The curent US debt of $9.5 Trillion to GDP of $14.2 trillion equates to a ratio of 66%, that means we are not eligible to meet the Euro entry criteria of 60%. Geez even Italy squeezed by albeit with a total fudge. I still recommend Norwegian Krone. Those American Peso's just won't get a fella very far in the world these days.
Oh and that S&P 500 is still effectively flat after 10 years. If one factors in inflation the average consumer has lost 26% since 1998 in purchasing power terms, and most investors don't beat the index. I know many are pointing to the S&P 600 and S&P 1500 as being better performers over the period, but that just sounds like arm chair quarterbacking to me.
The sad story is Joe and Jane Six pack probably have a pension fund that underperformed the S&P 500 by at least 1.2% year for a decade if they were lucky. That works out to a 37% decline in purchasing power. Are we winning yet? And hey what is it with those Europeans working less than we do and taking a month vacation each year plus time off for child care. We have to get smarter about this stuff as a culture.
20% bear market declarations are pretty much useless, but they give journo's and TV types something to sell ads with. Mathematically speaking, the hurt starts at 13% losses.
Losses over 13% require gains of greater than 13% for recovery. The graph below highlights how this works. The blue line approximates the intuitive relationship of losses equaling gains. The red curve is the reality.
Rule #1 in all investment allocation decisions is don't lose money.
Risk management is the name of the game at the asset and portfolio
level. If you are a European and invested in US shares you have lost
50% of your money after the currency conversion. You would need a 100%
return to break even.
The acceleration point for losses requiring greater gains is around a 13% loss. Think of it as inverting the power of compounding returns. Currently the S&P is 26% below it highs. To get back to the previous high point for domestic investors, the S&P 500 needs to gain a little over 35%. The long term +80 year historical average return for equities is around 7-8%, so back break even is in around 4 years based on historical average returns would be 2012-2013.
The ex dividend annual return for the S&P for a dollar based investor since 1998 has been roughly .3%. When one factors in an inflation estimate of 2.5% per year, one ends up with an effective loss of purchasing power of 25% over the last decade. Welcome to the lost decade.Download returncurve.xls
P.S. I am not such a buzzkill in real life, I am just pointing out some facts.
In epidemiology, risk of contagion spread is sometimes modeled using a chain model approach. The chain approach involves a continuous chain of risk from a single entity spreading through a network of contacts with various rates of success. Break the chain, break the spread. CDS exposure to netting failures can break the chain of cascading liquidity crisis with a buffer of excess capital.
CDS Notional amounts get a lot of headlines, but few really understand the nature of the risk and why it so large. Netting risk is rare and unusual. Bankhaus herstatt is the only institution I know of to have failed due to a failed netting where the other side was actually good for the deal.
Settlement is boring in terms of risk, most people like to talk about models, VaR, Swans etc. But netting is the plumbing that keeps it all going, failed CDS netting could lead to systemic risk on a significant scale. This risk is heightened due to the following factors:
Large Notional amounts outstanding
Low Tier 1 capital in place
Liquidity challenged environment
Crude netting, reporting and tracking in some institutions
Sometimes subjective EOD or delayed agreements of an EOD
An environment where EOD's are becoming more likely or concentrated
An environment where a netting counterparty failure may become more likely
Counterparties offsetting risk elongate settlement chains and therefore could amplify netting risk
Here is a simple graphic model that shows nettting exposure growing as OTC (non exchange traded participants each try to minimize risk by offsetting position with other counterparties. the transactions are identical in terms of reference credit and notional amount. We can consider this a Chain of settlements that all have to fall in sync assuming "no excess cash buffer". The Chain runs from A to D
Here is an example of exchange traded settlement as a centralized netting agent with the same behaviours of the institutional participants.
As we can see these two settlement systems have very different netting risk exposures in the event of default events. The nature of CDS's which act a bit like extreme barrier options is that these settlement chains rarely get tested or stressed. They haven't evolved robustness from a network perspective. Most organically evolved networks are formed and behave structurally in something called a scale free network topology. Basically this means the number of connections or relationships is logarithmically scaled. Imagine the 80-20% rule in action. Here are some crude assumptions with absolutely no empirical data behind them.
My general hope is that the efforts of ISDA to accelerate standardized terms for netting and the efforts of the major banks to establish an automated netting facility happen soon. I don't know what the capacity of the financial system is for a failed chain event, but it is certainly cause for concern. We certainly don't want any grad students writing theses with titles such as "CDS netting failure, the day money disappeared."
