Designing better futures

Noise outside of the box and quant models

An interesting paper has been published showing that many extinction events in nature happen due to correlated exogenous phenomenon which looks like colored environmental noise.  This is interesting as most biological models had assumed that environmental (outside the species) variables were random, ie. white noise.  The evidence indicated extinctions were accelerated due to correlated exogenous (environmental) noise.  See link here. 

This is important to econometric and finance models for the following reasons.  Most quant risk models which are used to justify extra leverage or risk allocations for banks and traders are limited to historical market or nearby associated econometric data.  The inherent assumption being that all prior data reflects enough prior noise and events to accurately reflect a noise profile for an instrument or portfolio of related risk. 

Think about it like this.  If I have a simple one variable non-interacting system that ranges from 1 to 100 over a given amount of time like a spring, I can be pretty sure that with enough samplings say X, I have seen the 1-100 range of likely events and their distribution.  If I have a 2 variable system with loosely interacting components I may need a Y times X samplings to see the extreme ranges of possibilities. 

One can see that  extending the context of the system drivers increases dramatically the amount of data required to understand the range of outcomes.  What isn't taken into account is the role exogenous harmonics might induce in the model.  Even weakly interacting system can sync up with dangerous effects.  For example, two grand father clocks set a few feet apart will eventually sync up.  Consider that for a moment.  Two systems could be set up to be non-correlated and yet over time will become exactly correlated, just like that portfolio last year experiencing a 25th standard deviation event.  The event wasn't 25th standard deviation, just the way it was measured in the first place.

An environmental system rapidly becomes complex enough to by impossible to model relative to the drivers and historical data available.  Even a simple closed predator prey network has vast complexity.

Economic systems or markets are the same way, in that the external variables make the pursuit of a true model challenging.  We are currently undergoing a rapid economic shift that is a result of a credit bubble which is impacting markets far removed from the perceived point source. 

The economic environment is going through a period of rapid accelerated extinctions due to these events.  Yet many still operate under the assumption we can model our way through risk control and portfolio construction going forward using the same tools that got us here with a few tweaks.

Finance models fail due to an inability to capture context both at the physical and at the agent behavioral level.  I have yet to see a risk model incorporate the risk that everyone else starts using the same model inducing over weighting and run away prices in an asset class or instrument. 

After all most modern finance risk models are mostly trend following band wagon style into whatever was hot over the last year, decade etc. with a little tweak for co-variance, CAPM, Mean variance approaches at portfolio construction etc.  Bandwagon finance as such isn't a thinking persons approach to risk or portfolio construction.  Most applied risk allocation models are clever but useless tools.  Perfect in a vacuum, but down right dangerous in the real world if you don't look at the assets underneath or the environment driving their price.

I remember studying Artificial Intelligence for fun in college and the professor discussed context in regards to a chess playing computer.  The computer might be able to analyze deeply the possibilities of the chess board, but wouldn't know that it was time to leave the game if the room caught on fire.  The context was limited and always would be by definition of a closed model.  The inability of most risk models to incorporate variable context, regime shift or environmental state shifts,"such as NINJA loans" coupled with our over-reliance on them is a dangerous proposition and sadly one we haven't learned yet.

My suggestion would be to drop any mean variance portfolio or bank risk model which assumes to show via historical data the risk relationship between economic instruments.  I advocate a return to simple leverage metrics and the elimination of VaR. 

Basic rule of thumb leverage is in-efficient but stable, a trade off many would be happy to make right now.  If it can't be understood within a traditional banking context don't touch it.  Ignorance admitted isn't a bad thing, false pride is.

Post Model Manifesto

Paul Wilmott, eminence grise of the quant world has posted a manifesto which among other things points to the wrongs of the past, but neglects the fundamental truth of models and risk. 

In applied systems the rules determine the outcome. 

The very concept of a "truth" in modeling or risk is flawed.  I am ashamed to use the term, but will.  Markets are post modern.  In that I mean that sustainable markets rely on multiple truths: perceptions of risk, reward and timing.  If everyone has the same truth, the system fails as it teeters toward an extreme.  A uni-model system is less stable than multi modeled one.  When everyone looks over the edge of the boat on the same side at the same time it tips over.  Everyone working in a Basel 2 or VaR type of framework will share very similar opinions.  We need radical dissent and it to hereticaly ignore the pursuit of collective models of risk.

If all groups pursue or use the similar models with slight tweaks they will reach similar conclusions, at the same time and like everyone on a life boat looking over the same side, tip it over.  The unified presentation of "correct" or "true" models and unified risk is what caused the problem with CDOs etc. in the first place.  The ratings monopoly on Truth combined with similar models and trader laziness among other things tipped the mortgage boat over. AAA all the way.

Bubbles and manias are caused by everyone sharing similar models and horizons of risk.  Whether it is gut feeling "mental model" that says Tulip Bulbs can only go up or a CDO valuation cranked through the latest hot quant model, shared truths become false truths.  Lets stop chasing them or forcing banks to pursue them.  Wilmott's proclamation is nothing but a request for the red queen to run faster, individually that is fine, but a collective pursuit is dangerous.

Basel 2 with its self similar approaches to modeling is crying out for reformation if not outright elimination.  Forced use of mean variance type models will induce nasty problems as everyone seeks to game the systems capital weighting in the same way.  SIV 2.0 will beget Credit Crunch 2.0, in a bigger more sophisticated way.  Our faith will be emboldened by faster computers and brighter quants. "modern" finance always comes up with new ways to blow up. Speed and greed translate into leverage in the financial world.  It may take 10 years, but we will get there and we will be sorry.  The first group to use a model will make money and the next few less, by the time it becomes a "risk" management tool, the boat tips over.  The model bears the seeds of its own destruction in a Popperian sense.

I prefer my inevitable banking failures small if you please.  Lets minimize systemic risk, by decoupling the system.  De-coupling means getting everyone to form their own opinion of risk and reward.  Naive inter bank trading "caveat beware" should return.  Yes this will lead to a less efficient system, but it will be a more stable one.  It is a Tobin type tax if you will, that acknowledges the unknown and the unknowable inherent in any economic transaction.  Get me there slower but safer at the over all system level. 

In every other engineering business the rule is safety first!  Safety should come before optimization or transactional efficiency.  A few basis points for the bankers bonus isn't worth the collective risk. Slow down.

When the models and regulations rule, actor's risk horizons and opinions converge.  This convergence on a truth put the system in a dire and unstable state.  Does anyone find it interesting that the only entity apparently capable of bailing out the current crisis is the FED which doesn't have a Tier 1 capital requirement? God help us if/when the bond market wakes up to the shenanigans going on at the FED.

As Churchill said," where all think alike, none think much."  Dissent and ignorance of counter party risk counter intuitively provides stability as actors tread lightly upon the stage of finance.
 

My credo is lets all use models mental or mathematical, but let none be beholden to a collective "truth" of them a la Basel 2 or regulatory regimes.

Texas ratios for 8,196 banks= 95 bank failures & $21.9 billion in bailouts?

A lot of noise is being heard about the Texas Ratio as a proxy for bank health.  Without knowing what is in a banks books and how those assets are going to perform who really knows.  I took the +8,000 US bank data set provided by http://www.lewrockwell.com/chris/banks/banks.html (Caveat emptor) and created a tool.

There has been a noted lull in the FDIC Friday night bankruptcy game as of late.  It may pick up after January 21st about the time the auto bailout is spent and the inauguration is winding down, coincidence?

If one assumes a Texas Ratio of 100 leads to trouble and that there is a 25% loss on assets in those 95 of troubled banks, then we are in for another $21.9 billion in net bailout fun.  Again all of this is pure speculation. I just thought I would organize the data and provide a tool for people to check out troubled banks and the potential impacts more easily. 

In a period of extreme uncertainty and volatility in the cost of money, the assumption of underlying asset values and the marked valuation of those assets banking can be considered an interesting sport these days.

So feel free to play around with the ole TexasBankorometer.  Happy 2009. Download Bankstexasratiov1.1

Anybody have an interesting data set to play with send me an e-mail.  I like to build models.

Heretics of Finance was my lump of Xmas Coal

  I ate a little too much on Christmas eve and couldn't sleep, so I thought I would read my fresh copy of the Heretics of Finance while I waited for the fat man to make his entrance through our chimney.  By 2:00 AM no Fatman, no gifts and a disappointing book was finished.

Andrew Lo faces a challenge with any book he writes or co-authors. That challenge is the quality of the body of work he has produced before.  He is one of my favorite academics in quant finance as he usually has a healthy skepticism of the efficient market hypothesis and is willing to entertain differing opinions and properly treat the EMH hypothesis correctly as hypothetical.  This is good science and good judgment, he is robust quantitatively and uses good tools and judgement.

The book Heretics of finance is a series of questions posed to some of the ancien regime of technicians.  I anticipated an intriguing insight into robust results of various technical approaches.  What was delivered was a series of interviews rife with confirmation bias, subjective review and sorely misplaced self congratulatory praise for "beating" the academics. 

