L. J. Rittenhouse spent ten years as an investment banker at Lehman Brothers (1981-1991) before leaving Wall Street to found her own firm, Rittenhouse Rankings, an investor-relations firm that advises businesses on improving valuation through candid assessments of corporate strategies, investor perceptions, and corporate communications. She is the author of two previous books: Do Business with People You Can Tru$t and Buffett’s Bites. Her latest book is Investing Between the Lines: How to Make Smarter Decisions by Decoding CEO Communications (McGraw-Hill, 2013).
The basic premise of the book is that high levels of executive candor are linked to superior market performance. On the one hand are the annual shareholder letters of Warren Buffett, the gold standard of executive candor. On the other hand are “FOG” communications, ones that abound in “fact-deficient, obfuscating generalities.” (p. 97) They use weasel words, clichés, jargon, and hyperbole. Their explanations may be incomplete, their grammar awkward. They often foreshadow subnormal, even disastrous returns.
Rittenhouse offers page after page of detailed analyses of corporate communications. These analyses are not always intuitively obvious. But the author is adamant: “When people tell me they don’t believe that they are smart enough to uncover the truth about executive FOG, I conclude that they either are lazy or lack the confidence to use their common sense.” (p. 271) Well, I guess that put me in my place!
I think back to Brand Blanshard’s 1953 lecture On Philosophical Style, the classic presentation of the thesis that profundity and clarity are not opposed philosophical virtues but rather required companions. Blanshard bemoaned the fact (in private 1980 correspondence) that “most writing nowadays is exceedingly shuffling, muddled, and ponderous.” By contrast, he noted in his lecture, John Locke and John Stuart Mill “each had the enviable faculty of making people say: ‘If he is not right, at least he deserves to be; he puts all his cards on the table; he keeps nothing back; he fights, thinks, and writes fairly, even to the point of writing clearly enough to be found out.’” For Blanshard, as for Rittenhouse, candor is a virtue.
The unfortunate reality is that good writing, whether in philosophy or in business, is a rarity. As Blanshard concludes his lecture, “We may have to agree with Professor Raleigh that ‘to write perfect prose is neither more nor less difficult than to lead a perfect life.’”
I’ve gone off on a tangent and I’m not quite sure how to bring this post home. Is it the case that for a CEO to write good (or at least candid) prose is neither more nor less difficult than for him to lead a good (or a profitable) company? I doubt it highly; in fact, the very suggestion sounds downright silly.
But a CEO has limited opportunities to communicate with shareholders, and shareholders have limited opportunities to find out how management views the company’s performance and its prospects. Rittenhouse works both sides of the street. She tries to help companies communicate better at the same time that she informs investors on how to decode these communications. It might be viewed as a conflict of interests, but I for one am grateful for her efforts.
Wednesday, January 30, 2013
Monday, January 28, 2013
Person, Mastering the Stock Market
Mastering the Stock Market: High Probability Market Timing & Stock Selection Tools (Wiley, 2013) is the latest book by the well-known technical analyst, educator, and author John L. Person. Although Person is probably most famous for his work on pivot points, this book is wide-ranging. It covers seasonal analysis (don’t forget, he’s the co-editor of the Commodity Trader’s Almanac), sentiment analysis, comparative relative strength, breadth studies, volume analysis, patterns and indicators, scanning, pivot point analysis, and management tools. And, despite its title, the book also deals with futures and options.
Traders and investors should probably have some market basics under their belts before they pick up this book. Person packs a lot of information into Mastering the Stock Market and, even though he writes clear, fluid prose, he doesn’t linger over elementary points. His intended audience, I would suspect, is comprised of traders above the level of rank novice who have not already read (and absorbed) dozens of books on technical analysis as well as those who are in search of a good review course.
Need a brush-up on the Commitment of Traders report, VWAP, or the McClellan Oscillator? Want to learn about the seasonal trends of market sectors or spread trading? Interested in illustrations of convergences and divergences? This book offers all of the above—and much, much more.
Here’s one example of a COT option strategy. The COT data, Person maintains, “can act as a great confirming tool, especially when combined with seasonal analysis.” When high-beta stocks or sector ETFs “and/or the broad stock market are in a seasonally strong period, and if the COT data suggest that small speculators are net short more than 12 percent of the open interest in the E-mini S&Ps, then once you have a bullish trigger such as the Person’s Pivot Study (PPS) to generate a weekly buy signal, sell an at-the-money put (credit) spread with an option expiration of less than 35 days but more than 15 days. For added confirmation, look for the 9-day simple moving average (SMA) to cross above the 18-day SMA. If the market moves up, you profit by keeping the premium collected.” If the market moves against your position, to reduce losses “exit the strategy if the PPS indicator generates a weekly sell signal and/or the 9-day SMA crosses back below the 18-day SMA.” (p. 76) The PPS indicator, by the way, is currently available on several trading platforms. It’s not one of those proprietary tools that you can use only if you subscribe to an expensive service.
Mastering the Stock Market is a well-executed book by a seasoned professional.
Traders and investors should probably have some market basics under their belts before they pick up this book. Person packs a lot of information into Mastering the Stock Market and, even though he writes clear, fluid prose, he doesn’t linger over elementary points. His intended audience, I would suspect, is comprised of traders above the level of rank novice who have not already read (and absorbed) dozens of books on technical analysis as well as those who are in search of a good review course.
Need a brush-up on the Commitment of Traders report, VWAP, or the McClellan Oscillator? Want to learn about the seasonal trends of market sectors or spread trading? Interested in illustrations of convergences and divergences? This book offers all of the above—and much, much more.
