Designing better futures

Grand Unification Theory of equities: a little something to upset everyone.

OK it's not quite a GUT for equities, but a neat trick involving Munger, Buffet, Graham, Sharpe, Claude Shannon, Thorpe, Kelly, Chan, Mr. Market and Douglas Adams.  Thus even if it isn't the GUT for Finance, this blog post is highly buzzword compliant.

Charlie Munger always says, "invert" which means look at the end or out come first.  I think he is right. So lets look at the end goal first.

The goal of any trader, investor or asset allocator should be in the words of Warren Buffet, "to maximize terminal wealth", the long run in Keynesian terms.  Maximizing terminal wealth is done be most efficiently allocating our risk or bets over time.

The brilliant Claude Shannon created information theory which lead to eventually to the Kelly formula used for optimal bet allocation and card counting. Ed Thorpe, card counter, hedge fund manager and mathematical bon vivant among others has made a lot of money using the Kelly formula to allocate risk in the hedge fund world.  You can read about gamblers, mafioso, card counting and information theory in William Poundstone's truly entertaining read Fortune's Formula.

Recently Ernest Chan published Quantitative trading.  For initiates to quant trading this book rules.  The introduction to basic strategies is well done, clear and concise.

One section in the book ties the Sharpe ratio and the Kelly formula together giving the optimal leverage size for maximizing terminal wealth based on Sharpe ratio and thus the expected optimal annualized growth rate for any stable system.   Please note implicit in the relationship is an assumed normal or guassian distribution of returns.  As we all know Guass exits stage left when the real world of finance enters and one of those rascally characters like Levy or Mandelbrot enters.  I met Mandelbrot while acting as Chief Analyst for Starlab, Europe's equivalent to the MIT media lab  a few years ago, nice fellow.  We researched Artificial intelligence, materials science, genetics, nano-tech, even time travel...no kidding.

Mr. Market at the end of the universe.

Mr. Market is Ben Graham's personified embodiment of the stock market, even though he is irrational sometimes, he should be working towards maximum terminal wealth so that he can eat at the Restaurant at the end of the universe with the late great Douglas Adams. 

In order to do this Mr. Market needs to use optimal leverage in the equities market in order to maximize his terminal wealth and pay for dinner.

The thesis is that if Mr. Market is truly an optimal allocator of capital then the relationship for equities between the Kelly Formula and the equity market Sharpe ratio should approximate a leverage ratio of 1.00 for optimal growth.  A 1.00 optimal leverage ratio shows Mr. Market is an efficient gambler and leaves nothing on the table. Given the standard equity assumptions below it looks like the old boy is pretty good at the tables.

 Neat trick huh? Here is the spreadsheet. Download KellySharpeChan

Fortunately, this appears to be the case given the assumptions shown.  Of course it isn't exact as the assumption all shift around, but it is close enough to interesting. 

Thus information theory, Mr. Market and parts of Modern finance all seem to co-exist happily ever after until dinner time.  From time to time the market gets a little ahead or behind itself, but in the long run optimal allocations for maximum terminal wealth are being made.  Now the message is please stay away from leverage and assume that the co-variance matrix isn't stable.  Efficient market theory individual is bogus, but in aggregate may be semi correct. Not Nobel Prize correct but okish.  Scholes & Markowitz should still give back their prizes and Nobel winners like Dr. Amartya Sen should get more daylight as they ultimately help the human condition more.

Please feel free to weigh in with thoughts, critiques and considerations.  The nice thing is that the equity premium puzzle gets resolved by using variance as a risk proxy.

Even if you don't like the thesis above, the tool is helpful in identifying leverage for a "Stable Asset Allocation System" regardless of horizon.

If anyone is looking for a global macro L/S PM with hints of quant talk to this guy, he returned +19.8% last year with +50% cash (no leverage) and a 1.0 Sharpe ratio, has worked in 6 countries and has a sense of humour. CV on request.

Quiztime: which instrument has a CDS priced default rate greater than 50% of its Yield?

Arthur  at Jesse's American Cafe was on this before I was. 

