Wednesday, April 16, 2014

Friedman, Fortune Tellers

I just finished reading Walter A. Friedman’s Fortune Tellers: The Story of America’s First Economic Forecasters (Princeton University Press, 2014), which I highly recommend. Readers will probably be familiar with some of the main characters, but in a depersonalized form—for instance, Babson action/reaction lines and Moody’s Investors Service. Other characters, such as Herbert Hoover and Irving Fisher, are rescued from the one-sided simplifications of history—failed president during the Great Depression, false prophet who claimed just prior to the 1929 crash that the stock market had reached “a permanently high plateau.”

Friedman accomplishes two main tasks in this book. First, he brings his characters to life, recounting their personal, intellectual, and entrepreneurial successes and travails, their pet social and political ideas—some that now seem appalling, and the battles they did with one another. Second, he describes the dominant styles of forecasting (and, by extension, investing) of the period, which remain with us today—“historical patterns, mathematical models, expectations, and empirical analogies.” (p. 210)

The book is a darned good read and belongs in the library of every investor and trader. After all, despite all protestations to the contrary, we are fortune tellers too.

Monday, April 14, 2014

Sandford, Goals to Gold

Lee Sandford left school at the age of sixteen to become a footballer—or, more precisely, an apprentice footballer. He turned pro the next year. When he was in his mid-thirties he retired from the game and decided to focus on trading, in which he had dabbled, along with real estate, for a number of years. He recounts this journey in the first part of Goals to Gold: Trading the Football Pitch for the Financial Markets (Harriman House, 2014).

The second part of the book deals with trading basics. Sandford’s preferred trading method is spread betting, legal in the U.K. but not in the U.S. (Spread betting firms bear an uncanny resemblance to bucket shops, which flourished in the U.S. from the 1870s until the 1920s.) For those unfamiliar with spread betting, Sandford explains: “you are betting a certain amount of money per point or pip that a product moves up or down. … we’re not buying anything, we are just betting on the movement of the price of something. … You never own anything, so there is no capital gains tax, and it is not seen as income so it is not taxable. The government still classes it as betting.” (p. 114) The spread bet has an expiration date; for instance, the wager may specify that the price of a stock will rise over a period of three months. Since spread betting firms don’t charge commissions, spreads on these trades are normally wide, the farther in the future the wider.

Spread bets are often levered; you need deposit only a small fraction of a trade’s total value in advance and you can potentially reap much higher returns than in the stock market proper. Let’s say, to use the author’s example, you firmly believe that shares in Lee’s Boots will rise and you are willing to wager $10 per point. When the stock is trading at $10 per share, you place your bet at the offer price of $9.98 and set a stop loss at $9.90. If the stock price goes up to $11 per share, you make $1000; if it falls, you lose $100. Sounds good, doesn’t it?

Well, spread betting firms make money not only because they normally demand wide spreads but because most of their customers lose money. (Some firms trade against their own customers.) Sandford describes basic technical analysis techniques, such as MACD divergence, and positioning guidelines that are designed to change these odds. He also takes the reader through a series of illustrative trades, many drawn from the forex market.

The final part of the book is entitled “Trading in Football Terms.” I must admit that I, who don’t follow soccer, didn’t quite connect with “play like you’re not going down” (and hence get out of the relegation zone). But most of Sandford’s analogies could have been drawn from practically any sport, or from life in general—for example, be patient and match your tactics to the situation.

Monday, March 31, 2014

Martin, Money

I can’t remember ever reading a book in which John Locke was a villain, nay perhaps the villain. But in Felix Martin’s Money: The Unauthorized Biography (Knopf, 2014) Locke is described as a “physician, philosopher, and, fatefully, monetary theorist.” (p. 116) “The old” and, for the author, the only defensible “understanding had been that money is credit, and coinage is just a physical representation of that credit. The new understanding was that money is coinage, and that credit is just a representation of that coinage. Lowndes and his ilk [the good guys] had believed that the Earth went round the Sun. Locke had explained that the Sun in fact revolves around the Earth.” (p. 131)

Martin’s work, written for the layman, is primarily a historical/geographical/philosophical account of the notion of money. He begins with the monetary system of the Pacific island of Yap whose coinage, as documented in 1903, consisted of fei, “stone wheels ranging in diameter from a foot to twelve feet.” (p. 8) He describes the accounting technology used in England from the twelfth to the late eighteenth century—the Exchequer tally, a wooden stick on which were inscribed details of payments made to or from the Exchequer. (In the nineteenth century the vast archive of tallies remaining in the Exchequer were incinerated in an “overgorged” stove in the House of Lords in an act that managed to reduce not only the sticks but both Houses of Parliament to ashes.)

