Happy new year

Banner, Speculation

Few people today call themselves speculators. The word is too loaded. Instead, they are traders, hedge fund managers, and the like. But, whatever they call themselves, they are speculators. They’re the ones people blame for everything from business cycles to political corruption to income inequality to financial crises. And the ones amateurs try to emulate when the economy and markets are booming—day trade, flip this house, risk money to make money fast.

Stuart Banner, in Speculation: A History of the Fine Line between Gambling and Investing (Oxford University Press, 2017), traces how American ambivalence toward speculation, especially as reflected in regulatory and legal decisions, tips one way and then the other. Is the speculator engaged in unsavory conduct or is he performing a service? Is he anti-American or the quintessential American?

Speculation has had its harsh critics since early in the history of this country. And much of the criticism gets repeated generation after generation. For instance, in 1835 a New Hampshire newspaper warned: “In our rising manufacturing villages this speculating mania rages to a great extent, and is laying a foundation for that poverty, dependence and wretchedness which characterizes the population of similar places in Europe. The few are becoming immensely rich, the middling interest poor, and the poor abject.” That has a familiar ring to it, doesn’t it?

Support for speculation is usually more muted. Alexander Hamilton argued that (in Banner’s rephrasing) “the buying and selling of paper did not remove capital from the productive economy … but added capital to the economy.” Elbridge Gerry defended speculators at the Constitutional Convention, saying that “They keep up the value of the paper. Without them there would be no market.” Another justification for speculators, common in the first half of the nineteenth century, is that they stabilize prices, buying when prices are low and selling when prices are high.

Legal attitudes to insider trading, to which Banner devotes a chapter, have followed a different trajectory. In a 1933 ruling, the Massachusetts Supreme Court found that Rodolphe Agassiz, president of Cliff Mining, had not broken the law when he made well over a million dollars in today’s money by trading on favorable inside information. The law, the opinion read, “cannot undertake to put all parties to every contract on an equality as to knowledge, experience, skill and shrewdness.” Seventy years later Sam Waksal sought to take advantage of his advance knowledge of bad news—that the FDA would not permit ImClone’s cancer treatment Erbitux to be sold. But the court no longer thought that exploiting one’s superior access to knowledge was at worst inevitable, at best good: Waksal was sentenced to seven years in prison.

Banner’s history is carefully researched and well documented. It shows just how difficult, and probably impossible, it is to find “the” proper place for speculation in the financial markets. Just when regulators think they have reined in speculators and made the financial world “safe,” allowing good risk and forbidding bad risk (gambling), financial engineers and traders will redefine those boundaries and send regulators scrambling again.

Crosby, The Laws of Wealth

Thinking about your New Year’s resolutions? You know, the ones you never keep? When it comes to investing, The Laws of Wealth: Psychology and the Secret to Investing Success (Harriman House, 2016) by Daniel Crosby might be a good antidote to yet another year of backsliding. His basic message is that one should engage in rule-based behavioral investing to help defeat behavioral risk.

In the first part of the book Crosby sets out ten sometimes counterintuitive rules of behavioral self-management, the behavioral risk side of his equation for success. They are: (1) you control what matters most, (2) you cannot do this alone, (3) trouble is opportunity, (4) if you’re excited, it’s a bad idea, (5) you are not special, (6) your life is the best benchmark, (7) forecasting is for weathermen, (8) excess is never permanent, (9) diversification means always having to say you’re sorry, and (10) risk is not a squiggly line.

He devotes the second part to behavioral asset management. Investing, he argues, is an area in which intuition and common sense fail us because, among other reasons, it is “performed infrequently, provides delayed feedback and includes an overwhelmingly complex array of variables.” In fact, stock picking can be fairly well described using five variables that, according to Daniel Kahneman, lead to suboptimal decision making: a complex problem, incomplete and changing information, changing and competing goals, high stress and high stakes involved, and must interact with others to make decisions.

