Wednesday, November 22, 2017

Bernstein, Secrecy World

Jake Bernstein’s Secrecy World: Inside the Panama Papers Investigation of Illicit Money Networks and the Global Elite (Henry Holt, 2017) is both riveting and dispiriting. Bernstein, a Pulitzer Prize-winning journalist, knows whereof he writes because he was a senior reporter on the International Consortium of Investigative Journalists team that broke the Panama Papers story.

Data siphoned off from the law firm of Mossack Fonseca in Panama “afforded an unprecedented look into the operations of an underground economy through which trillions of dollars flow annually. This river of cash exists in a largely unregulated place known as the secrecy world. It’s an alternate reality available only to those who can afford the trip. In the secrecy world, wealth is largely untouchable by government tax authorities and hidden from the view of criminal investigators. Through the secrecy world, family dynasties are nurtured, their fortunes—often acquired illicitly—laundered and passed on to heirs. It’s a place where capital always triumphs over labor and the well-to-do are free to ignore the laws that govern their fellow citizens.” That’s dispiriting.

But Bernstein’s account of who hid money and how they did it is fascinating. From Vladimir Putin, whose name of course never appeared in the files, only the names of his oldest and most loyal friends, to Donald Trump’s partners and customers, to brashly overconfident Icelanders—people created thousands of shell companies with Mossfon. Some were trying to keep their wealth secret from their spouses, others trying to avoid the tax man, still others were buying and selling art, often to move it to freeports.

Secrecy World is a must-read book for anyone with an interest in, and perhaps a sense of outrage over, how the rich protect their wealth. And, I should note, it’s not just through secret offshore accounts. Delaware and Nevada allow incorporations with virtually no due diligence.

Sunday, November 19, 2017

Arnold, The Deals of Warren Buffett, vol. 1

Glen Arnold, a former academic (professor of investment and professor of corporate finance) turned more or less fulltime investor as well as a prolific author of books on finance, is an unabashed fan of Warren Buffett. He is a Berkshire Hathaway shareholder and regularly travels from England to Omaha for the Berkshire annual meetings.

Arnold set out to discover why Buffett chose the companies he invested in and what lessons individual investors can learn from Buffett’s decisions. Volume 1 of The Deals of Warren Buffett (Harriman House, 2017) covers the period leading to Buffett’s first $100 million in net worth, which he reached in 1978 at the age of 48.

Contrary to myth, Buffett didn’t always have a Midas touch. Apart from his most notable failure, Berkshire Hathaway the textile company, he lost money when he was in his early 20s on Cleveland Worsted Mills and an Omaha gas station he bought together with a friend.

But many of his investments were staggeringly successful, certainly dwarfing the $2,000 he lost on the gas station. Arnold goes through Buffett’s early investments one by one, from lesser known companies such as Rockwood & Co., Sanborn Maps, Dempster Mill, Hochschild-Kohn, and Associated Cotton Shops to such Berkshire staples as American Express, Disney, See’s Candies, and the Washington Post.

Throughout, Arnold stresses Buffett’s investing principles, exemplified in each of these deals, that can withstand the test of time. Among them: Grand principles are more important than a grand plan. Market moods can be incomprehensible to value investors, but stick with sound investing principles in good times and bad. And, re managers, good jockeys will do well on good horses, but not on broken-down nags. And so, in general it’s important to avoid businesses with problems.

Buffett followers will welcome this addition to the already huge Buffett bibliography. Arnold’s book will be even more illuminating to investors who are in search of an overarching rationale for their investing decisions. Why not learn from the best?

Wednesday, November 15, 2017

Vermeulen, Breaking Bad Habits

Many of the principles articulated in Freek Vermeulen’s excellent book Breaking Bad Habits: Defy Industry Norms and Reinvigorate Your Business (Harvard Business Review Press, 2017) can easily be extended beyond the confines of business organizations. So even if you aren’t a business executive (but of course especially if you are), you can profit from the book’s antidotes to bad practices.

Bad practices thrive on inertia. To overcome this inertia and reinvigorate the organization one should implement “complementary processes that foster ongoing creation and renewal.” For instance, embrace change for change’s sake, make your life difficult, balance exploration with exploitation, be varied and selective. Here I’ll skip over the first recommendation, which, when “Change for Change’s Sake” appeared in HBR in 2010, prompted a spate of hate mail and emails where Vermeulen was addressed as “You Idiot.” To do justice to the nuanced concept would require too much space.