If anyone has data or a model on the "capacity" for a network to handle these failure it would be interesting to see. Assuming a 0.05% annual failure and clearing rate of 3 business days. with an 80-20% concentration of failure could lead to the system needing to clear $420billlion in a cycle. Assuming the same 80-20 rule for institutional concentration means the top 50 institutions would need a liquidity buffer of $336b.
Again these are made up numbers using the crudest of assumptions, but highlight the risk of failed netting even if the counterparty is good, that or a lot of bank holidays to stretch they cycle thereby increasing the netting capacity of the system.
I won't even touch on the component of an institutional failure being used as the reference credit. I call that recursive failure in the system and it is nasty indeed.
David Einhorn's book is an interesting introduction into the birth and life of a successful fund. Greenlight Capital doesn't trade so much as it invests in a thesis and is willing to take a longer term approach, a refreshing approach similar to my day job.
Einhorn's book is really a tale about managers, money and how things are wrong in so many parts of the industry. His book is most interesting for providing looks at the symptoms of a diseased system.
Einhorn tells the tale of someone trying to do the right thing and making a buck at the same time. His agenda and motives are clear.
Einhorn digs deeps like an investigative reporter cross bred with a forensic accountant. He discovers fraud and acts on it. The response to his actions from many institutions designed to engender faith in the American financial system are deeply disconcerting.
Caveat, I have only read Einhorn's book and so make these statements with limited knowledge.
The failing institutions include:
SEC
Wall Street Journal and many business journalists
SBA (small business administration which throws your tax money away)
NYSE (New York Stock Exchange, which is appears to be mostly a pimp for paper profits)
Mr. Spitzer's term as NY attorney general (which did some good, but was also a dangerous one man ego trip)
These failures appear to be symptoms of a disease of apathy and the lowering of ethical standards at the institutions that are designed to protect the integrity and thus the growth of financial markets and our economy. The sheriffs are asleep and corruption is seeping in, even worse people don't care or believe anymore.
WIIFM rules.
WIIFM (pronounced wifm) is a powerful acronym taught to me by a friend named Gina Budde. WIIFM stands for What is in it for me. This is psychology 101. No news, self interest dominates behavior of individuals and groups, it always has and always will. Rarely does someone steps outside of a WIIFM mentality to "do the right thing". As I tell friends, ethics don't count until they cost. Talk is cheap.
Unfortunately Einhorn's motivation of making money and uncovering the truth is seen to be mistrusted by the very operators who are supposed to uphold the integrity of the markets. Journalists, regulators and government officials decide it is easier to go with the flow than to do the right thing. Accuse the accuser becomes an all too frequent episode in these pages.
:WIIFM over Ethics
Independent actors behaving fraudulently to increase their own WIIFM's is nothing new. What is highlighted clearly in this book is that many institutions by failing to uphold their intended charters fail to make ethics easy. In successful economies and cultures doing the right thing and WIIFM align by design. This is the basis for a stable growing economic and cultural system, think whistle blower laws.
When institutions fail ethically and rot from inside, markets eventually become less efficient and we all lose. Einhorn's book is less interesting for the story itself. The roles of rogue, thief and sad bureaucrat have been around since Sumerian's started recording grain shipments on clay tablets. The roles are the same only the names change. I am an anthropologist first and foremost.
What is most interesting in the book is the picture of the sorry state of our "soft" cultural institutions. It is my belief that "soft" cultural assets such as trust, integrity and belief in cultural institutions and pursuit of truth are what drive long term economic stability and growth. They are leading indicators. Ethics only count when they cost, and the prevailing attitude among some of America's most important cultural, government and financial institutions appears to be WIIFM.
This scatterplot below sums up why Americans should be concerned about the symptoms highlighted in Einhorns book. Slipping institutional integrity could be a negative leading economic indicator. Click on the image to see the raw data from nationmaster.com
Occasionally one comes across a book that is educational,
historical, about economics and that could be made into a movie.Fortune’s Formula by
William Poundstone is just such a book.
What a lot of investors and fund managers don’t realize is
that they are gambling blindly.I won’t go into my issues with mean-variance asset
allocation, but suffice it to say, I consider mean variance approaches and VaR as belief systems that are far too popular
for our own systemic good.