The US 5 Year Note with 100 bps CDS price has a 1.92% Yield. 

That represents a strong divergence in opinion about what risk is.  The yield relative to the default estimate tells us something and when it is that high it can't be good.  Manic Depressive Market estimates of risk/return aren't good in "flight to quality instruments".

I am curious to know if there are any studies on the yield to CDS price ratios.  If I were a betting man, I would side with risk guys on this one. 

Who was that guy who returned +19.8% Sharpe 1.0 L/S equity with 50% cash in 2008?

Change happens faster

Change happens regardless of the economy, only the rate gets altered a bit.  There is some hype here so have the salt shaker ready. 

economics, technology, science and the singularity

Juan Enriquez usually gives some of the more intriguing talks at TED.  He jumps from point to point spinning disjointed concepts into amazing narratives.  As a former chief analyst for a "deep future" science research park and anthropologist, this is right up my alley. 

Be warned watching this video will make your head swim with possibilities.  As a hedge fund manager today, I believe imagination is the most important risk management tool.  This video has a lot of implications.

Check out Ray Kurzweils book the Singularity is Near to understand the drivers behind all of this.

The architecture of Capital Allocation

The architecture of allocating capital occurs at many levels with different styles and tools.  The time horizons and tools vary based on what level one wishes to gain expertise in.  This year was rough for many traders as the macro-environment which usually plays a slower and thus perceptually smaller role for those allocating at the company and sector level reared its head in a step function manner.

When choosing to allocate capital, it is important to consider many things and many levels.  The day trader who makes 50% a year in a hyperinflation country isn't going to be ahead for example. 

I haven't seen a good graphic depicting the various hedge funds, mutual funds etc. on a capital investment horizon ranging from global macro to ultra high frequency, but it would be interesting to see the plot, vs the expertise required.  Of course expertise at all levels yields optimum returns but is rarely found. Even Buffett claims to not time markets well.

Each level also has its biases, and opportunities.  Each level operates within the context of the larger level.  The rising US debt (2008 deficit potentially at $5.1 trillion) may not concern the day trader, but the macro trader should surely be looking about for stable environments.

 Any suggestions welcomed in regards to the rules and operational scales of the architecture of allocating capital.

One thing to be wary of at the macro architectural level in is pictured below.

The Post Earnings Economy. Time for the PY valuation ratio

  
According to data from Shiller we have never had an S&P 500 with negative earnings. Of course his data only go back to 1871. 

Estimates are now out for negative earnings on the S&P 500.  So I guess we stop talking PE or yield and start looking around at the e-bay resale value of firms assets less loss rate. 

Every era creates it own novel corporate valuation metric. The new metric for company valuation is probably the PY ratio which is the Price to Yard sale ratio of a firms assets.

Please note the yard sale below is supported by a handy TARP.  I knew that thing had some uses.

Brittle systems: when things fall apart

A tightly coupled supply chain may have many co-products and dependencies that rely on its inherent economies of scope or scale.  Efficiencies gained from scale or stability create dependencies based on positive externalities.  The more stable the underlying source of the dependency, the more dangerous its failing can be.

Did you know that a slow down in automobile manufacturing can impact the delivery of various life saving drugs?  Neither did I.  You can read about it here at the always interesting Blown mortgage blog.

This is a derivative form of risk that can't be modeled as the causal agents and feedback potential are to tough to model.  It is a qualitative NP hard problem if you will.

Black swans are are caused by cascading failures between what are believed extremely non-linked systems.  We usually think of derivatives in the first order.  

An S&P 500 option or future derives its value from the underlying value of the S&P 500 equity values which of course derive their value from the longer term expected prospects of their earnings.  Black swans are caused by 2 or more loosely coupled and viewed as independent events that link up causing extreme outcomes.

Current earnings estimates point to $30 worth of earnings for the S&P 500 which is currently priced at $835.  That equates to a PE ratio of 27.8 or an effective yield of 3.59%.  That yield sounds a little low to me.  The historical average PE ratio implies an S&P fair value at 490.   For those of you who think in Dow points that equates to a 4,400 DJIA.

