Thursday, March 31, 2011

Koesterich, The Ten Trillion Dollar Gamble

Russ Koesterich, iShares chief investment strategist and global head of investment strategy for BlackRock Scientific Active Equities, anticipates a rather bleak economic future for the United States. In The Ten Trillion Dollar Gamble: The Coming Deficit Debacle and How to Invest Now (McGraw-Hill, 2011) he explains why we should expect higher interest rates and slow growth. He then offers solid practical advice for the investor, from a series of tells that are useful in timing market shifts (because, as he writes, “timing is critical to your success” [p. 43]) to asset allocation in this new environment.

The picture Koesterich paints of the future is familiar. Barring major reform of entitlement programs, especially health-care spending, the U.S. structural deficit will only get worse. And “in the not-too distant future, it will start to push rates higher and economic growth lower, and it eventually may set off an inflationary spiral.” (p. 22)

“The not-too-distant future” is of course terribly vague. Given the looming economic risks, “you should hold a portfolio with less money in U.S. equities and bonds, more in cash, and a higher allocation to commodities. But you want to move to these new allocations at the right time. You don’t want to move too late, but you also don’t want to anticipate conditions that may take a few years to develop.” (p. 44)

What should an investor watch in order to decide when to act? A lot: debt (government, corporate, and consumer), both supply and demand; the yield curve; labor markets, especially wage growth; capacity utilization; the money supply; the Fed’s balance sheet.

The author’s recommendations do not require the investor to make a dramatic shift in asset allocation; it’s not that he should dump stocks and go into commodities whole hog. It is a question of more or less, not all or nothing.

In five chapters covering cash and debts, bonds, stocks, commodities, and real estate, Koesterich explains specific steps the investor should take in the new environment. For example, keep your debts long and your cash short—that is, have a fixed-rate mortgage instead of a variable-rate mortgage and keep cash in money market funds or short-term CDs. And hold a lot of cash in a rising rate environment.

Are TIPS a good way to hedge inflation risk? Yes and no. “The TIPS will not insulate the holder from a rise in real interest rates. Also, the extent to which the TIPS insulate you from inflation will be determined by the inflation expectations that are embedded in the bond and the breakeven level, as well as the holding periods. The breakeven level refers to the amount of inflation that the TIPS bondholders are expecting. If the expectations are too high, and you don’t hold the bond to maturity, you may still be better off with a plain vanilla bond.” (p. 108)

Koesterich recommends investing the majority of your stock portfolio outside of the United States, with particular attention to emerging markets. The remaining portion devoted to the domestic market should overweight “stocks and sectors that are more resilient to rising rates. Practically this means overweighting stocks in the energy, health-care, and technology industries and owning less of financial, utility, and consumer discretionary companies.” (p. 133)

Commodities should be part of every portfolio. The recommended allocation is half to a broad commodity basket and the other half to gold, starting with 5% of your total portfolio to each and doubling that position “when the leading indicators of inflation start to flash yellow.“ (p. 165)

Koesterich acknowledges that the economic scenario he envisages may not come to pass. There may actually be real fiscal reform, although the odds are against it. So he sketches out two portfolios, one defensive (if deficit spending continues unabated) and the other aggressive (in the wake of meaningful deficit reform). The former will hold 10-15% cash, 15-25% bonds, 40-55% stocks, and as much as 20% in commodities and gold. The latter will hold 5-10% cash, 20-25% bonds (especially high yield bonds), 60% stocks, and about 10% commodities (energy and industrial metals, not gold).

The Ten Trillion Dollar Gamble is a well-crafted book. At every turn the author explains the rationale for including or excluding particular assets in a portfolio, especially as they react to higher interest rates, slower growth, and possible inflation. The investor who is worried about protecting his wealth in the coming decade(s) would do well to consider Koesterich’s advice.

Wednesday, March 30, 2011

Meyers, The Technical Analysis Course

You’ve finally broken down and decided you need to know something about technical analysis. You could turn to classic texts such as Technical Analysis of Stock Trends by Edwards and Magee. But if you’d like a much easier read with more recent examples, you could instead opt for Thomas A. Meyers’ The Technical Analysis Course: Learn How to Forecast and Time the Market, now in its fourth edition (McGraw-Hill, 2011).

The book, covering both basic chart patterns and technical indicators, is structured as an introductory course. It includes frequent exams and a 110-question final. Answers are at the back of the book.

Since the paperbound book measures 8 ½” x 11”, the charts—some hand drawn, the rest produced using MetaStock software—are easy to read. In keeping with the author’s top-down approach to the equity market, there are charts of market indexes, industry groups, and individual securities.

For Meyers the structured approach to technical analysis is more or less the same, no matter what kind of chart it is being applied to. In the case of individual security analysis, it consists of seventeen steps, some basic and others optional. The basic steps are: (1) construct a bar chart of a security, (2) examine it for reversals, consolidations, and gaps, (3) draw trendlines and support and resistance lines, (4) perform relative strength analysis comparing a security to its industry group or to a market index, and (5) calculate and plot a simple moving average of closing prices. Optionally, one can: (1) draw trend channels, fan lines, percentage retracement levels, and speed resistance lines, (2) examine the chart for bull and bear traps and failed trendline signals, (3) perform a volume analysis, (4) calculate and analyze on-balance volume, (5) analyze volume using the volume reversal technique, (6) calculate and plot weighted, exponential, and multiple moving averages, (7) plot trading bands, (8) plot Bollinger Bands, (9) calculate and analyze momentum, rate-of-change, and moving average oscillators, (10) calculate and analyze the RSI, (11) calculate and analyze stochastics, and (12) calculate and analyze MACD. These seventeen steps pretty well summarize what is covered in the book.

One good feature of this course is that it includes a lengthy case study, using Starwood Hotels (plus its industry group as well as the S&P 500 Index). The author presents 40 marked-up charts over longer and shorter time frames, all generated as of December 31, 2009. Each chart comes with commentary.

My major concern with a book that is so elementary is that it may leave the reader with a false sense of competence. Although I didn’t take the tests myself, I looked at enough questions to realize that they were incredibly easy. Pity the reader who aces the exams and considers himself ready to commit money to the equity market using technical analysis. This is like getting an “A” in first-semester French and thinking you can land a great job in Paris, fluent French required.

Admittedly, Meyers makes no such claims for his book; indeed, he refers his readers on to twelve technical analysis books that “offer a wealth of valuable information.” (p. 329) So should those neophytes interested in learning about technical analysis skip the baby step and plunge into material that is denser and sometimes more nuanced? That’s all a matter of personal preference: do you want intense elementary French (two semesters packed into one) or a language course that proceeds at the normal pace? Given my singular lack of talent for learning foreign languages I would opt for the latter. But since I am a quicker study in things financial, I would probably choose the former.

Tuesday, March 29, 2011

Hirsch, Super Boom

Some of you may remember my review of the 2011 edition of the Stock Trader’s Almanac with its prediction of Dow 38820 by 2025. I was not the only skeptical voice at the time, and mine was far more muted than most. Undaunted, Jeffrey A. Hirsch has turned this prediction into a book, Super Boom: Why the Dow Will Hit 38,820 and How You Can Profit from It (Wiley, 2011).