Fortune's Formula includes great bios of Claude
Shannon and Ed Thorpe and an introduction to something known as the Kelly
Formula.Ed Thorpe is a mathematician,
hedge fund practitioner and in the eyes of some, including Nasim Taleb the
rightful co-creater of what is now known as the Black Scholes formula or the
(Thorpe-Bachelier) theorem.See Wilmott
Those of you familiar with LTCM are now thinking, “…an
academic mathematician hedge fund manager, this is going to have a nasty punch
line at the end of it.”The punch line
in this case is thankfully flat and deeply impressive, Billions of dollars
managed in one of the lowest variance profiles for decades.Thorpe has delivered the best financials met
by a very small handful of managers.
Kelly’s Formula
Kelly is described as:
“…working at the esteemed Bell
Labs, a chain smoker, liberal drinker, a lot of fun, the life of the party. He
was gregarious loud, and funny, quick to loosen his tie and kick off his
shoes.”
He was also brilliant.He came up with the optimal “bet” asset allocation strategy assuming one
knows the odds of playing the game and the payoff.His approach to asset allocation provides the
maximum return over a given set of time.
Please re-read the last sentence if it didn’t impact you
enough.
The basic formula is:Edge/odds=portfolio allocation (bet size) …what the heck does that mean
and how does one use it?If you are a
gambler it clicks immediately, if you are trader or mathematician, have
patience.For those familiar with
Markowitz asset allocation there is a nice section on Kelly vs. Markowitz.I personally consider Markowitz a version of
trend following and dangerously suspect in regards to the instability of
correlation drift.
The basic premise of Kelly allocation is that in order to
maximize the geometric return of a series of bets over time, one should go
about allocating capital based on the average edge one has in “winning” versus
the odds of winning that are paid out.
The
greater your perceived information edge, the more you should concentrate your
bet.There are many Kelly sites and
tools, some of dubious merit and intent.For those of you in the money management business, you may
want to “tone down” the geometric return and perform a variance analysis
relative to the risk profile of investors you have holding your fund.
Simple rules of thumb may be good sanity
checks.Having grown up in Iowa and
“played” futures as a teen,I can say
don’t ever bet the farm on a sure thing, don't worry we still have the farm back there. As a young runner, I used to watch smart traders managing there bets like this in the 10 year bond options pit at the Chicago Board of Trade.
Investing is a marathon event.Long tortoise, short hare. Investment clients may say they want the
highest return possible, most wouldn’t stick around after the drawdown
associated with a higher volatility approach even if they wanted to be “part of
the plan” in the early days.The pros,
Fund of Funds etc. usually say they are comfortable with a certain volatility
profile, but will bolt at certain drawdown levels.
True fact: most investors under perform their investment
vehicles.I have studied this using both
hedge and mutual fund flow data. Investors, invest high and exit low.In gamblers parlance, they make horrible
jockeys and can be their own worst enemies.
A simple tool is provided for playing with
the concept at the bottom of the post, I just lifted it off the web so make no endorsements for it or anything related to it.This approach might make sense for a portfolio of investment, drug
candidates, product launches etc., just beware of your own biases inherent in
the estimates.Like all models it
recycles all too efficiently: put garbage in and you will get garbage out.
The nice thing about investing buy and hold in equities, is
that unlike a casino, the odds are actually in your favor over time, assuming
your horizon is great enough to overcome transaction costs.
As a money manager I find this ties in nicely with Buffet’s
approach of a few eggs in a basket watched closely.The greater your information edge (remember
to be humble) the greater your holding concentration should be.
To learn more I would highly recommend buying the book, the story is a heck of a read.If there is a movie it will probably be horrible.
Even Warren Buffet makes an entrance into the book with his
passing interest in nontransitive dice.Warren is all Midwestern style, he speaks plainly, seems to listen a lot and gets
results without a lot of fuss, still waters running deeply.
Government reports of inflation are derision magnets.The freshly released inflation figure is
easily the least popular kid in the economic class of statistics and can
usually be found seeking solace next to his old punching bag buddy the
quarterly GDP estimate.
Why are inflation numbers so unpopular?My own opinion is that the anger and debate
this statistic engenders is due to the fact that it can’t possibly handle the
work load assigned to it.Everyone wants
inflation to tell a story about their current view on the economy and the
future, yet it can’t do that.
The whole problem with inflation is that it is a point
metric describing a complex system. What?Yes you heard me, it is a point metric, a single point trying to
describe the state of a complex system.
One Average I feel fine.
Inflation is limited as an economic barometer in that it is
an average.There is old introduction to
statistics about a man with his feet in a block of ice and his head an
oven, the old fellow replies that, “Oh, on average I feel fine.”Inflation currently reports the US is feeling relatively fine.Inflation is
a point metric describing a complex system.