Here’s one example of a COT option strategy. The COT data, Person maintains, “can act as a great confirming tool, especially when combined with seasonal analysis.” When high-beta stocks or sector ETFs “and/or the broad stock market are in a seasonally strong period, and if the COT data suggest that small speculators are net short more than 12 percent of the open interest in the E-mini S&Ps, then once you have a bullish trigger such as the Person’s Pivot Study (PPS) to generate a weekly buy signal, sell an at-the-money put (credit) spread with an option expiration of less than 35 days but more than 15 days. For added confirmation, look for the 9-day simple moving average (SMA) to cross above the 18-day SMA. If the market moves up, you profit by keeping the premium collected.” If the market moves against your position, to reduce losses “exit the strategy if the PPS indicator generates a weekly sell signal and/or the 9-day SMA crosses back below the 18-day SMA.” (p. 76) The PPS indicator, by the way, is currently available on several trading platforms. It’s not one of those proprietary tools that you can use only if you subscribe to an expensive service.
Mastering the Stock Market is a well-executed book by a seasoned professional.
Thursday, January 24, 2013
Fischer, Investing in Municipal Bonds
Philip Fischer, a Wall Street veteran, was head of Municipal Research and the Global Index System at Bank of America Merrill Lynch before co-founding eBooleant Consulting. He draws on years of study and practice in Investing in Municipal Bonds: How to Balance Risk and Reward for Success in Today’s Bond Market (McGraw-Hill, 2013), a book aimed at high net worth investors, financial advisors, and trust departments.
Fischer first offers what he calls “a little history.” One of the more interesting tidbits was a paragraph on mandamus suits during the Reconstruction period. “[T]he administrators from the North were often highly unscrupulous in their issuance of municipal debt. The citizens were so incensed that they refused to make payments on the bonds. They didn’t just default; they repudiated the bonds, saying that their issuance was null and void in the first case. Mandamus suits by out-of-state bondholders were of limited value when the court sought to compel local officials to pay and a different mayor showed up each day.” (p. 11) Even though there are municipal defaults today and even though our current political dysfunction is often compared to the Reconstruction period, this example exposes the hyperbole of that comparison.
Fischer’s account of municipal bonds is thorough but not dense. He explains the various kinds of bonds—from general obligation bonds where the funds for the payment of interest and the repayment of principal come from the general taxing power of the issuer to revenue bonds that rely on a specific revenue source (water, sewer, power) to moral obligation bonds where “the state is not required by statute to help the issuer, but the legislature has the moral obligation to do so.” (p. 56) Then there are conduit bonds. Here the proceeds of a tax-exempt municipal bond issue go to a private entity. For instance, an issue sold by the Arizona Health Facilities Authority raised money for Banner Health, a nonprofit corporation.
Most people assume that all municipal bonds are tax-exempt, but Fischer explains that even so-called tax-exempt bonds are not always tax-exempt in reality: “whether and how municipal bonds are taxed varies depending on whether they are bought in the primary or the secondary market and whether they are bought at par, a premium, or a discount.” (p. 110) If this sounds complicated, it is. Fischer writes that “the market discount tax rules are some of the most befuddling in the tax code for investors.” (p. 113) Moreover, some municipal bonds, such as pension bonds, are taxable.
Municipal bonds can be a tricky lot, but Fischer’s book goes a long way toward making them understandable. Anyone who is thinking about investing in this area or who is advising those who do owes it to himself to become better informed about both the basic principles and the quirks of the municipal bond market. Investing in Municipal Bonds is the perfect place to start.
Fischer first offers what he calls “a little history.” One of the more interesting tidbits was a paragraph on mandamus suits during the Reconstruction period. “[T]he administrators from the North were often highly unscrupulous in their issuance of municipal debt. The citizens were so incensed that they refused to make payments on the bonds. They didn’t just default; they repudiated the bonds, saying that their issuance was null and void in the first case. Mandamus suits by out-of-state bondholders were of limited value when the court sought to compel local officials to pay and a different mayor showed up each day.” (p. 11) Even though there are municipal defaults today and even though our current political dysfunction is often compared to the Reconstruction period, this example exposes the hyperbole of that comparison.
Fischer’s account of municipal bonds is thorough but not dense. He explains the various kinds of bonds—from general obligation bonds where the funds for the payment of interest and the repayment of principal come from the general taxing power of the issuer to revenue bonds that rely on a specific revenue source (water, sewer, power) to moral obligation bonds where “the state is not required by statute to help the issuer, but the legislature has the moral obligation to do so.” (p. 56) Then there are conduit bonds. Here the proceeds of a tax-exempt municipal bond issue go to a private entity. For instance, an issue sold by the Arizona Health Facilities Authority raised money for Banner Health, a nonprofit corporation.
Most people assume that all municipal bonds are tax-exempt, but Fischer explains that even so-called tax-exempt bonds are not always tax-exempt in reality: “whether and how municipal bonds are taxed varies depending on whether they are bought in the primary or the secondary market and whether they are bought at par, a premium, or a discount.” (p. 110) If this sounds complicated, it is. Fischer writes that “the market discount tax rules are some of the most befuddling in the tax code for investors.” (p. 113) Moreover, some municipal bonds, such as pension bonds, are taxable.
Municipal bonds can be a tricky lot, but Fischer’s book goes a long way toward making them understandable. Anyone who is thinking about investing in this area or who is advising those who do owes it to himself to become better informed about both the basic principles and the quirks of the municipal bond market. Investing in Municipal Bonds is the perfect place to start.
Tuesday, January 22, 2013
Morales and Kacher, In the Trading Cockpit with the O’Neil Disciples
In 2010 Gil Morales and Chris Kacher wrote the popular Trade Like an O’Neil Disciple: How We Made 18,000% in the Stock Market. Kacher made 18,000% between 1996 and 2002, although he was in cash for most of 2000-2002; Morales, almost 11,000% from 1998 through 2005. Once the bull run and the subsequent selloff were over and base breakouts were no longer effective entry points, the authors developed new techniques for dealing with the choppy markets of 2004-2005. I described one of their trade setups, the pocket pivot, in my post about the book.
Their new work, In the Trading Cockpit with the O’Neil Disciples: Strategies That Made Us 18,000% in the Stock Market (Wiley, 2013), expands on the strategies outlined in their earlier book and on their website, VirtueofSelfishInvesting.com. It is in large measure a workbook. Almost half of the book is devoted to pocket pivot and buyable gap-up exercises, with a full-page daily chart recto and the answer on the following verso (its flip side). For the 40 pocket pivot exercises the reader is asked to identify the pocket pivots and add any comments or qualifications. In the buyable gap-up chapter the reader is supposed to decide whether she would buy the gap-up move shown on the chart and why or why not.