The free PHaT tool may be helpful when thinking yield and trading ranges over the last 90 years.  For those interested, the low PE during the depression was roughly 5.6 in June 1932.  That equates to  167 for todays S&P 500 and 1,590 on the DJIA based on current earnings estimates.  I am not saying these are my opinions or fair values for the equities markets, merely pointing out that they are within the realm of the historically possible.  As a PM I think 98% of the time about risk.

Ouch! 5 Year CDS hits 82 bps

This is not good.  Alea is a great blog and covers more technical financial matters.  The latest quote on 5yr CDS for treasury debt is deeply worrying.   We are never going to hear the end of it from Roubini now :)

 The short end of the curve had finally started looking a little more civilized with bills floating higher, the TED spread coming down and the A2P2 spread coming back to rationality.  Not that I was buying any of it (pun intended).

The CDS price is indicating that the world isn't buying the US as reserve currency argument. No one is beyond default anymore.  And yes I still advocate a Norwegian Krone overlay on all portfolios.   Need a global macro manager? Lets talk.

This rules. The SEC is a pile of fail.

Ackerman goes to town on these guys. The SEC has done more damage to the American public than many of the perceived threats dreamed up over the years.

Look out Marketwatch says equities are the new bird flu.

Hmmm. Are equities the new bird flu?  Is there a shot of bonds I can vaccinate my portfolio with?  Should I keep my equities away from other assets so it doesn't spread.  Oops to late.  Take 2 TARP and call me in the morning.

As a long/short global macro PM who returned 19.8% on his carve out  last year with a 1.0 sharpe, I hope it isn't catching.  If you know of anyone looking for a PM, my offer still stands for the person who gets me a new role. CV on request.

Circus humour

As a portfolio manager lateral thinking is an important skill to have.  A sense of humor helps.  This is a joke I told my twin brother. 

Q: What did one cannibal say to another cannibal?
A: Do you think clowns taste funny?

Country quiz.

I try to stay apolitical in the ole blog, but liked the play on words.

Quant finance humour for a small audience

OK not that funny unless your into topological conjectures, Sharpe ratios and private jets. :)

60% decline for Manhattan? Tarp for Trump?

A very effective guide for long term home values is actually median home price to income.  Houses actually don’t gain in value over the long haul.  Urban density and usage shifts can dramatically change the value of real-estate, but outside of that real estate is just a flat asset.  Here is an academic paper showing the value of prime real estate in Amsterdam over a 400 year period, its a break even proposition.

A home is only worth what people can afford to pay for it.  If you can squeeze more people onto a given area of land and create more homes then you can maximize the value of the land such as in Manhattan over the last few decades.

Over time the utility function of real estate is scarcity relative to the available income of those seeking the homes.  I mention this relative to an article posted in June 2007 which anticipated a 20% nationwide property decline using this metric. 

Historically relative to growth and all things being equal homes are worth about 3 times the median income of a household.  Please note this includes adjustments for cultural shifts in 2 income households over time.  Economists see real estate more as a positional scarce good.  Housing capital with a life of 50 years for example has a replacement rate of 2% year.  If a housing market starts growing beyond that rate and the increased population something fishy is going on. Securitization magic anyone?

The US grand daddy real estate market is the metropolitan New York area which has been relatively immune to decline.  The excuses for why New York real estate is special equates to the number of residents in the city.  Unfortunately the quantity isn't equitable to quality.  Because people want to believe they are special they parrot messages they have heard to that effect. Such ethnocentric or industry centric myopia is the nectar for those wonderful bubbles that pop up every 10-20 years. 

According to the BEA, the MSA metropolitan statistical area known as “New York-Northern New Jersey-Long Island, NY-NJ-PA” has an average per capita income of $53,428 as of 2007.  If one assume 1.8 wage earners per household we end up with a household income of  $96,170.  Using the crude 3:1 rule of thumb, housing should be priced at $288,510.  The reality according to Realtor for Q3 2008 is a $452,500 per home.  Reversion to the mean indicates a 36% decline is reasonable to expect.

