Designing better futures

Naive trading strategies & young carbon markets

This week I am off to the wall street green trading summit on behalf of the seeking alphasters. Thanks lads.  I thought I would take a look at how the emissions (carbon) market is evolving from a traders and economic efficiency perspective.   Here is a snapshot of carbon prices or the right to emit 1 tonne of carbon about 11 euros:

Truly efficient markets have few opportunities for naive trading strategies to work long term.  A naive trading strategy is something so blindingly obvious only your brother in-law or crazy uncle thinks it will work.  Much to your and those pesky economists frustration it often does work.

I spent +20 years doing quant stuff and think about numbers and culture in my spare time, so cranking out naive spreadsheets is simple. caveat emptor, slippage, liquidity and real concerns haven't been addressed here, so your mileage may vary significantly.  This article is released to provoke thought not trades per se.

Here is the data and the trading system related to this article in Excel 2007.Download MOZ9 naive strategy

The original Naive strategy for equities is buy and hold

Naive trading or allocation strategies are the baseline by which all alpha or performance should be measured.  OK, I know the Beta puritans are screaming EMH, frontiers etc., but bear with me.

A naive strategy is used as a test or null hypothesis of other approaches or processes you are going to employ. If you can't beat the naive approach then just join it. Yes, value investing is a trading process which can be compared to by and hold.   HT: for the fundamentalists out there.

Markets are not stable they typically evolve or "regime shift" over time, just like an ecology.  These regime shifts typically involve participants eliminating or diminishing naive strategies for periods of time as their behavior (rent seeking) leads to shifts.  Most likely some physics student quant guy will eat your naive lunch with a souped up server looking at Lyapunov exponents and slicing VWAP into ever tinier pieces net hops and milliseconds for execution. 

I took a look at an Emission market traded in Europe to see how a Naive strategy would perform.  Here is the market and instrument description.

Below is the outcome, a 1.96 Sharpe ratio* with a strategy using the cunning logic: if today was up, buy tomorrow, else short tomorrow.  The Sharpe or risk reward ratio of index buy and hold equities is usually around 0.50.  So this naive strategy at first glance appears to yield roughly 4X better risk return in what is probably a low-correlated (as traded) asset class.

There are major caveats here, the logic implies, you can tell moments before the close which trade to make and there are no transaction costs or taxes removed.  Also please note this is a futures contract, so the volume is anemic to non existent for 2-3rds of the contract life. you need to research rolled contracts to really see what is under the hood here.  Look at the data yourself, I included the volume in the spreadsheet.
 
The interesting thing is that a naive strategy appears to provide interesting returns.  For those unfamiliar with a sharpe ratio, if one were to de-leverage the position so that the risk profile had a volatility of 15% per annum which is less than the historical returns of the stock market, the returns would be greater than 29% per year.

This is an interesting example of a young market where the naive strategy still appears to offer significant alpha returns. My thesis is, because there isn't liquidity and more sophisticated participants playing yet, the various Naive niches, like and ecology are unexploited.  Of course lucrative naive approaches will eventually attract participants and liquidity, leading to a regime shifts.  Strategies or market process are chaotically unstable based on simple agent behaviours and opportunity seeking.

I am not advocating a trading strategy or process in this article, merely highlighting an interesting young market and the use of studying naive approaches to assess trading allocation processes and their viabilities.  If you run a fund and want to talk quant carve out, shoot me an e-mail, getting portfolio level Sharpes north of 2.0 isn't really that tough.

*m sharpe didn't have an annual risk free rate removed, to simplify leverage assumptions etc.

The singularity and the real future of computing, post netbook

The future isn't going to be like the past, netbooks are nice and will have a 3 year life of novelty before they become another banal niche in the silecosystem.  Watch this 7 minute video and think about how fast the future is going to be here.  The technology that delivers this is unfolding no matter what happens in the economy.  The video shows what information anywhere really means.  It is a post Jetson's future, the kind that was tough to imagine just 15 years ago.

My guess is devices similar to this will be in the 3rd world in 7 years and in the developed world in 2-3 years.  As former chief analyst for a research institute Modeled on the MIT media lab, I have seen a few things and can assure you this video is a window into the very near future.

If this video doesn't shake you up a little bit, you need more coffee :;

If you want to see where this is all heading, read the singularity is near by Kurzweil.  I don't make book recommendations lightly, as it is the time of your life we are talking about.

Changing metrics in the Hedge Fund industry

The dog  illustration shows metrics, that may be important to wiener dog specialists. 
I look at a dog, smile and walk on. A specialist sees a whole set of parameters I don't.  I usually look at the tail.  Dogs smile by wagging their tails, so if the dog is happy, I am happy.

Hedge fund metrics.

The business of running a hedge fund is getting tougher on the performance side and the day to day office routine. Due diligence requests are up, redemptions are coming in and the staff is upset that the high water mark is receding faster than AIG's popularity.  It can feel a bit like being the captain of the nautilus in 20,000 leagues under the sea. 

Something else to look out for if you are a hedge fund manager. Inflation.

Many hedge funds don't think much about inflation at the business level and assume the quant guys will come up with a strategy or the trend following commodity approach you just started applying will cover it.

The problem is that if inflation comes back you are going to get hit with a metric shock at the business level and the market level.  Many funds promised to deliver whatever would get people to buy them.  Fund allocators, family offices, pension funds, seeders etc.  would ask for relative returns or absolute returns.  The benchmarks would be set and everyone would be on their merry way until the quarter or year end review.