The practitioners barely seem to articulate what they do or how they do it, much less present a convincing case "it" has been done.  The title Voo-doo market technician may stand tall after reading this book, if it is held up as the heretics defense.

Most technicians use variations on the theme of a filter (low or high) pass from a signals perspective and seek to transform a price signal into a secondary signal with lower variance and a mean that is shifted to the right with lower kurtosis than the original signal. 

Moving averages, RSI etc. and the usual cast of characters make their appearance here.  I have a lot of patience for the tools they use if they provide results, but little sympathies with the depth with which these practitioners seek to understand either how the tools work or why. 

Studying ancient Greek oracles reading chicken entrails teaches one a bit about Greek culture and the standing of the priestly caste, but woefully little about the drivers of history or fortune telling's ability.  The Heretics of finance, serves up the priests, hands covered in entrails, but with little else to speak of other than a knowing pride that technicians aren't academics.

Andrew Lo has written some good things on quant approaches such his work on statistical arbitrage failure and the dispersion failures in august 2007.  This book is disappointing as it neither entertains nor illuminates.  I should have picked a classic for Christmas eve as I scored an own goal with this one and got a big lump of coal for the effort.

P.S. I'm not anti-technician. I created a quant forex index based on a series of filters seperated by E to reduce harmonics years ago.  The approach works, becuase of serial correlation in central bank rate moves. No magic just extracting serial auto-correlation using a series of filters. The document is here. If you are interested in quant approaches or have a qaunt fund looking to work with someone.  Lets talk. I'm up double digits for 2008 with a 1.10 sharpe ratio using L/S equities.

Value @ Risk and Frogger

Large cultural failures or setbacks such as our current debt crisis are rarely due to technical faults or even individual greed.  They are often functions of collective myopia and a lack of imagination.  Many don't know it but one of the major ratings agencies had a securitisation rating model for mortgage backed CDO's that couldn't or wouldn't accept negative house price changes. 

This is mentioned in the vain of a current collective myopia which is the use of VaR (value at risk) or other mean variance approaches for assessing the risk of portfolios. VaR reports the potential for a given $ loss over a period time with a given % likelihood.  For example your portfolio may be reported to have a 99% daily VaR of $1m. 

Every day some back office system spits a report to an imagination challenged risk manager reading out that the portfolio VaR is something like $1m with a 99% likelihood for a single day.  The risk manager reads this report thinking his risk budget is $3m so he or she is fine with 3x coverage.  That my friends is where the trouble starts.

The report says nothing important only takes up time.  The only important days are the roughly 3 days per year that will exceed $1m in loss.  The report leaves these out and can't conceivably address them. 

The way to think about the report is using the Frogger model.  Every day the risk manager looks out across the road and is told that 99% of the time he won't get hit by a car very hard.  The risk manager can then decide to cross the road.  The manager knows that trucks and cars whiz by with great irregularity. Focusing on the crash or impact may be better than focusing on the 99% of time when nothing happens.  The 1% is the only thing that counts.  VaR as reported and modelled makes people feel safe. 

When people feel safe their behaviour changes and that is when they are most dangerous to themselves and others.  From a Popperian knowledge perspective the more confidence in a unified risk framework the more systemically dangerous it is. 

Beware Basel II it may make the useless ratings agencies and current economic problems look tame in the next 5-7 years.
 Belief in Myron Scholes and Markowitz ideas may be the more dangerous things for our culture and economy.  For what it is worth I am a CAIA holder and recovering quantitative analyst.

Fairly effective predictions tools and equity new highs in 2018

Here is a collection of some of the predictions made in this blog.  The blog missed the full scope of the Chinese bubble burst. I thought -40%, it turned out to be -70% and was 6 weeks early from the top.  Sornette, Gott and yield spreadsheets are helpful tools.  They are available here or for the asking.

China shares bubble bursting (thanks sornette)June 2007

First article on house decline June 2007

Warning of mark to market problems June 2007

A handy free prediction tool made public July 2007

Suggestion CDO would lead to global economic crisis July 2007

Home values lead to $6.6 trillion in losses Aug 2007

Discussion of the panic of 1893 as a pre-cursor to today

Warning on Citibank debt Nov 2007

Anti-VAR and Model Rant, yes I am a recovering quant now value focused Dec 2007

The ratings agencies are SEC abomination Dec 2007

Commercial real estate should be avoided Feb 2008

Fair Value on the Dow 8,800 March 2008 (the simple prediction tool in Excel free download)

Value at Risk is more dangerous than useless, have alway thought so March 2008

Municipal bonds will take a hit March 2008 this is still playing out

Indications that housing could still fall faster.  April 2008

Civilian employment peaked in 1999 May 2008

Recurring indication of overpriced equities dow 8,500 June 2008 

CDS netting risk July 2008

We weren't saving enough(not a prediction just a pointed fact)  Aug 2008

Hints of deflation when inflation was fashionable.Aug 2008

The real scary stuff is in 3-5 years when Basel 2 is in place.

China could experience radical political change in 6-12 months

The sad reality is that equities in the US are -40% from the highs and will need 60-70% in returns to get to break even.  Based on historical average equity returns that equates to 10 years depending on dividends and inflation.  Breakeven is 2018

The point of this post is that active listening to the numbers and ignoring popular opinions or the "wisdom of crowds" could help spot problems. 

There is a fascinating cultural phenomenon I call collective myopia.  It is powerful, in that groups can seemingly perform the heroic, stupid, foolish or sublime all while being oblivious to the obvious.  Understanding collective myopia and being able to listen for it, see it or spot is a useful skill. 

Hopefully our regulatory, legal and political institutions will learn from current mistakes, but there really isn't anything new under the sun here.  Read Kindelberger, we have been going through financial crises for centuries and will invent new debt instruments and buy "things that only go up" well into the future because our neighbors do it.  We are social animals and take our cues from each other, as Kindelberger says, "nothing makes a person lose common sense more than to see a neighbor get rich."

What should you do?

Advice to get into Norwegian T-bills May 2008  this could look good over the next year or two.

 According to Morningstar of 9,900 US mutual fund managers 3 were positive over the last 1 year period, and yes I am up for the last year, but it is no reason to be smug, I am just as scared as the rest of you, for the near future is uncertain.

Tomorrow Oct 10th may be the day without money, but have faith.  Banking, money and credit are cultural phenomonon and will be back.  In 5-10 years we can learn to create new dreams, it is the human drama playing out in all its Shakespearian form...all the world's a stage.

Please note, I do not and am not allowed to discuss positions related to the fund I work with in public forums.  I also believe portfolio theory and VaR type models had a lot more to do with today's crisis than is discussed.

On systemic collapse

Many like to yell "systemic collapse" in a crowded system.  Most studies of complex systems or networks of interactions realize there are 3 zones in which a system exists.

 Economies are systems.  In this example I label the 3 zones, stable, interesting and random.  Some use the term chaotic, for the 3rd zone, but this or "complexity" is really a gradient between zones 2 and 3. Lets not get started on a debate about Kolmogorov constants.  

The energy or system inputs in the model above range from 0 to infinity.  A basic example of this model is given by the carbon in #2.  The states are Diamond (Stable), interesting (organic) and finally gaseous (CO2) which could be paired on temperature gradient.

Moving out of stable interesting in the middle to the right or to the left is usually considered a "collapse" by those within the system.  We still don't know where the US is going to end up,  Hyperinflation volatility Latin America style on the right or Japan Land of the Living dead economic tomb on the left.  The dollar shoe has yet to drop (pun intended). 

Ideally we get back to the middle zone rapidly, but US debt and unfunded government liabilities causes this to be a challenging assumption.

In an economy or any complex system it is impossible to understand the relationships and dynamics in the interesting zone.  This impossible understanding of "inter" relationships however doesn't stop the lazy practitioner from modeling co-relationships and thus assuming detailed knowledge of the system dynamics.  Co-relationship analysis is useless and flawed in systems, such as economies or portfolios of loans or portfolios for that matter.  We are now witnessing these flaws of mis-understanding in the early stages of the US meltdown.  Common sense never got in the way of a large vocabulary or a good "working" model.

Don't even bring up options models, which are only really lucrative if you understand their flaws.  The myopia of the model builders can be quite a gold mine for the good gambler.

Common sense rules of thumb were overrun by correlations.  For example, imagine if the continuum above were leverage for a bank or economy.  Leverage runs from 0(no leverage) to infinite leverage.  Historically banks would use a rule of thumb such as 12:1 for our cultures fractional banking system.  Think of this as the tier 1 capital requirement.  A regulator can't understand the dynamics of the system so tells everyone to operate within a safe zone.  There are no further assumptions made such as sub zones etc.  The entire system has a single regulating variable, namely leverage.

This left the system "economy" safely in the interesting zone where it could evolve and grow maybe not the fastest, but safely.  No one really understood all the components or co-relations and if they did they were just deluded economists or some other garden variety charlatans.

