Saturday, December 27, 2014

Perfection and Coyote cosmology

I’m not prone to sermonizing in this blog—or anywhere else for that matter, but I was inspired by a wonderful short piece, "Coyote," in the current issue of The New Yorker. I’ve provided a link to the essay because I’m about to take all the fun out of it, and that’s not fair to either you or Rebecca Solnit, the author.

The worldview, religious or philosophical, that most of us have been steeped in draws a sharp distinction between the perfect and the imperfect. We are, as we are often told, imperfect creatures who nonetheless strive to be perfect, and in our failure we suffer all the attendant anxiety and guilt. In some versions we are doomed, in others we can be saved. Whatever the version, we can’t make ourselves perfect no matter how hard we try. We bear the burden of always being imperfect. We make mistakes, we disappoint others, we disappoint ourselves.

Or, in Solnit’s much more vivid prose, “The angel with the flaming sword kept us out of Eden because we talked to snakes and made a bad choice about fruit snacks. Everything that followed was an affliction and a curse. Redemption was required, because perfection was the standard by which everything would be measured, and against which everything would fall short.”

What if, in keeping with Coyote cosmology, we simply scrap the notion of perfection? What if everything is just better or worse and nothing is perfect? Wouldn’t that make life much more manageable? Wouldn’t we actually stand a chance of becoming better if we didn’t beat ourselves up every time we stumbled and fell short of some self-sabotaging notion of perfection?

Let me pause here to say that those who regard this suggestion as heresy should pretend they never read it. I’m not interested in engaging in theological debate. I’m writing, after all, for those of us who inhabit what is usually considered to be the house of mammon, though I hope we’re also trying to be good stewards of this earth.

The message is this. In 2015, strive to be good, better, and, if you swim in a small enough pond, best, but never perfect. Perfection is a mirage. End of sermon. No amen necessary.

Thursday, December 25, 2014

Happy holidays

Do you have time on your hands? Do you find doing the same thing over and over again therapeutic? Do you have a book you wish you had never bought and that even your local library doesn't want for its book sale--and that you're willing to trash? Well, here's the perfect winter project. Directions at SL.

Wednesday, December 24, 2014

Franco, Understanding Bitcoin

Although it seems that everybody and his brother have weighed in on the merits of Bitcoin, I suspect that few have more than a superficial knowledge of how it actually works. Pedro Franco aims to change that state of affairs with his in-depth study, Understanding Bitcoin: Cryptography, Engineering, and Economics (Wiley, 2015). Most of the book is easily accessible to anyone with a rudimentary grasp of financial transactions. It doesn’t even require a lot of mental effort to follow the general thrust of the author’s lengthy account of Bitcoin cryptography.

I have no doubt that money will increasingly be digitized and that paper bills and coins will be a thing of the past. The main question is whether decentralized cryptocurrencies can ever replace, in whole or in part, fiat currencies or whether fiat currencies will morph into some form of cryptocurrencies themselves.

As it stands now, critics argue that Bitcoin is not a currency because it does not serve the three functions of money—medium of exchange, store of value, and unit of account. But does it have to fulfill all three functions or can the three functions of money be unbundled? “A consensus seems to be emerging among economists that Bitcoin is a good medium of exchange, a risky store of value and a poor unit of account.” (p. 22)

We know that the price of bitcoins is extraordinarily volatile, making them a poor store of value. Bitcoin is also wanting as a unit of account: merchants don’t quote prices in bitcoins because the Bitcoin economy is tiny and, again, the price of bitcoins isn’t stable. Even as a medium of exchange, which is touted as its strength, Bitcoin is not without its problems. For instance, it is illiquid compared to fiat currencies, transactions take several minutes on average to be confirmed, and it could face scalability pressures.

But even if Bitcoin or one of its competitors/successors never becomes a generally accepted currency, the technology that underlies it could have other applications. For instance, the blockchain at the heart of Bitcoin could be used to register the ownership and transfer of any digital asset, such as digital bonds or shares, or even physical assets such as cars. And off-chain transactions could be used for frequent micropayments—such as paying for online newspaper articles read or for data consumption at WiFi hotspots.

Franco offers a balanced account of the pros and cons of Bitcoin as well as a clear description of how it works. All in all, the book was an enlightening read.

Monday, December 22, 2014

Ahuja, The Alpha Masters

Maneet Ahuja’s 2012 book The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds is now available in paperback. Somehow I missed the book when it first appeared, so in the spirit of “better late than never” I decided to write a few words about it here.

Most of the characters in this book are familiar: Ray Dalio of Bridgewater Associates, Tim Wong and Pierre Lagrange of Man Group/AHL, John Paulson of Paulson & Co., Marc Lasry and Sonia Gardner of Avenue Capital Group, David Tepper of Appaloosa Management, William A. Ackman of Pershing Square Capital Management, Daniel Loeb of Third Point, James Chanos of Kynikos Associates, and Boaz Weinstein of Saba Capital Management. Adding to the luminaries, Mohammed El-Erian wrote the foreword and Myron Scholes the afterword.