 The metric shifts with the fashions of finance.  Those who thought relative performance to equities would keep them high and dry are surprised that 1,500 bps of alpha over a -30% S&P index is met with redemption calls instead of a pat on the back. 

Because most investors in hedge funds bought the feel good story and didn't understand the process driving the returns, they are heading for the hills. 

The metric of absolute positive returns has now come into fashion.  Alpha shmalfa, liquidity, absolute returns and transparency are the watch words of the day. 

Inflation metric surprise.

So if you run a hedge fund here is something to think about from a business perspective, Inflation.  Rarely will your allocators or investors mention real vs. nominal returns in today's conversations.  That could change, yesterday's 15% absolute return with 1.0 Sharpe may not make such a bold statement if inflation spikes in the US greater than 10%.   Historical Sharpe ratios could be viewed through the lens of CPI instead of t-bills if inflation returns.  You may want to run the figures now to see how others could be looking at your returns when they fire up the Barra type tools for their annual CYA process reviews.  Co-variance using CPI or another inflation metric could become an important factor (pun intended) in your business.

From a fund business perspective the smart FoF's or hedge fund manager may wish to consider an inflation linked exposure today before things get crowded.  If inflation rears its head, the returns of hedge funds may start to look less appealing in a relative context.  A stable 15% return looks pretty risky in a high inflation environment if the process driving returns isn't understood and that 15% is invariant with respect to inflation. 

A smart thing to do right now is to run the frontiers and performance expectations against various inflation scenarios and metrics, then choose strategies and exposures accordingly.  The only fund, I have heard of publicly that does this is Bridgewater.  Ray Dalio seems to have the 2 key assets required for long term wealth maximization, imagination and discipline.  I have been trying to get a meeting with him to discuss culture, behavior and economics.  If anyone knows how get some of his scarce time, let me know.

 

The path is not the destination: process & choice point behaviour in asset allocation

  I have been attending quant lectures on asset allocation and reading books on endowments, family offices and hedge funds. 

One of the interesting things about throwing up historical charts and showing X% return over the last Y years for an asset class or allocation is the assumption that it can be used to to justify future "correct" behaviour.

Correct behaviour is of course making the decisions that lead to an optimal return or utility function for a group.  Mo money, in the lingua franca of the urban American dialect.

The truth is that each year, quarter, month etc. a choice point along a path is has been reached.  Things need to be rebalanced or decided upon.  When looking at a graph of historical returns consider yourself riding the curve and at each interval consider, would I go on? 

How would I have acted at the choice point?

Many people look at historical fund/asset returns with a nice high average performance and think, "thats for me".  The truth is, the draw-down, dip, peer pressure or change in financial fashion may have meant an early exit on that path.  When looking at a historical graph, think of it as a path and ask.  Would I have stayed on it and why?

Investors in hedge funds, legally considered sophisticated individuals have been shown to under perform the funds they invest in.  Being sophisticated is a legal distinction, not a behavioural or intellectual one.  As measured by money flow based returns, hedge fund participants and mutual fund participants under perform. 

There may be more value in knowing yourself or the decision making group you are a part of than knowing the history of a fund.

If you are part of a group making an allocation decision, re-run the historical performance to a low point for the fund, redraw the graph and present this choice point to the group and ask, "would we have gotten in here?".

In many instances significant returns may have come from participating through that low point in the fund or assets history.  The true test of your behavioural response to crisis isn't the the asset class, manager etc., it is your faith in the underlying process which is giving those returns.  To paraphrase Buffett, you can't be greedy when other are being fearful, if you don't understand what process drives the returns.

For example, an equity investor should be investing in the process underlying a firm and its ability to continue extracting high profit margins via that process within a culture.  The economy is background noise, but the process chugs along.  Coke will be here no matter what happens to inflation next year. If you are comfortable with a process in situ then you can weather the storm and act accordingly at the choicepoints.

So?

So perhaps one of the most important things to focus on isn't securities, funds, news/noise etc. but one's choice point behaviour and decision making approach.  Invest only in processes that you understand and believe during the tough times.  The process drives the returns.  If nothing has changed in the process then stick with where you are at.  If you believe equities as a profit making process yield 7% historically, stick with them.   

Investing or allocating is a marathon and should be approached as such by applying a +20-30 year process mentality.  A bad 2 or 10 years in an asset class doesn't mean one should run away unless the process has changed.  Think process and choice point when reviewing historical returns.  If you don't understand the process and consider it long term stable step away.

A few weeks ago I listened to some endowment specialists discussing historical equity returns going to back to 1976.  It seemed silly, as the history is brief 33 years of historical analysis to make what should be a +20 forward projections.  One could call into context the whole use of history, when relative value and process is the current issue at the choice point. 

Most studies going back to the 1930's for example are looking at a country with a median life expectancy and literacy rate that would put America squarely in an emerging market bin today.  Cultures and countries change.  We all agree the past doesn't repeat itself but cling to the myth of future repetition all the same. 

Using 100 years of historical data to make a 20 year allocation decision is a 5:1 sample ratio.  The country you wake up in 20 years from now would feel culturally foreign to you today.  In a 20 year period their is a 20% chance of the 1 in 100 year storm hitting.  VaR isn't dangerous in itself, but the belief it engenders in people, groups and institution in terms of knowing the future is.

Again relying on the understanding of the stability and drivers of the value creation process may help more than the historical narratives conjured up in many quantitative tools, studies and articles.

Ironically many decision making groups use the wrong tool at the wrong time.  Historical analysis offers little value in crisis situations as most crisis of historical significance are unique and the cultures response to them impossible to predict. 

