Sunday, August 28, 2016

2016 SBBI Yearbook

The 2016 SBBI Yearbook: Stocks, Bonds, Bills, and Inflation: U.S. Capital Markets Performance by Asset Class 1926-2015 by Roger G. Ibbotson and contributors from Duff & Phelps (Wiley, 2016) is an imposing book. Printed on high quality, heavy stock and measuring 8 1/2” x 11,” it offers 368 pages of beautifully presented returns data along with careful analysis. It is divided into 12 chapters: results of U.S. capital markets in 2015 and in the past decade, the long-run perspective, description of the basic series, description of the derived series, annual returns and indexes, statistical analysis of returns, company size and return, growth and value investing, liquidity investing, using historical data in wealth forecasting and portfolio optimization, stock market returns from 1815-2015, and international equity investing.

Here I’ve decided to focus on a single short chapter: liquidity investing, written by Roger Ibbotson and Daniel Kim, because some of its findings are surprising. First, risk, as measured by standard deviation, increases with liquidity. The authors analyzed the annualized returns (%) between 1972 and 2015 of liquidity quartiles of stocks traded on the NYSE, NYSE MKT, or NASDAQ. The geometric means of the returns of the quartiles, from least liquid to most liquid, were 14.93, 14.04, 12.20, and 7.32. Their arithmetic means were 16.74, 16.06, 14.56, and 10.94. And their standard deviations were 20.01, 21.29, 22.72, and 27.79. One dollar invested in the least-liquid quartile of stocks at the end of 1971 (an equally weighted portfolio with all dividends reinvested) grew to $456.72 by the end of 2015. One dollar invested in the most-liquid quartile grew to only $22.43 over this period.

Liquidity, the authors found, is a much better predictor of returns than size. Although small stocks tend to outperform large stocks in general, this pattern is reversed for the most-liquid stocks. The best performing category is made up of small, relatively less liquid stocks; the worst performing are the small, highly liquid stocks.

Analyzing the performance of value and growth stocks in terms of liquidity, the authors show that high-value, low-liquidity stocks perform the best and high-growth, high-liquidity stocks the worst. The geometric mean of the compound annual returns of the former was 18.85%; of the latter, 2.46%.

In brief, liquidity is a viable investing style and can be mixed and matched with other styles to add to performance.

The SBBI Yearbook has been published for over 30 years. Even in an era of digital data, it remains a wonderful publication. I wish it another 30 years of prosperity.

Wednesday, August 24, 2016

Gonzalez, How to Make Money with Global Macro

Intermarket analysis is tricky at best. Javier Gonzalez, in How to Make Money with Global Macro, offers a couple of templates to simplify the task. Reduced (and oversimplified) even further, we get the “dollar strategy.” “If the dollar is appreciating, it invests in the Nasdaq. If the dollar is depreciating, it invests in commodity-exporting markets or commodities. There are some conditions, whether the dollar is appreciating or depreciating, in which it is best to hold cash or bonds.” (p. 6)

At the heart of Gonzalez’s framework is the core-periphery paradigm. Although currencies exist in a continuum, the paradigm divides currencies into the world’s reserve currency (currently the U.S. dollar), hard currencies (ones that appreciate during episodes of risk aversion, such as the Japanese yen, the Singaporean dollar, and the Swiss franc), and soft currencies (emerging market currencies or commodity-exporting currencies). The reserve currency economy has many advantages over other economies. Most notably, “worldwide monetary conditions are typically ‘optimal’ for the reserve currency economy and only for the reserve currency economy.” It can “generate wealth out of thin air,” it has “longer uninterrupted business cycles” (witness 1991-2001), and it can “have a currency account deficit apparently indefinitely.” (p. 22)

Gonzalez presents two blueprints of the dynamics of global macro, the episode from 2003 to 2008 and that from 1995 to 2001. Here things necessarily become more complicated. Nonetheless, Gonzalez suggests that “there are some difficult-to-manipulate relationships” in these blueprints, which is “why they just might increase the odds of profiting from global macro.” (p. 32)

The bulk of the book is a history lesson, from the commodity boom of the 1970s through the monetary experiments of the 2010s. The author analyzes global macro events in each decade and follows that analysis with graphs covering such areas as currencies, U.S. economic policy, U.S. equities, commodities, global equities, U.S. real estate, and U.S. economics.