The track record of predictive literature has not been stellar. We have only to think about the embarrassing 1999 call of Dow 36,000 by James Glassman and Kevin Hassett. Since Hirsch’s price target is similar to theirs, though his target date is much farther out, he feels compelled to explain where they went wrong: basically, they had a myopic view of history.

In contrast to the many pie-in-the-sky predictions, Hirsch recounts forecasts that were both timely and accurate, most notably his father’s call in January 1977 that the Dow would rise 500% (to 3420) over the next 13 years. In an appendix he reprints this Smart Money special report, which included a portfolio for the superboom.

Following in his father’s footsteps, using similar reasoning and an identical 500% gain (from the intraday low of 6,470 on March 6, 2009), Jeffrey Hirsch explains why we should see outsized returns for the stock market in the coming years. What will trigger this super boom? “Super booms of the past were conceived during wartime and financial crises, which produced elevated government spending, rising inflation, and pent-up demand. They were weaned on peace, stable political leadership, and effective governing. Finally, they were fed a steady diet of cultural paradigm shifting, enabling technology that changed the world and the way the average person lived. As the boom gains traction and heightened consumer spending spurs business and economic growth, the so-called ‘animal spirits’ of business, entrepreneurs, and investors are restored, shifting the boom into high gear. Finally, the boom reaches overdrive before falling back to earth.” (p. 13)

At the moment the economy remains strangled, and the author thinks that “we will be in a funk for several years”; the next super boom won’t begin until around 2017. (p. 56) We are still involved in Iraq and Afghanistan, government policies have not always been supportive, and inflation—at least as measured by core CPI—remains tame. Even if we include the volatile food and energy sectors, between September 11, 2001 and the November 2010 reading “the inflation index is up a meager 23 percent.” Ah, but the CPI has been revised numerous times, to what end is unclear (perhaps to dampen perceived inflation). “Having made numerous trips to the market and gas station over the past decade, it is simply unimaginable that prices are only up 23 percent. Energy costs have doubled, if not tripled. Medical costs have skyrocketed.” (p. 119)

Even if it’s not here yet, more inflation, hidden or evident, is on the horizon. For the owner of stocks, that’s good news because “the secular bull will not start until inflation returns to our economy and has time to level off, allowing for growth and innovation.” (pp. 126-27) The best hedge against inflation, the author stresses, is the stock market. Between 1980 and 1999, when the CPI more than doubled, “the inflation-adjusted Dow was up 444 percent versus a 22 percent loss for inflation-adjusted gold.” (p. 122)

What kinds of stocks should profit from the coming super boom? Hirsch identifies five areas to explore for investment ideas--alternative energy, biotechnology and genomics, population growth, traditional energy, and emerging markets—and recommends specific ETFs in each area.

Super Boom may turn out to be a book that’s talked about around the water cooler, but in the final analysis it is disappointing. It’s not that I’m taking issue with Hirsch’s 38,820 target. (In this review I have referred to it as a prediction or forecast even though Hirsch himself writes that “DJIA 38,820 by 2025 is not a market forecast; it is an expectation that human ingenuity will overcome, as it has on countless past occasions throughout history.” [p. 110]) I have absolutely no idea where the Dow will be in 2025.

My problem is that the book is cobbled together from Yale Hirsch’s work, Stock Trader’s Almanac research, and a somewhat superficial survey of twentieth-century booms and busts. Arguments are brief (although on occasion presented more than once), and the reasoning is somewhat elusive. Often, it seems, the author is letting his father speak for him. Perhaps the book was simply rushed to press. Whatever the case, it did not rise to the level of my expectations, admittedly elevated because I have great respect for the Hirsch Organization.

Monday, March 28, 2011

Stein and DeMuth, The Little Book of Alternative Investments

I’m quickly becoming addicted to Wiley’s “Little Book” series. Its most recent addition is The Little Book of Alternative Investments: Reaping Rewards by Daring to Be Different by Ben Stein and Phil DeMuth. With the breeziest of styles the authors transform a topic that is somewhat shopworn into one that belongs on display in a (financial) store window.

The authors believe that an investor should start with a couple of low-cost broad market index funds, such as VTI, VEU, and BND, and then exploit market anomalies to make adjustments at the margins. Here are three such anomalies: (1) value stocks outperform growth stocks, (2) small cap stocks do better than large cap stocks, and (3) low beta stocks “perform better than expected on a risk-adjusted basis.” (p. 22) The authors suggest some mutual funds that capture these anomalies.

And then it’s on to alternative investments, not all of which are attractive. Take collectibles, for instance. The problem is that you always pay retail and you normally end up selling wholesale; you’re buying high and selling low. The authors criticize PBS’s Antiques Roadshow, which “gives viewers a misleading impression of the easy money to be made trafficking in collectibles. Their appraisers always tell people the insurance value or the replacement value of the gewgaw they have hauled in, or what it might fetch in some ideal auction before expenses…. What they don’t say is what they, the knowledgeable dealer, would pay for it in cash money right there and then on the spot, or what we might call the actual value.”

And, the authors continue, although “it’s always fun to watch the delight on the face of somebody who paid $250 for a painting in 1950 when he discovers that it’s supposedly worth $5,000 today … [w]hat this scenario doesn’t show is the opportunity cost: If he’d just put that same $250 in the stock market in 1950, he’d have $130,000 today.” (pp. 43-44) So, scrap collectibles as a good investment idea.

Joining collectibles in the scrap heap are private equity, buy/write funds, structured products, 130/30 funds, and precious metals. Let’s look at just two rejects. Why discard buy/write funds? Many buy/write funds hold a stock index and then sell covered calls against it, a strategy that “delivers nearly all the downside of equities with the upside clipped off.” Others add out-of-the-money puts to the mix, thereby collaring the portfolio. But the authors “were able to simulate the total returns of a buy/write fund from 1994 to 2010 almost to the penny just by putting half [their] money in the S&P 500 index fund and keeping the rest in T-bills. In other words, if you want to control risk, you don’t have to pay fund managers extra money to do it for you this way.” (pp. 56-57)

The case for owning gold is iffy; it “depends entirely on the start and stop dates we choose to make the argument. During certain date ranges, picked after the fact, gold adds a Midas touch. During others—and especially over the long haul—it sits there like lead.” Faced with goldbugs who claim that there are special reasons to own gold now, the authors pull out the ultimate weapon—Warren Buffett, who recently told the authors: “You have a choice. On the one hand, you can have all the gold in the world. It fits into a cube of metal about the size of a large McMansion. Or, you can have all the farm land in the United States. Plus, you can own 10 Exxon Mobils. Plus, you can have one trillion dollars of walking-around money. Which would you choose? Which is likely to be the more productive long-term investment?” (p. 64)

Having rejected several possibilities, the authors turn to the alternative investments a person should consider adding to his portfolio. First of all, commodities and REITs. And, the ultimate alternative investments, hedge funds or “hedge fund pigs in mutual fund blankets.”