Using a single equity market in a single country with a history that won't and can't be repeated to analyze a decision at a choice point is the wrong framework.  Ask yourself, is the process for value creation in place and stable?  Is the price/yield for purchasing that process good? 

When reviewing an allocation, use the squiggly lines going back in time to help you think about your choice points and anticipated behaviour along the path, then focus on understanding the process that creates value.

The green re-cession...via demand shock.

A lot of people try to guess at true Chinese GDP using Electricity consumption as a proxy.  Here is a little review of estimated US energy usage through since 1930.  I can't vouch for the source Wattzon or data integrity, but it really makes one think about firms in the peak energy management business like Enernoc or grid pressure relief systems.  I wish the graph below were semi-log to more clearly highlight the 1930's decline.

I found the chart in Paul Kedrosky's mention of an energy conference presentation.

Carbon credits, utilities etc. and anyone used to steady state energy consumption growth is probably in for a bit of a shock.  Smart metering, behavioral changes and other end point and grid efficiency gains will only exacerbate this shock for energy producers and their respective supply chains, railroads etc.

2 years on: Govt & AA risk & yield curve perspectives

I believe that behaviour is economics.  The path taken and its choice points usually say  more than the destination.  Although 10 years of flat equity markets make Treasuries seem sensible in retrospect, few allocation committees would have had the behavioral discipline (stones) to miss the equity party in the late 90's. 

Here are 2 charts showing the yield curves for govt debt and AA Sr. CDS from today and 2 years ago.  The gap in Sr. Corporates is amazing, but what's 2-3 orders of magnitude risk change between friends.

People reviewing historical graphs always assume a fixed frame of mind exists along the X axis when in reality allocations and perceptions change along that curve.  Having a disciplined process in place for the long term is key.

Most models would not have seen the corporate curve shift like this, as the credit crisis started in the real estate finance related sector. 

Garbage in garbage out is rarely the problem with quant models.  It is usually a failure in context, ie. the context of large events so broad that no particular model can effectively encompass them into the inputs.  Swans show up in the blind spots by definition. 

A good allocator watches many sectors.  My own belief is that any sector variance, seen as positive or negative is important.  Extreme positive variance is probably more important to watch than any other.  Our innate bias when seeing positive variance is too cheer lead instead of getting nervous, this behaviour is anti-thetical to good risk management. 

Hence my apparently elliptical reference to muni-credits lack of response to the Geithner plan yesterday.  The argument appears a non-sequitor, linking an equity rally with a flat muni-risk response.  I view it is a lack of confirmation in expected economic growth delivering taxable revenues at the state level. 

The woods are all around us, we aren't out yet, so stop looking at the equity market trees, this is a credit problem becoming a serious consumer demand problem.

The municipal credit market is un-impressed

Ok, we are all in the economic mother ship together. The other day the equity market got very excited by the Geithner plan.  It is kind of interesting to note that the State Municipal CDS markets didn't really care.
 If we are all in the ole economic boat together should the spreads have narrowed?  So who is right? 

Either the CDS market gets on board and starts singing Kumbya or the equity market may have gotten a little ahead of itself in the shell game that passes for economic policy these days.

Stimulus and the environment: some history lessons

This whole environmental movement combined with stimulus plans is really just a twist on an old idea.  We just have to make the sure money is managed in environmentally sound ways, like they used to do in the good old days.

Technically you can't destroy your dollars as you don't own them. They are the property of the federal reserve.  You could get up 5 years in prison.  But... if they can do it, shouldn't you be able to as well.

Here is a picture of a woman combining monetary policy and green thinking to get off the grid in 1932 Germany as she heats her home.  The stimulus bundles were cheaper than wood, burned better and gave off the sweet smell of Keynesian policy success.

 How progressive is that?  See how she quantitatively eases those blocks of notes into the fireplace... source

My wife is a from a record setting country Hungary, they produced the Quintillion Pengo note shown here on the streets of Hungary. 

Do you have any idea how much stimulus it takes to do that?  Those legislators and monetary theorists probably had to come up multiple rounds of plans.  Your really have to give those people some credit....ba da bing.

Note how environmentally friendly they were in Hungary, they weren't about to let stimulus clutter or litter the environment.  They swept it out of the street gutters. Source

We are only on round 2-3 of bailout mania and the Abbreviation machine is humming along well (TARP, TALF...full list and composite spreadsheet here)

But to really get somewhere with this stimulus we need to put our foot on the gas and stop worrying about silly debt holders and credit ratings.  We have got to get our stimulus on. 

Hopefully we can be as environmentally conscious with the outcome as they were in the good old days. 

Call me crazy but gold doesn't burn as well as wood and in all my anthropology and economic studies, I have yet to hear of any culture during any crisis letting gold sit in the streets. I believe gold is a bad investment and an overpriced hiding place, but it is sensible until they turn off the Acronyminator in Washington. Source of images.

PS. for those not versed in irony please visit here.

CDS Big Bang set for April 8th. Get out your party hats

Big Bang is an inauspicious nickname to say the least.  On April 8th a "big bang" is set to occur in the Credit default swap world. This involves implementing and adhering to more standard protocols for settlement, auctions and centralized netting.  Hopefully this will mitigate some of the risks in with these things.  AIG was a nice look at the tip of the iceberg, but the view under the water line is anything but pretty.

The hope is the new netting provisions limit the chain settlement risk which can act like a liquidity vortex.

