Designing better futures

Miniature faking. Making the real less so.

 
In our hyper real 1080p-3D 50mega pixel quest for reality, we assume that things are more accurate with more resolution etc.  Laser TV is going to produce 90% of the colors the human eye percieves, your best technology today delivers about 30%. 

However reality can sometimes by too garish and gory so it gets edited, distorted or disappears.  Here is an interesting technique that makes the real world look safer and under control.  Fascinating stuff with a technique called Tilt-shifting and Miniature faking.  check out the video.  More images and video at Twisted Sifter. 

The video below combined with Lo-Fi  deep house music in the background just makes sense.   Aesthetics in the 17th-20th century vacillated between the romanticized naturalism of an idylic countryside and the modern urban focus on humanities progress. 

Perhaps the future aesthetics pendulum will swing between ultra-hi res composed purity vs. the gritty complex authenticity of nature.  No change really, just new mediums delivering old messages.  Miniature faking seems somewhere inbetween :)  Recommended full screen viewing and check out MockMoons other work, very talented

miniature city 2 - featuring vividblaze - from mockmoon on Vimeo.

Does my Sr. compensation ratio look big in this....

Anthropomorphizing things is an innate human trait.  Here is a comic from the Abstruse Goose comic site.  If you liked math and science in school, you will probably enjoy Abstruse goose.

Lifestyle Arbitrage of the day $5 million in New York vs. France

The average townhouse in New York is now $5m.  Example to the left.

Here is a chateau in the Loire Valley in France for $5m, sounds like a fixer upper, but maybe a good project to hide out with during the recession. 

Description: built in 1897 for a French Viscount by the architect Albert Thomas (1847-1907). Located in the most wooded part of the Loire Valley called the Sologne, 120 miles from Paris by motorway A10/A71.

Directly inspired by the grandeur of Versailles , the chateau overlooks the Sologne forests and its private park of 41 hectares (103 acres) in the French style. There is a 1 mile driveway, courtyard, terraced parterres and a formal basin with monumental statues. Excellent privacy and structural condition.
There is about 36,000 square feet of living space, partially renovated, habitable and decorated. Very high ceilings and huge spaces: hall of 1,700 square feet with monumental staircase, great drawing room of 1,800 square feet…etc

Symmetrical outbuildings with stables, orangery, chapel, gate house and further potential. Incredibly prestigious palace, now listed as Historic Monument (Grade 2). more pictures here

 Here is a guidebook on the chateaux lifestyle.
 

 

Source: For those shopping for Chateaux across europe.

Buy now before those pesky euro's and dollars get deflated away.

Could you disconnect, even if you wanted to?

Here is an interesting map from William Easterly's site AidWatch. It shows the distance from major cities as a function of geography and time.  Most of us are a few hours away from each other.

 

A few things to consider when looking at a network diagram like this:

1. People and things spread fast
2. Ideas spread faster
3. Feedback loops amplify and intensify certain things
4. Individuals can't really opt out of this process easily

All of the above are true for ideas, emotions, things and the human condition in general.  The village is shrinking.  Increased competition in whatever form you imagine it (resource, economic, innovation, improvements) will accelerate and be amplified in such an environment.  Margins shrink as things get more connected.  The positive externalities of competition flow to customers. 

Warren Buffet pointed out 10 years in 1999 that the automotive and airline industries are great examples of global growth industries with limited investor economic output, but significant customer benefits delivered.  Bigger markets aren't always more competitive.  Globalization means fewer economic moats.

Bigger and more connected is different.

Full disclosure, the most remote, I have ever been was in 1992 when I was in the sub-Sahara in Ngigmy, Niger brushing up my anthropology field work skills in a village that took 3 days to reach via bush taxi, market car and finally foot. While staying in this remote village, I met an elder who eventually asked the biggest question on his mind of a young white American. In Hausa via a translator. I was asked, "Do you know Michael Jordan?"

Talk to the hand...of the free market.

More quality tom tommorrow here.

I am a sucker for cool Math: if you hate math, see if you like this video

Great math is beauty in form the same way architecture or painting can be poetry in motion.  Yes it is a bit of syesthasia for me. 

Great communicators are those who illuminate and share new worlds of understanding.  Here is Marcus du Sautoy talking about the history of Symmetry.  The language of math can be incredible and Marcus seems like a great teacher who is excited to share what he sees and understands.