The dangers in the system occurred when US banking regulators 5 years ago allowed entities to leverage up 30:1 etc. based on correlation or covariance analysis.  Basically a lot of very bright people who had no idea about system dynamics and lacked the humility to utter the words "I don't know" (Jim Crameritis), or god forbid, "I can't model it".    When a person tells you they can model a CDO,  they may as well tell you they can model a meadow.  You should thus leverage your CDO or bank accordingly. Basel 2 is a disaster waiting to happen, for it assumes knowledge of interactions within the system.

This leverage pushed the system to the point where it would inevitibly suffer collapse.  The pertinent question today is how much of the system is collapsing, housing, banking etc.  The system dynamics are too complicated for me to understand, but months ago on this blog, I made suggestions of more currently "stable" regions for investment consideration.

A person who understands the edge of statistics is Nassim Taleb.  Check out his great essay on "the limits of statistics" His pen and mind are far sharper than mine in these areas.

What are US equity investors expecting to happen?

The S&P 500 represents $10.8 trillion of US equities.  It is trading at roughly 20.6 times trailing earnings.  This works out to a current yield of 4.86%.  The S&P 500 has historically traded at a mean yield of 7.45% and a median yield of 6.46% since 1938. 
If the S&P 500 reverts to mean it would indicate one of the following things happening in the next year

• a 30% equity price decline or
• a 30% increase in earnings or
• a mix of both

I am curious to hear from some bulls, actively buying equities what do you see? Is the expectation of future debt yield so low that 4.86% seems like a fair equity risk premium even with zero growth.  Here is the data from S&P Download copy_of_sp500pe_ratio.xls

Here is a simple model to play with earning changes. 

Download modelequityearnings.xls

So what are you people seeing, low yields, increased revenues, decreased COGs & SG&A?  For the buy and hold crowd, I get it, don't time the market, but for someone piling in right now, what is it?

The metric system & investor value biases (lets start talking basis points)

Most people think "the market" is the Dow Jones and hear talking heads tell ever greater tales of markets, swooning, plummeting, soaring etc. connected to some number.  The market collapsed 10 points or jumped 50 points etc.  The TV character then attributes this activity to some random event and thus a fictive narrative is born.  These stories and storms in teacups then sell Escalades, soap and insurance etc.

The average person has no idea what Dow point movements mean.  Even experts who watch the market day to day use them as relative metrics.  Familiarity gives Dow points relative meaning.   For example, if the Dow Jones Industrial Average moves 50-60 points typically then  a 100 or 300 point move is understood to be a big thing. 

What counts is percentage of change

The DJIA maintains its dominance as a market barometer due to human cognitive failure.  The DJIA as a market barometer is horrible in both scope and construction comprising only 30 shares weighted in an abstract manner.

We get psychologically anchored to thinking about values in a relative way and thus become trapped within a mental framework.  Our perceptions get skewed.  Think about people who bought homes based on comparables across the street, the mental framework made sense from a relative value perspective, but was useless in terms of absolute value.

My suggestion for financial journalists would be to talk about index Basis Point moves.  So a 2% move in the dowjones would be 200 basis points.

This is the perfect time to do it with the dow near 10,000 the relative Point value of the Dow and Basis point value of the dow are about the same.  Basis points allow people to talk about something meaningful (i.e. relative percentage moves). 

People are anchored to the relative nature of Dow points, this is why the S&P 500 or other indexes will  never usurp the Dow's position for average people discussing the US equity markets.  There is an anchored value perception.  For all of you value investors out there, Dow Jones has a great moat with this.

This suggestion to discuss equity indeces in basis points of has about as much chance of succeeding as America's "war on english units" move to the metric system in the 1970's.  People are still blaming Jimmy Carter for that one. 

There are 3 countries in the world who haven't adopted the metric system, Burma, Liberia and the US

Once people gets used to a relative unit of value their mind gets anchored there.  The smart investor can use this to their advantage as the ast majority of people are too lazy to shift a relative frame of value to an absolute one.  This advantage become ever greater as values move to extremes.

One of the funnier quotes about value shifting came from the humorist author P.J. O'Rourke who wrote," Drugs have taught an entire generation of Americans the metric system", sad but probably true.  Don't expect the US equity market to be discussed in basis points anytime soon, expect it to keep swooning, leaping and generally carousing around in Dow points, and that folks sells advertising.

Beat the Market with Ed Thorpe

I have been studying for the CAIA Chartered Alternative Investment Analyst exam coming up.  It is a bit like the CFA but only 2 exams and focuses on alternative investments.  It may be geeky to admit but it is fun stuff.  I used to build trading models as a kid and play with neural networks and t-bond futures in college back in 1990. 

One of the areas that is new for me is Convertible bond arbitrage which is a great way to get back into math a bit.  The strategies and approaches are as I used to be a runner in the 10 year t-note options pit at the CBOT. 

Awhile back I reviewed Fortune's Formula which was all about Gambler's, gangsters and information theory.  It also had great stuff on portfolio allocation and risk which is a subject much like Taxation that few investors think about at their peril.

Successfully growing wealth via compounding returns needs tax deferment and minimal impacts from Siegel's Paradox (the fact that money lost beyond 13% has to work harder to get to break even.)   Risk management and portfolio allocation is sorely un-respected in the field of investing for the long term.  A simple understanding of portfolio auto-correlations and re-balancing approaches can add 100's of basis points to a portfolio at the fund or even asset class level every year.  Of course this mean thinking about 10-20 year horizons.

One of the Gurus of Convertible arbitrage was and is Ed Thorpe who runs a multi-billion dollar fund in New Port Beach, California.  He still publishes and is revered by Nassim Taleb and the Wilmott quantitative finance crowd for his pioneering work.

He published a book in 1965 called Beat the Market that is now out of print.  I found a copy via my grandmother in Iowa of all places and had it scanned.  You won't learn anything new in there, but it is interesting to see a pioneering piece of work and the historical bits such as:

• Spreads of 30-40% on warrants
• A capital gains rate of 25% considered long term after holding a position for 6 months
• Today we call them investment "ideas", back then they were "situations"
• and this view of the future: "We are misguided  when we exalt ourselves by insisting that the psychology of the marketplace and of man are unknowable.  The sciences of man are now emerging from the Dark Ages.  Economics and psychology stand today at Koestler's watershed just as astronomy did in the time of Tycho Brahe.  Our superstition, blind belief, and ignorance are being swept away forever by the scientific accumulation and analysis of data.  There will be predictability in the affairs of men."

Funny how the technology always gets better but the folly and fickleness of men never changes.  Glad a I took anthropology study psychology and sociology in my spare time. That scientific prediction of man is a little over the horizon.

If anybody is interested in a PDF of Thorpe's book Beat the Market for educational purposes drop me a line.

When robbing a bank it is best to wear a suit and carry an MBA not a gun.

Barron's pointed out a bull market in bank robberies.  It appears robberies in New York state have jumped 66% this year.  There are now 30 robberies per month in the charmed Empire state.  A little math indicates the average heist currently yields $12,270. 

 As an anthropologist hedge fund type, I am curious to see if this is a logical behavior.  So I did a little digging.  Here is a fun research paper from the Dept. of Justice on the topic.

We learn the following things:

• A death occurs in 30% of US bank robberies.  (ah the right to bear arms in action)
• 60% get caught. (really not a very gifted lot on the job)
• Interviews indicate that most robbers would be satisfied with much less. (please, how un-enterprising.  This is supposed to be a career not a thrill sport, where is the professionalism, the ambition and drive to get ahead?)
• The average heist takes 3 minutes or less. (minimal effort required really)
• Federal sentencing guidelines indicate 20 years.  +5 with a gun. (leave the gun at home)
• 80% most are solitary offenders working alone. (This is good management, keeps the operating costs down and reflects the ultimate flat organization, very avant garde really.)
• 60% are unarmed and undisguised. (A touch of vanity and exhibitionism I suppose.)
• 58% of robbers escape on foot. (very eco friendly when you think about it, please no crass comments about political biases of tree hugging robbers).
• Robbed branches are more likely to be robbed again.  One third of repeat robberies occur within 2 months of the original crime. (A recently robbed branch really isn't a place for a first date)
• Day of the week effect 25% of robberies occur on Friday. ( a thougtful tip for all you quant risk types on the look out for that little edge mentioned in the previous point.)

With a little math we deduce the following:  from a probability perspective assuming 20 years and a 60% catch rate, this works out to roughly 175,200 hours of jail time * 60%/$12,270 or roughly $.116/ hour probability weighted wages for those working alone.

At $0.12/hour this type of work really doesn't pay.  I mean isn't this the kind of work we outsource to China and look the other way in regards to human rights etc.?

This leads us to the conclusion that, to this day the best way to rob a bank is to either own or manage one.  Thus the most effective disguise for a bank robber is most likely a suit and and a 1st tier (no state schools need apply) MBA.  A far more suave costume than a balaclava and gun.  I won't even comment on those slackers who don't even go with some fun disguise on the job. 