From my perspective the large notional amount of outstanding non-netted CDS contracts are just a way of passing around a long fused systemic Gamma firecracker.

 Eventually it will go off and with enough exposure in a tight credit environment everyone gets invited to the party.  AIG is the party MC and got stuck with the most fun so far. 

Here is the document with some details about the bang. Download The Big Bang IM.Derivatives Alert 03.11.09

Bailout nation update: Where did your $1,000 go?

Here is compiled data from the government bailout programs which equate to about $1,000/citizen so far. I farmed the work to Mechanical Turk for $5.   Here is the spreadsheet dataDownload TARP summary.xls .

If it is useful for you, make a donation to journalists without borders.

Bailout nation has a few moving pieces which are grow like acronym kudzu:

• TARP=Treasury Asset Relief Program
• AIFG=Automotive industry finance program
• TIP=Targeted investment program
• AGP=Asset Guarantee program
• CABLIIP=Consumer & business lending initiative investment program

If you have been missing your tax dollars and wondering what they are up to have a look.  Your tax dollars have been visiting the following institution and hitting the high life in various states. 

I have just banged together the data.  There are over 505 institutions who received a little Bailout love, but I only graphed those receiving over $1 billion.  After all anything less is pocket change these days. Rolfe over at Optionarmageddon will do a better deep dive on this stuff. 

All info and graphs on the site are under a CC licence, use them as you wish just provide attribution.

And for some serious coverage on the issue there is always the Onion. Yet another news network with better analysis than Cramer or was that Jon Stewart:

Monty Hall: information & door #1 investing

One of the most famous problems in popular statistics is the monty hall 3 door problem.  Monty presents you with 3 doors.  Behind one random door is a new car and behind the other 2 doors are goats.

Being averse to goats you select a door hoping for a car.  Monty selects a door with a goat.  You are given the option of changing doors or staying with the door you choose first. 

You should change doors as it shifts your odds from 1:3 to 2:3.  Wikipedia solution.

Being an excel geek, I created a spreadsheet tool to simulate the game 1,000 times.  Warning it does have a macro.  Download MontyHall.xls

One of the things I learned in writing up the visual basic was that Monty does 2 layers of information processing before revealing his answer.

This has a lot to do with investing, as perceptions and behaviours while new information reveals itself are some of the biggest factors to success.  

Many firms operate in mature markets with known market shares and similar inputs to their competitors.  So maybe you are looking at 6-10 doors.

The dynamics of earnings margins are more about the competitive environment and or some structural edge to the respective firm.

The largest piece of information missed by "value" investors is competitive dynamics and the direction of the moat relative to them over time. Munger hints at this in his excellent book Poor Charlie's Almanack.

A firm that has a geographic, regulatory, behavioural or structural moats may grow or shrink that moat over time.  As an allocator, having a process to invest and allocate risk/positions is more important than each individual choice. 

The Moat=the Margin=Earnings edge=extra ROE=Equity price appreciation relative to peers.

Take a look at that relationship above and think about it.  This only works for firms in stable competitive dynamics i.e. mature stable industries.  Most technology lead firms have black swans flying at them out of garages in silicon valley everyday and may not be suitable as classic value investments.  It is my belief that Buffett understood microsofts and many technology businesses. I think he just didn't know how they could keep an edge over time.

You have 25 years and can make 1 investment among 3 choices: Coke, Apple or Google?

So how do you figure out what Monty Hall is telling you, skip the goat and get the car?

The car is a high ROE at fair price over time with a moat that expands as the firm grows leading to share price appreciation assuming you bought it at a reasonable value.

This is the proverbial snowball rolling downhill.  Coke in the 1950-90's was like that with a single simple product, and ever better distribution and purchasing power.  Eventually the behavioral moat "taste"triggered by marketing and lemming consumers watching each other guzzle the stuff meant a widening moat.  Also recognize the Mungerian (sic) lalapalooza effect of multiple feedback loops.

• increasing sales lead to better input margins
• increasing sales lead to more efficient advertising buys
• increasing sales lead to more points of presence
• increasing sales lead to more cultural behavioral visual cues triggers other to consume

Monty Hall is the historical margins earned by a firm relative to its peers gleaned from 10Q's and 10K's.  Watch firms with better operational margins or efficiencies.  Understand their moats and substitute products.  As a hedgie, anthropologist with a deep technology background it is fairly easy for me to see behavioral moats and the limited lives of most technology moats.  

Coke as a product will most likely be here with stable margins in 20 years, Abercrombie & Fitch less likely.  The half life of a fashion firm is limited and in its death throes, it will most likely spend any retained earnings away on marketing and other new forms of "coolness" that allowed it capture large margins in the first place.

The "problem" of asset allocation in mature business sectors isn't purely closed form like Buffett & Munger's pari-mutual betting analogies, but in some industries it is close enough that trends seen in expanding ROE over time may be indicative of sustainable advantage.

If one treats the sustainable comparable ROEs as indicator of competitive edge and longevity then there might be an investing edge assuming the price is right. 

It is critical to understand what drives the edge.  If it is a one off or something that doesn't scale with the business then think again.  Monty can be tricky and most likely 2008 was goatish enough.

Where did value investing go wrong in 2008?

One could argue value investing didn't go wrong, the economy did.  Value investing just tagged along with the market.  Value investing isn't market timing or macro analysis per se, it occurs at the security level.  Portfolio exposures at the economic level are another matter.

The diagram above explains why.  The grey circle represents a firm at some fair value operating in a mature competitive dynamic. 