Instead, let me start with the second recommendation: make your life difficult. The author suggests undertaking a challenging variant on one’s existing product or service. For instance, a fertility clinic might treat a 49-year-old woman with one ovary; a law firm might take on a difficult legal case that no one else wants to touch. “It needs to be a challenge, but … one from which you could see or at least feasibly suspect that its learnings will spill over into your normal-day stuff.”

The third recommendation, balance exploration with exploitation, means that a business should try new things but at the same time focus on profiting from existing competitive advantages.

And, the last recommendation: be varied and selective. Essentially this calls for letting a thousand flowers bloom but allowing 999 of them to die.

On another front, this one complete with an investing tip, Vermeulen cites a study on employee satisfaction. The share price of companies that made it onto Fortune magazine’s list of best companies to work for “rose about 3.5 percent faster than others’ did.” The stock market, however, underestimates the effect of happy employees. Investors did not factor employee satisfaction into their valuation of the company. “Only when—inevitably—the employees’ happiness started to bear fruit in terms of the company’s profits did the share price make a happy jump in surprise.”

Sunday, November 12, 2017

Diaconis & Skyrms, Ten Great Ideas about Chance

Ten Great Ideas about Chance by Persi Diaconis and Brian Skyrms (Princeton University Press, 2018) grew out of a course that the authors team-taught at Stanford, which had as a prerequisite one undergraduate course in probability or statistics. It is, as the authors describe it, “a history book, a probability book, and a philosophy book.” In writing about the ten great ideas—measurement, judgment, psychology, frequency, mathematics, inverse inference, unification, algorithmic randomness, physical chance, and induction—they proceed more or less chronologically within each topic, starting with Cardano and Galileo and the notion that chance can be measured.

The second idea, that judgments can be measured and that coherent judgments are probabilities, is the one most obviously relevant to finance. Here, as clearly seen in prediction markets, “the probability of A is just the expected value of a wager that pays off 1 if A and 0 if not. If you pay a price equal to P(a) for such a wager, you believe that you have traded equals for equals. For a lesser price you would prefer to buy the wager; for a greater price you would prefer not to buy it. So the balance point, where you are indifferent between buying the wager or not, measures your judgmental probability for A.” In this idealized model “an individual acts like a bookie—or perhaps like a derivatives trader—and buys and sells bets. … She buys fair or favorable bets and sells fair or disadvantageous bets, doing business with all comers. A Dutch book can be made against her if there is some finite set of transactions acceptable to her such that she suffers a net loss in every possible situation. We will say that she is coherent if she is not susceptible to a Dutch book.” Over time, given a change in evidence, she will revise her probabilities using the “unique coherent rule,” Bayesian updating. “Any other rule leaves one open to a Dutch book against the rule—a Dutch book across time, a diachronic Dutch book.” Market makers, beware the diachronic Dutch book!

Ten Great Ideas about Chance takes intrinsically difficult notions that great minds struggled with over the centuries (I personally would put induction at the top of the list) and makes them accessible to anyone with a basic grasp of probability.

Sunday, November 5, 2017

Johnson, Derivatives Markets and Analysis

R. Stafford Johnson’s Derivatives Markets and Analysis (Bloomberg/Wiley, 2017) is part of the Bloomberg Financial Series. As such, the Bloomberg terminal, and how to use it, plays a central role in the text.

The book is a wonderful resource, however, even for the financial professional or student without access to a Bloomberg terminal. Johnson, a professor of finance at Xavier University, has put together more than 750 pages of information about and case studies involving futures and forwards, options, and financial swaps. He includes problems and questions, along with Bloomberg exercises.

Although Johnson starts with the basics, quickly enough he takes the reader into the complexities of hedging. For instance, in the case of options, in one chapter he explains the standard strategies and some defensive follow-up strategies. In the next chapter he discusses ways to hedge stock portfolio positions—by creating a floor or a cap for a stock portfolio using index options and by using range forward contracts. He also discusses hedging currency, commodity, and fixed-income positions with options.

The book has a section on option pricing, with chapters on option boundary conditions and fundamental price relations, the binomial pricing model, the Black-Scholes pricing model, pricing non-stock options and futures options, and pricing bond and interest rate options.