The authors give an uncommonly clear account of the desirable alternatives, especially hedge funds. I have shot my wad in this review by focusing on what to avoid whereas the authors rightly reverse this: they spend most of the book explaining what to buy. They describe ten basic hedge fund strategies and then point readers in the direction of mutual funds that try to capture these strategies. They even suggest a way to set up a “do it yourself” mini-portfolio that “has a low beta, a low volatility, and a low correlation to the market’s volatility” and that would be “a satellite to the rest of your holdings.” (p. 186)

All in all, this is a great little book for investors who are trying to improve their asset allocation. Lots of meat and fun to read.

Friday, March 25, 2011

Cornehlsen and Carr, Conquering the Divide

Conquering the Divide: How to Use Economic Indicators to Catch Stock Market Trends by James B. Cornehlsen and Michael J. Carr (W&A Publishing, 2010) is an intriguing read for investors with some talent for system design. The authors are in search of economic indicators that turn ahead of the stock market. “Ideally,” they write, “the indicator would offer a signal in advance of a bull and bear market, but that may not be possible. We will focus on the risk aspects. Spotting a potential bear market early and avoiding losses can be more meaningful to the individual investor than being able to time stock market bottoms.” (p. 79)

Cornehlsen and Carr focus on cyclical stock market trends that reflect the underlying business cycle, trends that can last from a few months to a few years. Using regression analysis, they tested a host of economic indicators to see whether they have any predictive value. Among the candidates (and here I’m pulling almost at random) were the 10-year government bond, average hourly earnings, building permits, consumer confidence, copper, CPI, crude oil, ECRI weekly leading index, employment advertising, Fed funds rate, imports of goods and services, ISM manufacturing and non-manufacturing, retail sales, and the unemployment rate.

A book review is not the place to delve into statistical methodology; suffice it to say that they smoothed both the raw monthly S&P data and the economic indicator data by using a six-month rate of change. They then studied regressions when the economic series led the S&P 500 by three, six, and nine months, when it lagged over the same time frames, and when it was coincident. They determined statistical significance using the P-value.

Of the indicators the authors tested, eighteen proved to be reliable leading indicators. But some of them were available only by subscription, others were redundant, still others had too short a data history, and some just didn’t make sense. The authors therefore winnowed the list down to three: ISM manufacturing, the Baa corporate bond spread, and new orders of durable goods. They then set out to construct a composite model with simple buy and sell rules and tested it out on S&P data from 1992. The bottom line is that following their rules would have more than doubled the performance of a buy-and-hold strategy.

Cornehlsen and Carr’s book opens a window for investors who have a penchant for research and system design. It’s too bad that there is no accompanying web site with Excel spreadsheets, which would make the process a tad easier for the statistically challenged. The tabular summary of the authors’ regression analysis is no substitute.

Thursday, March 24, 2011

Sincere, Start Day Trading Now

Michael Sincere’s Start Day Trading Now (Adams Media, 2011) is written for the rank novice who missed the heady days of the late 90s when anyone with half a brain was a genius and who now dreams of catching up. Day trading equities is not a moribund enterprise, but it’s no longer the cash cow that it was perceived to be earlier. Many day traders, butting up against the restrictions of pattern day trading and looking for greater leverage, have moved over to futures. Sincere, however, sticks with equities.

Not surprisingly, a good chunk of the book is devoted to chart reading, interpreting patterns, and using technical indicators. The author also explains the basics of order entry and trade management. Then comes a chapter on Hal—not the computer but a rookie trader who makes every mistake imaginable and in one very costly trade learns 33 lessons.

The penultimate chapter is the most interesting because it contains advice from three professional traders—Toni Turner, John Kurisko, and Peter Reznicek. Timothy Sykes also outlines some shorting strategies. Let me share one quotation that I particularly enjoyed, in part because it starts with the name of this blog (well, okay, I the overachiever claim to read more than one market).

“Reading the market is like getting lost in a dangerous forest… An experienced guide will know what signs to look for, see the animal tracks, and find a way out. If an inexperienced person got lost in the forest, he probably wouldn’t last the night.”—Toni Turner (p. 154)

Although the paperback cover screams “Anyone Can Day Trade!” Michael Sincere is much less sanguine. He points out potential pitfalls and urges caution at every turn. He stresses the need for hard work and continuing education. This is definitely not a get rich quick book. It is a measured, well written account of what it takes to get started day trading.

Wednesday, March 23, 2011

CSS Analytics

A heads up to readers who thought that CSS Analytics had gone dark except for its weekly update of the Livermore “Active Issues” Index. David is back, offering technical indicators that are the product of data-based, imaginative reasoning. Those of you who aspire to be system traders should try to emulate his thought processes, though you probably won’t succeed.

Tuesday, March 22, 2011

Trongone, Trading in the Footsteps of Sherlock Holmes

Some books are too clever by half. Anthony Trongone’s Trading in the Footsteps of Sherlock Holmes: Balancing Probabilities for Successful Investing (W & A Publishing/Traders Press, 2010) is one of them. The idea—to encourage traders to adopt an analytical mindset and achieve emotional discipline by relying heavily on quotations from Sherlock Holmes novels and stories—sounded promising, even fun. And fun is a rare commodity in trading books. Although the book started off well, as it progressed Holmes became a less and less useful coach and analogies from detecting to trading became increasingly strained. It’s hard, for instance, to invoke Holmes in a discussion of order types.

But why waste a post emphasizing the negative when there are so many passages that will undoubtedly delight traders who are fans of Sherlock Holmes? Herewith a very limited sampling.

We all know the difficulties of trading a rangebound, “featureless” market. In The Boscombe Valley Mystery Holmes and Watson have the following exchange that speaks to this point:

“I have just been looking through all the recent papers in order to master the particulars. It seems, from what I gather, to be one of those simple cases which are so extremely difficult.”

“That sounds a little paradoxical.”

“But it is profoundly true. Singularity is almost invariably a clue. The more featureless and commonplace a crime is, the more difficult it is to bring it home.” (p. 43)

Holmes reiterates this notion in The Red Headed League: “As a rule,” said Holmes, “the more bizarre a thing is the less mysterious it proves to be. It is your commonplace, featureless crimes which are really puzzling, just as a commonplace face is the most difficult to identify.” (p. 97)

In The Hound of the Baskervilles Holmes responds to Dr. Mortimer’s assertion that “We are coming now into the region of guess work.” “Say, rather, into the region where we balance probabilities and choose the most likely. It is the scientific use of imagination, but we have always some material basis on which to start our speculations.” (p. 108)

In a KISS or Ockham’s razor moment, Holmes says to Inspector Hopkins in The Adventure of the Abbey Grange: “Perhaps when a man has special knowledge and special powers like my own, it rather encourages him to seek a complex explanation when a simpler one is at hand.” (p. 116)

On occasion Trongone twists a passage to fit into his discussion. In the chapter on risk he quotes The Adventure of the Missing Three-Quarter: “Let me introduce you to Pompey,” said he. “Pompey is the pride of the local drag hounds, no very great flier, as his build will show, but a staunch hound on a scent.” Trongone writes: “Similar to the bloodhound, to be successful you do not have to be an action junkie, but you do have to be staunch on the scent of downside risk.” (p. 137)

Finally, in the section entitled “step away from the computer,” we find this wonderful excerpt from The Adventure of the Devil’s Foot: “It won’t do, Watson!” said he with a laugh. “Let us walk along the cliffs and search for flint arrows. We are more likely to find them than clues to this problem. To let the brain work without sufficient material is like racing an engine. It racks itself to pieces. The sea air, sunshine, and patience, Watson—all else will come.” (pp. 145-46)

Trongone’s book will undoubtedly appeal to avid Sherlock Holmes fans. And, by way of a footnote, just as there are many ways to trade a market, there are many ways to make the Holmes quotations work for you.