The investor is looking for the car behind door number one over time.  It is important to realize that relative to its peers the firm may well have delivered #1 results, but occasionally the larger economic environment overwhelms that success.  The background represents the ups and downs of the larger economy green is positive and red is negative.  The GDP and credit, normally limited factors in returns loomed large as the acute credit crunch became chronic.

The loose credit from 2004 on created a false economy probably 20% larger than the "real sustainable one" due to the wealth effect of perceived house values and easy credit. 

When the macro economy credit crunch hit a "value" investment, the investment went down like everything else.  Equity appreciation will most likely return faster to those value firms that truly possessed the attributes of value.

A few weeks back a colleague in my office asked, "When do you think the economy will get back to normal", I  replied, "I think it's on its way there now." 

I wasn't trying to be funny. The statement was meant to indicate that spending levels based on false credit meant an economy as measured by GDP that was 10-15% ahead of itself in terms of spending was reverting to its longer term growth rate. 

A contracting real GDP may overshoot the long term growth rate on the downside but will eventually find equilibrium with a better current account balance and savings rate in the years to come.  Yes it will take years.  Fear doesn't dissipate quickly and the greed built up for a long time as shown in the savings rate. 

The major issues now are how the economy ebbs and flows relative to the latest acronym dreamed up in DC.  The new "normal" economy looks more like a big spending program perched dangerously on top of a massive t-bond bubble trading at a fear premium of 3% for 10 yr government bonds. Dollars anyone?

Drinking & Learning about Quantitative Analysis = Quafafew

Quantitative analysis is a puzzle without a solution.  There is no exact quantitative solution to investment as it is a social behavioral problem.  Even approximations can fail spectacularly a la LTCM. 

Soros refers to the socio behavioural dynamic in markets as reflexivity.

Investing, trading, allocating risk etc. are all processes with the same desired end state, maximum terminal wealth.  As Charlie Munger says it is important to understand things from multiple frameworks.  Quantitative analysis can be one of those frameworks. 

Many cringe at the phrase quant as its conjures images of Nobel prize winning economist types creating belief systems (models) that cost tax payers money...cough cough (securitization ratings).  Quantitative approaches should be taken with a large pinch of salt. If they appear merely descriptive as opposed to explanatory run away. 

If a quant approach doesn't have a causal driver that is behavioral it is probably flawed and never ever believe the "with enough leverage" it works lie.

If you aren't familiar with quantitative approaches then try reading Chan's Book first. It is one of the few books sitting usefully between the "pick the right moving average and win the lottery crowd" and the "if these 5 impossible assumptions about execution, the risk free rate etc. hold true then X....academics". 

With time a practitioner can learn something from both camps even about purely fundamental investing or enough to stay away from quants at parties.

Being able to quantify and qualify investment processes is important to understanding them.  The trick is not to believe one has total understanding.  Humility is key whether fundamental value/growth or quantitative asset allocator/trader.  Humility in applying the process aids the outcome.

Qwaf a few

In New York, Boston, Chicago and Connecticut there is a group of people who meet monthly in bars to discuss quantitative findings in finance called Qwafafew. say it out loud and it makes sense.  Say it on the way to a bar and it makes even more sense.

The meetings are held monthly involving bar food, a few drinks, some bad jokes and a presentation or two from a practicing quant professional.  One of the best things about the meetings is the atmosphere.  Give and take, thrust and parry of ideas in a bar setting.  The pretensions of academia are relaxed enough so that the critical practitioner can throw or yell a few barbs and the presenter can rebut.  This makes for bad theater but great potential learning. 

I highly recommend joining the linked in group or e-mailing Herb.  Attend a meeting, best case you learn something or meet some one who knows something. Worst case you just paid $50 for some hot wings and bad jokes about co-variance stability failure.

Here are some power point slides from a recent New York meeting presented by O'Shaugnessy Asset Managment's  ($4b under management) Founder

The first slide shows an optimistic view of equities based on rolling 20 year returns.  If equities return 6% going forward, the rolling returns will equate to the same level seen after the great depression.  I don't agree or disagree with the data, just wanted to give an example of a Quafafew presentation.

The second slide highlights the returns from purchasing the cheapest 10% Price to Sales shares vs the top 10% price to sales shares.  I believe the data were controlled for survivorship bias, but contact O'Shaugnessy to be sure as this kind of study has huge potential for survivorship bias skew.

Make Interactive Excel Models in under 2 minutes

Making a model that lets people interact with variables via scroll bars is one of the most powerful and underused components in Excel.

If you enjoy making models for people to "walk around" or feel the sensitivity assumptions, this is for you.

A warning about the tutorial below, it pops open another window and autoplays. It is a little loud.

Value investing combined with Kelly betting smarts: The Dhandho Investor by Mhonish Pabrai

Mohnish Pabrai puts forth a quick read for novice and expert value investors in The Dhandho Investor.  Value investing is more than just buying something cheaply, it involves understanding the nature of a business and the markets in which that business operates as well as the intelligent allocation of risk capital at the portfolio level.

Pabrai is a successful investor who understands the major lessons for long term terminal wealth maximization.  He is quick to credit those whom he has learned from and comes across as a helpful and supportive teacher.

Pabrai clearly articulates the keys to value investing for maximum terminal wealth

1. Understand a business and its operating market dynamics, cycles and position
2.  Think about moats as margins that contract or expand overtime or due to catalysts
3. Understand intrinsic value and work back from this figure
4. Come up with a few outcome scenarios and probability weight their likelihoods
5. At the portfolio level focus your portfolio bets according to a fractional Kelly betting/allocation mentality. Only risk a little to gain a lot.  Understanding how and why the odds are stacked against you is the first lesson to overcoming them.
6. Exhibit patience

Many value investors stop at step 4 and never contemplate the nature of change inherent in item2 or the dynamics and importance of item 5 about bet allocation.  Pabrai presents his thoughts clearly on these items.