If we are to be successful investors, Crosby argues, we must automate the process by which we make decisions. We must follow a model and not taint it with on-the-fly judgment calls. We must “set systematic parameters for buying, selling, holding and re-investing funds and follow them slavishly.” We must take advantage of human fallibility and pursue rule-based behavioral investing.

Crosby suggests one such investing model , which combines value and momentum along with risk assessment (using such metrics as Montier C-scores and Altman Z-scores to vet all purchases).

The Laws of Wealth does not offer a path to consistent outperformance (which, Crosby argues, is one reason his model will have lasting power). Over time, however, systematic behavioral investing should produce an impressive track record. Which, of course, should translate into wealth.

Happy holidays

Bytheway & Metzler, Central Banks and Gold

Central Banks and Gold: How Tokyo, London, and New York Shaped the Modern World (Cornell University Press, 2016) by Simon James Bytheway and Mark Metzler is an academic study that covers the period between the late 1890s and the 1930s. Although it’s no page turner, by relying on extensive archival research and bringing Japan into the picture it highlights some hitherto unknown aspects of the international central banking system.

Here are a few bullet points.

In the 1890s Great Britain was the world’s largest creditor country, replaced by the United States in 1914. In the 1980s Japan replaced the U.S. as the world’s largest creditor country and remains so today.

The Bank of England and the Bank of Japan “secretly developed a close form of cooperation in the early years of the [nineteenth] century. … [F]or much of the period from 1896 to 1914, the BoJ was the Bank of England’s largest single depositor. The Bank of England’s ability to maintain its global financial position during the decade and a half before 1914 was supported by its ability to manage these Japanese funds and quietly to draw on them in moments of need.”

In early 1915, well before the United States entered World War I, American private banks, backed by the Federal Reserve Bank of New York, “began to finance the enormous military purchasing programs run by the British and French governments in the United States.”

“Every truly major international financial crisis of the era—1907, 1920, 1929—appeared first in Tokyo, having an onset some three to six months earlier than in New York and London.” Tokyo markets were “a sensitive leading indicator.”

Eckett, The Harriman Stock Market Almanac 2017

This is the first year I’ve seen The Harriman Stock Market Almanac by Stephen Eckett, although its first edition was published in Great Britain in 2004. This is the tenth edition. (Yes, I do know how to subtract. It seems that the almanac wasn’t put out every year.)

Although clearly inspired by the American Stock Trader’s Almanac, now in its fiftieth year, the British almanac has some unique features that make it particularly valuable.

First, the calendar section includes daily historical data for the FTSE 100 (from 1984), FTSE 250 (from 1985), S&P 500 (from 1950), and NIKKEI (from 1984). For each of these indexes the almanac provides three numbers (Sinclair Numbers) for every trading day, week, and month of the year: (1) the proportion of returns that were positive, (2) the average change, and (3) the standard deviation of the returns.

Second, the almanac looks at quite a few trading strategies, some nonsensical (like the Super Bowl indicator), some most likely coincidental (like the market rising sharply between lunar eclipses occurring in consecutive months), some producing inconsistent results (odd and even week returns). Others might have some merit, or at least trigger further ideas for testing: the FTSE 100/S&P 500 monthly switching strategy, the quarterly sector strategy, and the bounceback portfolio.

Oh, and if you didn’t know the conclusion of the adage “Sell in May and go away,” it’s “don’t come back till St Leger Day.” The St Leger is “the last big event of the UK horse-racing calendar and usually takes place in mid-September.”

The Harriman Stock Market Almanac is hardbound, which means that, unlike its American counterpart, it doesn’t open up flat. Even so, it’s going to be my desk “calendar” for 2017. Time for a change, for a more global outlook.

Millstein, The Activist Director

Ira M. Millstein practiced law for over 50 years, counseling some of the top U.S. companies on governance matters. Among his clients and policy projects in which he was involved were General Motors, American Express, Westinghouse, Macy’s, Drexel Burnham Lambert, Mayor Abraham Beame and New York City during the fiscal crisis, Con Edison, Planned Parenthood, the Organization for Economic Cooperation and Development, the New York State Task Force on Pension Fund Investment, and the New York State Commission on Public Authority Reform. In The Activist Director: Lessons from the Boardroom and the Future of the Corporation (Columbia Business School Publishing, 2016) he recounts stories of corporate governance failures (and, in the case of Planned Parenthood, success) and offers guidelines for making boards more active and effective.