Sadly the decline in financial jobs which ballooned to a ridiculous percentage of S&P 500 earnings means a drop of %50 from peak to trough is not unimaginable in the New York MSA.

 The same figures if plotted for Manhattan are even worse as the distortions of increasing density and influx of high flying finance jobs which was a positive force for property values is now going to go in reverse with a multiplier effect.  Predicting Peak to trough declines of 60% does not seem egregious, especially when one considers the shift in desirability for certain neighborhoods as services diminish and vacancies increase.

The tide of hip, cool or gentrified that crested after the Starbucks arrived on the corner is now ebbing rapidly.  The city has a 23% poverty rate. Grande Latte soy moccachino anyone?

 Although dangerous, to put a number and a date to an opinion, my guess is a 60% peak to trough decline in 12-16 months for Manhattan residential property.  As things decline rapidly in the metro area.  We are all living faster now, still not sure what the rush is about, but we if we keep those Blackberry's and i-phones humming we feel connected and thus must be winning. 

The only caveat I put on this prediction is please keep it in nominal terms as the printing presses are humming at the fed.  Oh and if you liked paying for bankers bonuses you’ll love the catch phrase “Tarp for Trump!”

Dear Mr. Buffet: a book review with a little "extra"

Dear Mr. Buffet, What an Investor Learns 1,269 Miles from Wall Street

Janet Tavakoli is one of the top experts in the fields of structured finance. She is one of the most vocal critics of a system gone horribly wrong and saw disaster looming early on. She even tried to sound the alarm many times with an SEC that in retrospect looks to be on the wrong side of the subpeona issuance business.

The current multi-trillion dollar financial crisis didn’t come about due to any single act of brazen greed or stupidity, rather it was a case of many people all looking for a little extra. Pushing the boundaries at each level has a multiplier effect. Common sense and ethics went out the window as it was all mostly legal and appeared at each level to be just a little “extra” nudge.

Here is my diagram of how each level of the sense of “entitlement” to a little “extra” will cost a generation. The era of rules meant be bent and self-entitlement will haunt the world for years to come.

Actor	Extra	Self deluded Justification
Home Owners	Bedrooms, bathrooms etc.	The neighbors have it, the finance is available and everyone else is doing it. To paraphrase Kindelberger, ”nothing will cause a person to lose their sense of economic rationality than to see the idiot neighbor/relative get rich.”
Realtor/Mortgage broker	Extra income from activity	We are putting people in beautiful dream homes and making a little on the side. Who cares about the loan forms, it’s the loan that counts.
Mortgage “packager” securitizer	Extra yield maybe 0.75% on a few loans via securitization	If the ratings agencies say it is AAA and there is a market for it, then it must be OK.
S&P, Moody’s etc.:ratings Agencies, who have a Government granted monopoly on truth.	Make a little extra income for rating new securitized instruments. An investment grade ratings could increase income by a factor 20x	The models indicate that the loans or OK. We are the original kids who never learned “just say no!” We can model anything and in the face of “free money” or having to say we are ignorant, we will take the money.

 

 One of the problems with securitization as elaborated by Ms. Tavakoli so adroitly is the chain of responsibility and accountability that was broken between lender and borrower. Long term responsibility was packaged up and sold in a heart beat to the next yield hungry bidder looking for a little "extra".  This is a classic agency problem.

Like any drama involving a major loss for an entire generation, this one has many systemic failings. No single actor failed totally, many failed just enough. This multiplied into what is still unfolding as the largest economic crisis in many generations. The reality still hasn’t hit main street America. Wait 6-9 months.

In any group human endeavor some greed, stupidity and laziness will be present. Most cultural institutions and systems are designed to handle these individual components. The crunch was a case of multiple actors giving way just enough to cause a cascading failure.

Ms. Tavakoli uses her letters and relationship with Warren Buffett as an homage to Buffett's ability to distill the basic essence of complex matters into simple facts of money and value. Buffett has the gift of simple language and metaphor to illustrate complex financial truths. He is the Richard Feynman of finance.

