, so the founders wanted the congress to rule the country.  Early Presidents didn't propose bold legislation or even really campaign.

It is now the President’s job to grow the economy, teach our children, provide protection from terrorist threats, and rescue Americans from spiritual malaise. It's an impossible job, yet as our dissatisfaction with the President increases, the amount of power he wields grows. We are morphing towards an emperor, a Putin.

William Hazlit wrote in 1819 that "Man is a toad-eating animal [ie, a toady], naturally a worshipper of idols and a lover of kings." He saw behind this impulse a crave desire to dominate others, even if only vicariously. "Each individual would (were it in his power) be a a king, a God; but as he cannot, the next best thing is to see this reflex image of his self-love, the darling passion of his breast, realized, embodied out of himself in the first object he can lay his hands on for the purpose."

It's not a left-right thing, too many venerate the Elmer Gantrys who become President. Yet a funny anecdote was provided by liberal Nina Burleigh, former White House correspondent for Time magazine, who noted during the Lewinsky scandal that she'd "be happy to give [Clinton oral sex] just to thank him for keeping abortion legal. I think American women should be lining up with their presidential knee pads on to show their gratitude for keeping theocracy off our backs." It's nice to see her thinking she's above those who venerate religion, but instead of championing skepticism and rationality, worships the simple hucksters who make all those trite speeches

The Trolley Problem

Over on Bloggingheads, some psychologists were discussing the neurology of moral judgments. They discussed the trolley problem, which is pretty famous among moral philosophers.  The basic conundrum is this:

A trolley has lost its brakes, and is about to crash into 5 workers at the end of the track. You find that you just happen to be standing next to a side track that veers into a sand pit, potentially providing safety for the trolley's five passengers. However, along this offshoot of track leading to the sandpit stands a man who is totally unaware of the trolley's problem and the action you're considering. There's no time to warn him. So by pulling the lever and guiding the trolley to safety, you'll save the five passengers but you'll kill the man.

Most people pull the switch, killing the one man to save five. That wouldn't be so interesting by itself, but then the problem is extended to a seemingly similar problem:

As before, a trolley is hurtling down a track towards five people. You are on a bridge under which it will pass, and you can stop it by dropping a heavy weight in front of it. As it happens, there is a very fat man next to you – your only way to stop the trolley is to push him over the bridge and onto the track, killing him to save five. Should you proceed?

Most people would not push the fat man. These grave dilemmas constitute the trolley problem, a moral paradox first posed by Phillipa Foot in her 1967 paper, "Abortion and the Doctrine of Double Effect." I don't really like any of the popular resolutions as to why people think it's OK to kill the first guy but not the second.

I think a good resolution is that in the second case there is a significant probability that one does not save the 5 men, and instead merely kills the fat man. I've never pushed a fat man in front of a trolley, but I suspect most would simply run right over him and keep going. In the first case, if you  killed the one man you definitely save the five men, it's not possible to kill both the one man and the five men by switching tracks. In the other case the probability is clearly less than 1, perhaps only 0.1. That's the difference. As a rule, acting on a theory and killing x people with certainty to perhaps save 5x people is morally wrong, mainly because these theories are often wrong, so all you do is kill x people (eg, a lot of evil is legitimized as breaking eggs to make an omelette, but then there's no omelette). The move from certainty to mere 'highly likely in my judgment' is huge.

Great Minds Confabulate Like Small Minds

James Heckman won a Nobel Prize for his work on econometrics, statistics applied to economics. His latest work on education looks at the effects of programs on human capital.

In a recent Boston Review article on social mobility he highlights the results from two experiments in early childhood intervention that demonstrated significant benefits. Charles Murray was one of several comentors  Murray noted these programs were small, having about 60 kids in each, and so are probably random outliers among the many different programs being conducted. After all, one really great teacher undoubtedly can make a difference in such a small sample, but really great teachers, by definition, aren't easy to replicate. Heckman, as is his wont, responded rather angrily that

Charles Murray mischaracterizes the quality of the evidence on the effectiveness of early childhood programs. In doing so he suggests that my evidence is highly selective. The effects reported for the programs I discuss survive batteries of rigorous testing procedures. They are conducted by independent analysts who did not perform or design the original experiments. The fact that samples are small works against finding any effects for the programs, much less the statistically significant and substantial effects that have been found.

A small sample will have more trouble demonstrating statistically significant results--it has low 'power'--so Heckman is technically correct. But it's not as if these two programs were the only ones generated since 1962; these are really order statistics, not simple statistics. I see job seekers with fabulous backtests all the time, and cherry picking winning algorithms applied to a large class of rules is the most common problem.

As Einstein noted, "common sense is nothing more than a deposit of prejudices laid down in the mind before you reach eighteen." That a great econometrician could dismiss the clear selection bias in a couple of 60-kid studies selected out of hundreds (thousands?) highlights that no amount of education or intelligence can overcome one's prejudices, or overcome one's common sense.