Monday, March 21, 2011

About me

Several people who so generously responded to my request for input suggested that I expand my profile. Since Google limits “About Me” to 1200 characters and I didn’t know how to edit my life that dramatically, I opted instead to write an autobiographical post. Perhaps this option is preferable. At least my exercise in self-absorption will be buried in the blog, not prominently displayed.

I was born in a town in western Pennsylvania that, as a result of the remaining traces of a regional accent, I still have difficulty pronouncing properly. I grew up not far away in a place that, during the height of the coal boom, had the most millionaires per capita of any town in the country. By the time I arrived that was a long forgotten memory. Instead, the town was to become the site of a food stamp pilot program.

It was easy to excel academically in an environment in which 20% of the students went on to “higher education,” which included beauty school, and where most scholarships were awarded to athletes—many of them admittedly extremely talented. All I wanted to do was get the hell out. I rehearsed my exit by reading voraciously.

In college, to the annoyance of the English department which thought it had a lock on me, I discovered philosophy. I guess I’ve always been attracted to questions that don’t lend themselves to easy answers. Unfortunately, I also have a penchant for burning myself out. So after graduation I worked for a year at the Carnegie Corporation of New York, an educational foundation, which was a wonderful place to recharge my batteries. Then it was on to graduate school.

Throughout college and grad school I dabbled in the stock market, usually—contrary to all wisdom—on borrowed money. My trades, normally lasting only a few months, were on balance quite profitable. The notable exception occurred when I took the advice of a student who, by the way, went on to a brilliant career as a hedge fund manager. Good personnel decision, bad stock choice.

After serving as the first female residential college dean (Yale College had just gone co-ed) and while still teaching part time in the Yale philosophy department, I decided to go to law school. What was I thinking? I lasted only a term and a half before I threw in the towel—bored and exhausted.

I had to reinvent myself. Teaching jobs were incredibly scarce and the few posted openings were unattractive. Moreover, I had ties to New Haven. So I launched Brevis Press (actually pre-press, I kept the name intentionally vague in case the business evolved from pre-press to full-blown publisher, which it didn’t). For a couple of decades I and the press’s dedicated staff faced impossible deadlines and worked far too many hours. I was so busy producing books that I had no time to read.

My only escape during those years was the occasional weekend of dog shows. Of course, in order to have something to show I had to breed (which entailed many sleepless nights), develop an eye for a good dog, train show prospects, groom, and learn how to show a dog. And, oh yes, take care of a kennel of unruly basset hounds. (Basset hounds, by the way, are not normally unruly; I was the anti-“Chinese mother” who encouraged unbridled spirit. While other basset hounds slept peacefully at ringside, my lunatics were jumping up on the trophy table seeing what they might win. And guess who took home the trophies!)

Aside from funding my IRA I invested only sporadically until around 1995 when I became more active. This was also about the time that the book production business was starting to disintegrate. The barrier to entry had fallen dramatically ($250,000 became $5,000), printers began to accept electronic manuscripts, and manufacturers of typographic equipment and software folded. Brevis Press outlasted many, but when backup systems failed and replacement parts were no longer available it too shuttered its doors. Reinvention time again.

Too young and not flush enough to retire, I decided it was time to learn more about trading. I studied far more than I traded, which meant that the market didn’t hand me an outsized tuition bill. Nonetheless, I made my share of really dumb mistakes.

Today I continue to evolve as a squint-eyed trader and investor. My plan is to retire at the age of 90, at which point I anticipate my retirement account will be fully funded! Until then, I’ll keep busy trading, reading, gardening, and (at least for a year or ten) shoveling snow. And, with any luck, adapting rather than reinventing.

I’ll share my reading—at least until I decide that the effort far exceeds the reward. This blog, as you can imagine, is a huge time commitment. I may be a fast reader, but I’m a slow writer.

My trading, however, remains a private journey. It’s not that I have a proprietary system that I refuse to share. I just don’t play well with others. I tried that once, and it had a decidedly negative impact on my trading. I don’t want my retirement to be set back another ten years.

Saturday, March 19, 2011

Chabris’ invisible gorilla

Christopher Chabris, winner of a 2004 Ig Nobel Prize and co-author of The Invisible Gorilla: And Other Ways Our Intuitions Deceive Us (Crown, 2010) gave an AtGoogle talk in October 2010. If you haven’t seen the video, you should. It’s about an hour long and addresses several psychological issues that might resonate, especially with discretionary traders. Chabris also looks at why investigators believed Madoff’s lies about his consistent record and why financial professionals thought they understood complex derivatives.

Friday, March 18, 2011


Wonder Bread or a delicious homemade loaf, both get stale over time. And so do blogs.

Although Reading the Markets will continue to be a go-to site for book reviews on trading and investing (and seemingly off-topic books that may yield insights for traders and investors), I think it needs some freshening.

I’m soliciting suggestions. Is there something you’d like me to write about that I am currently ignoring? More pictures? Puzzles? Offbeat stuff? You can either comment on this post or email me at I want this blog to be one you keep returning to because it offers something that you can’t get at a thousand other financial blogs. I’d really appreciate your input.

And speaking of appreciation, I want to thank those of you who are using this blog as a portal to Amazon. As I have written before, you don't have to limit your purchases to books. I get a small referral fee on anything you buy.

Thursday, March 17, 2011

Bigger, How Traders Achieve Creative Flow

Nonfiction books are a fragile commodity, and I use the word “commodity” advisedly. We are increasingly being bombarded with ever more abbreviated forms of information, and much of what we want to learn about in more depth is freely available via a simple Google search. Yet publishers keep churning out boilerplate books that target the enthusiastic novice. Dog breed books are a classic example—perhaps a quarter of the text is devoted to the specific breed and the rest is generic stuff that appears in both the Yorkshire Terrier and the Irish Wolfhound books.

The reality is that few nonfiction writers have 250 pages of original or imaginatively synthesized thoughts in them. Just think, for instance, about how most trading books are padded with the seemingly mandatory, usually thoroughly uninspired concluding chapter on risk management.

Moreover, even among reputable publishers there is an uptick in blurring the line between information and advertising in books that, while purporting to educate, also promote a product.

It’s therefore not surprising that entrepreneurial spirits have entered the world of self-published mini-books, often merging information with product- or self-promotion. These mini-books are an upscale version of infomercials.

Michael Bigger’s How Traders Achieve Creative Flow, which he kindly sent to me for review, falls into this category. Actually, Bigger is even more minimalist because he turned over authorship of at least a third of the text to other writers (Sean McLaughlin and Renita T. Kalhorn). At 41 pages in length and available only digitally, it doesn’t come cheap. Well, yes, of course it does at $9.99, but if you consider that Scott E. Page’s 296-page Diversity and Complexity (paperback only) is $13.07 on Amazon or Crossley’s 544-page bird identification book with 640 color plates is $21.00, you’re paying something of a premium. Is it worth it?