In the shorter second part of the book Gonzalez offers a topical analysis: the war effect, crashes and crises, commodities, fallacies and the chairman cycle, macro and power, dollar stability, and the gray swan.

The “mother of all gray swans,” according to the author, is climate change. He considers four scenarios—rising sea levels, lack of water in a metropolis, pandemic, and drought—and offers suggestions about where to invest and what to avoid. He recommends that the sophisticated investor monitor water levels in major cities around the world just as she monitors the dollar index. “Other variables to check upon are agricultural inventories, livestock levels, and more-accurate-than-official climate projections. Just as observing U.S. dollar trends has been profitable in the past (and might still be in the future), monitoring the above mentioned variables might produce outsized returns in the future. It might become a necessary defensive strategy.” (p. 282)

Sunday, August 21, 2016

Dittrich, Patient H.M.

A change of pace, off topic, take your pick in describing today’s brief post. It’s August, after all, so I feel justified in taking a mini-vacation from the financial markets. And Luke Dittrich’s Patient H.M.: A Story of Memory, Madness, and Family Secrets (Random House), released earlier this month, is a captivating book.

In the popular history of neuroscience two patient names stand out. First, Phineas Gage (1823-1860), who, as one writer described him, “had a metal rod blown through his head and lived to get cranky about it.” Gage’s personality changed radically, and not for the better, after the accident. Second, Henry Gustav Molaison (1926-2008), known simply as Patient H.M., who, after a lobotomy to control his epilepsy, could no longer commit new events to his explicit memory. He was a hollowed out human being. But he became the subject of intense scientific study. Psychologists researching the formation of memories had in Patient H.M. a classic case study in how “the broken illuminate the unbroken.”

Luke Dittrich is the grandson of Dr. William Beecher Scoville, the surgeon who performed the lobotomy on H.M. and countless others, including, as it turns out late in the book, his own wife. Scoville proselytized for psychosurgery and especially for lobotomies. In performing lobotomies, he found “a way to unite his passion for tinkering and his interest in experimental surgery.”

Scoville, known to medical residents as “Wild Bill,” pushed the boundaries of medicine, to the point that the line between his work as a doctor and his work as a scientist eventually became “impossibly blurred.” The pretext of healing mentally ill patients gave him cover to carry out surgical experiments. ‘Pretext’ may be too strong a word, but there was scant evidence that lobotomies were beneficial to the thousands of patients who underwent them. Scoville’s surgery was not quite the stuff of the Nuremberg trials, but it was ethically sketchy nonetheless.

Patient H.M.is one of those books you can’t put down, and also one you can’t forget.

Sunday, August 14, 2016

Priest et al., Winning at Active Management

William W. Priest, Steven D. Bleiberg, and Michael A. Welhoelter are, respectively, CEO and managing directors of Epoch Investment Partners. It’s important to note this up front because their book, Winning at Active Management: The Essential Roles of Culture, Philosophy, and Technology (Wiley, 2016), is in part a paean to their firm. Understandably, they believe that Epoch exemplifies the best practices of active management.

The first task of the authors is to make the case for active management in the face of the industry’s pretty grim performance numbers. Even before fees, a minority of U.S. large-cap core equity managers managed to outperform the S&P 500 over one year (42%), three years (48%), and five years (46%). Only over a ten-year time horizon did a majority outperform (69%).

The authors’ argument is that the real-life insights of behavioral economists have effectively defeated what “started off as an ironclad theoretical case for passive management.” (p. 85) Even so, the strongest conclusion this argument can reach is that successful active management is possible.

Several factors work against active managers. Periods of higher correlation and lower dispersion are challenging for managers, as are times when the stocks of lower-quality companies outperform those of higher-quality companies. Active funds also experience a drag from cash holdings. And, of course, they fall victim to the paradox of skill. As Mauboussin described this paradox, as participants in an endeavor become more skillful as a whole, luck becomes an increasingly important component of any one participant’s results.