How it really works
and why we should be nervous.
The system illustrated isn’t fine, eventually the output is
going to be in for a wild ride. One
could suggest that variance in the system components may say more about future
GDP change than inflation alone.
Tools & entrails
Most people assume the inflation number represents a flow
metric driving another flow metric, namely future GDP growth (economic output).One could argue that inflation metrics are
better used when combined with component variance as an indicator of future
likely GDP variance.Most likely
variance is tied to inefficiency and thus temporary GDP contraction.
Central bankers, economists and other dangerous folk try
stabilizing inflation using basic monetary tools.The assumption being that stable inflation is
correlated with higher stable GDP growth.The reason I call these people dangerous is that they are attempting to
control something mostly outside of their control with blunt tools.Most central bankers are oracles with only
half the required amounts of entrails required for predicting the future ;).What should one advocate as proper policy for
the system illustrated above?
I believe
central bankers to be well meaning people, but my hunch is that outside of
regulatory oversight roles, the least active central bankers are probably the
most effective ones.Many interventions
meant to stabilize the system may actually increase uncertainty and variance in
the system, thus lowering long term GDP growth.
The safest thing a central banker can say is, “I don’t know what is really going on right
now, but I am going on holiday until it sorts itself out.”The economic system eventually stabilizes
itself.This is the laissez faire
economics schtick after all.Unfortunately oracles who claim not to possess the gift of fortune
telling typically get replaced, so we are all a bit to blame as well. Please put down those monetary control tools, you may hurt someone.
The working thesis is that low 1-2% stable inflation is
correlated with growing GDP.The things
that create stable GDP and stable inflation are probably regulatory certainty
and monetary stability.Perhaps the
politicians should go on holiday with the central bankers and let the rest of
us get on with it.
No more stimulus checks please, its beginning to economically
look like Zimbabwe around here.What next will they get up
to next, perhaps adding a zero or two the currency to create a perceived
“wealth effect”.Bread and circuses
folks, that’s what we are asking for, and what we are getting delivered.
The typical assumptions of dampening the economic cycle via
active monetary policy is nice, but may be flawed due to the multiple feedback
loops in the economy.See or better yet play the beer game
to understand how this works.
So the next time you see a central banker or politician,
encourage them to take it easy and perhaps find a bit of sun somewhere far
away.
If anyone has some pointers or research on economic
component variance as a future GDP indicator or monetary policy inactivity as
it relates to GDP growth please post a link in the comments.I enjoy listening and learning.
Ok, just winding you up with the title there. Derivatives aren't good or evil, they are powerful. I just completed 2 books that touched on derivatives this weekend.
is a very interesting read. His thesis on reflexivity is always fun. I will comment on two core components of his thesis, but am not sure I appreciate them fully, so feel free to chime in with comments.
Falsifiability, in the Popperrian sense means by definition that economics is not a science, merely a pretender. I would agree with this, due to the fact human actors are participating, the rules are dynamic and reflexive. Any system that responds not only to outward stimulus, but to its own perception of that stimulus and guesses in the future is inherently non-falsifiable as the presumption of "knowledge" precludes hypothesis. It reminds me of my social anthropology training.
Derivatives are WMD (weapons of mass destruction). I tend to agree with this quite a bit. Derivatives themselves have long left the "hedging" risk transfer function and have evolved into gambling instruments. As zero-sum instruments they aren't in themselves dangerous from a purely economic perspective. I do believe however that from a risk concentration perspective failed netting in CDS could lead to a massive multi-bank failure. The recursive nature of settlement failure in financial networks combined with CDS's sometimes fuzzy notion of EOD and settlements is a cause for concern. Centralized effective netting is a start to resolution, but needs to be put in place faster than is currently happening. These conditions when combined with the fact that many reference credits are over-written relative their value and may in fact be netting participants themselves is great cause for concern. The financial system is a belief system and will face challenges in the light of a major netting counter-party failure. Let's hope the appropriate central bank steps in as a back stop at the right time. It worked for Bear Stearns (a non-CDS) related issue, but that was a relatively minor problem. The CDS concentrations of settlement risk is becoming less of a vague risk and more a statistical inevitability.
