Friday, February 28, 2014

Clark, The Son Also Rises

Social mobility, or the lack thereof, has been a hot topic of late. James Surowiecki summarized the recent findings of a team of American economists in a recent New Yorker column: economic mobility has remained “relatively stable” and depressingly low “over the entire second half of the twentieth century. … What the political scientist Michael Harrington wrote back in 1962 is still true: most people who are poor are poor because ‘they made the mistake of being born to the wrong parents.’”

Gregory Clark and his team of researchers worked on a larger canvas both historically and geographically in The Son Also Rises: Surnames and the History of Social Mobility (Princeton University Press, 2014). They used surnames to track the rich and poor through many generations in various societies. They analyzed mobility not only in the American “land of opportunity” and in egalitarian Sweden but in medieval England. They studied caste and endogamy in India, mobility after Mao in China and Taiwan, social homogeneity and mobility in Japan and Korea, mobility among the oligarchs in Chile, and mobility among various religious and ethnic groups (Protestants, Jews, Gypsies, Muslims, and Copts).

The book’s claim is that “social status is inherited as strongly as any biological trait, such as height.” Consequently, even though counterintuitively, “the arrival of free public education in the late nineteenth century and the reduction of nepotism in government, education, and private firms have not increased social mobility. Nor is there any sign that modern economic growth has done so. The expansion of the franchise to ever-larger groups in the nineteenth and twentieth centuries has had no effect. Even the redistributive taxation introduced in the twentieth century in countries like the United States, the United Kingdom, and Sweden seemingly has had no impact.” (pp. 9-10)

In light of these findings, those who want the best possible outcomes for their children should not worry so much about getting their kids into the right schools and providing them with all kinds of social perks. Rather, they should choose the best possible mate. This involves looking beyond a prospective partner’s social phenotype (achieved education, occupational status, health, etc.); after all, some high achievers got there through sheer dumb luck, sometimes even fraud. “To discover the likely underlying social genotype of your potential partner, you need to observe not just their characteristics but also the characteristics of all their relatives. … The point here is not that any of these relatives will contribute anything directly to the social and economic success of your child. … But the social status of the relatives indicates the likely underlying social status of your potential mate.” (p. 283)

This thesis is supported by looking at endogamous marriage within elite groups and low-status groups. “When marriage is endogamous within an elite group … high status can be maintained forever. Witness the Brahmin class in Bengal, or the Copts of Egypt. Conversely, endogamous marriage can condemn low-status groups such as the Muslims of West Bengal to perpetual deprivation.” (p. 282) “Since Coptic surnames are those that stand out … as the highest-status group in the United States, all else being equal, if you want high-status offspring, find yourself a partner named Girgis, Boutros, or Shenouda. Chinese and black African surnames also stand out as particularly high status. So again, all else being equal, choose Chen over Churchill, Okafer over Olson.” (p. 285) Or, given a choice between two equally highly educated possible marriage partners, one of Ashkenazi Jewish background and the other of New France descent, select the Jewish partner.

The author’s thesis, it should be stressed, applies only to low social mobility, not to inequality. In fact, he argues that “if low social mobility rates really are a law of nature, … then we should spend less time worrying about them and instead worry about the institutions that determine the degree of inequality in social and economic outcomes” such as a country’s tax system and its public interventions in education and health care.

Lots to ponder in this controversial book.

Wednesday, February 26, 2014

Rhoads, Trading Weekly Options

Weekly options have become popular trading vehicles for both hedgers and speculators. By late 2012, the last year for which annual market statistics are currently available, weekly SPX options accounted for over 20% of average daily volume. But weekly options are not simply monthlies divided by four. Instead, the trader is always navigating expiration week, which can be as unforgiving as it can be profitable.

In Trading Weekly Options: Pricing Characteristics and Short-Term Trading Strategies (Wiley, 2014) Russell Rhoads, an instructor for the Options Institute at the CBOE, offers an overview of ways to trade these short-dated derivatives. The general principles and strategies should be familiar to any reader with a basic understanding of options, but Rhoads tweaks them to accommodate a weekly setting.

After some introductory chapters Rhoads offers a straightforward discussion of time decay and implied volatility. He then turns to what makes up the bulk of the book—strategies. He describes long option trades, short option trades, covered calls and buy-writes, hedging with short-dated options, bullish spread trading, bearish spread trading, neutral spread trading, split strike long spreads, calendar spreads, diagonal spreads, and trading earnings releases. He wraps up the book with brief chapters on leveraged ETFs and VIX-related ETFs and ETNs.