The authors also offer a 75-page trading simulation, “step-by-step, day-by-day through the relevant price/volume action in two leading stocks from recent bull market cycles”—FSLR and APKT. “In this manner,” they claim, the reader “can gain a practical understanding of just how decision making occurs in real time according to the rules and techniques embraced by our particular brand of the OWL (O’Neil-Wyckoff-Livermore) investing and trading methodology.” (p. 265)
Despite the hype in the subtitles of both books, and despite the fact that most of the touted gains were made before the authors developed their own strategies, OWL traders will find a lot to like. They will even learn more than entry signals in a bull market. The last chapter on FAQs addresses such issues as when to sell and how to short stocks.
Their new work, In the Trading Cockpit with the O’Neil Disciples: Strategies That Made Us 18,000% in the Stock Market (Wiley, 2013), expands on the strategies outlined in their earlier book and on their website, VirtueofSelfishInvesting.com. It is in large measure a workbook. Almost half of the book is devoted to pocket pivot and buyable gap-up exercises, with a full-page daily chart recto and the answer on the following verso (its flip side). For the 40 pocket pivot exercises the reader is asked to identify the pocket pivots and add any comments or qualifications. In the buyable gap-up chapter the reader is supposed to decide whether she would buy the gap-up move shown on the chart and why or why not.
The authors also offer a 75-page trading simulation, “step-by-step, day-by-day through the relevant price/volume action in two leading stocks from recent bull market cycles”—FSLR and APKT. “In this manner,” they claim, the reader “can gain a practical understanding of just how decision making occurs in real time according to the rules and techniques embraced by our particular brand of the OWL (O’Neil-Wyckoff-Livermore) investing and trading methodology.” (p. 265)
Despite the hype in the subtitles of both books, and despite the fact that most of the touted gains were made before the authors developed their own strategies, OWL traders will find a lot to like. They will even learn more than entry signals in a bull market. The last chapter on FAQs addresses such issues as when to sell and how to short stocks.
Friday, January 18, 2013
Wolfinger, The Option Trader’s Mindset
Mark D. Wolfinger of Options for Rookies fame has launched an e-book publishing venture. The Option Trader’s Mindset: Think Like a Winner (150 pages and available for under $10 through Amazon) is the first of a planned series of books for option traders.
Self-publishing is always fraught with danger: never underestimate the value of a good editor and proofreader. The copyright page, for instance, has the usual caveat but with an unfortunate twist: “No part of this book may not be reproduced….” (my italics) A good editor would undoubtedly have restructured this book to minimize repetition and to expand on some of the telegraphic points, but then it would probably have cost upwards of $30 or $40. And the reader would not have learned all that much more, perhaps even less.
The main theme of the book is how to develop a way of thinking that benefits a trader’s career. Basically, it comes down to putting risk management and money management center stage and overcoming the psychological baggage that impels people to focus exclusively on potential profits (preferably quick and outsized). Yes, yes, I know you’ve heard this before. But I’d wager to say that most traders, with the exception of the nervous Nellies who find it difficult even to pull the trigger and for whom risk is something to be avoided at all costs, still haven’t absorbed the lesson.
Wolfinger takes the trader through a range of risk management techniques with specific examples, from adjustments to pulling the plug. He draws on his time as an active blogger to address questions from his readers, many of whom found themselves in losing positions and sought ways to turn the tide. His advice is almost always eminently sound. For example, one reader was desperately trying to repair a losing position. Wolfinger wisely answered: “When you make money, the dollars spend the same, regardless of which stock produces those profits. Do not feel compelled to earn money from XXXX.” (p. 62) Indeed, sometimes adjustments are just throwing good money after bad; better to move on.
This book is not meant as a guide to options strategies, but there are some useful tips about how to match strategies to market conditions. Iron condor traders are particularly well served.
Wolfinger recognizes that the path to profits is personal. He offers guideposts but consistently stresses that one size doesn’t fit all. “The winning mindset is to find a way of trading that is both comfortable and profitable.” (p. 127)
Although this book is editorially rough-edged, it conveys a lot of valuable information, particularly for the newer (or the not consistently profitable) options trader.
Self-publishing is always fraught with danger: never underestimate the value of a good editor and proofreader. The copyright page, for instance, has the usual caveat but with an unfortunate twist: “No part of this book may not be reproduced….” (my italics) A good editor would undoubtedly have restructured this book to minimize repetition and to expand on some of the telegraphic points, but then it would probably have cost upwards of $30 or $40. And the reader would not have learned all that much more, perhaps even less.
The main theme of the book is how to develop a way of thinking that benefits a trader’s career. Basically, it comes down to putting risk management and money management center stage and overcoming the psychological baggage that impels people to focus exclusively on potential profits (preferably quick and outsized). Yes, yes, I know you’ve heard this before. But I’d wager to say that most traders, with the exception of the nervous Nellies who find it difficult even to pull the trigger and for whom risk is something to be avoided at all costs, still haven’t absorbed the lesson.
Wolfinger takes the trader through a range of risk management techniques with specific examples, from adjustments to pulling the plug. He draws on his time as an active blogger to address questions from his readers, many of whom found themselves in losing positions and sought ways to turn the tide. His advice is almost always eminently sound. For example, one reader was desperately trying to repair a losing position. Wolfinger wisely answered: “When you make money, the dollars spend the same, regardless of which stock produces those profits. Do not feel compelled to earn money from XXXX.” (p. 62) Indeed, sometimes adjustments are just throwing good money after bad; better to move on.
This book is not meant as a guide to options strategies, but there are some useful tips about how to match strategies to market conditions. Iron condor traders are particularly well served.