Perhaps, especially if you are interested in Internet dynamics and how blogging, and interaction with your followers, can ostensibly improve your trading bottom line. (Don’t look to me for proof of this claim.) But there’s an element of hucksterism and self-promotion in this e-book, and I think that in the final analysis the trader has better sources of inspiration. I will, however, share one of the author’s thoughts: “Everyone is a genius for at least five minutes a day. Capture that moment.”

Alas, I don’t think that my last five minutes came anywhere close to rising to the level of genius.

Wednesday, March 16, 2011

The Forbes/CFA Institute Investment Course

The Forbes/CFA Institute Investment Course: Timeless Principles for Building Wealth by Vahan Janjigian, Stephen M. Horan, and Charles Trzcinka (Wiley, 2011) is an introductory text for the beginning investor. It covers topics ranging from the role of the stock market in building wealth to the use of derivatives, from selecting a broker to fundamental and technical analysis.

The book is thorough in its approach and, although aimed at the novice, is no “investing for dummies.” For instance, in the chapter on reading financial statements (including the often telltale footnotes) the authors focus on Wal-Mart’s numbers from 2006 through 2010. They explain how to decipher the company’s income statement, balance sheet, and statement of cash flows. They then look at key financial ratios such as profitability ratios, asset utilization ratios, leverage ratios, and liquidity ratios. Overall, the authors conclude, Wal-Mart’s financial ratios look strong. But should you buy the stock? Is it underpriced or does its stock price already reflect its strength? Most often a company’s health is already priced in; “research suggests that investment returns from stocks with the highest ROEs are similar to the returns from stocks with only average ROEs.” (p. 112)

In a section entitled “Can You Trust Financial Statements?” the authors address the issue of fraud but also explain why conducting a proper peer analysis can be daunting. Take the case of “companies having different fiscal year-ends, especially when their businesses are seasonal. … Wal-Mart’s fiscal year ends in January, a full month after the Christmas selling season. As a result, the company’s inventories are likely to be low. In contrast, a retailer whose fiscal year ends in October would have high inventory levels as it gears up for holiday shoppers. This difference will affect inventory turnover and profitability ratio calculations.” (p. 116)

Although this book focuses on individual stock selection, it includes chapters on fixed-income securities, derivatives, and mutual funds. And it ends with 22 “tidbits of wisdom” which, we are advised, should be taken with a grain of salt.

In brief, The Forbes/CFA Institute Investment Course is a first-rate introduction to what we all hope is not a mirage: building wealth through investing.

Monday, March 14, 2011

Kolb, Financial Contagion

Financial Contagion: The Viral Threat to the Wealth of Nations, edited by Robert W. Kolb (Wiley, 2011), is a collection of short papers written primarily by academics. Kolb’s lead chapter frames the problem quite elegantly. He distinguishes between contagion and an epidemic: contagion implies “a mechanism of transmission from one infected victim to other potential victims,” whereas in an epidemic the disease may either be contagious or may be spread by entities such as fleas or mosquitoes.

Kolb notes that “there is some danger of conflating contagion with the evidence of contagion. … According to many studies, a contagious episode in finance typically results in a particularly heightened correlation among the affected domains. … Although increased correlations may provide a method for identifying the occurrence of a contagious episode, the jump in correlations is hardly contagion per se.” (p. 4) Moreover, he suggests that there may be contagion without the “economic record that would statistically show the contagion that economists labor to discern.” Even though “there can be little doubt that Goldman Sachs and Morgan Stanley terminated their existence as investment banks as a direct result of the financial difficulties that took Lehman Brothers to oblivion and induced Merrill Lynch to throw itself into the arms of Bank of America,” there wasn’t enough time between these events to generate a statistically significant data series. (p. 9)

The book is divided into six parts and forty-six chapters ranging over theory, the Asian financial crisis, emerging markets, the financial crisis of 2007-09, regional contagion, and contagion within an economy. Although many authors rely on correlation analysis for their findings, there is little math in the book. That would be fine, but it’s symptomatic of a larger problem: most of the articles read like expanded abstracts.

Nonetheless, there are nuggets here and there, and for data geeks some staggering statistics. For instance, at the end of 2007 the foreign claims of Austrian reporting banks on Central, Eastern, and Southeastern Europe amounted to “more than 70 percent of Austria’s GDP and 26 percent of its banking system assets.” (pp. 302-303)

Financial Contagion: The Viral Threat to the Wealth of Nations (and I repeat the subtitle because, unlike 90% of the subtitles out there, I think this one is really good) covers a lot of territory. It is, of course, terribly important to analyze case histories to discover potential triggers, mechanisms of transmission, and viable ways to contain the damage of financial contagion. The problem is, as these articles amply demonstrate, that there’s always a new virus or a mutation of a former one lurking in some corner of the financial world. We don’t know what it is or where it is. And, even if we had some inkling, there’s almost never enough time to develop a financial “flu shot.”

Friday, March 11, 2011

Whenever Perry Kaufman writes a new book, and he’s not exactly prolific, system traders take note. After all, his New Trading Systems and Methods (now in its fourth edition) is considered to be a classic. Alpha Trading: Profitable Strategies That Remove Directional Risk (Wiley, 2011) is his latest effort. In it, Kaufman introduces the reader to stat-arb setups, primarily pairs trading in stocks and futures.

What separates Kaufman’s work from that of many other writers on trading strategies is that he goes into the nuts and bolts of designing and testing system candidates. Let’s say that a trader has an itch to go long Ford when it’s relatively oversold and pair that trade with a short in GM when it’s relatively overbought assuming that the two stocks will come back in line with one another. Does this trade make sense? Does it have a shot at being profitable once slippage and commissions are factored in?

Kaufman would probably send this trader to the back of the class while he worked with those students who were willing to learn the fundamentals of pairs trading. For starters, are the stocks correlated? What is the volatility of each stock? How should the position be sized? (We clearly can’t just buy 100 shares each of Ford and GM.) How can we identify movements away from equilibrium?

Kaufman explains, usually with the appropriate Excel formulas, the process of developing a pairs trading strategy. Volatility is an essential ingredient. First, without sufficient volatility trading profits will be eaten up by the cost of doing business, commissions, and slippage, so a volatility filter might be appropriate. Second, in identifying adaptive buy and sell levels volatility must be normalized. Third, position sizing should be volatility adjusted. Fourth, when combining pairs into a portfolio the trader has to take into account target volatility.

The book begins with examples from the world of stocks. But for the trader who is not part of the high-frequency elite, pairs trading with stocks can be frustrating: “the returns for many stocks are small, and the demands on good execution are high.” (p. 93) So Kaufman moves on to pairs trading using futures. Although the basic concepts remain the same, he provides information specific to futures trading and offers examples of pairs that were relatively consistent in his 2007-2009 test (crude-EURUSD), poor performers (crude-gold), and inconsistent (EURUSD-gold).

Classic pairs trading assumes that prices are mean reverting. It therefore focuses on relatively short time frames where noise dominates price. (By the way, there’s a very good chapter on the importance of price noise with efficiency ratios for 44 markets. Not surprisingly, the equity markets are the noisiest, with the Russell and the S&P leading the pack.) Trends begin to surface over longer periods of time. Therefore, risk-adjusted spreads are an option for trend traders. Kaufman illustrates these spreads using LME data. He also studies cross-market trading, using such pairs as soybean-ADM and crude-XOM.