To get a sense of the level of Rhoads’s analyses, let’s look at a single strategy—the iron butterfly. Rhoads describes two trades in GLD, one with three days until expiration and the other with one day until expiration. The rationale for structuring a short-term trade as an iron butterfly is that “iron butterflies are very precise as far as the price target. Also, since they are often short at-the-money options the position will benefit from at-the-money time decay. Because of the precision needed to make close to the maximum profit iron butterflies are good candidates for very short-term trades—even for trades that last a single day.” (p. 152) The one-day trade can have a narrower or wider payout range (in his example, 123/124/125 versus 122/124/126). “The choice between the two iron butterfly spreads may come down to the certainty that GLD is going to stay in a narrow range the following day and finish the trading day near 124.00. The dollar risk-reward favors the 123/124/125 spread where 0.68 may be made or 0.32 lost, while the 122/124/126 iron butterfly would pay out 1.02 or lose 0.98, depending on the price change in GLD. The choice may also be based on historical price moves from GLD and the current implied volatility relative to expectations.” (pp. 156-57)

As should be evident from this example, Rhoads is writing for the relative novice (and presumably for the novice who hasn’t yet learned that nothing is certain in the financial markets). The reader who is looking for a more advanced, sophisticated discussion will have to turn elsewhere.

The book comes with access to an online video course in four modules: introduction to the course, introduction to weekly options, trading earnings announcements, and index option trading strategies.

Monday, February 24, 2014

Baker and Ricciardi, Investor Behavior

Investor Behavior: The Psychology of Financial Planning and Investing, edited by H. Kent Baker and Victor Ricciardi (Wiley, 2014), goes beyond the standard literature on behavioral finance. In over 600 pages and 30 chapters the contributors write about everything from demographic and socioeconomic factors of investors to financial therapy, from money and happiness to the surprising real world of traders’ psychology.

The book is divided into six parts: foundations of investor behavior, personal finance issues, financial planning concepts, investor psychology, trading and investing psychology and strategies, and special investment topics.

For this post I’m going to focus on a single paper, “Human Psychology and Market Seasonality,” by Lisa A. Kramer, associate professor of finance at the University of Toronto. It is a survey of research findings (incorporate them into your trading at your own peril) on links between seasonal factors and market performance. For instance, “the cloudier the weather is in the city of the exchange (relative to seasonal weather norms), the more negative is the impact on returns for that exchange.” (p. 367)

Following up on several studies showing that depressed people are more averse to risk, researchers tested hypotheses linking seasonality of moods and seasonality in markets. A 2003 study hypothesized that “if diminished length of day in the autumn causes investors’ risk aversion to increase, those investors become less inclined to hold risky stocks. … Following winter solstice, as the length of day starts to increase, investors would begin recovering from their depression and would become more willing to hold risky assets, at which time stock prices and returns would be positively influenced.” (p. 368) A later study, “after controlling for standard stock return regularities,” found “significant evidence of seasonal variation in returns consistent with seasonally varying investor risk aversion that arises due to seasonal depression. The patterns are more prominent in stock markets at extreme latitudes, such as Sweden, where the seasonal fluctuations in daylight are more extreme. Furthermore, both the seasonal patterns and the seasons are six months out of sync in southern hemisphere markets such as Australia.” (pp. 369-70)

Yet another study looked at analyst earnings forecasts and found that analyst optimism “decreases during the months when seasonal depression is commonly observed.” (p. 371) Even IPO prices seem to come under the spell of seasonality. Of more than 4,000 issues of which just under half occurred in the fall and winter, there was “significantly more IPO underpricing in the fall and winter seasons compared to the rest of the year.” (p. 371)

Even daylight saving time changes seem to affect the markets. A study looking at stock index returns from Canada, the U.S., Germany, and the U.K. found “significantly negative returns on the trading day that immediately follows the time change, both in the spring and in the fall. This finding is consistent with the possibility that investors become more averse to financial risk when their routine sleep habits are disturbed by the daylight saving time change.” (p. 373) Weekend sleep disruption may also account for the generally negative Monday results.

And not only does weekend sleep disruption have a negative effect on Monday market returns. It seems that “stock returns are lower on the Monday immediately following high attendance at comedy movies” since “individuals in a good mood are more likely to be cautious.” (p. 376) This finding would seem to contradict the association between negative mood states and negative daily stock returns, but I assume some fine tuning and psychological wizardry could reconcile these findings.