Many of their stories are familiar as well. So why does this book remain a compelling read?

It introduces us to a very bright, hardworking, resilient group of people. We see how their research leads them to formulate hypotheses, how they translate these hypotheses into market positions, how they push their advantage, and how they bounce back when their hypotheses don’t pan out.

In chapter after chapter we begin to see what it takes to be an alpha master (or, as Scholes would have it with a nod to Ohm’s law, an omega master, “where omega is the varying amounts of resistance in the market”). It matters not where you start or what niche you carve out for yourself. But it matters enormously that you mold your fund to fit your own interests and expertise, that your research is relentless and subject to constant testing and potential revision, that you understand (and respect) risk. It matters that you can see things in available data that other people don’t, that you or your team have a set of skills that can offer a fresh perspective when weighing potential investments.

If your goal is to become a master investor/trader, this book may inspire you to work harder and smarter than you ever thought necessary.

Wednesday, December 17, 2014

Sears, The Indomitable Investor, 2d ed.

Steven M. Sears, probably best known for his options column in Barron’s, wrote The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails in 2012. Wiley recently issued a second edition with a new preface. Although I reviewed it when it first came out, it’s time for another look.

Sears focuses on the “make or break” things most investors blithely ignore, such as risk and when/how to sell. With respect to the latter, he writes: “Selling is Wall Street’s essence just as surely as buying is Main Street’s. … If you don’t learn to be a disciplined seller, you risk losing more money than you make. … Selling is not about timing the stock market. It is about managing the risk of your own investment portfolio, and tempering your decisions.” (pp. 23, 24) There’s no single right philosophy of selling, although Bernard Baruch’s timeless advice to “sell while the stock still is rising or, if you have made a mistake, to admit it immediately and take your loss” (p. 35) remains a good place to start.

At home in both the stock and options markets, Sears contrasts the two, saying that “the options market is driven by fear” and “the stock market is driven by greed.” He admits that “this is an oversimplification—but not by much.” (p. 89) The SKEW Index, an option-based indicator that measures the risk of 30-day S&P 500 returns two or more standard deviations below the mean, can be a useful guide for the risk-conscious stock investor. “When the SKEW Index is at 100, it means that the probability of a steep stock market decline is minimal. When it rises above 100, the odds of a sharp decline increase.” (p. 90) Its all-time low was on March 21, 1991, as the recession that had begun in July 1990 was winding down. Its all-time high—146.88—was in October 1998 during the Russian debt crisis and the unexpected Fed move to lower interest rates. It was also high in March 2006, shortly before the housing bubble burst. Using the SKEW Index in conjunction with the VIX can be especially helpful.

Sears also describes an alternative approach to asset allocation, relying on the work of Mark Taborsky, then at PIMCO. This was a strategy that Mohammed El-Erian’s Harvard team tried to execute but found very difficult to quantify and optimize. As El-Erian outlined the strategy in When Markets Collide, “The ideal situation is to come up with a small set (three to five) of distinct (and ideally orthogonal) risk factors that command a risk premium. The next step is to assess the stability of the factors and how they can be best captured through the use of tradable instruments.” (p. 233) Instead of relying on historical asset class performance patterns and assuming that markets are mean reverting, Taborsky explained, PIMCO looked at factors such as risk, volatility, correlation, interest rates, or even time.

These short takeaways from The Indomitable Investor offer only a glimpse into the richness of Sears’s book. Investors who are serious about managing their money and who want to be among the few who succeed can learn a great deal from Sears.

Monday, December 15, 2014

Davis, Being Right or Making Money

Ned Davis started his eponymous investment research company in 1980. Thirty-four years later NDR employs nearly 50 researchers and has a client base of more than 1,200. It is widely respected for its objective analysis and its timing models.

The third edition of Being Right or Making Money (Wiley, 2014) showcases the firm’s guiding principles and some of its research. Although I have neither the first (1991) nor the second (2000) edition of this book, I think we can safely discard the idea that the 2014 edition is merely an update. The simple fact that the second edition was 150 pages long and the new edition runs some 231 pages is probably sufficient to disavow anyone of that notion. Chapters that deal with current topics, such as a potential bear market in 2014 and the game-changing nature of U.S. energy independence, are another tip-off.