Theoretically, active managers can outperform stock market averages because behavioral biases create market inefficiencies. Practically, “most managers have not been following an approach that is likely to work.” The authors contend that “capturing the impact of stock-specific inefficiencies requires a disciplined process that (1) understands the forces that create an inefficiency, (2) captures it by ‘casting a wide net’ across stocks that are likely to be affected, and (3) properly structures the portfolio so as to filter out the impact of any factors (e.g., size or industry effects) for which the manager currently has no forecast, and which might otherwise swamp the excess return generated by the inefficiency that the manager is trying to capture.” (p. 106)

The investment philosophy of the authors’ firm is that “cash flow is the origin of value in stocks, and that forecasts of cash flows should be the basis for security selection.” (p. 133)

The authors also address the role of technology in investing. Will computers eventually take over the world of investment management? The authors not unexpectedly take the position that “investing is too important for robots alone.” Instead, they are, in the words of one of their firm’s recent initiatives, “racing with the machine.”

Three appendices to the book present selected articles and white papers of Epoch Investment Partners, a review of principles of valuation for financial assets, and a case study about disclosure written by Jack Treynor in 1993.

Wednesday, August 10, 2016

Cofnas, Trading Binary Options, 2d ed.

Binary options are simple trading instruments that are designed to offer an attractive alternative for the directional trader with a small account. As Abe Cofnas explains in the second edition of Trading Binary Options: Strategies and Tactics (Bloomberg/ Wiley, 2016), the trader makes a straightforward bet: that the settled price of an underlying market will be at, above, or below a target strike barrier by a defined future time. If he’s right, he gets $100; if he’s wrong, he gets nothing. At least that’s the way it works on Nadex (North American Derivatives Exchange).

Traders who have shied away from options because they seem overly complicated may be relieved to learn that understanding the Greeks is not essential in the world of binary options. Yes, market makers use them to price the binaries and Cofnas even introduces the reader to volatility smiles, but the trader’s major decisions are whether to buy or sell binary options, at what strike price, and for what duration. How much does he think the market will move in a given length of time and in what direction?

Of course, getting the direction, magnitude, and timing of a short-term trade (weekly, daily, and a selection of intraday expiries) right is a daunting task. Cofnas therefore devotes four chapters to tools the binary options trader can use to improve his skills: sentiment analysis, tracking fundamental forces that impact markets, technical analysis, and volatility tools.

He then describes in some detail seven major binary option trading strategies that can be used to respond to global market-related events: in-the-money, deep-in-the-money, at-the-money, out-of-the-money, deep-out-of-the-money, range trades, and breakout trades. He offers, among others, examples of gold and EUR/USD trades during the Greek debt crisis, a crude oil play at the time of revolts in Tunisia and Egypt, a GBP/USD trade just before the referendum on Scottish independence, and a USD/CHF trade the week of U.S. congressional elections. He draws these examples from trading alerts he sent out in Agora Financial’s Strategic Currency Trading newsletter. Cofnas also devotes a full chapter to using binary options to trade the non-farm payroll report.

The book concludes with chapters on risk management, metrics for improving trading performance, performance tools and training for improving trading, and a 51-question quiz.

Traders who want to get a feel for binary options can create a free paper trading account at Nadex. If they have experience trading other instruments they will most likely be struck by the incredibly wide bid/ask spreads here. For instance, whereas the front-month crude oil futures normally have a penny-wide spread and options on CL have spreads of about two to seven cents, the day I checked crude oil binary spreads on Nadex, on a weekly contract with two days left, they ranged from $5.25 to $7.00, with bids from $0.50 to $93.50 and offers from $5.75 to $98.75. And in contrast to Cantor, NYSE, and CBOE, Nadex takes the other side of the trade. The trade-off here, as Cofnas points out, is the potential lack of liquidity on the “true exchanges.”

Cofnas’s book is useful to anyone considering adding binary options to his trading portfolio. As, of course, is trying out some strategies in a paper account to see whether they are solid enough to overcome the wide spreads and, in the case of Nadex, to beat the house.

Sunday, August 7, 2016

Gottesman, Derivatives Essentials

Derivatives Essentials: An Introduction to Forwards, Futures, Options, and Swaps (Wiley, 2016) by Aron Gottesman is an excellent textbook/self-study guide. It describes the basic concepts of derivatives in refreshingly clear prose. And it’s perfect for those who want to understand some of the math behind derivatives but have a limited, though more than rudimentary math background. After all, there’s no way you can explain Black-Scholes to someone with only high school algebra.

Gottesman is a professor of finance at the Lubin School of Business at Pace University in Manhattan. I don’t know how sophisticated or focused his MBA students are, but he expects from his readers only a willingness to learn how derivatives function and an ability to work through formulas that he explains step by step. After every couple of pages or so he inserts a knowledge check, easy to answer if you’ve been paying attention, a wake-up call if you haven’t.