Wolfinger recognizes that the path to profits is personal. He offers guideposts but consistently stresses that one size doesn’t fit all. “The winning mindset is to find a way of trading that is both comfortable and profitable.” (p. 127)
Although this book is editorially rough-edged, it conveys a lot of valuable information, particularly for the newer (or the not consistently profitable) options trader.
Wednesday, January 16, 2013
Taulli, High-Profit IPO Strategies, 3d ed.
Post-Facebook and pre-cliff, IPOs faltered in 2012. As of December 10, the Bloomberg IPO index was down 3.1% year to date; the S&P was up 12.9%. The major culprit was Facebook. But over the last ten years the index, which tracks the performance of IPOs over their first twelve months as publicly traded companies, is up 164% as opposed to the S&P’s 83%. (Once again, thanks to Bespoke for this data, even though by now it’s a bit stale.) IPOs may still be a potential source for outsized profits, just not for quick automatic profits. The go-go years are gone.
Moreover, fewer deals are getting done. In 2012, 128 companies went public as opposed to 154 in 2011. It was also a year of smaller deals, with median proceeds falling 23%.
Tom Taulli, of course, recognizes this shift in market sentiment. Still and all, IPOs can be attractive investments if you have done your homework and if you either get an allocation (unlikely for the retail investor) or enter wisely in the secondary market. In the third edition of High-Profit IPO Strategies: Finding Breakout IPOs for Investors and Traders (Bloomberg/Wiley, 2013) Taulli explains the IPO process and the resources that investors can use in their quest to separate winners from losers.
About half of the book deals with the requisite homework: finding the best IPO information; making sense of the prospectus; reading the balance sheet, income statement, and statement of cash flows; risk factors; IPO investment strategies; and short selling IPOs. Another sixty pages is devoted to IPO sectors (tech, biotech, finance, retail, foreign, energy, and REITs). Finally, Taulli looks at alternative IPO investments (funds, spin-offs, angel investing, and crowd funding).
For those who like to dream, there is always the 100x IPO. If you had bought $10,000 in shares on the first day of trading, you would have (as of the writing of the book) $1.3 million in AMZN,$1.5 million in DELL, $1.7 million in AAPL, $3.5 million in MSFT, and $10.3 million in WMT. Even if you had waited a year before buying stock in most of these 100-baggers you would still have made a fortune. Of course, for every mega-winner there are scores of mega-losers. The most often cited example is pets.com, but I consider myself a winner here: I never bought the stock and I still have a promotional pets.com mouse pad with a photo of my last litter of basset hounds.
Unlike most authors, Taulli has thoroughly updated his book for the third edition. For example, he studies the prospectus of Zynga, the income statement of Annie’s, and the statement of cash flows of Facebook. Under risk factors he cites a slew of reasons that IPOs turned out to be bad investments. To take but a single case, Zeltiq Aesthetics (ZLTQ), which “sold sophisticated machines that it claimed allowed physicians to reduce people’s stubborn fat bulges,” faltered badly because it faced serious competition. “What’s more, the company was also having trouble differentiating its approach. Its advertising campaign, which was called ‘Let’s Get Naked,’ had people running around in their underwear! It was not a clear marketing message.” (pp. 105-106) I must admit that I had never heard of Zeltiq, but its “Z-q” name alone would have given me pause. I don’t think the firm hired the late Michael Cronan (responsible for the TiVo and Kindle names) to brand it.
Taulli’s book is thorough, informative, and well written. Anyone who’s interested in IPO investing, especially in avoiding pitfalls, can profit from it.
Moreover, fewer deals are getting done. In 2012, 128 companies went public as opposed to 154 in 2011. It was also a year of smaller deals, with median proceeds falling 23%.
Tom Taulli, of course, recognizes this shift in market sentiment. Still and all, IPOs can be attractive investments if you have done your homework and if you either get an allocation (unlikely for the retail investor) or enter wisely in the secondary market. In the third edition of High-Profit IPO Strategies: Finding Breakout IPOs for Investors and Traders (Bloomberg/Wiley, 2013) Taulli explains the IPO process and the resources that investors can use in their quest to separate winners from losers.
About half of the book deals with the requisite homework: finding the best IPO information; making sense of the prospectus; reading the balance sheet, income statement, and statement of cash flows; risk factors; IPO investment strategies; and short selling IPOs. Another sixty pages is devoted to IPO sectors (tech, biotech, finance, retail, foreign, energy, and REITs). Finally, Taulli looks at alternative IPO investments (funds, spin-offs, angel investing, and crowd funding).
For those who like to dream, there is always the 100x IPO. If you had bought $10,000 in shares on the first day of trading, you would have (as of the writing of the book) $1.3 million in AMZN,$1.5 million in DELL, $1.7 million in AAPL, $3.5 million in MSFT, and $10.3 million in WMT. Even if you had waited a year before buying stock in most of these 100-baggers you would still have made a fortune. Of course, for every mega-winner there are scores of mega-losers. The most often cited example is pets.com, but I consider myself a winner here: I never bought the stock and I still have a promotional pets.com mouse pad with a photo of my last litter of basset hounds.
Unlike most authors, Taulli has thoroughly updated his book for the third edition. For example, he studies the prospectus of Zynga, the income statement of Annie’s, and the statement of cash flows of Facebook. Under risk factors he cites a slew of reasons that IPOs turned out to be bad investments. To take but a single case, Zeltiq Aesthetics (ZLTQ), which “sold sophisticated machines that it claimed allowed physicians to reduce people’s stubborn fat bulges,” faltered badly because it faced serious competition. “What’s more, the company was also having trouble differentiating its approach. Its advertising campaign, which was called ‘Let’s Get Naked,’ had people running around in their underwear! It was not a clear marketing message.” (pp. 105-106) I must admit that I had never heard of Zeltiq, but its “Z-q” name alone would have given me pause. I don’t think the firm hired the late Michael Cronan (responsible for the TiVo and Kindle names) to brand it.
Taulli’s book is thorough, informative, and well written. Anyone who’s interested in IPO investing, especially in avoiding pitfalls, can profit from it.