Your world Interface anywhere: The Video

This may seem passe to say, but the rate of change and how you interact with the world is going to change faster than ever.  I am not talking about e-books (next years commodity) killing newspapers etc. or anything that banal.  (don't worry journalism will survive).

The world is going to get more fragmented.  Did you know that your view of the web via google is now different from everyone elses?

Soon your world will not be the same as anyone elses.  I hope this sense of disintegrated reality and individual control doesn't create more selfish people. 

We already control the ambient noise and music, people we choose to interact with/ignore around us etc.  If you work in media you need to be aware of this, partial attention is the pre-cursor to augemented reality.  The hardware for all of this is out there and this stuff is going to be everywhere. 

In the future, people will probably take info: vacations where the seek authenticity and no digital input.  If you feel you are on a digital leash/ addiction with a blackberry, you haven't seen anything yet. 

PS. Apple, microsoft and RIM don't own the moats or competitive edge to be a part of this.  The future is up for grabs.  Google has the strongest position in my mind as they get "infonomics and anthromation.

Creating alternative scenarios is imagination

Thinking about what might be is important for designing better futures.  Here is a stunning visual answer to the question, What if the Earth had rings like Saturn?

Thinking in Prime Numbers

Visualizing relationships, be they mathematical, cultural or physical is a powerful skill.  Here is a great site about an interesting quest for visualizing prime numbers.

 I am a big fan of Phi, the Golden Ratio.  One of the best books on this is Mario Livio's The Golden Ratio.  Livio is a serious mathematician, historian and story teller who brings alive the beauty of seeing how things relate.  The golden ratio shows up in many optimal packing and density solutions involving complex systems, it abounds in nature from the circling of an attacking hawk to the positioning of leaves on stems. 

My guess is we haven't scratched the surface of applied uses for constants like Phi or Feigenbaums constants.  For those interested in how growth and form emerge from nature and complex systems I would suggest studying morphogenesis, starting with the classic On Growth and Form.

All of the above end up relating to and explaining a simple elegant shape such as the a nautilus shell.

Don't trust your senses they can make things disappear: the Troxler effect and change blindness.

Stare at the red dot in the center of the figure for a minute or two. Before long, the green ring will disappear--it simply seems to fade into the white background. There are no tricks: This is a simple, static image file. The effect has been known for more than two centuries and is named for its discoverer, Ignaz Paul Vital Troxler (1780-1866), a Swiss physician and philosopher. "Troxler fading" is actually related to what you experience when you get "dizzy": You become so habituated to a phenomenon (spinning in a circle or seeing a green ring in your peripheral vision) that you stop noticing it's there.

Or, rather, you don't realize that your perceptual system has begun actively ignoring it. It's only when your circumstances change that you see what the phenomenon has done to your perceptual system. When you stop spinning, the world seems to continue, in reverse. When you look away from the green ring, you see a red ring in the same part of your visual field.  From the excellent blog Cognitive Daily.

Something similar to this happens in Media, if we don't hear about it is assumed to have gone away.  In many areas of risk, there are risks, I refer to as Oxygen risks, ie things that are so common and pervasive in the environment that we only notice their absence.  Liquidity and the efficacy of a Triple AAA rating used to be like that.  Flawed or un-considered assumptions due to unchanging environmental factors.

If that green circle doesn't mess with you check out the Change Blindness video. again Courtesy of Cognitive Daily.

Finance Models, a bit of knowledge and Mt. Doom

One of the current debates going in finance is about models and the role they played in the current problems ie. CDO disasters and ratings flaws.  To paraphrase a popular expression, models don't shoot holes in balance sheets, overly confident bankers shoot holes in balance sheets.

The models are merely one of the tools used to establish the false beliefs (over confidences) that collectively lead to many financial actors taking bad actions.

Many have debated that we should get away from "fancy" risk models and others argue that if people just understood more about how to use or not use models we would be OK.  Unfortunately the debate is a little stale, so I will throw in my bit.  With these 2 fundamental rules:

1. Models aren't dangerous, misapplied models are dangerous. 
2. The likely misapplication of a model on a large scale is a function of a groups confidence level.