Ms. Tavakoli is an expert in the area of the most sophisticated areas of credit derivatives having authored such tomes as Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization. For Dear Mr. Buffet, she has opted for a simple approach to tell the tale of actors gone bad and trust abused at many levels. This book is an accesible popularization of the issues, and as such no heavy securitization math etc. to deal with.  I agree with this approach as the story needs to get out to as many as possible.

It is a tale of oversight and minor characters who loomed large in their time, but will be seen as petty by future generations. Financial debacles and their actors rarely make sweeping historical reads.

The embodiment of the Wall Street tyrant appears to be Dick Fuld, a small man in many ways ,who is the essence of the bully standing in the atop an empty castle with nothing to offer but an angry wimper. Mr. Fuld, Sandy Weill, Stan O’Neill, Angelo Mozillo etc. are the sorry human reflections of a failed culture.

Buffett comes across in classic form as modest and thoughtful in dodging the mess and politely not making too much money from it. His low ball bid for MBIA’s good assets gets scant attention in the book. If the bid had been put forth by anyone else, it would have been seen as good business, but poor taste. Buffet can pull this stuff off and still look saintly.

One small critique I have of the book is Ms. Tavakoli’s light treatment of Buffett in regards to Moody’s rating agency. Buffett talks his book in regards to his holdings in Moody’s, but there needs to be a house cleaning among the entire NRSRO system. My suggestion would be to eliminate it and all SEC mandates referring to ratings. Better no risk system than chasing a flawed one.

Ratings agencies are the pimps of Wall Street, dressing up securities to happily service Bankers and Fund managers too lazy to do their own due diligence. The average fund manger is happy to look for a little yield with minimal effort at due diligence or god forbid independent thought. The coming storm in the Muni-bond market will be eye opening for those managers who buy alphabet soup from the rating agencies and sell "extra" basis points to their investors as performance without knowing what is under the hood of their funds.

The game the ratings agencies play with Municipal bond ratings would make any mafia member’s eyes swell with envy as a protection racket. The ratings agencies are an in-built American systemic failure in a system that causes catastrophic “normal accidents”. The U.S.S.R. had Pravda and we have the NRSRO to separate state truth from fiction for us.

A word of warning about reading this book, it will make you angry. If it doesn’t, read it again until you understand it. The more one understands the nature of what caused this hyper-accident, the more blame there is to go around.

As a hedgie, I studied the bond insurers, attended last year’s asset securitization conference(blow out Super Bowl party sponsored by the US taxpayer) in Vegas and watched the Senate testimony from the front row  given by the likes of MBIA, AMBAC and Moody’s.

A fitting touch at the senate testimony was the happy coincidence that Mr. Spitzer put on his special show as Client #9 only hours before his testimony. We can only be thankful that Mr. Spitzer’s attempts at corning the market on self-righteousness have been doused as his powers of heightened self importance seemed to be getting out of hand.

Mr. Dinallo, the New York insurance superintendant appears to be genuinely trying to making the best of a bad situation. My own opinion is that the bond insurers still have a role to play in the credit debacle as Municipal bonds start defaulting and the insurance they so happily offer is seen to be as valuable as Joe Brown’s piercing insights into MBIA’s own solvency or lack thereof.

Stay tuned, this will play out in the next 6-9 months as municipalities across the country start defaulting and the bond insurers get handed from the State level up to the Feds. Tarp which should be Latin for financial herpes, really is the taxpayer gift that keeps giving.

The story Ms. Tavakoli shares is not a simple one, the actors are all intelligent and each plays their role in inflating the credit bubble. None are innocent and yet all profess to be victims in retrospect. The saying is that success has a thousand fathers and failure is an orphan. The credit bubble that is engulfing the world was a web of greed that reaches down from Government to Wall Street across main street and right to the front door of your neighbors.

Everyone was entitled to bigger homes, free money etc. a few players highlighted in Ms. Tavakoli’s book delivered that little “extra” that now engulfs the world.