Monday, January 14, 2013
Crowder, Schneeweis, and Kazemi, Postmodern Investment
Postmodern Investment: Facts and Fallacies of Growing Wealth in a Multi-Asset World by Garry B. Crowder, Thomas Schneeweis, and Hossein Kazemi (Wiley, 2013) is a cautionary book. “Financial myths contain enough plausibility to encourage intellectual laziness; enough truth to support the lie; enough pathos to snare the human condition; and, enough visceral appeal to be widely embraced. But, more importantly, myths and misconceptions are usually based on rigorously tested past truths.” (p. xix)
The authors analyze a range of asset classes—equity and fixed income, hedge funds, managed futures, commodities, private equity, and real estate. Yes, they analyze; they don’t merely describe or explain. In the process they poke holes in common myths and misconceptions about each asset class as well as the overarching theories of asset allocation and risk management.
We live in “interesting” times. Old rules of investing have been tested and often found wanting; newer rules have sometimes been even worse. Markets keep evolving, with new products and new challenges for investors. It is up to the individual investor or portfolio manager to keep abreast of current market realities and to adjust his investments accordingly.
Let’s look at just a couple of points the authors make. First, they argue that it’s a myth that “commodities provide a natural diversifier to traditional assets.” As they write, “The concept of a natural diversifier often refers to the idea that the return movement of a particular investment will consistently offer positive (or negative) returns when the other asset performs poorly (or well). The problem is that because many commodities do not have a long-term positive expected rate of return … the natural return may be regarded as near zero. An analysis could reveal a low correlation between the commodity and a stock or bonds return simply because the commodity has no consistent return pattern. The commodity could be called a diversifier in the same way a U.S. Treasury bond would be identified—a low expected return and no correlation with risky assets.” (p. 184)
And speaking of diversification, what about time diversification? That is, despite the volatility of stocks and bonds in the short run, does time diversification reduce their volatilities in the long run? No, the authors contend. “[S]ome believe that in the long run, traditional stock and bond investments can be viewed as almost riskless because U.S. stock and bond investments have always offered positive returns over long investment horizons (e.g., 20 years). Nothing could be further from the truth. Simply put, the two-year expected rate of return should be twice the one-year expected rate of return and, all else equal, the three-year expected rate of return is three times the one-year return. The same linear relationship exists for risk. The two-year expected variance is twice the one-year rate, and the three-year expected variance is three times the one-year variance. Summarizing, in the long run both the expected return and the expected risk increase—there is no free lunch. It is the linear relationship between expected return, risk, and investment horizon that makes reducing risk a prime goal for investors (e.g., the long-term rate of return is related to the annual return and volatility such that the lower the annual volatility, the greater the long-term rate of return).” (p. 58)
Postmodern Investment challenges the investor to rethink his portfolio—and his often misguided preconceptions. It’s a breath of fresh air.
The authors analyze a range of asset classes—equity and fixed income, hedge funds, managed futures, commodities, private equity, and real estate. Yes, they analyze; they don’t merely describe or explain. In the process they poke holes in common myths and misconceptions about each asset class as well as the overarching theories of asset allocation and risk management.
We live in “interesting” times. Old rules of investing have been tested and often found wanting; newer rules have sometimes been even worse. Markets keep evolving, with new products and new challenges for investors. It is up to the individual investor or portfolio manager to keep abreast of current market realities and to adjust his investments accordingly.
Let’s look at just a couple of points the authors make. First, they argue that it’s a myth that “commodities provide a natural diversifier to traditional assets.” As they write, “The concept of a natural diversifier often refers to the idea that the return movement of a particular investment will consistently offer positive (or negative) returns when the other asset performs poorly (or well). The problem is that because many commodities do not have a long-term positive expected rate of return … the natural return may be regarded as near zero. An analysis could reveal a low correlation between the commodity and a stock or bonds return simply because the commodity has no consistent return pattern. The commodity could be called a diversifier in the same way a U.S. Treasury bond would be identified—a low expected return and no correlation with risky assets.” (p. 184)
And speaking of diversification, what about time diversification? That is, despite the volatility of stocks and bonds in the short run, does time diversification reduce their volatilities in the long run? No, the authors contend. “[S]ome believe that in the long run, traditional stock and bond investments can be viewed as almost riskless because U.S. stock and bond investments have always offered positive returns over long investment horizons (e.g., 20 years). Nothing could be further from the truth. Simply put, the two-year expected rate of return should be twice the one-year expected rate of return and, all else equal, the three-year expected rate of return is three times the one-year return. The same linear relationship exists for risk. The two-year expected variance is twice the one-year rate, and the three-year expected variance is three times the one-year variance. Summarizing, in the long run both the expected return and the expected risk increase—there is no free lunch. It is the linear relationship between expected return, risk, and investment horizon that makes reducing risk a prime goal for investors (e.g., the long-term rate of return is related to the annual return and volatility such that the lower the annual volatility, the greater the long-term rate of return).” (p. 58)
Postmodern Investment challenges the investor to rethink his portfolio—and his often misguided preconceptions. It’s a breath of fresh air.
Wednesday, January 9, 2013
Hecht, How to Make Money with Commodities
Andrew T. Hecht’s How to Make Money with Commodities, written with Mark S. Smith (McGraw-Hill, 2013) is a surprisingly good book. I say “surprisingly” because it joins a crowded and for the most part uninspired field and yet manages to stand apart.
Despite the fact that the book is intended for two radically different audiences, the equities investor and the beginning to intermediate commodities trader, it artfully glides between them. The investor learns to read futures data as a guide to the prospects of his commodity-driven investments. The beginning commodities trader is introduced to the landscape; the intermediate trader gets a richer context and some tips.