Johnson’s book is not for the average retail investor. But, with its mix of theory and practice, it is exceedingly useful both as a textbook and as a reference book.

Sunday, October 29, 2017

Hirsch, Stock Trader’s Almanac 2018

The Stock Trader’s Almanac is now in its fifty-first edition. It remains a must for traders who use seasonal factors to time the market.

The spiral bound, navy-covered almanac opens flat for easy access to its data or for jotting down notes. The format remains essentially the same as in previous years, with a calendar section, a directory of trading patterns and databank, and a strategy planning and record keeping section. The calendar section has on facing pages historical data on market performance (verso) and a week’s worth of calendar entries (recto). January’s verso pages, for example, give the month’s vital statistics, January’s first five days as an early warning system, the January barometer (which has had only nine significant errors in 67 years, including 2009, 2010, 2014, and 2016, so it may be losing some of its predictive power), and the January barometer in graphic form since 1950. Each trading day’s entry on the recto pages includes the probability, based on a 21-year lookback period, that the Dow, S&P, and Nasdaq will rise. Particularly favorable days (based on the performance of the S&P) are flagged with a bull icon; particularly unfavorable trading days get a bear icon. A witch icon appears on monthly option expiration days. At the bottom of each entry is an apt quotation. There’s about a five-square-inch space in which to write.

The Stock Trader’s Almanac pays particular attention to the presidential cycle, and the prospect for 2018 is mixed. “Midterm election years have been the second worst year of the four-year cycle, while eighth years of decades have been the second best, so 2018 promises to be laced with cross-currents.” On the negative side, “in the last 14 midterm election years, bear markets began or were in progress nine times.” But if the market sinks in 2018, it might provide an excellent buying opportunity because, ”from the midterm low to the pre-election year high, the Dow has gained nearly 50% on average since 1914.”

What other seasonals are powerful? The best six months strategy has a good track record. “Investing in the Dow Jones Industrial Average between November 1st and April 30th each year and then switching into fixed income for the other six months has produced reliable returns with reduced risk since 1950.”

The first trading day of the month is uncommonly strong (save in 2014). Beginning in 1997, the Dow gained a total of 6352 points in 238 first days, for an average daily point gain of 26.69. The other 4733 days gained 7232 points, only 1.53 on average.

This almanac is chock full of data that will delight those traders who believe that past is prologue. Even those who are skeptical have to pay attention to data that seasonal traders rely on and that therefore tend to move markets.

Wednesday, October 25, 2017

Bayoumi, Unfinished Business

Do we need yet another book on the financial crisis? For those who take banking regulation in the European Union and the United States seriously, the answer is yes. In Unfinished Business (Yale University Press, 2017) Tamim Bayoumi, a deputy director at the IMF, delves into, in the words of the subtitle, “the unexplored causes of the financial crisis and the lessons yet to be learned.” He shows that the Euro crisis and the U.S. housing crash were “parasitically intertwined.”

Policymakers were deluded by the efficient markets hypothesis into thinking that financial markets were largely self-regulating. And they were overconfident in the effectiveness of monetary policy. For instance, after the 1980s, when the U.S. experienced a noticeable decrease in the volatility of output (the “great moderation”), conventional wisdom attributed most of this moderation to better monetary policy. And after the technology bubble popped in 2001, the Federal Reserve “ascribed the limited impact on the US economy to its swift monetary response.” So why, if there was a major downturn in house prices, wouldn’t the Fed be able to do the same thing again?

Policymakers in the U.S. and Europe were not only overconfident in their ability to contain crises. They also adopted a stance of benign neglect, “the view that countries should look after their own internal affairs and that the benefits from cooperating with other countries are too small to be worth the trouble.” They were convinced that financial market spillovers between countries were small. “Across the North Atlantic, the main consequence of benign neglect was that policymakers missed the implications of increasing external financing of the US and Euro area periphery housing booms.”

Bayoumi extends his analysis by offering a history of the international monetary system in five crises: the collapse of the Bretton Woods fixed exchange rate system, the Latin American debt crisis, the European exchange rate mechanism crisis, the Asian crisis, and the North Atlantic crisis (which in many respects was “an amalgam of these earlier experiences”).

In the wake of the financial crisis regulations were imposed on banks in the U.S. and Europe. But “many deeper weaknesses remain.” There is, in the words of the author, “still an awful lot of unfinished business.”