Financial knowledge is not  a linear thing, it is like chess.  You learn it in levels and at each level the skills required change and the understanding of the game changes.  Consider the following levels of knowledge in chess:

1. What is the objective of the game?
2. Which way does the bishop move?
3. What is castling?
4. How many points is a rook worth?
5. What is En Passent
6. What is the Spanish opening?
7. What is it like to "see the board" like a grand master

Each level of knowledge has different rules and new ways to appreciate the game.  The application of math in finance and risk is the same way.  The difference is that instead of losing the game, if one overly relies on a piece of knowledge it can be disastrous.  Over confidence kills and a little bit of knowledge can lead to over confidence.

In formal learning there is a taxonomy of knowledge known as Blooms Taxonomy.  I submit the following diagram below to show an example of Bloom's taxonomy laid onto the learning of mathematical finance.

Each practitioner will proceed up the chain with a piece of knowledge such as how Value at Risk VaR for example works until they have either mastery or have reached their personal peak capability for comprehension.  We can't all be Gary Kasparov.

Now for the Dangerous part.  There comes a point in our learning when we believe we understand enough to act on our knowledge.  Confidence can be a very dangerous thing in finance or knowledge as it may lead to the application of knowledge in a flawed way.  Belief may rush ahead of skill.  The graph below highlights the case for the individual financial modeling practitioner.

As one progresses along from ignorance(1) to mastery (6) our ability screw things up is not a flat line.  In the beginning a person wouldn't act on a financial model or approach out of ignorance or unfamiliarity.  As we learn a few things we get confident enough "to give it a shot".  Ideally people learn the limitation of a model or approach and move on. 

VaR for example stops being the Silver bullet of market risk once one appreciates the flaw of averages, extreme leptokurtosis of financial data etc. or the whole silliness of a the EMH and most modern finance in general.

This mismatch of confidence and application occurs on the group level as well.  Consider a firm engaging in a new initiative (FAD) such as CDS's, Value at Risk or moving into the hot new Phoenix condo market.  They will move slowly at first until a few $'s hit the balance sheet and the organization runs into the new goldmine and no one wants to get between the rapacious banker and their bonus.  Sr. management definitely doesn't want to kill the new golden goose.  Organizationally groups go through the same phases.

Now for the final point.  An entire industry can go through these phases which causes huge potential for disaster as the industry "learns" its way forward.  If you imagine the individual actors (banks) and an industry going through an evolution and were to plot the to hills as 2 axis other you may get something like the chart below.

The failure of acting without full competence or knowledge now becomes a much larger issue.   CDSs were a classic case of this. My guess is that 1-3% of the participants new about the convexity risk inherent, but the industry was right in the middle of the learning curve and confidence was extremely high as mark to market balance sheets made many confuse skill (applied knowledge) with luck.

I mention this because of a personal concern with Basel 2.  Individual firms will each be acting and learning how apply and game a new unified risk approach.  They will be doing this more or less simultaneously throughout the world.  As each bank starts applying its "skill" the Basel 2 framework will get more tightly coupled. 

My concern is that this tightly coupled risk framework will amplify systemic risk creating something that no single participant (central bank) is experienced enough to understand much less control.

A banking system filled with ignorant participants with low confidence is safer than a group of highly confident mediocre participants.  Ignorance and fear, keeps many from acting to boldly.

As an anthropologist, I view money as a social phenomenon, a belief system that sometimes gets ahead of itself.  Understanding behavior, overconfidence and group motivations of various actors in finance can be a helpful tool in the world of money.

Using the Iron Prediction Triangle to pillory pundits

Acme Rocket Motor's shares are going to the moon because Wily E. Coyote uses them all the time to chase the Road Runner....

A lot of financial writing and prognostication is poorly done.  I am not merely speaking of the outcomes, but rather the rigor of the presentation and thought behind the processes.   Few escape the sobriquet, of bad punditry, be it Joe Random Blogger or the once august periodicals such as the Wall Street Journal and the increasingly banal Barron's which serves as an over priced blog in paper form with increasingly dubious editorial quality and declining relevance. 

Forget John Galt, where is the Tyler Durden of Print? It probably isn't Matt Taibbi.

The pundit who says X will go up and Y will go down is noise.   A prediction or opinion to be useful and actionable needs 3 components.  