Even a sub par Sr. VP of something or other could "Steal" $12k just by padding the expense account at a nice weekend mortgage risk management conference in Monaco or Gstaad with far less dire consequences than 172,000 hours worth of opportunity to meet new and interesting people.  Note to the ethically challenged please choose your careers wisely and leave the gun at home.  And if for some reason banking with its dry people isn't quite your thing, there is always politics.

US savings & tax 1959 versus today....

As an anthropologist you acknowledge culture is a fluid concept in relation to geography or nation state.  The US of the 1950s was a different culture and country than the US of 2008.  This isn't necessarily bad, it is just a fact, you can never step in the same stream twice.  So lets take a look at the US back in 1959 when there were a mere 148 million of us running about vs the 307 million today.  We were a younger country median age 29.4 vs 36.8.  Men got married at age 22.5 and women at 20.2 in 1959 on average vs. 27.5 and 25.5 today.  check out 1959 vs today snapshot here.

This younger US was also saving a lot more.   Here is a graph and data of this change over the years. For all of the griping and fighting over taxes they have been fairly banded.  This is BEA data so your mileage may vary.

Here is the data

Download debttableBEA.xls

and source link to the BEA.gov.  I had to do a little work with a population adjuster.

My point with all of this is that behaviour and cultures change over time.  The long term investor should watch these ebbs and flows in culture.  If we saved as much as the adults in the 1960's the average person would be saving roughly $3,900 per family member.  That is the average, the median figure is lower.  It is important to note that this data uses averages and that medians probably tell a lot more about group experience as high end incomes are more responsive to tax and investment policy. 

A high savings rate in the midst of a recession could give us the Japanese problem of the 90's with a lack of domestic consumer consumption to get us out of the mess we got into. 

Better fire up the export engine and fuel it with cheap dollars.  Inflate our way out of this.  PS, please don't let the Sovereign wealth funds in on this.  We need them to keep buying our paper based assets.

Back to breakeven for equities in 2012-2013

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.

P.P.S .  Found this at Wolfram Research.  This phenonomon is know as Siegel's Paradox.

Asset allocation (Fortune's Formula) book review & tool

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.

Fortune’s Formula by William Poundstone combines Claude Shannon's information theory with gamblers, hedge funds, card counters, crooks and history. 

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.

Derivatives: for good and evil

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.

George Soros; The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means

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.

1. 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.
2. 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.

Traders, Guns and Money

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. 

T-bill vs S&P 500 earning yield 1936-2007

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:

Download SPDJIAPEriskfreeyieldpredictionV1.1.xls

Get rid of your recency bias to price the market.

Beliefs and behaviors are what drive us all. Charlie Munger is probably one of the best practicing sociologists alive. Munger, the lesser known of the Warren Buffet and Charlie Munger duet has a passion for understanding cognitive biases and beliefs.

Many prognosticators etc. are asked to predict the market. Barron€™s newspaper drags out a few Guru€™s every year for their psychic dog and pony show. Inevitably the wrong question gets asked. Where do you think the market is going to be next year questions abound?

Ken Fisher does an interesting job of plotting gurus as a distribution and then placing bets on the holes in the distribution. His conclusion basically could be summed up as the blindness of crowds.

Here is a tool to pick where the market should be priced€ while removing the recency bias associated with thinking about todays index level.

As an anthropologist, I believe how questions are asked of others or oneself greatly determines the value of the answers.

1. As a percentage rate what do you believe will happen to corporate earnings next year?

2. What is your perception of a fair percentage return for equity risk over the risk free rate?

Using the tables below you can see where “you” predict the fair value of equity. The value of your prediction is most likely the equivalent of the price you have paid for it, i.e. don'€™t try and buy a cup of coffee with it.

 

A crude match up of the Dow Jones Industrial Average could be seen here.

 
The Point of this exercise is to get rid of your own recency bias. In asking about fundamentals and value, you may find yourself coming up with a very different answer to a very popular question.

Here is a screenshot of the simple excel tool available for Download SPDJIAPEriskfreeyieldpredictionV1.0.xls .

Here are the stats from last year for the S&P 500 as of this week: 

1. Earnings are down 25.3% YoY according to Barron'€™s. $62.28 last week vs. $83.39 for the S&P 500.
2. The current yield on the S&P 500 4.37% and 5 year T-notes yield 3.11%. This a current S&P 500 risk premium of 1.26%
3. The historical risk premium for equities ranges from 2.5-4.3%
4. Earnings can be seasonal (you may wish to use annualized data)
5. Even a positive earnings yield might be destructive.  The game is increasing your purchasing power long term, remember inflation erodes that.

Being able to pose the counter factual or re-frame a situation allows you to adjust beliefs and assess others behavior. This is a powerful life skill. Maybe it is even reflexive, have to ask George Soros about that. George if you are free for dinner, my wife is Hungarian and makes great gulyas.

 

*important notes, yes the risk free rate will change so your mileage will vary.  Please submit changes and suggestions.

 

 

One measure of employment peaked in 1999

The Civilian employment ratio peaked in 1999.  This is a little food for thought.  Make your own graph here. 

T-bills at 5.76% from Norway

As an anthropologist, I am fascinated by behavioral and social biases.  One bias investors have is over allocation to their home markets.  This makes sense if there is an information edge but otherwise can be expensive.

The objective for many investors isn't to maximize return, it is to increase purchasing power.  To that end currency allocations should be considered.  The dollar's weakness is old news.  The fundamentals of US debt to GDP when one considers outstanding legislative entitlements and demographics do not paint a happy picture going forward for the USD.

An interesting place to put cash investments is the Norwegian Krone.  Norway has the following economics attributes.

• 17.2% GDP government surplus expected for 2008
  
• Stable political environment
• 2008 predicted GDP growth of 3.8%
• Rule of law
• Intelligent resource allocation of petroleum reserves and state petroleum fund
• Current T-bill yield of  5.76%

As a former foreign exchange quantitative analyst and prop trader, it is interesting to note that currencies have a tendency for serial autocorrelation.  If you are a professional money manager, it is fairly easy to gain access to the Norwegian Krone and pick a point on the yield curve that matches your risk and investment horizon. 

Information from the Norwegian central bank can be found here.

For retail investors, www.everbank.com may be interesting to look at.

The data for the chart above is from OANDA.com

Here is the spreadsheet data. Download USDNorwegianKrone.xls

Full disclosure: I have no relationship with OANDA, Everbank and don't currently hold a Norwegian Krone position.  I did live in Denmark and Sweden with my wife for brief periods of time and found them highly agreeable. :)

Housing affordability points to 20% more declines from Feb level.

a freindly comment on my blog asked for a housing update.  I posted that I predicted home could decrease >20% resulting in $6.6 Trillion paper losses last summer.   Nick posted a comment below and I have adjusted the income by the CPI.  Pretty poor on my part to have not caught that the first time.  This chart is now updated.  The average ratio of HH income to Home value is 2.95:1.  As of Feb 2008 we are roughly at 4:1, sadly we could have 25% more price declines if we return to historical norms.

Unfortunately we are only half way there.  I have visited the securitisation forum, watched the ratings agencies and a few of the other crazy activities that lead to this very predictable bubble.  Everybody liked free money and value on the way up, right.  It was a glorious sanctimonious ride.

All along the way few pointed to the obvious housing indicator affordability.   something is only worth what people can pay for it.  Supply and demand are bogus concepts as housing is very elastic, think of the 4-6 people that lived in the average 1,000 Sqf US home in 1950 vs. the 2.3 residents of today average 2,300 sqft McMansion Barn.  Please note my architectural sensibilities leave me with little love for the contemporary US home.  My wife puts up with my complaining about it all the time.  Give me a great modern scandinavian home anytime over some jumped piece of wooden sticks wrapped in Tyvek and plastic siding.  Most of the post 1970's US housing stock is utter junk. 

Anyway here is an update of the affordability data, the spread sheet and the source material.  Make up your own mind.  I am but an opinion in the wild and just here to spice things up a bit.   I was very disappointed to make my data more robust.  I  used  household income instead of  individual income.  If I have made a mistake here please point it out.  The picture is worse than I thought.

Here is the Median US house price end of year.  Here is the number of houses.  Median household income pg. 37.  I made a generous estimate of median income increases of 2% for 07 and 08.  please note the use of median instead of average as it is a better way of describing the "most common experience" of the affected.  Unfortunately the news is worse. 

I have included household income instead of individual incomes.  This adjusts for the 2 income household which was scarce in 1968, but common today.  Also please consider the average number of residents per household are fewer.  We are working harder for bigger emptier homes.  I hope everyone has fuller lives.

here is a horrific data table.  And for those who like to do there own homework, here is the updated Download realestate1.1xls.xls spreadsheet.  If have made a mistake i.e. non-inflation adjusted figures etc. help me out here.