Millstein starts with “the previously untold story of how GM directors finally woke up twenty-five years ago to deal with the company’s financial meltdown. … For the first time, independent directors, meeting separately, challenged an angry, typically imperial CEO [Roger Smith]—and later fired his chosen successor publicly.” During the ten years, beginning in 1985, in which Millstein was involved with GM, the company became competitive again. What happened after that time, how it ended up needing a government bailout, Millstein leaves for others to tell.

Then there was Drexel, “the terror of Wall Street.” Millstein’s client was Fred Joseph, Drexel’s CEO, so he had “an excellent perch from which to watch a good thing going wrong.” And wrong it definitely went. By the end Drexel was bankrupt and Michael Milken was in jail.

Millstein was deeply involved in all of these crises and provides a fresh perspective on them. That alone would make this book worth reading. But he also makes recommendations on how boards can “partner” with management, valuable advice for corporations that want to remain competitive.

Best books of 2016

Readers are forever prodding me to do a list of the best books of the year. My inclination is to resist, in part because my list is inevitably idiosyncratic, in part because I don’t relish being a prize committee of one. But, with apologies to the authors of books that on any other given day might well have bumped chosen titles off this list, here’s my stab at the best books of 2016, with links to my reviews.

Howard B. Bandy, Foundations of Trading

Anders Ericsson and Robert Pool, Peak

William N. Goetzmann, Money Changes Everything



Aron Gottesman, Derivatives Essentials

Wesley R. Gray and Jack R. Vogel, Quantitative Momentum

Michael Lewis, The Undoing Project



Mark Andrew Lim, The Handbook of Technical Analysis

Richard L. Peterson, Trading on Sentiment

Gray and Vogel, Quantitative Momentum

It’s always noteworthy when the folks at Alpha Architect produce a new book. Their offerings thus far are Quantitative Value, DIY Financial Advisor, and now (well, actually not so “now” but my review copy was slow in arriving) Quantitative Momentum: A Practitioner’s Guide to Building a Momentum-Based Stock Selection System (Wiley, 2016). The most recent volume was written by Wesley R. Gray and Jack R. Vogel.

Momentum can, as countless studies have shown, be the basis of a sound trading strategy. Of course, implementing a successful momentum strategy is not as simple as buying strength. Between 1927 and 2014 buying short-term winners returned less than the risk-free rate while buying short-term losers outperformed the S&P 500. Long-term momentum is also a sub-optimal strategy. The sweet spot is, as has again been well documented, intermediate-term.

Less extensively researched is the path dependency of momentum. Using a simple algorithm based on the percentages of negative days, flat days, and positive days, the authors distinguish between high-quality momentum, which has a relatively smooth path, and low-quality momentum, which has a jumpy path. Over the same 1927-2014 timeframe, high-quality momentum outperformed low-quality momentum by about four percentage points annually and outperformed the S&P 500 by more than seven percentage points annually.

Since momentum is a highly seasonal anomaly, the authors recommend exploiting seasonality in timing portfolio rebalancing. The difference between the annual results of a rebalanced portfolio using seasonality and an agnostically rebalanced portfolio is about half a percentage point.

Gray and Vogel spell out their reasoning and their methods in detail. No black box here. No complicated math. And they make the case for the persistence of momentum outperformance into the foreseeable future. As they write, “strategies like value and momentum presumably will continue to work because they sometimes fail spectacularly relative to passive benchmarks.” So investors, both the DIY variety and professional fund managers, will be loath to commit to quantitative momentum strategies. The momentum anomaly will persist.

Bhargava, Non-Obvious 2017

For the past seven years Rohit Bhargava has been making annual predictions about business and marketing trends in his non-obvious trend series. I missed the 2011-2016 editions but am now on board with Non-Obvious 2017: How to Think Different, Curate Ideas & Predict the Future (Ideapress Publishing, 2017). Although most readers of these books are undoubtedly trying to capitalize on the author’s predictions, I am going to focus instead on the art of curating trends.