Mr. Das, funny and thank fully un-politically correct look at the world of bankers and derivatives is an excellent view of the world through the eyes of someone with 25 years of experience a keen wit and a sharp pen. The veneer that is put on the overly compensated, overly dressed and dangerously unaware participants in the OTC derivatives market is very refreshing. It is nice to have the pretensions dropped by an insider. Everyone is in it for the money and those with the most information win. Customers are sheep for slaughter and traders use banks as either a veneer of legitimacy or the patina of patriarchal legitimacy. At the end Mr. Das calls BS when he sees it, which is pretty nice and makes for an informative read.
My only critique of the book is its audience level stretches too broadly. At one point Variable Basis Points are discussed and in the next instance basic bond calculations are mentioned. I think a good editor might have separated the specialist and the non-specialist bits. The humour and trader anecdotes are very true to form and dealbreaker worthy.
Traditional finance (CAPM) says risk and reward have a give and take relationship that is stable. regardless of your opinion on that, I am offering a free tool to reach your own conclusions.
The reported PE ratio of the S&P 500 is the reciprocal of the earnings yield of the firm, there are many flaws with this, but it is a good starting point. Historical the S&P 500 has yielded 3.3% more than T-bills. Using that historical information lets see what "fair" value for the S&P 500 would be today.
Here is a free spreadsheet tool for with yield premium assumptions. The idea is to guess what you think S&P earnings growth will be next year and then come up with a "Fair Value" for todays S&P 500. For those who think in terms of the Dow Jones, there is a crude price adjuster.
The spreadsheet requires 3 known values and 2 predictions about the future. Using today's data and a 4% earnings growth expection the S&P 500 is 8% over priced. A corresponding move in the Dow Jones Industrial Average DJIA would put it at 11,500. If you believe the risk free rate should be closer to inflation instead of t-bills, i.e. 3.0%, then "fair value for the DJIA would be 8,500. If you think the Risk free rate is higher, download the spreadsheet and check out the predictions.
Looking at the historical data will show that these figures and the "fair value" spread vary widely over time. Use this tool as you see fit. As they say in the auto world, your mileage may vary.
I have included quarterly S&P 500 PE ratios and yearly T-bill yields going back to 1936 as well. Unfortunately the T-bill data I had was only available on an annual basis.
Here is the Excel tool and associated data:
Being from Iowa and having worked in the fields and trading futures as a teenager, I always keep an eye on the agricultural economy. Farmland had a good return last year according to the Federal Reserve.
Farmland is usually purchased as a function of cash yield. I know what you are thinking, what a novel but dated concept in real estate: yield based pricing. I have a feeling it may come back into vogue :) Even if Moody's will rate it AAA, please don't buy a Farmland CDO it will only encourage more silly securitization and things have been bubblicious enough thank you.
There are of course federal crop subsidies which skew the economic output of the land which drives the cash rent and thus the effective yield, so caveat emptor. If you want to talk with someone about Farmland, the good people at Hertz Farm Management know a thing or two about it. They even manage a few acres down in Brazil. Ask for Dick Pringnitz. Full disclosure: my family owns a few acres back in Iowa and have for over a century, probably won't be selling anytime soon.
Farmland is an investment, not a trade. A lot of people don't know it, but one of the most crazy speculative bubbles in the late 20's was Farmland. This post isn't a buy or sell recommendation, just a highlight. Here is an excerpt from a lawyers letter posted by Dr. Housing Bubble.
“The boom period of the last years of the World War and the extremely inflationary period of 1919 and 1920 were like the Bubble and the Tulip Craze in in their effect upon the general public.Farm prices shot sky high almost over night.The town barber and the small-town merchant bought and sold options until every town square was a real estate exchange.Bankers
and lawyers, doctors and ministers left their offices and clients and
drove pell mell over the country to procure options and contracts upon
this farm and that, paying a few hundred dollars down and expecting to
sell the rights before the following March brought settlement day.Not
to be in the game marked one as an old fogy, while paper profits were
pyramided and Cadillac cars and pleasure trips to the cities took the
place of Fords and Sunday afternoon picnics.Everyone then maintained that there was only a little land as fertile as the fields of Mississippi, Illinois, Iowa and Minnesota and everyone sought to get his part before it was all gone.Like gold, it was limited in extent and of great potential value.Prices skyrocketed from $100 to $250 and $400 per acre without regard to the producing power of the land."
The next major issue in the financial markets will most likely be flawed CDS netting leading to a bit of a banking issue. None of this is new under the sun. My recommendation is to get educated / jaded by studying human behaviour and also reading Kindelberger's Manias, Panics and Crashes.