The Rice Bowl Cracks

China is likely to suffer a significant political change in the coming 12-18 months.  In June of last year, I predicted a 70% decline for the Chinese stock market by Sept 1. I was wrong.  The peak of the market was 6 weeks later. The Chinese stock market is currently down 25% from that high. 

Like most closed economic and political systems, stability is easy to maintain in the face of distributed economic growth.  Closed systems do not respond to distributed economic shocks well.  Central planning is good for point disasters but not distributed issues.  A point disaster is an earthquake, flood etc. a single point of failure that can be identified and overcome.  A distributed problem involves policy insight and thought.  The communist mindset of centralized control does not allow for rational response to economic crisis. 

China has put a cap on fuel prices.  Many policies such as the natural gas policy are linked to this price.  Basically, the Chinese are still trying to control the economy.  Problems will arise as shortages accelerate as a natural response to these policies.

From a relatively small statistical sample most closed economic and closed political system regimes last between 30-40 years on average.  This would put a probability of 2-3.33% chance of failure in any given year with a bias towards failure with age.  As the system ages and an internal political or economic shock looms, the chances increase significantly of a systemic collapse or regime change.  The change may or may not be a systemic revolution, ie. capitalism to communism.  For example, in China, the gang of 4 had a brief period but the old guard stepped in.  China has changed in the 20th century about 5 times, once every 20 years (5% probability /year).  Current internal economic policy has been widespread for about 15 years.

I would put the odds at 70% that China undergoes a significant political and economic change in the next 18 months (500 days).  Tibet will most likely not be the cause of this as it is an external threat.   Internal  motivations are more likely to accelerate significant change.  The outcome of the change is impossible to ascertain.  Tighter fascism or a move to democratic open society is impossible to predict.  Without evidence, I would estimate this to involve an economic contraction of 7-15% for over 2 years.  If anyone has research on this please forward it.

The Iron Rice bowl cracks.
It is important to remember that the inherent contract between the PLA (people liberation army) and the Chinese people was the promise of food and stability in exchange for power.  The Iron Rice bowl could crack this year.  Among other stressors, Rice stocks are at 25 year lows globally.

The current regime instituted broad economic opening in the late 80's and 90's.  Using Gott's theorom and a 12 year estimate for the broad phenomonan, we find there is a 25% the regime will shift in the next 7.2 years.  That is a 3.5% chance of change in a given year.  Given current economic potentials the 1:28 odds are low.  I consider the need to tighten inflationary policy and the negative economic & social feedback loops, I am bringing the probability up to 60% for the coming 12 months.

Ask your china fund manager what odds they give of regime change in China, most likely they will guffaw and say 1 in a million.  Change managers.

Flaming VaR (value at risk)

One of my interests is financial risk.  I am fascinated by complex problems involving numbers and behaviour.  One of the most popular approaches to financial risk management is called Value at Risk or VaR.

VaR and the assumptions underlying it are some of the key elements of todays financial system.  VaR is most likely to be the key risk methodologies going forward.   VaR has been created in lots of flavors.

• Parametric
• Historical
• Extreme
• Vanilla
• Flaming

Ok, I am making the last one up, the good people in academia and Risk metrics haven't invented flaming VaR on purpose.  Flaming VaR has been created by market reality hitting bad models.  There is a tiny secret that people in the multi-billion dollar financial risk business don't want you to know...  VaR blows goats. The nice thing about VaR as a system of risk is it only fails 1-5% of the time, of course this is when you need it the most.  It is a bit like buying airbags for you car and being told they work for every accident situation except head on collisions.
Why does VaR fail and why should we be scared.
VaR fails because it assumes prices are log normally distributed. Common sense and a brief reading of financial history will tell you this isn't so. 
VaR scenarios are usually built using price data sets that are limited. Example: today people are pointing to previous US recessions looking for clues about the future.  Most of these commentators are looking back to the 70's or 50's and only the US.  Small hint: a statistical sample of 3-7 is pretty pointless for analysis.  An anecdote is not analytic.

VaR expresses risk as a dollar amount at risk over a given period of time with a confidence interval.  Right now some bright risk manager at some bank is dutifully reporting to someone, "sir, we have $5m at risk daily within the 99% confidence interval."  His counterpart is then replying "good Humphrey, because we have $10m of risk padding". 

Confidence intervals and statistics make most people roll over and play dead.  The certainty with which someone quotes VaR makes the other person think, "hmm ok, we are safe, this fellow speaks math and must be bright."  But lets look at that earlier VaR statement.  It basically says for that for a given 1 day period there is 1% chance that we are going to lose more than $5m.  Hey there are most likely going to be 3 of those days next years.  Now the belt and suspenders genius in the room multiplies the $5m by 2 and says we are OK.  You may have noticed some problems already, most financial losses take place over many days. 

VaR approaches are such that the longer the length of time the less accurate the sample.  huh???  Think about it, If I have a pool of 30 year data and there are roughly 7,800 days to look at.  If I want to sample a one month period I have 360 samples, for the smart kids in the class a rolling approach can be used.  Even the rolling period has the flaws that I am trying to understand maybe an extreme externally driven price driver (macro-economic shock etc) with a 30 year window.  Those shocks are rare and far between, and this is the problem with historical and even parametric approaches to risk modeling, they treat markets like the live in a bubble.  It is a classic system failure.  Hint Warren Buffet thinks VaR and Options theory is junk.

Some of the bright lads over Goldman got this wrong, but they are in good company with the Nobel Prize winner of LTCM among others.  They calculated that the chance their portfolio would blow up was a 25th standard deviation event.  To normal people 25th Standard deviation is statistically equivelant to 1 in over a trillion billion chances give or take, which equates to the sun blowing up  in 7.5 billion years before the portfolio would be stressed.  Now if this market worked in a bubble that might be right, but disasters happen, govt.s fall, things change, stock markets disappear every 150 years or so.  I am sure there is some poor quant looking at his numbers wondering how this could happen.  It happened at LTCM and it will happen wherever VaR approaches are used.  The problem is the model, read the Black Swan for a good insight into the problem.  Historical price data are useless for external event based shocks.  I bet there isn't a financial model out there that has the impacts for a second (post 1907) San Francisco Earthquake modeled into it, but that is a 25% probability by 2025 for such an event.  Historical data approaches that use market price data are flawed and doomed. 

It is a bit like driving a ship and predicting the landscape for the next few months by looking out the side port hole.  For those of you who like Monte Carlo forecasting, feel free to look out the port hole a few million times, the information won't be any more effective, but you will have greater statistical confidence to order the ship to go faster.

Imagine if back in 1905, you and I are planning to build the Titanic.  You tell me that after looking over all of the history books you discover that a ship that size has never sank.  You then proceed to tell me that given this fact, statistically speaking, my ship will never sink.  I then proceed to build a bigger and therefore safer ship.

Once you give a mathematician a framework, good or bad they will iterate (improve it) forever.  Nothing is more fun then honing a fine model to a pointless point.  Rarely do people challenge the framework, I mean look at all the data and the dancing around they can make it do.  I would advise using common sense or Gott's theorom to pull them back to reality. Expand the referent frame. Hint: there isbig money to be made betting against the VaR heads.  Go long gamma in the tails and spread the bets.

Moody's and S&P for example have securities called CDO squareds, that are rated super AAA.  These things were and for some fools still are considered safer than the US govt.  The flaw in this of course is that things that are themselves components of other larger systems at risk can't overcome the failure of the larger system.  Logically if the US govt were to have an issue, most likely US based securities may have even greater issues.  Common sense isn't a requirement with a math or economics PHD.  I think there should be a variable CS applied to each equation in risk a CS would be positive or negative indicating whether someone with common sense had agreed that the results, not the approach made sense.

The reason to be nervous about this  whole thing is that having a bad risk system is worse than no risk system.  Financial risk is a mix of human behaviour in the pursuit of return.  If we believe we are risk secure vs. exposed we exhibit different behaviour.  The current horrible risk systems; VaR, Basel II and others are far more dangerous than earlier naive risk systems usually based on rules of thumb and common sense.  It is safer to have everyone a little bit worried and driving more cautiously than have everyone told they are driving hummers and have Michael Shumacher skills when they don't.  Basel II is going to cause a financial disaster.

Prepare for more fall out in the coming 6-9 months as one or two more international banks fail and a few hundred mid sized US banks suffer the same fate.  The ratings system which used a mean variance approach to risk and past prices delivered this one. 

It turns out we are all collectively safer when we all feel a little more at risk.  Quite a few hedge funds in the statistical arbitrage, debt arb and mortgage back space will also be closing in the coming weeks and months as margin calls and collatoral requirements get upped.  The global macro guys and 130/30 equity guys should be ok as they were seeking real alpha with less leverage.

The sad thing is that the global fianancial system is implementing Basel II.  This means that after we start making it out of this issue most likely in late 08 to early 09.  We can get ready for the big one, which will probably be a 30th standard deviation event starting in 2011, just 1,000 days away.

Is the stock market too high?

Value is relative.  A lot of people discuss the market as up or down daily. The chuckleheads on business TV make their living putting the most interesting modifiers in front of X.