I should note in closing that the website that accompanies the book has spreadsheets that make the calculations necessary for setting up trades ever so much easier.

Alpha Trading is somewhat repetitive because Kaufman uses only a few ingredients in his strategies. Anyone who is looking for 99 ways to win in the pairs or spread trades arena should turn elsewhere. What Kaufman offers is different—essentially a do-it-yourself manual for the trader who wants to develop strategies that remove directional risk and unearth opportunities for creating alpha.

Thursday, March 10, 2011

McMillan et al., Investments

Investments: Principles of Portfolio and Equity Analysis, coedited by Michael G. McMillan, Jerald E. Pinto, Wendy L. Pirie, and Gerhard Van de Venter (Wiley, 2011), was written for financial analysts as well as aspiring financial analysts. Part of the CFA Institute’s book series, it is a weighty tome of more than 600 pages. In twelve chapters it covers such topics as market organization and structure, security market indices, market efficiency, portfolio management, portfolio risk and return, portfolio planning and construction, equity securities, industry and company analysis, equity valuation, equity market valuation, and technical analysis. There is also a separate paperback workbook with problems and solutions.

I debated what to focus on in this post and finally decided to look at two methods for valuing equity markets. The assumption is that, whatever the short-term effects of momentum, “economic fundamentals will ultimately dictate secular equity market price trends.” (p. 470) (For those who read yesterday’s post, this assumption is in sync with the theory of Frydman and Goldberg.)

First is the neoclassical approach to growth accounting, which uses the Cobb-Douglas production function to “measure the contribution of different factors—usually broadly defined as capital and labor—to economic growth and, indirectly, to compute the rate of an economy’s technological progress.” In imprecise and non-mathematical terms, the percentage growth in real output (or GDP) can be decomposed into its components: growth in total factor productivity (a measure of the level of technology), growth in the capital stock, and growth in the labor output. Applying this model to the Chinese economy, the authors of the chapter suggest that Chinese economic growth will eventually moderate; nonetheless, they project a near-term growth rate of 9.25%. They arrive at this by adding total factor productivity of 2.5%, a growth in capital stock of 12% times a value of 0.5 for the output elasticity of capital—that is, 6%, and a labor force growth of 1.5% times a value of 0.5 for the output elasticity of labor—or 0.75%. An ultimately sustainable growth rate might be 4.25% [1.25% + (0.5 x 6%) + (0.5 X 0%)].

Second is the effort to calculate the forward justified P/E ratio for an equity market using the H-model. The H-model assumes that dividend growth rates will “decline in a linear fashion, over a finite horizon, toward an ultimately sustainable rate from the end of that horizon into perpetuity.” (p. 476) This model is most frequently used to value emerging markets because in mature developed equity markets “supernormal growth would not generally need to be modeled.” (p. 477) The current 19.1 forward P/E ratio for Chinese equities, the authors conclude, is not unreasonable. But “only those with a very optimistic long-term dividend growth rate forecast and/or a low required discount rate would find the Chinese market to have substantially better than average current attractiveness.” (p. 481)

These two methods are examples of top-down analysis, but many analysts proceed from the bottom up. “When engaged in fundamental securities analysis,” the authors write, “it can be wise to use both top-down and bottom-up forecasting. However, when we use both approaches, we often find ourselves in the situation of the person with two clocks, each displaying a different time. They may both be wrong, but they cannot both be right!” When the two methods lead to significantly different results, the analyst must go back to the drawing board. “After all, if forecasts cannot be consistent with each other, at least one of them cannot be consistent with underlying reality.” (p. 487)

But “in rare and significant instances,” they conclude, “we will find that carefully retracing the steps reveals a gap between the two forecast types that gives rise to significant market opportunities. In such instances, the process of reconciling the two types of forecasts creates instances where we differ significantly and correctly from the consensus.” (p. 487) For instance, in the early 2000s top-down forecasts were more subdued, and more correct. In the recent financial crisis bottom-up forecasts were more telling.

Investments: Principles of Portfolio and Equity Analysis is not light reading, but it covers material crucial to the work of financial analysts. It also provides insights for the independent investor who wants go beyond the basics. The workbook is a welcome addition.

Wednesday, March 9, 2011

Frydman and Goldberg, Beyond Mechanical Markets

Participants in the financial markets as well as those who theorize about them and set policy governing them yearn for predictability and, as much as possible, rigorous quantifiability. Alas, as we know only too well, their yearnings are for the most part intellectual fantasies. Roman Frydman and Michael D. Goldberg in Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State (Princeton University Press, 2011) offer an alternative approach to markets that they call Imperfect Knowledge Economics (IKE). I suspect that by now their friends and colleagues have deluged them with vintage “I Like Ike” buttons.

There are essentially three legs to the IKE stool. First, history does not proceed in a predictable way; change can be nonroutine. Second, market participants are neither predictably rational nor predictably irrational; they do the best they can with imperfect knowledge. And third, fundamentals are, well, fundamental.

Let’s look at the question of fundamentals. The authors rely in part on a study that scores Bloomberg News daily market-wrap stories on the U.S. stock market (January 4, 1993 through December 31, 2009). These stories, the authors suggest, provide a “window into the decisionmaking of the professional players whose trading determines prices.”(pp. 129-30) The scoring reflects the fundamental, psychological, and/or technical factors that were deemed important in driving prices each day. The result is that at least one fundamental factor was mentioned on virtually every day in the sample, at least one psychological factor was mentioned on 55% of the days (almost always in conjunction with a fundamental factor—pure psychology was mentioned on only 1% of the days), and technical factors were mentioned on 6% of the days.

The authors admit that the data may be too soft to refute the bubble theory of markets according to which crowd psychology dominates and long upswings are unrelated to fundamental factors. Indeed, we know how tenuous the relationship often is between after-the-fact explanations of market movement and the real causes of that movement.

But they present other evidence, such as the relation between stock prices and current earnings, to press their case. They argue that even where swings are excessive “such excessive fluctuations result not because market participants’ trading decisions ignore fundamental factors, but because, in forecasting future outcomes, participants must cope with ever-imperfect knowledge about how to interpret trends in fundamental factors.” (p. 120)

Excessive swings in key asset markets, even if not driven by a herding instinct as is generally believed, are nevertheless obviously damaging to the economy. They “are associated with distorted relative prices and misallocation of financial capital” (p. 222) and can lead to financial crises. Therefore, excessive (and only excessive) swings should be dampened by regulators. The authors suggest some criteria for defining excess and some steps that policymakers could take.

Throughout the book as the authors take on proponents of the rational expectations hypothesis (who, they contend, are not all that different from the old socialist planners) and the efficient market hypothesis as well as the fabulists who view price swings as bubbles, they invoke the ghost of John Maynard Keynes. They offer a nuanced reinterpretation of some of his key ideas in support of their own.