A few interesting notes in the book include reference to company longevity.  For example companies have finite lives something glossed over in CAPM etc.  Pabrai mentions , the book  The living company by  Arie de Guess and how the average major corporation is shrinking with age as Schumpterian innovation goes into overdrive.  Innovative competitive environments are anti-thetical to value investing as the represent moat uncertainty.

With regards to patience, Pabrai offers an extract from a table of major events seen below. 
It speaks highly to the virtues of patience in light of responding to acute news events which may not be economically chronic. As Portfolio manager and not a trader, he discusses waiting for 1-3 years for ideas to work. Again the anti-thesis of having an emotional Cramer moment a la CNBC.

DJIA declines and subsequent performance after crisis events paper here.  You may be surprised at the resilience in markets after an acute news shock.

 
Pabrai also gives acknowledgment to Joel Greenblatt’s useful book and approach from The little book that beats the market.  Greenblatt's book offers a helpful approach to portfolio design via a basic ranking system.

The Dhandho approach is to risk little in order to gain a lot over a period of time and focus on long term wealth maximization.  Pabrai comes across as level headed and as a person with a significant future ahead of him creating and contributing value in many areas.

Discipline and patience are vital. 

I have found in my research of Mutual and Hedge funds that most investors under perform both the mutual and hedge funds they invest in.  Here is a paper on the phenomenon.  Think about that for a moment, even after the work of selecting a great vehicle, the average investor manages to extract below average returns from that investment vehicle. 

If the average actively managed fund under performs the index by 2% and the investor under performs the fund by 2% and equities return 8% over the long run in real terms.  An individual is left with 4% before taxes which in an active portfolio may be short term capital gains weighted.  If the individual switches often "less than a year" to the next HOT thing they are in trouble.

The stream is swift and you are going up and into it, plan carefully and thoroughly. 

Side note: reading & investing your most important asset (Time):

I haven't owned a TV in 20 years even though I was a former chief analyst for Europe's equivelant to the MIT media lab called STARLAB.  My suggestion, sell or turn off the TV, read a book, excercise or spend time with your friends and  family, these are the sources of real health and wealth.

Your Federal Reserve Bank: a video primer & trivia

Central banks are weird animals. The US Federal reserve is a no exception.  In the UK they would call it a quango, quasi government public entity.  The FED is owned by shareholders and is actually a private not govt. entity, buts it management is appointed for 14 years terms by the president.  Sounds like a heck of a system.  Here is some more info.

Trivia about the fed:
The fed isn’t allowed to participate in lotteries

Not sure if that is on the selling or the buying tickets end of the deal.

Earnings of the fed can be used to top up the gold of the US treasury. 

The net earnings derived by the United States from Federal reserve banks shall, in the discretion of the Secretary, be used to supplement the gold reserve held against outstanding United States notes, or shall be applied to the reduction of the outstanding bonded indebtedness of the United States under regulations to be prescribed by the Secretary of the Treasury.  

The Fed is exempt from all taxes except real estate
Federal reserve banks, including the capital stock and surplus therein, and the income derived therefrom shall be exempt from Federal, State, and local taxation, except taxes upon real estate.

The fed is still allowed to produce $10,000 notes. 
Let's hope we don’t see those floating around.  If you find yourself buying cigarettes and beer with a $10k note, things have probably slipped a bit and we are on TARP version 30.1. 

TIP:They discontinued the $100,000 note in 1945, so don't take one as change, it may be fake ;).

Foreign securities aren’t allowed to be pledged as security
No obligations of any foreign government, individual, partnership, association, or corporation organized under the laws thereof shall be eligible as collateral security for advances under this section.

The federal reserve can create its own “police force”

Law enforcement officers designated or authorized by the Board or a reserve bank are authorized while on duty to carry firearms and make arrests without warrants for any offense against the United States committed in their presence, or for any felony cognizable under the laws of the United States committed or being committed within the buildings and grounds of the Board or a reserve bank if they have reasonable grounds to believe that the person to be arrested has committed or is committing such a felony.

Fed meetings schedules are determined by whether it is an on odd or even year.
1. before the Committee on Banking and Financial Services of the House of Representatives on or about February 20 of even numbered calendar years and on or about July 20 of odd numbered calendar years;
2. before the Committee on Banking, Housing, and Urban Affairs of the Senate on or about July 20 of even numbered calendar years and on or about February 20 of odd numbered calendar years.

The Fed uses a rating system known as CAMELs which ranks banks from 1-5 for soundness. 
You don’t want a lot of 5 camel banks.  In a very interesting approach to game theory which I agree with the CAMEL rating system and ranks for banks aren’t published.  One hopes this prevents gaming of the system and reporting.  This lack of disclosure is based in my own opinion on an understanding of the nature of behavioural dynamics and rules systems.  To sum up people always try to get a ahead and when it comes to risk that can be collectively very bad.

In a very interesting approach to game theory which I agree with the CAMEL rating system and ranks for banks aren’t published.  One hopes this prevents gaming of the system and creative reporting jiggery pokery.  This lack of disclosure is perhaps based on an understanding of the nature of behavioural dynamics and rules systems.  To sum up, people always try to get a ahead and when it comes to risk that can be collectively very bad. 