One thing that distinguishes this book is its stories. Hecht has many of his own (such as the outsized silver position that he and three other traders at the Philbro division of Salomon Brothers had in 1995, “a bigger position than the Hunt brothers took back in 1979”). Some come from his friends: for instance, the “fiasco of the giant sugar cube.” “Because of the low value of sugar, the ships that transport this sweet commodity are often old and sometimes not in the best state of repair. Raw sugar is loaded onto and off a ship with a device that resembles a vacuum cleaner.” In this case, “at some point during the journey, moisture had leaked into the cargo—so much moisture that the shipment had turned rock solid.” The trader who had negotiated the deal needed some quick thinking to reduce his losses. “He hired a team of laborers to break up the giant sugar cube with jackhammers. The laborers then had to remove thousands of smaller cubes by hand. The cargo was eventually unloaded and delivered to the buyer, who then demanded a discount because the sugar was not in the form contracted for. While insurance paid for part of the fiasco, the trader’s profit margin was not enough to cover the losses, which amounted to several million dollars.” (p. 48)
Hecht also recalls one of the problems that coffee traders encountered in the 1980s. The vessels of drug smugglers often carried “huge coffee shipments to mask the aroma of the drugs.” On one occasion “a dead body arrived with a massive coffee shipment, along with a large cache of marijuana and cocaine.” (p. 209)
Another distinguishing characteristic of the book is its detail. When discussing natural gas, Hecht describes among other things its dramatic historical volatility, the divergence between UNG and the price of natural gas in early 2012 when the book was being written (signaling that “either UNG is too low or that the price of natural gas will rally from levels shown on the chart”—the latter happened), and the negative correlation between heavy natural gas users such as Potash and the commodity.
And he demonstrates how the trader who understands commodities can profit in the stock market. A case in point was his 2008 trade in JetBlue as oil made new all-time highs and JBLU was dirt cheap. “When the price of crude oil fell, there was a short-term correction in JetBlue’s price—it shot up by more than 100 percent in six months.” (p. 110)
Hecht had skin in the game for nearly 35 years, and it shows in this book. Both investors and traders can learn from him.
Despite the fact that the book is intended for two radically different audiences, the equities investor and the beginning to intermediate commodities trader, it artfully glides between them. The investor learns to read futures data as a guide to the prospects of his commodity-driven investments. The beginning commodities trader is introduced to the landscape; the intermediate trader gets a richer context and some tips.
One thing that distinguishes this book is its stories. Hecht has many of his own (such as the outsized silver position that he and three other traders at the Philbro division of Salomon Brothers had in 1995, “a bigger position than the Hunt brothers took back in 1979”). Some come from his friends: for instance, the “fiasco of the giant sugar cube.” “Because of the low value of sugar, the ships that transport this sweet commodity are often old and sometimes not in the best state of repair. Raw sugar is loaded onto and off a ship with a device that resembles a vacuum cleaner.” In this case, “at some point during the journey, moisture had leaked into the cargo—so much moisture that the shipment had turned rock solid.” The trader who had negotiated the deal needed some quick thinking to reduce his losses. “He hired a team of laborers to break up the giant sugar cube with jackhammers. The laborers then had to remove thousands of smaller cubes by hand. The cargo was eventually unloaded and delivered to the buyer, who then demanded a discount because the sugar was not in the form contracted for. While insurance paid for part of the fiasco, the trader’s profit margin was not enough to cover the losses, which amounted to several million dollars.” (p. 48)
Hecht also recalls one of the problems that coffee traders encountered in the 1980s. The vessels of drug smugglers often carried “huge coffee shipments to mask the aroma of the drugs.” On one occasion “a dead body arrived with a massive coffee shipment, along with a large cache of marijuana and cocaine.” (p. 209)
Another distinguishing characteristic of the book is its detail. When discussing natural gas, Hecht describes among other things its dramatic historical volatility, the divergence between UNG and the price of natural gas in early 2012 when the book was being written (signaling that “either UNG is too low or that the price of natural gas will rally from levels shown on the chart”—the latter happened), and the negative correlation between heavy natural gas users such as Potash and the commodity.
And he demonstrates how the trader who understands commodities can profit in the stock market. A case in point was his 2008 trade in JetBlue as oil made new all-time highs and JBLU was dirt cheap. “When the price of crude oil fell, there was a short-term correction in JetBlue’s price—it shot up by more than 100 percent in six months.” (p. 110)
Hecht had skin in the game for nearly 35 years, and it shows in this book. Both investors and traders can learn from him.
Monday, January 7, 2013
Weatherall, The Physics of Wall Street
James Owen Weatherall’s The Physics of Wall Street: A Brief History of Predicting the Unpredictable (Houghton Mifflin Harcourt, 2013) is an engrossing book. Even though I was familiar with many of the stories the author recounts, at no point was I tempted to skip a page. Coming from me, that’s high praise indeed.
In the first chapter Weatherall takes the reader on a journey from sixteenth- and seventeenth-century attempts at a systematic theory of probability (Cardano, de Méré, Pascal, and Fermat) through Bachelier’s 1900 dissertation, A Theory of Speculation. Bachelier is credited with having come up with the random walk model/efficient market hypothesis. Like many quants, he was ahead of his time. “In a just world, Bachelier would be to finance what Newton is to physics. But Bachelier’s life was a shambles, in large part because academia couldn’t countenance so original a thinker.” (p. 27)
It wasn’t until Maury Osborne’s 1959 paper entitled “Brownian Motion in the Stock Market,” similar in both topic (predicting stock prices) and solution to Bachelier’s thesis, that people began to understand that physics could make a substantial contribution to finance. By then, as Osborne said, “Physicists essentially could do no wrong.” (p. 28) Scientists were in demand in industry, research facilities, and government. Pre-The Graduate, think nylon and the Manhattan Project.
Osborne found that stock prices don’t follow a normal distribution as Bachelier had suggested; rather, the rate of return on a stock (the “average percentage by which the price changes each instant”) is normally distributed. “Since price and rate of return are related by a logarithm, Osborne’s model implies that prices should be log-normally distributed.”