The book is divided into five parts: introduction to forwards, futures, and options; pricing and valuation (including the Black-Scholes and binomial option pricing models); the Greeks; trading strategies; and swaps.

Gottesman often takes a different approach to derivatives from most textbook writers. For instance, he explains theta by saying at the outset that “there are two ways that a decrease in the time to expiration can impact the value of a position:

The present value effect: As time to expiration decreases, the present value of the forward price/strike increases.

The optionality value effect: As time to expiration decreases, optionality value erodes.”

Traders who want instant gratification in the form of specific setup recommendations will find Gottesman's book disappointing. But anyone who wants to understand what options are all about, especially in the context of other derivatives, and how the pieces fit together mathematically should read this book. It’s also a book that deserves a permanent place on a derivative trader's reference shelf.

Sunday, July 31, 2016

Lu, Inside the Investments of Warren Buffett

I have no idea how many books have been written about Warren Buffett, but sometimes I have the feeling that he is giving George Washington a run for his money. The latest addition to the literature is Yefei Lu’s Inside the Investments of Warren Buffett: Twenty Cases (Columbia Business School Publishing, 2016).

Lu examines 20 investments Buffett made over the course of his career that, in Lu’s opinion, “had the largest material impact on his trajectory.” He puts himself in the shoes of imaginary investment analysts “studying the businesses at the same time … Buffett did.” Why would an ordinary analyst either recommend or, as would often have been the case, argue against investing in a company to which Buffett eventually opted to commit funds?

The book is divided chronologically: five investments between 1957 and 1968 (the years of Buffett Partnership Limited ), nine investments between 1968 and 1990, and six after 1990. I found the first section the most interesting, both because it was the period I knew the least about and because it shows Buffett’s willingness to pursue a variety of analytical and risk management strategies, perhaps even some long-short pairs trades. Here I will limit myself to Buffett’s activities when he was running BPL.

The five investments Lu chooses as illustrative of Buffett’s investing during this period are Sanborn Map Company, Dempster Mill Manufacturing Company, Texas National Petroleum Company, American Express, and (of course) the ill-fated Berkshire Hathaway.

Sanborn Maps produced maps primarily for fire insurance companies. Its maps “included details of not only streets and houses of a city but also such items as diameter of water mains underlying streets, number of windows, elevator shafts, the material of construction for buildings, and production lines for industrial facilities. The commercial product sold to its customers would typically be a large volume of maps that weighed approximately fifty or so pounds….” Sanborn was a successful company, with steady revenues, until the 1950s, when a new technology, “carding,” threatened to undermine its existence. By 1958, when Buffett began investing in Sanborn, the company was struggling. Between 1950 and 1958 net income had declined approximately 10% per annum. Why, then, would Buffett have been interested in it? First, it had a securities portfolio worth more than the value of the entire company and, second, Buffett believed it could be turned around. Buffett was an activist investor in this instance. Over the course of three years he acquired a controlling interest and separated the company into two separate entities. Sanborn Maps exists to this day.

Dempster Mill, a Nebraska-based company, sold windmills and assorted agricultural equipment such as seed drills and fertilizer applicators. In the 1950s windmills were anything but a growing business. Buffett wrote that Dempster Mill’s “operations for the past decade have been characterized by static sales, low inventory turnover and virtually no profits in relation to invested capital.” But Buffett could buy the company’s stock at a significant discount (on average 63%) to book value, the bulk of its assets could be readily sold and turned into cash, and with better management it could be revitalized. Once again, Buffett played the role of activist investor, a role it turned out he didn’t enjoy and came to abandon.

The next two investments were different. Texas National Petroleum was a special situation. It had an offer to be acquired but had not yet accepted the offer. American Express, a growing business then best known for its travelers cheques, was reeling from the “salad oil swindle” and faced “unknown and potentially enormous liabilities.” Judging the ramifications of the scandal to be temporary, Buffett was willing to forgo the “cigar butt” strategy and pay a fair price for a really good business. As for Berkshire Hathaway, although it is often viewed as a mistake, “the shrinking business actually provided the capital with which Buffett would invest in many other businesses starting in 1967 with the purchase of National Indemnity.” And so, Lu concludes, “it likely did not actually lose money for Buffett in absolute terms.” And it provided Buffett with an iconic name.