I won't go into details about why the ratings secrecy is important, but for those of you who know the ratings agency games and how securitization really worked you will get it.

Fed ownership is a bit circular these days.

The fed is owned by shareholders.  It is generally assumed these shareholders are major banks.  The fed has been bailing out the major banks.  I will leave it up to you gentle reader to interpret the implications of the associated megaponz diagram.

The FED has a kids section

In an example of inflation for kids using babysitting as an example, the fed suggested that if inflation eats into your popcorn money you should ask your neighbor for a raise.  No advocates of eating less popcorn.  Wonder why we had a savings problem... 

The wikipedia entry for the FED
History of central banking in the US.

The price of stuff is holding up pretty well

I exchanged a few emails with Jim Rogers the other day, he knows what he is talking about in terms of govt policy and the potential for making things worse.

Here is the Rogers commodity index, it has taken a beating with the recent demand destruction and commodity bubble burst. 

Yes, it has been a wild ride, but compared with other paper based assets, the index hasn't fallen that far.  I am still perplexed why anybody chases the yield available on US treasuries.  30 Year strips did extremely well last year, but that was last years bet.

Liquidity and lack of other options isn't a responsible or reasonable answer.  Think about how stupid that could sound if the yield on 10 year notes goes to just 6%?  The pay:skill parity between astrologer and fund manager is seriously out of whack.  You gentle reader can determine how the spread should narrow.

For the quants out there, the single day auto-correlation trade no longer works on the time series, but longer time horizons may be interesting :).

Liquidity, solvency and acute vs chronic banking system states

I learned in my medical anthropology class, there are two broad types of illnesses in medicine, acute and chronic.  Acute illnesses are typified by rapid onset and short course.  Chronic illnesses are longer lasting more prolonged and assumed to be multi-symptomal and or multi-causal. Chronic illness could be a state of multiple regression in subsystems.  Both terminate in recovery limited capacity or termination.  Lehman is a case in point of an acute case leading to termination.

For those of you quants out there, think of an acute illness as an extreme jump diffusion process and chronic onset as drift or diffusion, both are or can lead to regime changes.

Here is a snapshot of various big money banks CDS (credit default swap) spreads, presented as risk condition proxies. 

The analysis shows the acute crisis of Lehman brothers considered a liquidity crisis in sept 2008 and the current more persistent chronic crisis reflecting fundamental solvency issues. 

It appears that the acute attack was mitigated with liquidity, but the chronic condition persists.  Sadly I see know way out of the chronic process other than inflation or termination of the current banking infrastructure and nationalization is only an ownership change not a radical restructuring.  Neither "solution" is near term (3-7 years) appealing, but please look at the alternative of 28 years of stale growth in Japan as measured by equity returns.

My choice between the Scylla and Charibdis of inflation vs banking Ctrl+Alt+Del is actually Ctrl+Alt+Del for the banking sector.

We are currently distorting the banking market by crowding out the institutions (if there) are any that were prudent.  Keeping the current structures and systems in place isn't so great.  Lets have the prairie fire and restart fresh and fast.

The chart indicates a sharp return to the levels of the acute phase of the problem seen earlier.  The actions taken today will determine the next 15-20 years economically.

I offer the chronic vs. acute discussion, because we are trapped by language in sharing our understanding of things.  The language of economic phenomonon is limited and the 7th inning stretch and uncharted waters metaphors popular last summer do little to help the discovery process or debate.  Medicine has a robust  lexicon to decribe complex sytemic issues.  Lets hope economics can advance to more nuanced concepts.

28 lost years in Japan as equities revisit 1981

Forget the lost decade. If you can't imagine 28 years ago.  Here are the top 10 songs from 1981 to put it in perspective. Ouch.

The new Big Mac index for banks Uber/Sub Mac @ $3.54/share

The Economist has the Big Mac index as a tool for tracking currency parity. I have been an Economist fan for 20 years, probably my biggest addiction next to coffee.

The index currently sits at $3.54 USD for a big mac. Considering the Share Prices of various banks these days, we might consider them over or under the big mac.  When Bear Stearns originally went out for $2 it was sub mac. 

So how is your favorite bank, uber or sub mac these days?  Sorry folks, I just didn't think the Happy Meal reflected the mood and Starbucks is too upmarket these days.

Citibank at below $1 will barely get you fries or an apple pie.  Bank of America (BAC) is now submac.   Who is next for the Mac Attack.

Enjoy the Old Skool ad with Ronald McCreepy.  Considering its new powers and roles I think the Fed needs a mascot and rebranding, any suggestions.

Inflection points and thinking meta

When things are "fluid" to use the popular term, it is important to think in a broader context, to go meta if you will.  History, geography and anthropology are great tools to think about finance and markets. As a former anthropology student focused on sustainable economics,the stimulus talk sounds a lot like bad Worldbank and NGO planning for other countries.  Big bag of money chasing an ill defined problem with immeasurable goals.  How do we know if it worked?

Juan Enriquez does a very powerful job of thinking meta in a video with a question. How many stars will the US flag have in the future?  FYI D.C. is thinking about becoming a state. Check it out video and think about a few questions.  How many more countries will there be in a few years?

A few points in the video

• Some US states are net payers vs. receivers of federal government largesse a factor that will become important with looming New York and California defaults.  Today the Irish, Italian and Eastern European strains on the EU could bring it to a restructuring.  Non-EU Switzerland which is a series of cantons also has banking risks that exceed GDP.
• The decline in duration of a fortune 500 member from 94 years in 1935 to 14 years in 2006 reflects macro institutional churn increase.
• The rate of change and why countries or regions split apart (hint: it is often about money)
• Don't take your country, political regions or currencies for granted.