“A great trend,” Bhargava writes, “is a unique curated observation about the accelerating present.” That’s not an accurate statement: a trend is not the same as the observation of a trend. But I quoted it nonetheless because it has the ingredients of a powerful concept. Start with the notion of an accelerating present, combine it with the author’s definition of curation (“the ultimate method of transforming noise into meaning”), and add an element of creativity. I would recast Bhargava’s point as follows: To identify a non-obvious trend is to observe and process a signal about an accelerating present in a creative way.

Bhargava elaborates on the notion of curation, listing five habits of trend curators. They are curious, observant, fickle (in the sense of “moving from one idea to the next without becoming fixated, or overanalyzing each idea in the moment”), thoughtful, and elegant (that is, they seek “beautiful ways to describe ideas that bring together disparate concepts in a simple and understandable way”). Put a little differently, trend curators always ask why, see what others miss, learn to move on, take time to think, and craft beautiful ideas.

For his own work Bhargava uses the haystack method. This is “a process where you first focus on gathering stories and ideas (the hay) and then use them to define a trend (the needle) that gives meaning to them all collectively.” I guess you could call this method a low-level form of data mining. The haystack method has five steps: gathering (saving interesting ideas), aggregating (curating into clusters), naming (creating elegant descriptions), elevating (identifying broader themes), and proving (validating without bias).

Investors and traders who are in search of non-obvious trends might well find some insights in Bhargava’s book.

Lewis, The Undoing Project

Assume you’ve never heard of Michael Lewis but you’ve read a slew of books and papers about behavioral finance. You might decide to skip this one, figuring it’s more of the same. Put that cognitive bias aside. The Undoing Project (W. W. Norton) is a moving account of the incredibly productive but eventually fraught friendship of Daniel Kahneman and Amos Tversky.

Michael Lewis, the author of such best sellers as Flash Boys, The Big Short, Moneyball, The Blind Side, and Liar’s Poker, is a consummate storyteller. In many fields algorithms may trump experts, but so far writing is not one of them. We still rely on skilled writers to tell us stories we need and want to hear. The Undoing Project is one of those stories.

Other than their brilliance and their commitment to the defense of Israel, Kahneman and Tversky had little in common. Kahneman was insecure, moody, “like Woody Allen, without the humor.” Yet he was a brilliant teacher and bounced from one enthusiasm to another, trying anything, readily accepting failure, moving on. Tversky was the life of the party, an intellectual magnet who “had a preternatural gift for doing only precisely what he wanted to do. … He didn’t pretend to be interested in whatever others expected him to be interested in—God help anyone who tried to drag him to a museum or a board meeting.”

The intense collaboration between these two men produced work that changed the way we think about decision making, risk taking, predicting, our own inherently flawed rationality. It gave rise, at least in some circles, to a collective self-doubt—doubt that we could make wise investing decisions, for instance. And to more of a reliance on models that may exploit cognitive biases but don’t themselves succumb to them.

Although Lewis describes some of the most important discoveries of Kahneman and Tversky, his book is at heart a poignant drama. Dare I admit I cried at the end?

For those who expect something other than emotion from me, here are some notes that Tversky took on conversations he had with Kahneman in 1972, “early fodder” for their paper on how people make predictions, usually quite badly.

People predict by making up stories
People predict very little and explain everything
People live under uncertainty whether they like it or not
People believe they can tell the future if they work hard enough
People accept any explanation as long as it fits the facts
The handwriting was on the wall, it was just the ink that was
  invisible

People often work hard to obtain information they already have
  And avoid new knowledge
Man is a deterministic device thrown into a probabilistic Universe
In this match, surprises are expected
Everything that has already happened must have been inevitable

Since I had no commitments on Thanksgiving, I spent the day reading The Undoing Project. It was a true feast. We should give thanks for people like Daniel Kahneman, Amos Tversky, and Michael Lewis.