And what is their central position? “Imperfect Knowledge Economics stakes out an intermediate position between erratic animal spirits and the contemporary presumption that change and its consequences can be adequately prespecified with mechanical rules. In contrast to the contemporary approach, the mathematical models of Imperfect Knowledge Economics explore the possibility that change and its consequences can be portrayed with qualitative and contingent conditions. These conditions are context-dependent, and … the qualitative regularities that they formalize become manifest—or cease to be relevant—at moments that no one can fully predict.” (pp. 253-54)

Beyond Mechanical Markets is a thoughtful book with an admittedly modest premise. I suspect that increasing numbers of macroeconomists and financial thinkers will start to build on some of their ideas as they struggle to make their models relevant to the real world.

Tuesday, March 8, 2011

Leeds, Invest in Penny Stocks

I have always shied away from buying penny stocks, although admittedly on occasion I have sold penny stocks. Oops! So I thought that Peter Leeds’s Invest in Penny Stocks: A Guide to Profitable Trading (Wiley, 2011) might expand my horizons. Unfortunately it only reinforced my image of the penny stock world. Leeds uses this book as an extended advertisement for his stock picking newsletter. Although he claims that he and his team take no compensation from companies they promote, have no vested interest in their picks, and offer a money-back guarantee—in brief, they aren’t penny stock sleazes, the self-promotion in this book is obvious. The author’s photo even graces the dust jacket.

The method the team uses to sort through investing possibilities is called, of course, Leeds Analysis. It has, the author states, “rapidly become the standard in penny stock research.” (p. 33) It is a mix of 80% fundamental analysis, 10% technical analysis, and 10% “third level analysis” such as branding, employee poaching, and the habits and personal life of top management. In brief, it crunches the numbers, looks at the charts, and adds qualitative analysis. As described, it is an exhaustive (and exhausting) process that few individual investors would want to undertake. How much easier just to subscribe to the newsletter—and then, as the author constantly stresses, perform your own due diligence. (The stock pickers don’t let you off the hook that easily.)

It’s too bad that this book hypes a service so mercilessly because, in fact, it’s quite a decent overview of stock screening procedures that can be used for selecting stocks in any price range.

Monday, March 7, 2011

Brandt, Diary of a Professional Commodity Trader

Peter L. Brandt is a seasoned, wildly successful commodity and foreign exchange trader; over a period of almost twenty years of active trading his prop funds have averaged a 68.1% annual rate of return. In Diary of a Professional Commodity Trader: Lessons from 21 Weeks of Real Trading (Wiley, 2011) he both shares some of his guiding principles and lets the reader look over his shoulder as he plies his craft from December 2009 through April 2010.

Brandt uses high/low/close bar charts as his primary trading (not, he stresses, forecasting) tools. He is for the most part a longer-term discretionary pattern trader who enters on breakouts that meet his stringent requirements. Since he knows that only 30 to 35% of his trades will be profitable over an extended period of time and up to 80% will be unprofitable over a shorter time frame, he is exceedingly cautious about leverage. For instance, his trading assets committed to margin requirements rarely exceed 15%.

In the first two parts of the book Brandt offers the reader a thorough course in identifying and categorizing trading signals, placing initial protective stops and subsequent trailing stops, pyramiding, and taking profits. The course addresses traders at all skill levels. For instance, he describes his own trading plan as simple, but some of its elements require a degree of judgment and sophistication that can only come with extensive practice. One example: “time phasing is a hurdle all traders must clear in order to be consistently successful.” (p. 88)

The third part of the book is Brandt’s five-month trading diary, and it’s a fascinating read. Not only does it describe individual trades but it shows how good traders evolve. Take month four, where the author is in a drawdown period. He writes that he has always known that there were flaws in his trading plan but that “good times provide cover for the deficiencies of a trading plan.” During tough times “markets have a way of exploiting flaws in a trading plan. … The challenge is to find the fundamental flaws, not just to make changes that would have optimized trading during the drawdown phase. … Almost always the changes [the author has made to his own plan] have dealt with trade and risk management, not with trade identification.” (p. 189)

This time was no exception. If anything, it was more intense because of the book project. “Keeping a journal of trades and writing about them forced me to define, examine, and analyze my trading paradigm and algorithm like never before. … I reaffirmed myself in many of my trading practices. In some areas, however, I now believe I have the opportunity to make my trading plan more efficient and effective.” (p. 220)

Brandt’s Diary of a Professional Commodity Trader should be required reading for all traders. And that includes even day traders, whom Brandt considers a doomed breed. There are lots of tidbits that might spice up the reader’s trading plan and improve his bottom line. And, better than any book I have read before, it clearly demonstrates the necessary dialectic between staying true to one’s trading plan and improving upon it. This one’s a keeper!

Sunday, March 6, 2011

Charts for the bears

The folks at The Chart Store keep updating a series of charts on S&P secular cycles adjusted for inflation by the CPI. Or, to be more precise, they update the first (1871 to present) and last (2000 to present) chart in the series of five. The premise is that "there is a good chance that the S&P Composite is in a fourth secular bear market."

Saturday, March 5, 2011

Ray Dalio’s principles

I saw Ray Dalio, founder and CIO of Bridgewater Associates, currently the largest U.S. hedge fund (or, quip, the second largest, behind the Federal Reserve Bank), on CNBC a couple of days ago. I was curious to learn more about him, and a quick Google search offered up a lengthy .pdf file of his principles, subtitled “that might be right or wrong, for you to take or leave.” They are definitely worth a weekend read.

Friday, March 4, 2011

Taulli, All About Short Selling

All About Short Selling: The Easy Way to Get Started by Tom Taulli is the twenty-first title in McGraw-Hill’s “All About” series. Despite the subtitle, the book demonstrates that there is no easy way to get started—or at least no easy way to zero in on winning opportunities. Investors need not go to the extremes of Bill Ackman, who analyzed some 140,000 pages of documents prior to shorting MBIA. Nonetheless, the author acknowledges, “the best short sellers use painstaking research and analysis.” (p. 37)

Taulli adopts a three-pronged approach to analyzing potential shorts. First is fundamental analysis, by which he means looking for opportunities among fads, disruptive activity by new competitors, the transition to commoditization, and failed business models. Consider, for instance, the hit that Blockbuster took when NetFlix became a significant player in the video and DVD market. Or the impact on GPS companies such as Garmin and TomTom when Google developed its own free GPS platform.

Second is accounting, which involves among other things the analysis of a company’s balance sheet, income statement, and cash flows. This is an area where many successful short sellers focus their attention. Admittedly, accounting is complex and often nuanced; even highly reputable companies massage their numbers to paint the most flattering portrait legally possible. And although Taulli spends four chapters on accounting issues, he only scratches the surface of what a savvy short seller would need to know.

Third is technical analysis, which is used not to find viable candidates but to determine entry and exit points in individual positions and to assess general market conditions.
Although many investors limit themselves to the stock market, Taulli looks at alternative techniques, normally requiring less margin, to express a negative hypothesis. For instance, one can short with options, futures, mutual funds, hedge funds, and ETFs. He concludes his survey with a chapter on risk management.

There is a lot of information in this book. For instance, Taulli introduces the reader to the potential pitfalls of spin-offs and tracking stocks. He discusses the multiple manifestations of arbitrage—stat arb, merger arbitrage, and convertible arbitrage. And he explains the complications of a market-neutral portfolio.