• The Dow is gushing up X this morning...
• The market tanked Y today...
• The yen went out for a pack of cigarettes and hasn't been seen since...
• T-bonds rallied, did a loop de loop and then went to the kitchen for some milk...

All of this is entertaining, but entertainment should be kept in its place, a seedy bar or family outing.   Price is relative to its value.

The S&P 500 is a proper equity index unlike the Dow and is currently priced very highly, especially if one considers its future earnings prospects relative to an inflationary environment.  Here is a chart from the Bespoke Investment Group.
The S&P is priced at  a PE of 19.09, thus yielding 5.2%.  This may be a bit higher than Cheech. 

• The current equity premium is about 1.67% over 10 year treasuries which is historically below the average equity risk premium of 2.5%-4.3%. Thanks Fama & French.
• Given the environment expectations for earnings growth next year may be a tad optimistic, of course treasuries could fall as well.

If one assumes that earnings will not contract in the future, then we are roughly 1-2.6% historically over priced in the stock market. 

If we assume that equities need to yield 1.8% more reflecting there historical risk premium, then the S&P 500 should be yielding 7% (have a PE of 14.2).  Here is the big headline, equities would have  25.6% more to drop for this to happen or treasury yields drop significantly.
 

For those in the entertainment industry reading this blog, that equates to 331 S&P points or approximately 3,000 points on the Dow taking it to Dow 8,800.  Now that could really make that puppy turn a few loops and sit quietly in the corner for awhile. 

on credit ratings...and the American Securitisation Forum

I so want to get a puppy and name it "AAA CDO".  "AAA CDO" will  have a huge appetite on the front end and produce nothing but badness on the back end wherever it wants for about 7-8 years.    And like a AAA rating it will make everyone feel good, but basically be pointless. 

Now where should I shop for this puppy?  Moody's puppy hut, Standard & Poor's Pound or Fitch's Bitches.

For those of you not in the Bond biz just ignore this post, I have been in vegas too long among the hordes of securitization people looking for jobs and painting ever bleaker pictures of real estate.  Everyone wants to know what went wrong.  some answers from today included greed.  I think we can also add correlation risk, and bogus ratings agencies who get  roughly $25k for bad ratings and $600k for a good rating.  A lot of things start looking good when you get paid $600k.

Warning past correlations may be larger than they appear

The most dangerous tool in the financial modelers tool kit is correlation only bested by its kissing cousin co-variance.

In order to keep this blog from being drier than a popcorn fart in July, I will forgo detailed statistical treatises.

Most modern historical accidents relied on a blind belief in correlation statistics.  The belief that the non occurrence of co-incident events in the past surely indicates the un-likely event these events could bump into each other in the future.

Many financial modelers have had the good fortune to replace common sense with a PhD.  This has lead them to great salaries and recognition at least temporarily on Wall Street.  The recognition will continue for some time in the future but will alas not be conjoined with good cheer and great  salaries.

Most of the accidents in finance, the current CDO and CDO squared bubble are due to the dubious belief that past relationships are indicative of future relationships.  In a closed physical system this is true.  For the rest of the real world it is not.  As Warren Buffet has stated if the past was a way to predict the future, then the wealthiest people on the planet would be librarians. 

Mathematicians who aren't known for being famous with relationships in the real world are taken far too seriously when it comes to the financial world. 

For the mathematicians in the audience please wake up and realize the financial world is not a loosely coupled Hilbert space.

Being a recovering quantitative analyst I can assure you that the faith placed in financial math models is scary.  I have worked with 2 of the world's largest global banks albeit in jr. roles and wrote my masters thesis at a top engineering school on quantitative approaches for hedge funds. 

The greatest danger in finance is the ever shrinking *.  The * (asterisk) starts life in the world as a caveat or warning that a model rests on certain assumptions.  As money is made and people want to believe, the asterisk seems to shrink and disappear in importance.  After the inevitable accident the stunned financial modeler will bring back up the * in order to save his own asterisk.  The current asterisk that should be quoted in regards to CDO's and CDO's Squared is "Assuming the correlations in mortgages debt holder payback etc. holds steady."

Many a flawed Markovitz asset allocation has fallen foul of the correlation error.  As products are created that are ever more "Markovitz efficient", such as structured products we will all be at risk of correlations that are larger than they appear in the rear view mirror.

 

The next big Asterisk to read about will be RMBS (retail mortgage backed securities) and the inevetible failure of a few CDS (Credit default Swap) counter-parties.   This will lead to yet more banking problems.

Unfortunately the problems of the credit crisis are still unfolding.  Things will most likely be improving by 2009, but the nadir has not been reached.  A few banks are going to be caught out when "winning" CDS trades are activated by default events and the counter-parties are found to be troubled banks, iffy hedge funds or suspect trading vehicles.  Full disclosure I make a living in the financial markets and trade based on some of the information in this blog.

SEC creates the Ministry of Truth

Warning gentle reader, this is a personal rant.  The Securities Exechange Commission has a small power that makes it indirectly manipulate over $3 trillion in debt Securities.  This power is vested in them by their declaration to determine who is and who is not an NSRO (National Statistical Ratings Organization). 

The NSRO's are the organizations who gave AAA ratings to the instruments known as CDO Collatoralized Debt Obligations.  These NSRO's have mis rated businesses and municipal govt's for decades.

The NSRO scam is tantamount to creating a legal monopoly on truth, something still in vogue only in the bureaucracies of North Korea, Cuba and a few other less cheery holiday destinations.  The irony of these actions happening via the SEC is strong.

The SEC's act of anointing NSRO's is tantamount to the creation of a ministry of Truth.  Imagine if you will that a small group of companies anointed by the government told you which investments you could and could not make. You dear gentle reader might like to seek a second opinion.  Unfortunately that second opinion while readily available would not carry the weight and benefits granted by the NSRO's.

Anyone in a democracy wouldn't stand for a government monopoly on truth setting the price on investments and yet that is exactly what the SEC does via its creation of NSRO's.  This monopoly on truth is one of the systemic flaws that has lead to the current credit crisis. 

The credit crunch of 07-08 is a logical follow on to the credit bubble.  The nature of the failure is what is known as a normal accident.  Normal accidents, sometimes called systemic accidents occur when the very structure of a complex system leads to its failure.  If you are interested in these types of accidents read the book Normal accidents by Charles Perrow.

The global credit market is undergoing a "normal accident".  The very structure of limiting debt ratings to a few agencies helped facilitate this.  It is a classic case of unintended consequences, whereby a safety mechanism induces a failure.  Usually in banking risk arrives in the form of moral hazard, here it showed up in limited opinions and dubious math via a few limited groups.

It seems a bit flawed to limit legally recognized opinions of creditworthiness to an anointed eight firms.  One should have multiple opinions and none should be more equal than others.  I look forward to industry and academic papers which call for  the doing away of the whole NSRO system.  My greatest fear is that the SEC anoints a few more firms as NSRO's such as the recent granting given to Egan Jones.  Now we have 8 geniuses establishing truth for the world's debt markets.

In my opinion the whole business is rotten and risks greater future problems.  Every ministry of truth system has been found to ultimately rest on falsehoods which lead to their collapse.  As Karl Popper has indicated correctly, every system ultimately bares the seeds of its own destruction and this holds true for the NSRO's. 

There is a need for dissenting voices and the discrediting of the entire NSRO system for the shambles it is.  For the sake of the debt markets, please contact your local congressman and ask them to tell the SEC to give it a rest on anointing those debt market geniuses known collectively as our NSRO's.  The NSRO system needs to be eliminated for it is fostering the very risk it seeks to mitigate.

Calling all Quants.....

Warning this is for quants only.  If you understand the problems of leptokurtosis in options pricing or the nature of gamma risk read on.....

I have recently been reading the Black Swan, which any serious quant will have finished a long time ago.  Thinking about black swans etc. the inherent failures of Black Scholes variants to work as a good pricing mechanism got me to thinking.....

If one converts a vol point on a curve into a probability or likely hood event, then one can also construct a time likelihood etc. easily, ie. this is a in 10 trillion year event (See Goldman Sachs alpha fund et al for details.)   The post fact analyst and pundit always can say that common sense made it obvious such and such was a falsehood.

I think a more interesting way to step out of the fallacy of pricing extreme events or price variants is to step outside of the price box altogether and to posit a regime type question.  ie. how long has this phenomenon existed.  Then using the work of Gott, one could arrive at the probability of it not existing.  Here is an example instead of pricing AAA CDO's based on a finite time series of a few years and then assessing the shift outside of say 2 stdev's.  My suggestion would be to use Gott's theorem pose the question how long has this instrument been priced below/above X.  Then convert the time back into a probability to use in pricing the instrument.

Now this approach has flaws in that, the answer will vary on the way the question is framed.  I would posit however that the naive approach of only using previous price is also only a singular frame of reference to assign value. 