An interesting chart from William Easterly shows China to have a either a Democratic deficit or a false sense of autonomy.  China is probably in for some deep changes in the next 6 months.  For the long term investor geopolitics is starting to become more important as the scale of shift moves up from company:sector:economy:country to global.  It is time to think meta and then perhaps to act meta. Watch the video and read some Bill Easterly.  He is a specialist in development economics.  For those of you not aware development economics is basically when really smart people try to stimulate an economy.  Easterly shows when and why external stimulus fails better than anyone.

Quantitative Trading, Ernest P. Chan’s New book is extremely useful

Quantitative Trading, Ernest P. Chan’s New book on trading is extremely useful for Asset allocators, portfolio managers and traders.  They should be doing the same thing, maximizing terminal wealth.

The path and tools choosen varies among the participants. The important thing is to understand what role a person plays and what the processes and tools are for being most effective in that role.

In his book Quantitative trading Ernest P. Chan offers techniques and recipes in Matlab and Excel VBA for the trader wishing to learn more about strategies such as Co-integration, money management, back testing, mean reverting and momentum strategies etc.  Chan has broad experience with tools and techniques for various strategies and explains things clearly with the voice of an experienced practitioner. 

Some of the most important work Chan offers in his book has to do with tying the trade or position level and its potential role in a long term portfolio context.

Many traders and asset managers think in terms of $’s or % of portfolio at risk. Many trade with rules of thumb but may not have studied how to maximize the terminal wealth of their strategies and approaches. 

 
The Sharpe ratio is the standard risk metric that most allocators and analysts use to assess a manager or trading systems performance. The Sharpe ratio is typically shown as the annual rate of return minus the risk free rate divided by the annualized standard deviation. This metric is a simple way to measure risk vs. return.

Many gamblers are familiar with card counting and betting strategies based on the odds of the game they are playing. Years ago a formula was derived called the Kelly formula for optimizing the return on a given strategy over the long run. 

For example, lets say you play a coin toss game that pays you 101% of your bet each times heads comes up and costs you 100% each time tails come up. How much of your “portfolio” should you wager each time to maximize the returns with this game over the long run? The Kelly formula answers that question.  

The transaction pyramid to the right shows the activity levels of various practitioners.  All of them can learn a little thinking about the Kelly and Sharpe Ratio relationship.  Whether gambler or student of high finance, it is one of the keys to terminal wealth maximization.  I recently created a free spreadsheet tool for exploring this relationship based on Chan's work.

Chan comes up with a simple solution for assets allocators wishing to maximize terminal wealth using Sharpe ratios. With any trading system or allocation approach caveat emptor. Investing in fundamentals with a margin of safety that skews the odds in your favor may be a better approach for portfolio managers. 

For the asset allocator converting the Sharpe ratio into a single asset allocation % may be an interesting starting point in allocations, but macroeconomic issues are probably more important than variance assumptions given the time horizons and principal return factors involved. 

The correct application of the Sharpe to Kelly relations is usually to apply a “sub-optimal” allocation to arrive at a margin of safety. Sub-optimal allocations are chosen as portfolio level assumptions of correlation and co-variance are unstable, this is referred to as a fractional Kelly implementation. These days sub-optimal means an increased Cash or a high cash proxy. Please choose your currency carefully, risk free isn't risk free anymore. My bias is for the Norwegian Krone for the next 2-3 years. 

I would highly recommend Chan’s book for the fundamental, technical or quant trader. Chan is concise and clear in teaching the basic methods and tools for a quant. You can visit Chan's excellent blog to get an idea of his thought processes.

For the fundamental portfolio manager, simple factor based analysis may help provide a piece to the puzzle about cyclical influences.  My personal interests are studying inter-market company level competitive dynamics and likely moat variance over time.  This is probably due to my anthropology background.

I consider economics and markets as nothing more than simple group behavior pursuing individual interests.  These groups and individuals are capable of collective myopia and flawed beliefs due to ritualized knowledge and codified social structures.  Watching an economy from the outside like a field researcher can be fascinating and lucrative. 

One just sits and waits for knowledge to ritualized to the point where it isn't questioned and then take the opposite position.  Ritualized knowledge can be in the form of structures such as flawed systems like ratings agencies or Mean Variance risk tools.  False ritualized knowledge can also be in the form of aggregate memes such as house prices can't go down, we are in the 7th inning of the economic storm etc. these narrative become group myopic beliefs leading to blindness and flawed group behaviours.  The chain of logic that generated the meme is collapsed into an oft repeated truism which ultimately proves false.

CNBC is the meme machine of American casino capitalism.  When it goes off air in 6-8 quarters, it  may be time to buy equities again.  The silence will be golden. The ratio of octoboxes and decaboxes to viewers must be sliding. The more CNBC screams and rants the fewer people care to listen.  There is some good stuff on CNBC, but the needles are getting lost in ever more haystack.

Both fundamental and technical trading and allocation approaches have merit when used as part of a long term process. For those interested in applying technical tools to fundamental allocators, check out AlphaClone.

The opportunity to learn yet another approach to asset allocation such as the trading techniques illuminated by Chan, even if not pursued help one think in yet another frame. Cognitive code swithing in linguistics is related to intelligence.  I should like to think multiple analytical framework application is the tool for maximizing terminal wealth at the individual and collective levels.