A rank beginner would be overwhelmed by this book, but then a rank beginner should never be a short seller. For the investor with some experience, All About Short Selling provides both a good introduction and most likely a long to-do list.

Thursday, March 3, 2011

Walker, Wave Theory for Alternative Investments

Metaphors are tricky little beasts. Used well, they can make prose vivid; used poorly, they can sometimes become intrusive clich├ęs. In the case of Stephen Todd Walker’s Wave Theory for Alternative Investments: Riding the Wave with Hedge Funds, Commodities, and Venture Capital (McGraw-Hill, 2011) the reader often yearns to move inland and be done with waves, surfers, and forced quotations. (Among the most egregious offenders in the quotation department is [on p. 309] the following: “In Herman Melville’s Moby Dick, the author explained that ‘[t]he sea was as a crucible of molten gold, that bubblingly leaps with light and heat.’ One can plainly see waves with the commodity gold.” Poor Melville and his "explanation.")

Although the author pays lip service to Elliott wave theory, his waves are more generic. As he writes, “Wave theory is simply the belief that all securities move in waves (patterns, cycles, or trends).” (p. 3) Few people today would dispute this belief, so we can quickly dispense with any further talk about waves and move directly to the substance of the book—investing in venture capital, commodities, and hedge funds.

The most informative part of the book focuses on venture capital, with which the author was involved in the 1990s when he worked at Alex. Brown. He traces the history of venture capital, highlights some of the principal players, assesses the performance of venture capital, and discusses advantages and disadvantages for investors. One of the disadvantages is the phenomenon of capital calls. A client commits a certain amount of money, say $1 million. But “few funds take all the money up front today. As the venture fund identifies new opportunities, they will call on their investors to put more money into the fund…. Because these calls are random and over long periods (years), it can be burdensome to an investor. Should the investor (for whatever reason) decide not to invest, there are normally severe penalties.” (p. 172)

Traditionally, venture capital exit strategies were limited to IPOs and mergers and acquisitions. “Today, however, there is a third area developing that might make it more difficult for individual investors to participate in private equity or venture capital unless they have $100 million to invest. The third leg of the stool is Rule 144A securities.” (p. 154) These offerings are pre-IPO (PIPO) and trade on private exchanges, primary among them Portal Alliance and SecondMarket.

The second part of the book, commodities, is competent, but it has already been eclipsed by several books devoted specifically to commodities investing. The treatment of hedge funds is more interesting because, in addition to describing the hedge fund market and listing advantages and disadvantages of investing in hedge funds, it appeals to our Forbes-style curiosity. Who are the highest earners (as of October 2008), what are the best-performing funds (as of January 2009)?

Walker’s book is not a core investment library holding. But it is a reasonable place to start for anyone thinking about investing in alternative assets, especially venture capital.

Wednesday, March 2, 2011

Hungarian philosophers under attack

I know that everyone is focused on the Middle East, but I’d like to call attention to a witch hunt that is going on in Hungary against liberal, mostly Jewish philosophers. The 81-year-old Agnes Heller is the designated chief witch. She is deemed a serious intellectual threat to the regime, democratically elected but bent on stifling democracy.

Yesterday she appeared before the European parliament, pressing her case. Here’s the recorded stream.

Tuesday, March 1, 2011

Mansharamani, Boombustology

Vikram Mansharamani’s Boombustology: Spotting Financial Bubbles Before They Burst (Wiley, 2011) is based on a residential college seminar he gave at Yale. As such, it is structured to fit a thirteen (or so)-week semester, with an introduction, twelve chapters, and a conclusion. It presupposes no knowledge of economics or the markets but is directed at quick, foxlike learners. (No hedgehogs need apply.)

The book’s primary thesis is that it is only by adopting a multidisciplinary perspective can we hope to understand boom-bust cycles. The reason is that financial booms and busts are mysteries as opposed to puzzles. Unlike a puzzle, which (to use Malcolm Gladwell’s words) “grows simpler with the addition of each new piece of information, … mysteries require judgment and the assessment of uncertainty.” In trying to understand boom and bust mysteries “we need a framework for connecting the dots in a manner that helps extract insight from the tremendous amounts of information and data that are already available.” (p. 5)

The author describes five lenses through which to view, and identify, bubbles before they burst: microeconomics, macroeconomics, psychology, politics, and biology.

The first offers a model that seeks an ad hoc reconciliation of the efficient market hypothesis with Soros’s doctrine of reflexivity. “Most of the time, efficiency logic works and deviations from equilibria tend to self-correct. However, there are instances in which reflexive dynamics are able to overcome the self-correcting force and creative self-fulfilling extremes.” (p. 22)

The second lens focuses on the impact of debt and deflation on asset markets and prices. The author gives a pedagogically brilliant account of the fates of three sets of homeowners—the Safe Smiths, the Optimistic Osbornes, and the Carefree Carrolls—in happy times and sad times to illustrate the point that “the relationship between debt, collateral (i.e., down payment or equity amount), and asset prices has the potential to create a toxic cocktail that can greatly improve or deteriorate one’s financial condition quite rapidly.” (p. 30) He then attempts to combine the Austrian cycle, Minsky’s financial instability hypothesis, and debt-deflation theory into one theoretical construct, “with debt and its magnifying power as the primary drivers of the cycle.” (p. 42)

The third lens is psychology, primarily the findings of behavioral economics that unearth our consistently nonrational biases. Fourth, the author tackles the problem of distortions that occur as a result of government decisions regarding private property rights, price floors and ceilings (e.g., minimum wage and rent control), and tax policy (e.g., the mortgage-interest deduction). The fifth lens is in effect a bifocal biological lens, an epidemic lens and an emergence lens (as in swarm intelligence or uninformed consensus).

The author uses these five lenses in concert to demonstrate how observers might have been able to identify past bubbles before they burst. The bubbles in question are tulipomania, the Great Depression, the Japanese boom and bust, the Asian financial crisis, and the U.S. housing boom and bust.

One intriguing point, seen through the lens of macroeconomics, is that financial innovation was involved in each case. Consider the purchase of tulip bulbs in seventeenth-century Holland. “Physical tulip bulbs could only be uprooted and exchanged between May and September. To accommodate the need for speculators to trade these bulbs throughout the year, contracts were developed and notarized for purchasers to commit to buying (and sellers to commit to selling) bulbs at an arranged price at the end of the growing season. Because these futures contracts did not require full payment, they effectively enabled purchasers to obtain economic and financial exposure to tulip prices with leverage.” (p. 105) But regulators went a step further, in effect converting futures contracts into option contracts and thereby creating “asymmetric reward for limited risk.” (p. 108) Apparently this regulatory change accounted for the massive surge in prices; when several months later the regulators opted to return to the futures-contract structure the bust followed.

Mansharamani has developed a compelling set of analytical tools that seem to work well in retrospect. But will they have predictive power? The author is loath to go that far. Nevertheless, the book ends with an evaluation of a possible bubble in the Chinese economy.

Boombustology is an enjoyable, well organized read. Critics might consider it superficial in places; it is certainly not on the level of This Time Is Different. But, with all due respect to Reinhart and Rogoff, I’d rather take an undergraduate course based on Mansharamani’s book.