The major thesis is to not diminish VaR, and BS theory but rather to add an infinite number of ways to assess the framework of price and value and to free valuation from the context only of price and potentially put valuations into a wider framework of analysis.

Any comments...?

Scary financial stuff

demon of our own design is an interesting look at the world of financial risk.

The Author is a practitioner and academic who provides a welcome perspective on the area of contemporary finance and the environment of financial risk. 
The book is a bit heavy going for the lay person who may not be comfortable with options and and basis points, but for the market practitioner it is a must read.

The author put forth a very reasonable account of the foibles and mistakes that have been made in recent areas of finance.  He articulates the theory of Normal Accidents and how they relate to finance in a great way.  Normal accidents, are a phenomenon of design whereby a complex system, be it a nuclear reactors, airplane safety procedures or any complex system is designed to fail.  This design for failure of course isn't intentional but unfortunately due to complexity of interaction the system fails in an un-intended but wholly preventable way, 3 mile island, Chernobyl and about any financial accident you can think of falls within this group.

The author does a good job of explaining why there really is no such thing as a hedge fund and also posits a few interesting questions about the half life of a trading strategy and the usefulness of ever more esoteric instruments.  As he states, just because you can swap out a cash flow based on a state variable doesn't mean you should.

The clarity, candor and perspective in this book are refreshing.  My own personal concerns in terms of financial risk were only re-enforced.  The current credit crunch articulated in this blog will grow in size significantly but most likely not pose any systemic threat on a global basis. 

The current credit issue will be acute not chronic a $2-4 trillion mess at most.  Looming in 3-5 years will be a crisis which will ultimately be attributed to the Basel II capital accords.  This will be chronic and most likely caused by the safety mechanism of the Capital accords which are being put into place to mitigate risk. 
My sincere hope is that more people read this book and think about the dangers inherent in layering on ever more esoteric risk management systems with finer models thus allowing ever greater financial "innovation".  Gamma risk will look like nothing compared to Basel II model risk when it is fully realized.  Innovation is rarely a good thing in finance and banking especially when it involves ever more esoteric ways of "deriving" value by seperating an asset from the fundamental information or sources of it value creation.

Will America lose $6.6 Trillion? E-Moh

The home price bubble in America is truly large.  The sub-prime issues are minor in the context of what is probably going to happen in the coming weeks and months.  Here is a scenario: I have an investment for you that is called E-moh.  E-moh pays a dividend below treasury bills and is higher than it has ever been in terms of price.  The market place for E-Moh is enormous but saturated.  I am going to ask you to buy shares in E-Moh that are worth 5 times your annual salary.   

Now, E-Moh might sound like a dot-com with a ridiculous value proposition.  It isn't, it is actually a way of looking at Home in a different light.  Here is some data a dug up.  If the ratio of homes to wages were to revert to it historical average the U.S. domestic real-estate market would lose $6.6 trillion paper value. 

Ouch.  Here are the graphs and spreadsheet.  The Green line is the average ratio.  Now many people will argue that homes are different etc. 2 people incomes etc.  I would counter the size of the average household has fallen dramatically.

Download realestate.xls

The US balance sheet and market panic

The global markets are all excited about Sub Prime mortgages, this is mostly a bank event and shouldn't concern main street.  It may offer a great opportunity for value investors :)

An interesting way of looking at the US financial condition is to look at the whole countries balance sheet. Ken Fisher does this and produced one in his book 3 questions that matter.  I am reproducing his work here.

Now most people can't relate to numbers measured in billions, so I have reproduced the balance sheet for the average American citizen, by dividing by 300 million.  The numbers may appear larger than your used to as there is an income skew, thus making the average different from median.  All the same check out the "average" american's balance sheet here: As you can see things aren't really "End of the world" headline making.  There are some bad issues with American mortagages and some serious issues with people taking out loans that are 5-8 times greater than their combined incomes, but by and large America doesn't have many major problems economically or structurally. 

Newspapers and Journalists need to fill their pages and time slots with action grabbing headlines, this means 98% of financial reporting is less than news worthy.  Occasionaly someone creates real insite or something interesting happens.  The most interesting thing about the most recent volatility is the Fed move.  It will be interesting to see what happens in the next few weeks.  My bet is on continued volatility (reverting back to 10 year mean), but not much net directional change (+/- 10%) after the dust settles.  This activity will be choppy and horrendous for hedge funds that were short vol or used barrier options as insurance, as they will get whipsawed.  These same hedge funds will face the indignity of customer redemptions etc.  This is all good news for traditional value investors, who may view this as a buying opportunity.  I am still bearish U.S. dollars vs. the Euro but it is a structural bet on lower U.S. rates and shift in the EURO being seen as a more serious reserve currency.  It will be interesting to see how the ECB handles the next few weeks as it is a real choppiness test of political and fiscal nerves.  The source file for the U.S. and per capita spreadsheets are hereDownload us_balance_sheet.xls . and are a creative commons "attribution licence"

the ABX index continues to slide

The ABX index has 20 components in it and tries to reflect the value of complex pooled assets that have been securitized and traded between 16 of the largest banks.  This is a small world specialized market, but very important to showing what is going in the world of more exotic forms of u s debt.  I wrote about this awhile back and said it would be getting worse.  It is.  Here are 2 pictures.  The first picture is for junk rated AAA just like US govt. bonds.  The second picture is for the really toxic debt rated BBB.  It isn't pretty.  Basically a loss of 7% and 45% respectively.  Hmm a few more hedge funds are facing some real problems and the CDS and guys aren't happy either.  Considering that some of these guys will leverage this stuff 5-20 times.

Predict anything...kind of

 

Now here is a neat trick, using Gott's interpretation of a Copernican observation.  You can predict the likelihood of almost any event terminating based on how long it has been happening so far.  Gott made a famous observation about the Berlin wall falling and got it right :) 

I took Gott's math and converted into a handy predictor excel sheet for you.  This is sure to wow your friends.  To read about the estimates behind the end of mankind (no kidding) check out this new york times article. 

Gott is a pretty interesting astro physicist at Princeton university and deals with the anthropic nature of cosmology and universe. 

Me, I am just a sucker for good probability and Bayesian type party tricks. Feel free to download the Nick Gogerty predictor Download observation.xls to wow your pals with.  Please don't pull this out on a first date unless she is a math major.

Warning finance geek speak: If you are a quantitative hedge fund manager or event driven macro trader it may spark some ideas involving long dated Volatility and drift ;) as this allows one to tweak certain Volatility assumptions with event probabilities, such as extreme exogenous shocks or cessation of existing regimes.

Asset Allocation & the magic question

Asset Allocation is the sport of kings.  Ok not really, but in terms of returns allocating between Cash, bonds and equities it is more important in determining investor returns than the individual securities you hold.  For those of you not versed in asset allocation etc. or aware of the nature of risk associated with Market timing.  please buy an S&P 500 index fund.  Generally if you are under 65 years of ago. You should put all of your assets into it.

Ok The interesting fact is that your asset allocation strategy determines over 93% of your long term portfolio returns.  It was more important than sector, security etc.  If you don't believe me check out the paper here.

Ken Fisher's firm has the right approach, here is a diagram I lifted from his site.

I first came across the importance of asset allocation while reading an earlier edition  of Asset Allocation in by Gibson while writing my masters thesis on hedge funds.  I just re-read my copy for fun today.  The central tenants still hold true.  People who focus significant amounts of time on securities should instead scale their efforts in proportion to the determinant factors of return. Think about your asset allocation a lot.
In general people are under weighted in equities and over weighted in either cash or real estate.  If you want to become a professional money manager read Asset allocation. 

Another important thing to remember as a money manager/investor is that money flows out at all the wrong times.  When I was designing quant hedge funds in the late 90's, I discovered an interesting phenomenon that you won't hear about from your stockbroker etc., almost every investor under-performs the investments they are in.  If you study the flow of money's into funds people buy high and sell low.  Say a great hedge fund has yielded 22% net of fees over the last 5 years.  You will discover the majority of investors will under perform the fund.  People will have purchased the fund when it was hot and dumped it when it was cold, the exact opposite behaviour they should have done.  Ideally of course the sit and hold. 

The magic question for investment owners.
Many people ask my opinion about selling this or that share, security or investment they have.  I usually know very little about these individual investments much less what is going to happen in the future to them.  I can start a conversation on Price vs. Value etc.  But the single best question I ask of someone is the following.

"Given everything you know today about the price and value of the investment, If given the opportunity would you buy more today."

If the answer is no then sell it.  Simple really, but an interesting twist on psychology and it usually gives people an interesting perspective on something they already own.  Framing a question can be big help in coming to an answer.  By the way 99% of the time the answer should be hold onto it.

Mortgage mess

The graph shows the price of a CDO index rated AAA.  full info is here.