Shorting Green Energy

A Business Insider post showed the remarkable 98% decline in the RENIXX since 2008, and index that tracks the world´s 30 largest companies in the renewable energy industry.

I found a green ETF, GEX,which is Market Vectors Global Alternative Energy fund. It's down about 85% since 2008.

Perhaps there's a very simple strategy here.

Marxism Lives

Paul Krugman vaguely implies that productivity is the cause of stagnant wage growth, in that robots are taking over former 'good' jobs. 20 years ago he railed against those kind of theories, but now he notes that for this theory:

It has echoes of old-fashioned Marxism — which shouldn’t be a reason to ignore facts, but too often is.

His insinuation is we are ignoring the rise of the robot elite because of anti-Marxist ideology. I'm an anti-Marxist ideologue because I think Marxism is wrong: it's based on false assumption about value (ignores the marginal revolution) and the omnipresence and importance of class war, and doesn't work empirically (socialism starting in the most productive states, the falling rate of profit, lower wages over time, an increase in the breadth of recessions).

Big bad ideas like socialism never die. The desire to expropriate the rich and make all businessmen kowtow to government really drives people like Krugman, and the class struggle paradigm, where the captains of industry are parasites and the proles are Job-like in their devotion and suffering, is very attractive to these people.  A recent Gallup poll found 53% of Democrats had 'favorable' views on socialism, and Peter Schiff found many Democrats who favored a ban on corporate profits.

Hong and Sraer's Explanation of the Low Vol Anomaly

In 1977 Ed Miller proposed a simple model where greater dispersion in in beliefs generated a greater price for stocks because those holders of a stock are in the 95th percentile of valuation, and given a constant mean, a higher variance implies a higher 95th percentile. Key to this model is the short sales constraint, because otherwise sellers would see these assets as overpriced and short them. Another key is limited rationality, because people should simply not include high beta assets in their portfolio; the market portfolio is dominated by one that excludes high volatility assets.

Harrison Hong and David Sraer have a new version of their Speculative Betas paper (see here).   It is basically the Miller model though it's more dynamic, and they emphasize the 'new' finding that their model shows that when there is greater disagreement, there will be a greater low volatility premium.  I don't think that's really new, in that it follows pretty straightforwardly from the Milller model.

It's an alternative to the 'constrained leverage' model of Frazzini and Pederson. However, like Frazzini and Pederson I don't see how it's consistent with the below average returns. Lower than CAPM is different than lower than average. Further, it requires irrationality by those who don't have opinions on stocks, because it seems obvious that investors without a view should simply avoid high volatility stocks in their index funds. Thus, in both these models, low volatility investing should be much more popular than it is.

I think low volatility investing is a fringe strategy still because of tracking error, the fact that one underperforms 'the market' too much too often. Sure, over time it's a higher Sharpe ratio, but the real objective is a relative return, or an Information Ratio. This is an equilibrium, requiring no ad hoc constraints or massive irrationality if one presumes a relative status utility function, as I propose in my book The Missing Risk Premium.

When I documented the low return to highly volatile stocks, the main reason professors found it unconvincing was because it implied irrationality. I didn't think of the relative utility solution, and that basically only leaves theories with ad hoc constraints and massive irrationality. That was certain irrelevance circa 1993, but after 20 years several trends in the zeitgeist have changed a lot, in large part due to the increase in behavioral finance, Freakonomics, and the simple persistence of the low volatility cross-sectional fact.  But I guess I have the intellectual equivalent of Stockholm syndrome, as the irrationality obstacle was simply burned into my brain. I don't like results that imply massive arbitrage to this day.

Taleb's Sokal Hoax

Taleb's latest book he mentions a little trick he played on academics, basically, he created a bunch of nonsense in abstruse mathematics just to highlight what fools they are. Here's his description of this work in Antifragile:

According to the wonderful principle that one should use people’s stupidity to have fun, I invited my friend Raphael Douady to collaborate in expressing this simple idea using the most opaque mathematical derivations, with incomprehensible theorems that would take half a day (for a professional) to understand ... Remarkably—as has been shown—if you can say something straightforward in a complicated manner with complex theorems, even if there is no large gain in rigor from these complicated equations, people take the idea very seriously. We got nothing but positive reactions, and we were now told that this simple detection heuristic was “intelligent” (by the same people who had found it trivial).

I presume this refers to his SSRN paper, Mathematical Definition, Mapping, and Detection of (Anti)Fragility. It contains a lot of unnecessarily complex notation, technically correct and totally meaningless. He basically defines anti-fragility as the difference between the expected value of a function and a function of an expected value over some arbitrary range of that function, and notes that nonlinear functions are more volatile than linear functions, and you want to be long convex payouts.

Taleb doesn't present any data suggesting it is useful for pricing or managing risk, just mentions some really simple examples (stress tests for where unemployment is 8% and 9% that are typical guesses of macro) that highlight how losses can increase exponentially for different assumptions. For complex systems like large corporations, assessing the effect of macro inputs is a similarly vague exercise if you've ever been witness to them (to get a sense, ask yourself what your net worth would be if GDP fell by 5% or 10%).