Throughout Martin advances his view that money is a social technology, “a set of ideas and practices which organize what we produce and consume, and the way we live together.” (p. 30) This stands in stark contrast to Locke’s view that “economic value is a natural property, rather than a historically contingent idea.” (p. 193)

The author introduces us to the Aegean invention of economic value as well as to the sophisticated monetary theories developed at the Jixia academy in China during its heyday in the late fourth and early third centuries B.C. The Jixia scholars argued that “money’s value was directly proportional to how much of it was in circulation compared to the quantity of goods available. They wrote: “[i]f nine-tenths of the kingdom’s currency remains in the hands of the ruler and only one-tenth circulates among the people, the value of money will rise and prices of the myriad goods will fall.” If, on the other hand, the ruler chooses an inflationary policy, “[h]e transfers money to the public domain, while accumulating goods in his own hands, thus causing the prices of the myriad goods to increase ten-fold.” (p. 72)

Walter Bagehot, editor of The Economist and author of the 1873 classic Lombard Street, is one of the author’s heroes. He argued against the abstract, mechanical theories of Locke, Adam Smith, and John Stuart Mill. Instead, he focused on the empirical realities of money, banking, and finance where the social properties of trust and confidence reigned supreme. As he wrote, “Credit is an opinion generated by circumstances and varying with those circumstances”; “no abstract argument, and no mathematical computation will teach it to us.” (p. 185)

The “biography” part of Money, by far the longest, is also the strongest. When Martin turns to policy recommendations in his closing chapters, the argument flags. (Or perhaps we’ve just heard so much about how to fix our banking system that everything begins to sound banal.) But for anyone with even a passing interest in the history of money and banking, Martin’s book is a treat.

Sunday, March 30, 2014

Michael Lewis interview

Michael Lewis will be on 60 Minutes tonight talking about his most recent book on high frequency trading, Flash Boys: A Wall Street Revolt, due out tomorrow. I haven't read the book, but CBS offers a glimpse into it in its tease of the segment. Also appearing will be Brad Katsuyama, founder of the new exchange IEX that is designed to thwart high frequency traders, and David Einhorn, who has invested in the exchange.

Lewis wrote a lengthy piece last fall for Vanity Fair that reinvestigated the case of Sergey Aleynikov, the programmer who was sentenced to eight years for stealing code from Goldman Sachs. In a discussion with New York Times contributing writer Diana Henriques on Friday Lewis said: “It was curious to me that in the aftermath of the greatest financial crisis of modern times” — in which Goldman Sachs played a key role — “the only time someone ends up in jail is when it’s someone that Goldman Sachs wants to put in jail.”

Saturday, March 29, 2014

On big data and behavioral finance

Two links for your weekend reading pleasure. First, a piece by Tim Harford in the FT about the pitfalls of big data. And, from, reflections on the influence of Daniel Kahneman's research.

Wednesday, March 26, 2014

Potter, How You Can Trade Like a Pro

I don’t think I’ve ever started a review by highlighting the book’s cartoons, but the “trader tips” in this book, illustrated by Noble Rains, are great. Two examples (sorry, in this "teaser" captions only, no graphics): “Entering a trade is like attending a party. You don’t want to be the first person to arrive or the last one to leave.” And “It might be tempting to trade in the shadow of another trader, but a shadow will never see the light.”

Sarah Potter’s How You Can Trade Like a Pro: Breaking into Options, Futures, Stocks, and ETFs (McGraw-Hill, 2014) may sound like an overreach, but it is in fact a good introduction to active derivatives trading.

In the first third of the book Potter, creator of the blog, covers the basics of chart reading over multiple time frames as well as the use of market internals and correlated markets to inform trading decisions. The next third (actually, a bit more) of the book is devoted to options and futures. Finally, she presents her trading plan template and delves into trading psychology.