1. Entry (A time, price, fair value or point of entry)
   

2. Exit (A time, price, fair value or point of exit)
   

3. Risk : Reward (Sharpe ratio, Loss limits, Stop losses, Probability of success, risk of ruin etc.)

Please note that a useful prediction does not mean a correct one.  A useful prediction is one which can be acted upon with some measured degree of confidence and then assessed for effectiveness in hindsight.  Not all predictions are correct, but some are useful. 

In project management there is a standard triangle model of framing the boundaries or constraints of a project.  Using these constraints, communicating and managing a project and its participants becomes easier as the expectations are understood as bounded. 

The graphic shows, the traditional project manager's model.  If you are a project manager you tell the respective parties that they can move any 2 points on the project triangle, thus keeping the potential quality area realistically fixed.

The equivalent in the prediction sphere is that all three components need to be explicitly stated or implicitly understood for an effective prediction to be potentially considered much less acted upon.

If an individual suggests you buy this or that stock, your next questions should be for how long and at what risk in addition to why?  Without the other 2 legs to the prediction triangle you have pretty much nothing. 

It is tough enough with all 3 legs to choose a prediction or model, but without 3 legs, it is impossible in retrospect to assess the value of a prediction or selection process.

Entry can be explained as buy now or this asset is worth price $ or value.  An exit can be expressed as hold for 10 years or until price/ value Y is reached.

The trickiest and most often missing component is the Risk:Reward qualifier or quantifier.  If one is investing/trading/betting, it is better to know whether to bet the farm or merely a farthing. 

Predictions are acted on in the context of alternative choices in a portfolio of options, so it is important to understand the risk reward scope of a particular choice.   Risk can be expressed as a stop loss, likelihood of major loss or potential probability weighted outcome etc. even the dreaded VaR.  This doesn't mean the risk assessment will be correct, but it is better to discuss risk in some context leave it as the unmentionable issue blighting the brilliant predictor.

So there you have it.  If some joker shows up on television, print or digital form lacking a robust prediction triangle with an Entry, Exit and Risk Reward stated, please discount said blather, ink or bits accordingly.

Flaw of Averages a useful book and tool

Sam Savage's latest offering Flaw of Averages is a useful book and set of thought tools he calls mindles.    If you have a PHd in statistics or mathematics, your job or role rarely begins and ends with you.  Often your models will need to be explained to people.   More importantly the places where the models could or would go wrong need to get explained.

The Flaw of Averages provides a great read and introduction to basic concepts in probability and real life situations where things behave in un-intended ways, such as the hidden stories in the "average". 

The book's core strength is the author's fun and helpful voice .  He is the stats teacher you wish you, your kids or co-workers wish you had.

Sam Savage has spent a long time in industry explaining and teaching how statistics and models work across sectors.  His chief skills is as a creator of simple stories and mental models that let managers and regular people understand the value of statistics applied.  Dr. Savage sells powerful "light bulb goes on in the head moments" for a living and sells the tools that let people have those light bulb moments in their own respective domains.

If you want a way to understand something from a new angle or some interesting new thought tools, take a look at the Flaw of Averages.  Quite a few useful examples and free simulations are available at his website. 

Topics covered include:

• Flaw of averages in finance and real estate
• Flaw of averages in supply chain management
• Examples of more successful product launches
• Petroleum (peak oil is hinted at)
• Many other real world applications and examples that would allow managers to share powerful concepts.  If you can't afford a $2k/day stats manager to assess some of your business issues, try a few hours of reading this book.

Disclosure: 10 years ago, I bought one of Sam's modeling tools for excel and over the course of 4 years proceeded to lose it somewhere between living in Dubai, Denmark and Brussels.  I called Sam up explained the situation and he let me pick up an upgrade for minimal cost.  He is not only a great teacher/practitioner but a nice fellow as well.

Free resource for learning about finance, statistics, physics etc.

Education is one of the most important ways we have of passing "progress" on.  The Khan academy is a great free video resource for learning.

The available subjects are very cool: including the current economic crisis, the Geihtner plan etc.  Also tutorials on great stuff in math.  If you hated math or some subject in college or high school, give it a shot here, you may find a new way to look at and understand the world.