What has remained the linchpin of all three editions is Ned Davis’s own investment philosophy. Even here there has been one major change: “the evolution of my belief that the most successful money managers are risk averse.” (p. xv)

Davis maintains that the four keys to making money in a business characterized by making mistakes are objective indicators, discipline, flexibility, and risk management. There is, of course, a dynamic tension between discipline (“remaining faithful to [one’s] systems through good and bad times”) and flexibility (the ability to change one’s mind when the evidence shifts). Davis readily admits that “there are periods, historically, in which model indicators tend to fail or stay wrong against a major move.” (p. 35) Risk management-–in the simplest terms, being willing to take small losses but avoiding big losses—helps to resolve this tension. And hence “the bottom line at Ned Davis Research is that our timing models, at every stage of development, are designed with one thought foremost in mind, and that is controlling big mistakes.” (p. 36)

Three chapters of this book are devoted to model building. The first describes the process of model building; the next two offer a stock market model and a simple model for bonds.

In building a timing model, the investor should first make sure he has clean data. He must then investigate “which data series, out of the innumerable possible sets out there, are the most useful or relevant for asset-allocation and market-timing purposes. Some data is best suited for aggressive, short-term trading, while other data is best suited for long-term asset allocation and risk control. Finding out what is useful is the biggest challenge the investor faces….” (p. 42)

NDR employs both internal and external indicators in its timing models. Internal indicators include such things as the slope of a moving average, breadth-thrust, and momentum. External indicators include interest rates as well as sentiment and valuation. Numerous charts illustrate indicators NDR has found useful in its models.

The final three chapters of the book—the first by Ned Davis, the second by Alejandra Grindal, and the final one by John LaForge—are examples of the kind of research NDR does. They are chock full of graphs, some comparing data that might not seem to be obviously connected such as the U.S. petroleum trade deficit and the goods deficit with China.

Being Right or Making Money is a tribute to the kind of research that can help the investor make money, even if he’s not always right.

Wednesday, December 10, 2014

Smith, Catching Lightning in a Bottle

Winthrop H. Smith, Jr., the son and namesake of one of the founders of Merrill Lynch (the Smith in Merrill Lynch, Pierce, Fenner and Smith) and himself a 28-year veteran of Mother Merrill until he resigned in 2001, has written a compelling history of the firm. Catching Lightning in a Bottle: How Merrill Lynch Revolutionized the Financial World (Wiley, 2014) starts with the rise of the ambitiously charming 5’4” Charles E. Merrill and the man he chose to be his partner after he went out on his own, the big-framed, skeptical, sometimes bullying Edmund Lynch.

The relationship between the partners was often fractious. Managers “remembered the two locked in sulfurous glares, faced off like the Monitor and the Merrimac, Lynch’s forehead knotted in fury, Merrill’s blue eyes turned into ice fields. The debates were bare-knuckled, and both were capable of extended, loud, and imaginative invective. At the root of these disagreements were fundamentally different approaches to life. Merrill was the visionary, Lynch the realist—but only Merrill recognized that a business needed both.” (p. 73)

Initially, the brokerage business was secondary to the investment banking business at Merrill, Lynch & Co. The firm’s bread and butter was underwriting stock issuances in expanding chain stores such as McCrory’s, Kresge’s, Penney’s, Kinney Shoes, and eventually Safeway.

After Lynch died in 1938, the company began to shift direction. At the urging of Win Smith, a partner of the ailing brokerage firm E. A. Pierce, Merrill merged the two firms. This “would be the realization of Merrill’s dream of a ‘department store of finance’ operated in the chain-store mold—a high volume of transactions with a small return on each to maintain profitability.” (p. 139)

Americans didn’t trust brokers; their main complaint was that brokers churned accounts in order to generate commissions. Merrill Lynch decided to offer a new model, where brokers were paid a straight salary, “with annual bonuses to reward special contributions to the firm.” … “This approach,” Smith notes, “lasted into the 1970s when competitive pressure forced the firm to change its method of compensation back to a commission-based one.” (p. 143)

The new Merrill model embraced ideas that were radical at the time: the customer’s interest would come first, the firm would advertise extensively, it would publish an annual report, its brokers wouldn’t give investment advice unless asked for it. But, despite efforts to cut costs and boost sales, in the early 1940s the brokerage firm was flailing financially. “The firm had an average income per transaction of $10.17 and an average cost of $14.29. According to Merrill, ‘When you figure that one of our clients, the Carnation Milk Company, can content the cow, milk it, pasteurize the milk, put the milk in the can, put a label on it, put it in a box, advertise it, and ship it all over the world, and sell the can of milk for five cents, then you realize how perfectly frantic these figures make me feel.’” (p. 158)

Smith recounts the subsequent successes of Merrill, and exposes its warts, with the fondness of an insider and the objectivity of a reporter. His anger about the course the firm took after Stan O’Neal became CEO (and after he resigned) is, however, barely contained.

Merrill is now 100 years old and no longer an independent legal entity. It, like so many Wall Street firms, was hijacked by a leader who did not understand the company’s principles and “unique culture” that had “allowed it to grow and prosper and survive in many challenging environments.” (p. 515)

Catching Lightning in a Bottle is not only an account of what was but a call for what should be. It’s a first-rate read.