He then asserts:

It outperforms all other commonly used measures of risk, such as CVaR, “expected shortfall”, stress-testing, and similar methods have been proven to be completely ineffective... It does not require parameterization beyond varying Δp

So, the 'data' showing his equations are helpful are stress-test thought experiments, but this supposedly dominates this same test as well as everything else. Further, it does require density functions for the inputs, and functional forms, subjective thresholds, which for anything like a corporation is simply not amenable to such precision; for specific assets or portfolios there are more direct tools (eg, in options, kurtosis, twist, rho). Like so many things he says, this is not even wrong.

He tried to intimidate a journalist at FTAlphaville with this, and the journalist basically said 'whatever.' The paper was presumably accepted by Quantitative Finance, a journal where Taleb often publishes and seems highly favorable towards his work. This seems identical to the infamous hoax by Alan Sokal, a physics professor who submitted an intentionally meaningless article  to Social Text, an academic journal of postmodern cultural studies. However, Sokal was mocking the journal and its readers by publishing self-acknowledged gibberish. Taleb's mocking his biggest fans ('stupid', he calls them). I bet the journal editor won't find this very amusing.

By admitting that his models are merely "expressing [a] simple idea using the most opaque mathematical derivations, with incomprehensible theorems that would take half a day (for a professional) to understand", he's admitting his math does not add, it's merely to impress via excessive abstruseness. Surely many academics have created excessively technical articles reluctantly, but this shows real bad faith on his part, because presumably this journal aspires to apply rigor in pursuit of making ideas as clear as possible, not the opposite. I must admit it's kind of funny, but perhaps too mean.

New Low Vol Index

This one is a bit too cute for me. The CBOE LOVOL Index combines a portfolio of SP 500 stocks and simultaneously selling SPX calls and buying one-month VIX 30-delta calls on a monthly basis. The LOVOL mix of VIX and SPX options reduces the chance of shortfalls below -10% but still preserves the bulk of market gains. By construction, the LOVOL delivers returns between the BXM and VXTH, or a risk profile between a cushion and a tail hedge.

The key seems to be reflected in the following total return chart above, where you have the new index in orange, the SPY in white. The low vol index generated a lower downturn in the 2008 recession. Alas, these are indices created post-2008, so they overstate the benefits (backtest always look better than real-time). Further, the benefits are pretty small, just in really big downturns...perhaps.

Embedded Leverage and Returns

Frazzini and Pedersen, the duo behind AQR's Betting Against Beta theory behind the low vol anomaly, have a new paper out on embedded leverage. Their theory is basically that investors are constrained in their allocation to equities, so overload on those equities with the highest betas in order to get more equity exposure. The paper looks at both levered ETFs, and options (from 1996-2010).  Here's a graph showing the embedded leveage (aka omega) in options, and monthly returns.

Monthly Returns (y-axis) and Option Omega (x-axis)

This adds more data to the fact that options are not just bad investments, but worse the more out-of-the-money they go. These are horrible long investments (large negative returns to out-of-the-money aka AntiFragile options)

I don't really see how this comports with their theory, however, because if investors want more access to the equity factor, they are getting extremely negative returns. Thus, it really isn't a rational theory of constrained optimization, but delusional speculation.  Further, investors are acting the same to puts and calls, and constraints on access to short positions doesn't seem to make sense in their model unless they have heterogeneous (and persistently wrong) beliefs.  So, the idea that rational, constrained, investors explains this effect doesn't make any sense.  Perhaps they can explain.

The Perils of Winding Down

I drove home listening to a left-wing talk radio show that focused on the $1.8MM in bonuses that Hostess Brands is using to retain 19 executives during its wind down. They thought this was pure evil and unfair.  Hostess has hundreds of millions of dollars in assets, so this is at most 0.5% of the value of the firm. For a top guy to get an extra $100k to do this correctly seems cheap.

It reminds me of a case where after a blow up in the convertible bonds space around 2006, the firm decided to wind the fund down. They told employees there would be no bonuses, just wind down, and leave. So one guy sold his portfolio at bargain basement prices to his favorite brokers. He then had lots of credit in the favor bank, and was able to land a great job at a new firm, which since then has done very well. 

Another fun story is when Niederhoffer blew up in 1997. As the fund was being liquidated, the agent for the liquidation with no skin in the game went to the pit to close out a large amount of eurodollar positions. Everyone knew he was going one way, and when he asked a price, they all stopped and looked at each other, silent. Eventually he sold his positions at such a low price, it was the best day ever for at least one firm there. The liquidator did not act in the investor's best interest, but he was not incented to.

 When someone is in charge of a lot money, if you take away direct incentives, they will game the system indirectly. It's foolish to think people in charge liquidating hundreds of millions of dollars will do this without simply giving away stuff to people that can (and will!) be helpful to them later. Navigating the favor bank is part of life, and people act in the self interest.