Calculus  |  Precalculus  |  Trigonometry  |  Algebra  |  Finance  |  Pre-algebra  |  Arithmetic  |  Geometry  |  Physics  |  SAT Preparation  |  Probability  |  Linear Algebra  |  Differential Equations  |  Credit Crisis  |  Banking and Money  |  Paulson Bailout  |  California Standards Test: Algebra II  |  California Standards Test: Algebra I  |  California Standards Test: Geometry  |  Venture Capital and Capital Markets  |  Statistics  |  Geithner Plan  |  Current Economics

Here is a video about the housing bubble.  You may not agree with it, but the explanation is clear and lucid.

Watch your money at work www.usaspending.gov

The CIO of the USA has put an interesting tool for looking at spending in the US at www.usaspending.gov.  It looks pretty whizbang.  I haven't checked the data available etc. and what is under the hood, hopefully it has a good signal to noise ratio.  I put a little chill Moby into the soundtrack.  Watching the govt spend is anxiety inducing enough. The video doesn't show much of a story, just the widgets at work.

For those interested in making videos, windows movie maker is probably on your PC via Microsoft and camstudio video screen capture software is available free. Here are the steps to animate an excel series

1.  Load a data series and chart into excel
2. Open up the developer section and put in a For loop to increment the appropriate variable
3. In the For loop tell excel to "activate the chart worksheet" which will recalculate it. you can play with recording you actions to see the code for this.
4. Run the loop while record the chart region of the screen with Cam studio running
5. Excel is usually so slow updated charts that you can capture the motion
6. Import the CamStudio AVI file into windows moviemaker
7. Create your relevant information slides in powerpoint as graphic stills( titles pictures etc.).
8. In powerpoint use the saveas:picture setting to export the still frames
9. import the pictures into movie maker
10. For extra speed adjustments in the excel video clip use the half speed, or double speed effect in Windows MovieMaker
11. Season with music to taste by importing MP3 etc into windows movie maker
12. Upload to video sharing site of your choice

This sounds complicated, but it takes 7-15 minutes once you get the hang of it and can bring data to life for many people.  It is a great way to understand data as relationships or time unfold. 

US Yield Curve Mambo 3 month to the 30 year Dance

I am looking at taking a role as a prop trader/PM with RCG (Rosenthal Collins Group) in Chicago.  They do a bit of Yield curve trading among other things, so I thought maybe I could liven the data up a bit.

The typical yield curve looks boring and doesn't show relationships over time or the whole yield matrix.
Being interested in getting a feel for the data means understanding all the US swaps spreads. So I put them into excel and created a nice scrollable  matrix.
 
But hey even that isn't fully helpful and discovering anomalies in data (which is fun for me) means getting a feel for the relationships.  So I ended up with something like this video.

Trading the curve still means ferreting out the anomalies, but I have already found some things in currency swaps. I am hopeful the US  Mambo will yield some alpha (insert bad pun groan).  One caveat, the data matrix didn't have data for the full duration, for example 7 yr. issuance is fairly new etc., and the curves aren't interpolating the null data.  This is more for fun than information value.  The flattening of the curve and then the spread gaps are interesting to watch from 05-09.

If you want the yield curve mambo get it here from on the Godsdog album from De Phazz

If you are an educator you may use a simple video editing program to illustrate the flattening of 2005 and the risk expansion during the crisis.  Here is the Raw AVI file for editing and educational purposes. Enjoy.Download Testfilm3 (50MB).

The Best Political Series: House of Cards

Fire up the netflix/torrent video pipe of choice. The best example of political television comes from the BBC.  If you like your characters direct and with a wicked Machiavellian streak there is none Finer than Ian Richardson playing Francis Urquhart the Prime Minister in the BBC Series House of Cards.

It doesn't get better in terms of devious characters and a marvelous introduction into politics as it probably really is. The pleasant American supposition of doing the public good is missing, but the pursuit of power is on clear display.

House of Cards sets the bar very high for any political drama or political character you may ever see again.  Consider the current bailouts and other games a foot these days while watching.  There is nothing better than a crisis as a pretext for the exercise of power.

What are you paying attention to? Equity tricks & Fed Magic or the dependency ratio?

Some things in the world appear to be changing rapidly, yet one should focus on the big picture.  Magic is the art of deception.  This video takes the trick out of the magic and yet still amazes.