The plots “show what these two distributions look like at some time in the future, for a stock whose price is $10 now. Plot (a) is an example of a normal distribution over rates of return, and plot (b) is the associated log-normal distribution for the prices, given those probabilities for rates of return.” (p. 37)
Osborne later modified his Brownian motion model, which had assumed that prices are equally likely to move up or down. “Osborne showed that if a stock went up a little bit, its next motion was much more likely to be a move back down than another move up. Likewise, if a stock went down, it was much more likely to go up in value in its next change. That is, from moment to moment the market is much more likely to reverse itself than to continue on a trend. But there was another side to this coin. If a stock moved in the same direction twice, it was much more likely to continue in that direction than if it had moved in a given direction only once. Osborne argued that the infrastructure of the trading floor was responsible for this kind of non-randomness, and Osborne went on to suggest a model for how prices change that took this kind of behavior into account.” (p. 46)
Osborne’s methodology (though not his model), Weatherall maintains, is worth emulating. First, you study the data and “make simplifying assumptions to derive simple models.” Then “you check carefully to find places where your simplifying assumptions break down and try to figure out, again by focusing on the data, how these failures of your assumptions produce problems for the model’s predictions. … For instance, Osborne showed that price changes aren’t independent. This is especially true during market crashes, when a series of downward ticks makes it very likely that prices will continue to fall. When this kind of herding effect is present, even Osborne’s extended Brownian motion model is going to be an unreliable guide.” (p. 47)
These few paragraphs are just a taste of what’s in The Physics of Wall Street. We meet Benoît Mandelbrot, Ed Thorp, Fischer Black, James Doyne Farmer and Norman Packard of the Prediction Company, Didier Sornette, and finally Pia Malaney and Eric Weinstein.
Weatherall defends quants and argues, with Weinstein and Malaney, that there are ways to make economic and financial models better by using “more powerful mathematics to avoid having to make strong assumptions about people and markets.” (p. 211) Whether you agree with him or not, he makes a thoroughly enjoyable and beautifully teased out case.
In the first chapter Weatherall takes the reader on a journey from sixteenth- and seventeenth-century attempts at a systematic theory of probability (Cardano, de Méré, Pascal, and Fermat) through Bachelier’s 1900 dissertation, A Theory of Speculation. Bachelier is credited with having come up with the random walk model/efficient market hypothesis. Like many quants, he was ahead of his time. “In a just world, Bachelier would be to finance what Newton is to physics. But Bachelier’s life was a shambles, in large part because academia couldn’t countenance so original a thinker.” (p. 27)
It wasn’t until Maury Osborne’s 1959 paper entitled “Brownian Motion in the Stock Market,” similar in both topic (predicting stock prices) and solution to Bachelier’s thesis, that people began to understand that physics could make a substantial contribution to finance. By then, as Osborne said, “Physicists essentially could do no wrong.” (p. 28) Scientists were in demand in industry, research facilities, and government. Pre-The Graduate, think nylon and the Manhattan Project.
Osborne found that stock prices don’t follow a normal distribution as Bachelier had suggested; rather, the rate of return on a stock (the “average percentage by which the price changes each instant”) is normally distributed. “Since price and rate of return are related by a logarithm, Osborne’s model implies that prices should be log-normally distributed.”
The plots “show what these two distributions look like at some time in the future, for a stock whose price is $10 now. Plot (a) is an example of a normal distribution over rates of return, and plot (b) is the associated log-normal distribution for the prices, given those probabilities for rates of return.” (p. 37)
Osborne later modified his Brownian motion model, which had assumed that prices are equally likely to move up or down. “Osborne showed that if a stock went up a little bit, its next motion was much more likely to be a move back down than another move up. Likewise, if a stock went down, it was much more likely to go up in value in its next change. That is, from moment to moment the market is much more likely to reverse itself than to continue on a trend. But there was another side to this coin. If a stock moved in the same direction twice, it was much more likely to continue in that direction than if it had moved in a given direction only once. Osborne argued that the infrastructure of the trading floor was responsible for this kind of non-randomness, and Osborne went on to suggest a model for how prices change that took this kind of behavior into account.” (p. 46)
Osborne’s methodology (though not his model), Weatherall maintains, is worth emulating. First, you study the data and “make simplifying assumptions to derive simple models.” Then “you check carefully to find places where your simplifying assumptions break down and try to figure out, again by focusing on the data, how these failures of your assumptions produce problems for the model’s predictions. … For instance, Osborne showed that price changes aren’t independent. This is especially true during market crashes, when a series of downward ticks makes it very likely that prices will continue to fall. When this kind of herding effect is present, even Osborne’s extended Brownian motion model is going to be an unreliable guide.” (p. 47)
These few paragraphs are just a taste of what’s in The Physics of Wall Street. We meet Benoît Mandelbrot, Ed Thorp, Fischer Black, James Doyne Farmer and Norman Packard of the Prediction Company, Didier Sornette, and finally Pia Malaney and Eric Weinstein.
Weatherall defends quants and argues, with Weinstein and Malaney, that there are ways to make economic and financial models better by using “more powerful mathematics to avoid having to make strong assumptions about people and markets.” (p. 211) Whether you agree with him or not, he makes a thoroughly enjoyable and beautifully teased out case.
Friday, January 4, 2013
Darst, The Little Book That Still Saves Your Assets
In 2008 David M. Darst, currently the chief investment strategist of Morgan Stanley’s global wealth management group and chairman of its asset allocation committee, wrote The Little Book That Saves Your Assets. Five years later he is back with an update: The Little Book That Still Saves Your Assets: What the Rich Continue to Do to Stay Wealthy in Up and Down Markets (Wiley, 2013).
The recommended keys to protecting your wealth, as you might suspect from Darst’s credentials, are asset allocation and diversification. The author does not, however, offer the reader a model portfolio that would be appropriate for investors of all ages and personalities and for all situations. Portfolios must be personalized. What is right for a 25-year-old who wants to buy a house in two years is different from what is right for the 25-year-old who is saving for his child’s college education. As Darst writes, “The single most important factor in determining how you manage your investments and structure your asset allocation plan is you. … From the start, you need to establish your goals, honestly evaluate your current financial condition, and be aware of your state of mind and feelings about the financial markets.” (pp. 91-92)
Throughout the book Darst assumes the role of a trusted financial advisor, and sometimes a meta-advisor, with the help of words of wisdom from “Uncle Frank.” If you have a small portfolio and a resolute do-it-yourself attitude you can heed his advice and perhaps profit. Otherwise, you can learn what to look for in a money manager.