In the options and futures chapters she starts by explaining the language specific to each of these markets—terms as basic as calls and puts, weekly and monthly contracts. She shares the three option trading setups she uses most often—selling credit spreads that are at or out of the money and buying single-legged directionals—and explains when each of these trades is most appropriate and how to set them up.

As for futures, she writes: “I pull up the ES every morning. Looking at the ES chart helps me to decide what markets I will focus my attention on during the day. … Generally, … I look for a market that is correlated with the ES and does not have resistance in the direction of the move. I look through the ES, YM, and TF and make my decision about which one I will focus on. Whichever market has cleaner charts will be my market of choice for that day. If I look at all three and I can’t see a nice trend, then I will focus all my attention that day on options instead of futures.” (p. 210)

Potter is not simply a trend trader, however. Her three futures trading setups include “the Coffee-Break trade (after the morning rush), the In-Fashion trade (trading with the trend), and the Va-Va-voom trade (momentum scalp [into support or resistance])."(p. 227)

Like many authors of trading books, Potter offers a subscription trading idea service. If you read her book, however, and believe the cartoon caption about trading in the shadow of another trader, you might be more inclined to sit down and do the hard work that is necessary to start learning how to do it on your own.

Monday, March 24, 2014

Piketty, Capital in the Twenty-First Century

Thomas Piketty’s Capital in the Twenty-First Century (translated from the French by Arthur Goldhammer, Belknap Press of Harvard University Press, 2014) was published on March 10 if you believe Amazon, or will appear on April 15 if you believe the Harvard press release. It is already beginning to cause a stir. Admittedly, some responses, for instance Paul Krugman’s, have only been promised, not yet delivered. And the reviewer for The Economist, who is “live-blogging” the book, has just finished chapter 2. The delay is understandable. Capital is a nearly 700-page book, rich in data as well as social policy recommendations. Both will be controversial.

For fifteen years Piketty’s research centered on the historical dynamics of wealth (a notion he uses interchangeably with capital) and income. His goal was to understand what drives inequality. The short answer: Inequality happens when the return on capital exceeds the overall growth rate of the economy. His solution: a worldwide progressive tax on capital.

Critics in the popular press will seize on these bullet points and denounce Piketty for what he is, a French socialist, or what he’s not, a Marxist. Case closed—and the book can remain unread. But the case isn’t closed—and the book should definitely not remain unread.

If, more nuanced critics may argue, Piketty’s policy prescription is not only unworkable (which the author pretty well admits) but fundamentally misguided (as many in the investment community would contend), does this taint his research findings? That is, did he either skew or misinterpret the data to reach the conclusion that inequality rises dramatically when countries experience the lethal combination of rising returns on capital and falling or negative economic growth?

I am not an economist, so I will have to defer to their expertise. I can say, however, that I found the historical data, quite independently of the overall thrust of the book and some of the causal links Piketty suggests, revelatory, even shocking. I realized, reading this book, how short-sighted I have become or perhaps always was. And I suspect I have a lot of company.

To take but a single example, consider the “new normal.” In a recent piece in Business Insider, Mohamed el-Erian described the concept as signaling “the likelihood that western economies would not reset in a typical cyclical manner,” that “economic activity would remain persistently sluggish and unemployment unusually high.” Piketty views the so-called new normal as a replay of the old normal in the sense that “there is no historical example of a country at the world technological frontier whose growth in per capita output exceeded 1.5 percent over a lengthy period of time.” But, he points out, “a per capita output growth rate on the order of 1 percent is in fact extremely rapid, much more rapid than many people think.” (pp. 93, 95) Over a generation (30 years) growth would be more than 35%.

In this book Piketty eschews most technical economic terms, links faceless data to English and French novels (especially those of Austen and Balzac), and sets his arguments against the backdrop of political history. I assume that Piketty takes this tack not so much to appeal to a broader audience as to illustrate his belief that economics is not a science whose doctrines can be captured in mathematical formulas. In fact, he prefers the expression “political economy” because, to his mind, it “conveys the only thing that sets economics apart from the other social sciences: its political, normative, and moral purpose.” (p. 574)

Capital is not light reading; I spent many days in its company and suspect I haven’t seen the last of it. But I consider my time to have been exceedingly well spent. The book challenges commonplace beliefs and almost compels the reader to engage in a running dialogue. I would put it on my very short “must read” list.