After watching this, think about your own perceptions as filtered through the media's "today" focus.  My suggestion for information is a healthy diet of 1 part news :3 parts book, research and exposure to other fields of thought in order to maintain perspective. 

This is part of a series in Wired magazine on Magic and cognitive science that is well worth considering.

The point is that we hold our cognitive skills in greater esteem than they deserve.  Reality is a perception.

Consider these perception biases when seeing reports from whatever captures the media's attention today or this millisecond. While focusing on a few billion $'s of losses or bailouts sloshing around here or there, the background of many developed countries "dependancy ratios" have changed significantly in the last 30 years.  Here is a little snippet from an older Harvard Business article. 

Demographics are mostly inevitable, but discussing a dependency ratio that moves at a constant rate hardly merits CNBC's attention.  My bias is for Charlie Rose interviews which offer more considered views on serious matters.

Our current economic issues are happening to a country and world that is slightly different than the 1930's etc.  That chart of this bubble or that bust should be considered interesting, but limited.

My  bias is for structural similarities to the panic of 1893.  A useful source for thinking about these things is Kindelberger, that man knew his bubbles and their causes.

The big picture is changing drastically and yet attention and energy is focused on the current day to day details.  Enjoy the economic show, as taxpayers we all paid for premium tickets, but what happens to automakers and the major banks is really just a sideshow in the context of the next 20 years.

UK & US Govt 5 Year CDS spreads still in extreme territory

I have been using a trial of a nifty credit service called Advantage Data to look at credit spreads and risks.  Here is a look at the last 3 months of the CDS prices for US and UK 5 years.
Looking back over the last 3 months, it looks like things are getting better.  This chart shows  a CDS bid price in bps, referencing the likelihood of default of the UK and US government debt over the next 5 years. 

Below is the chart with a time horizon going back a year or so ago. The message is that the credit crisis while apparently getting better is still posing extreme systemic risk according to CDS spreads.  I posted this data help people think about what is going on in the credit world's view of things. 

The equity markets are important to peoples perception of wealth and confidence etc. in the near term. It is the perception of risk and liquidity in conjunction with demand that actually determines how we get through this.  The current plans have been greeted optimistically, but are not priced in as a full resolution to these national crises.  Let hope spreads keep tightening.  The Q1 US GDP could be an eye opener.

As indicators of perceived risk, the equity markets don't tell a person a lot.  The CDS spreads offer a lot more information and are exhibiting strong signals that appear directionally promising, but still chronically high.  Tarp V 3.5 anyone?

Here is a the same information for the G-10 from Bloomberg. The fat lady isn't singing quite yet.

The singularity and the real future of computing, post netbook

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

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

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

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

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

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

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

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

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

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

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

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

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

The municipal credit market is un-impressed

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

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

Monty Hall: information & door #1 investing

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Where did value investing go wrong in 2008?

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

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

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

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

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

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

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

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

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

Make Interactive Excel Models in under 2 minutes

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

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

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

Change happens faster

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

The architecture of Capital Allocation

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

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

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

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

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

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

The Post Earnings Economy. Time for the PY valuation ratio

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

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

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

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

Circus humour

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

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

Country quiz.

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

Quant finance humour for a small audience

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

Perspectives on this years Banker's Bonus situation

There is an old British Colonial Joke that goes like the following:

Jr. Officer rushing in concerned and afraid :"Sir! Sir! The natives are revolting!"

Sr. Commanding officer drinking cup of tea calmly replies: "I quite agree."

In that vein the following diagram and phrase is offered.

As a tax paying hedgie who returned +19.80% w/ 1.02 Sharpe in 2008 and got $0 bonus due to the team nature of our firm, I stand firmly in Joe Public's circle. 

Most risk failings and opportunities for designing better futures deal with imagination.

Being able to draw it on a cocktail napkin like this book teaches or sum it up in 1-2 sentences, is a test for good ideas.  Jessica Hagy is one of the more funny picture thinkers.  Her site is here she also has a  book.  XKCD is funny technical picture thinker.  Gaping Void by Hugh McLeod is also a brilliant picture thinker.  I garuntee you won't find answers to technical finance problems at these sites, but you may find inspiration or at least a smile. Both are important and rare assets these days.  Share them.

FYI: I am creating a new section of the blog called thinking in pictures in order to sharpen my own thinking.