I have been a bear for 5 years on real estate and been wrong for 5 years.  The graph shows some of the prices for CDO's which are bundled securities.  this particular index has securities from Morgan Stanley, Merill Lynch and other big houses in it.  The scary thing is that this shows a market trying to price in anticipated default risk at the quality end of the market.  Any PHD doing VaR modelling or other standard stochastic modeling wouldn't really have seen this coming, especially in the "high grade paper".  This market will most likely get over sold in the near future as sellers start dumping paper to cover margin calls and get their risk capital positions back in place.  In the mean time spreads will widen in this space.   So far this is a Wall Street event, but it may be a predictor of a main street event in the next 9-12 months when many ARM's reset and the reality of negative equity sets in.

Volatility Caveo : volatility beware

A lot of people don't realize how bad losing can be.  Behavorial economists, show that we psychologically feel loss about 2.5 times greater than gain.  Thus finding $10 and losing $10 isn't the same thing.  If you lose $10 it feels like a $25 loss. This is psychological.
In investments and fund management a mathematical truism is in place.  If you buy a share in a company or fund and it loses 50% of its value, that same share has to gain 100% from that point onward for you  to be at break even.  This relationship of the  "extra" effort required by an investment is shown  in the graph.   Basically after 12% the extra return required is climbs fast.  The first objective for an investor is to not lose.  Seek safety and think long term.  Another interesting fact is that most fund losses and points of maximum loss (peak to trough extremes) sometimes referred to as drawdowns are highly correlated with the volatility of a funds monthly returns.  Years ago I did work in studying hedge funds and found this correlation between volatility and maximum drawdowns held true statistically.  This makes sense as a hedge fund manager can't predict their own monthly or yearly returns.  If they could they would control for it.  Thus if you are selecting a fund, a recommendation is to look for a fund with a  monthly volatility of less than 25%.

Meeting Dr. Fractal and good dinners

Way back in the past, a long, long time ago when dinosaurs roamed the earth and I still had a bit of hair, I was involved in a financial modeling workshop on behalf of Starlab.

Here is a picture of myself with Dr. Keith Still (far left), Benoit Mandelbrot (middle) and me.

We were working together at conference in Texas in 2001 over a weekend.

One of my favorite things to do is have a good dinner conversation over a bottle of wine.  When I worked at Starlab, I lived on site and used to do just that.  I considered myself fortunate if I could rope  people together for a meal.  I found myself surrounded by PHd's in Math, Physics, Biology, Robotics, Artificial Intelligence etc.  This is a fantastic way to spend an evening, just listening to learn how each of them viewed how their world works or could in the future.  Some of my other friends were sociologists, architects, musicians, designers etc.  Most were from all over the globe, usually I was the token American :)  Great meals and great conversation. 

Today, I am lucky and so are my dinner guest in that my wife likes great conversation and is an amazing cook, this means better food for the guests. I do the dishes :)

Back to Mandelbrot, he is one of the most famous mathematicians alive today and I have a great deal of respect for him, he never sold out or allowed his name to be used improperly.  He discovered many interesting aspects of financial markets among his work in mathematics. To my knowledge he never allowed his "brand" to be used in a way that might mis-represent the truths he found in finance.  He was a nice and  bright man with a gracious wife. 

I had the pleasure of working with Dr. Keith Still in Brussels, again a bright man gifted in many areas of science and possessing an interesting ability to analyze and put things together.  He is one of the world's experts on movements in crowds and egress.  He has done work in modeling irregular heart beats, foreign exchange and a few other fields, truly a polymath, no pun intended.  He possesses a a great knowledge of modeling complex systems with multiple interacting agents.

One afternoon Keith introduced my to his mentor  Dr. Ian Stewart (Mathematician) and Dr. Jack Cohen  (biologist) I conjunction with Keith, Ian and Jack was a Stem Cell biologist.  We had a 3 hour lunch in an English pub in Warwick.  Great stuff, funny conversation and incredible opportunity to try and keep up with everyone.  We spent the whole time discussing morphogenesis and other fascinating topics.  A great afternoon. If you get the chance check out some of Stewart or Cohen's books they are great reads for the layman or sci-fi fan.

CDO's raining down. Get a Eurobrella!

Ouch the CDO situation is sadly going the way I thought it would. 
It won't be getting any better soon. Expect to hear a lot more noise in the future as hedge funds mark to market positions with some very ugly numbers. 

The fallout will continue and U.S. credit spreads will widen in the flight to quality.  My recommendation would be to invest in Sovereign Euro deonominated Zero Coupon Bonds.  If you don't know what that phrase means just do the following:

1. stick to index funds
2. Act long term.
3. and as they say in the hitchhikers guide to the galaxy.  Don't panic!  :)

The graph is taken from the big picture. Read it carefully.  It reflects AAA rated mortgage backed securities.  Houston we have a problem.

China shares will bust in 8 weeks before Sept 1, 2007

ADDENDUM: since posting this originally, I have gotten some feedback from the Economist indicating Shanghai a-shares are at a 45 PE.  I thus recant my prediction and state it thus.  A 40% decline is possible if PE's get to 70.

The economist made a surprising mistake this week.  The showed this graphic in an article about the potential for a bubble in Shanghai A shares.

The mistake is showing a "bubble" on a straight graph and not a semi-log chart.

The assertion by the Economist is that Alan Greenspan's assertion that china is at risk of a bubble is wrong.

The graph to the left is the wrong "bubble-o-meter"  and here is why.  Bubble are psychological and not mathematical phenomenae.   The ups and downs of a bubble are felt in percentage terms  by the participants. 

The graph to the left tries to articulate with a simple normalized data set that bubbles take  5 years and that the Chinese share bubble is below previous bubbles. 
This is a bogus presentation of the facts.  If we were to pick the lowest trough of the bubble roughly 4 years into the current curve "roughly equivelant to 75 in this chart and then calculate the rise , we would see a  renormalized peak  climbing faster than the nasdaq Bubble to roughly over  500 in  a much shorter time.   Again this would be obvious with a semilog paper and normalized series.  

As they saying goes, prediction is hazardous, especially about the future.  My personal prediction is for a decline of 70% in Shanghai A-shares from sept. 1,2007.  The political fall out will be huge due to the popular participation in the markets. Many "Average" people are now playing the markets and will lose out.  The political fallout may require a bail-out by the Chinese government to quell dissent.  If that occurs, it could require a major sell off of US treasuries held by the Central Bank.  This would cause a slight dollar decline, a potential excuse to let the Yuan rise and potential Rise in US interest rates.

The graph below is not semi-logarithmic, but shows how "normal people" see shares in terms of participation (turnover).  A blog about this is here.

For comparison sake, please have a look at the famous South Sea Bubble as well.

If anyone has recently been to China and has the "cab driver/doorman" with a winning stock tip anecdote as contrarian indicator.  Please post a comment.

Systemic failure is an ugly phrase

Systemic failure means what it says.  A system filled with complex parts fails.  Most complex systems evolve over time to be robust and contain multiple subsystems.  They may be mechanical, biological or informational.  Think of a an airplane, your body and the internet.

A major system system is the financial system.  Every once in awhile, it faces a serious challenge, not the kind that USA today writes about, but the kind that historical economists study and write about for decades to follow. 

The current hedge fund and debt markets using ever more esoteric instruments deriving value from literally 3 degrees of seperation from their underlying instruments are facing a challenge.  Hedge funds are not huge financially $1.5 trillion under management which in the global scheme of $50-$60 trillion in global fiscal assets isn't huge.  However Hedge rely on leverage and liquidity like you and I use oxygen.  Without it things get awkward fast. 

The most recent CDO issues are most likely the tip of the iceberg.  My past posting on hedge fund risk probably makes for interesting reading about systemic risk and yet more failed VaR models.

new algorithm for a new day!

First off lets ignore the lame image here.    One of the more interesting companies playing around in the field of Machine learning (AI) whatever you wish to call it has opened up their development algorithms.  Numenta, the baby of Jeff Hawkins has opened their doors for developers to drive there development environment.  This is fantastic stuff.

Hawkins book "on intelligence" which I reviewed earlier is a fascinating read on consciousness and mind and the role played by the Neocortex.  I would urge anyone interested in AI or theories of learning to read it.  I used to work with early neural nets and genetic algorithms trying to predict bond and currency markets as an undergrad.  It was a hobby.  Needless to say, I was getting a lot of action as an undergrad:)

The theories postulated here and the potential for moving forward with machine learning is deeply interesting.  Hawkins HTM theory is interesting with its focus on the Neocortex and associative learning.  It treats this thin layered outer coating of the brains the place where the magic happens, converting qualia into biological associative bits so to speak.  This leaves the bulk of the grey matter out of the equation.  It will be interesting to see how the wetware guys think about this new silica approach. 

Hawkins got slammed a bit in a video presentation as just putting up a new recursive neural net.  I think that was mistaken.  I look forward to reading papers and stories about Numenta's approach.  A lot of researchers will debunk the approach showing it to be poor at older tests and data sets that neural nets excel at.  But in the long run, I bet with Hawkins.  HTM won't answer the mystery of consciousness, but it will start making things a lot smarter a lot faster.  The future just started getting here a little faster.

check out an older video of him here or this one from MIT