Admittedly, the DIYer who is new to investing will face a pretty steep learning curve and will need far more than this “little book” to design and implement an appropriate investment plan. Darst introduces him, for instance, to strategic vs. tactical asset allocation—a distinction deceptively simple in principle, tough to carry out effectively. A single sentence highlights the difficulties: “A large part of your success in using Tactical Asset Allocation is the ability to determine what an asset’s true, intrinsic value is at a given point in time; how far out of line the asset’s price is versus its true, intrinsic value; and what conditions will make it return to its value.” (p. 85) Considering that even those who earn their livings as stock analysts usually lack this ability and that so-called true value rarely coincides with price, the amateur investor who wants to pursue this tactic faces an uphill battle.
For those with some experience in the financial markets Darst’s book is an enjoyable, nay wise, read. You’ll have two new uncles to guide you in your effort to save your assets: Frank and David.
The recommended keys to protecting your wealth, as you might suspect from Darst’s credentials, are asset allocation and diversification. The author does not, however, offer the reader a model portfolio that would be appropriate for investors of all ages and personalities and for all situations. Portfolios must be personalized. What is right for a 25-year-old who wants to buy a house in two years is different from what is right for the 25-year-old who is saving for his child’s college education. As Darst writes, “The single most important factor in determining how you manage your investments and structure your asset allocation plan is you. … From the start, you need to establish your goals, honestly evaluate your current financial condition, and be aware of your state of mind and feelings about the financial markets.” (pp. 91-92)
Throughout the book Darst assumes the role of a trusted financial advisor, and sometimes a meta-advisor, with the help of words of wisdom from “Uncle Frank.” If you have a small portfolio and a resolute do-it-yourself attitude you can heed his advice and perhaps profit. Otherwise, you can learn what to look for in a money manager.
Admittedly, the DIYer who is new to investing will face a pretty steep learning curve and will need far more than this “little book” to design and implement an appropriate investment plan. Darst introduces him, for instance, to strategic vs. tactical asset allocation—a distinction deceptively simple in principle, tough to carry out effectively. A single sentence highlights the difficulties: “A large part of your success in using Tactical Asset Allocation is the ability to determine what an asset’s true, intrinsic value is at a given point in time; how far out of line the asset’s price is versus its true, intrinsic value; and what conditions will make it return to its value.” (p. 85) Considering that even those who earn their livings as stock analysts usually lack this ability and that so-called true value rarely coincides with price, the amateur investor who wants to pursue this tactic faces an uphill battle.
For those with some experience in the financial markets Darst’s book is an enjoyable, nay wise, read. You’ll have two new uncles to guide you in your effort to save your assets: Frank and David.
Wednesday, January 2, 2013
Sundheim, Taking Smart Risks
If I repeat myself on this blog it’s not because I’m becoming senile—at least not that I’m aware of. Rather, there are only so many good, or at least fashionable, ideas that traders and investors can incorporate into their mental game plan. Writers latch onto them, repeat them, and apply them to a range of disciplines. Doug Sundheim’s Taking Smart Risks: How Sharp Leaders Win When Stakes Are High (McGraw-Hill, 2013) is a case in point. The book shows how individual entrepreneurs and business leaders can use the idea of smart risk taking to enjoy sustained success.
Let’s look at a few of the ideas that I consider worth repeating yet again, however telegraphically.
You must identify what you’re willing to fight for, what makes you come alive. Otherwise, all the “how-to” advice in the world will be wasted on you.
Playing it safe (alternatively stated, staying in your comfort zone) is fraught with dangers: to wit, you don’t win, you don’t grow, you don’t create, you lose confidence, and you don’t feel alive. (p. 7)
Two figures illustrate the central thesis of the book. First, the paralysis perception.
And second, the power perception.
Of course, you have to move from thought to action. “Often, the amount of force needed to start something isn’t that big. … It doesn’t have to solve every problem. In fact, it doesn’t even have to be the right move. It just has to get things in motion. It just has to lead to another action. And then another. It’s easy to get so fixated on a big end goal that you discount the small efforts needed to start a process. You think they’ll barely make a dent in what you’re trying to do. However, it’s only through repeated small efforts that you ever make progress.” (p. 133)
Those repeated small efforts won’t all succeed. In fact, failure is essential to progress. In the words of a chapter title, “fail early, often, and smart.” What does it mean to fail smart? “One of the keys to failing smart is to keep things simple, picking a few key variables to experiment with and test before doing anything too big.” (p. 158)
Sundheim fleshes out these (and other more “corporate”) ideas with case studies and tools for action. He’s written a smart book.
Let’s look at a few of the ideas that I consider worth repeating yet again, however telegraphically.
You must identify what you’re willing to fight for, what makes you come alive. Otherwise, all the “how-to” advice in the world will be wasted on you.
Playing it safe (alternatively stated, staying in your comfort zone) is fraught with dangers: to wit, you don’t win, you don’t grow, you don’t create, you lose confidence, and you don’t feel alive. (p. 7)
Two figures illustrate the central thesis of the book. First, the paralysis perception.
And second, the power perception.
Of course, you have to move from thought to action. “Often, the amount of force needed to start something isn’t that big. … It doesn’t have to solve every problem. In fact, it doesn’t even have to be the right move. It just has to get things in motion. It just has to lead to another action. And then another. It’s easy to get so fixated on a big end goal that you discount the small efforts needed to start a process. You think they’ll barely make a dent in what you’re trying to do. However, it’s only through repeated small efforts that you ever make progress.” (p. 133)
Those repeated small efforts won’t all succeed. In fact, failure is essential to progress. In the words of a chapter title, “fail early, often, and smart.” What does it mean to fail smart? “One of the keys to failing smart is to keep things simple, picking a few key variables to experiment with and test before doing anything too big.” (p. 158)
Sundheim fleshes out these (and other more “corporate”) ideas with case studies and tools for action. He’s written a smart book.
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