I’m being very unfair to the breadth of Investor Behavior by writing about only one article, and a controversial one at that. (Perhaps unfairness correlates with depth of snow and persistence of storms.) The book contains a wealth of information supported by academic studies that should be of interest to the intellectually curious investor.

Thursday, February 20, 2014

Gerken, The Little Book of Venture Capital Investing

Despite its “miniature” size, Louis C. Gerken’s The Little Book of Venture Capital Investing: Empowering Economic Growth and Investment Portfolios (Wiley, 2014) covers a lot of ground.

Gerken opens with a brief but scathing critique of the Occupy Wall Street movement, arguing that “if it wasn’t for capitalism,” and venture capitalists in particular, “none of the resources they had relied on to fuel their righteous indignation would even exist.” (p. xiii) In fact, as he contends later, “Venture capital investment has been almost singlehandedly responsible for delivering huge productivity gains to the U.S. economy by way of financing new information, communication technologies, and innovations.” (p. 52)

The text proper is divided into nine chapters encompassing a historical overview of venture capitalism, the VC industry today, the value proposition, the prevailing investment climate, VC investment options (both listed and nonlisted), and the investment process (sourcing and screening, due diligence and selection, and portfolio construction, monitoring, and monetizing).

Gerken is writing for the investor who wants exposure to venture capital. It is not enough, of course, for the individual investor to know the investment options that are (and some that may become) widely available. Whether he wants to invest in a publicly traded fund or to get involved at the grassroots (via crowdfunding, for instance), he has to understand how venture capital works.

For starters, venture funding is no guarantee of success. In fact, a study showed that “of 2,000 companies that received venture funding between 2004 and 2010, about 75 percent of them failed to have a successful exit.” (p. 193) (That’s even worse than restaurants do, at least according to a research study of Columbus, Ohio restaurants published in the Cornell Hotel and Restaurant Administration Quarterly in 2005. Admittedly, I’m comparing apples and oranges here since—among other things—a successful exit often means an acquisition, but during the first year of operation slightly over one-quarter of all restaurants closed or changed ownership; by the end of their third year, just short of 60% of all restaurants closed or changed ownership.)

Gerken offers the reader a host of web resources. These tools, coupled with the valuable information he provides in his own analysis, are excellent ways to research the viability of becoming a venture capital investor.

Tuesday, February 18, 2014

Karabell, The Leading Indicators

Traders and investors wait with bated breath for the release of key economic statistics. How fast is the economy growing? What is the unemployment rate? Is inflation (or worse, deflation) in check? What about the trade balance? How is the consumer feeling? Zachary Karabell, currently president of River Twice Research (named with a nod to Heraclitus), explains how these statistics were developed, what purposes they were designed to serve, and some of the ways in which they fall short. The Leading Indicators: A Short History of the Numbers That Rule Our World (Simon & Schuster, 2014) is a quick but often enlightening read.

Consider, for instance, the nonfarm payrolls number. “Until the nineteenth century, the concept of unemployment was alien. Most people didn’t earn a wage; they did not have ‘jobs.’ They farmed, or traded, or served, or fought. Some were artisans or blacksmiths or stevedores, but most worked the land to nurse food out of stubborn soil. Factories were small, with a few dozen workers. There were mines here and there, and, of course, servants. But there was no framework of employment versus unemployment, only of want versus plenty, hard work versus idleness, good times versus bad.” (p. 27) And “well until the end of the nineteenth century, people without work were indicted as lazy and degenerate.” (p. 28) It was certainly not the role of government to help those able-bodied men who couldn’t support themselves and their families.

The Great Depression changed all that. The Hoover administration started collecting data on how many people lost their jobs between 1930 and 1932. And during Roosevelt’s tenure the unemployment rate was born. “Of course,” Karabell writes, “it was only the birth, because the government would not start compiling an actual number until the 1950s.” (p. 42)

If the Great Depression focused attention on unemployment, “the next great global cataclysm, World War II,” catapulted the “wonky and academic” GNP figure “to the center of public policy.” (p. 68) And “because of a felicitous convergence of the marketing of the American dream in the 1950s and the demands of the United Nations that new countries measure their economies, GNP and then GDP became the litmus of economies everywhere. As Americans competed to prove that their system of free-market capitalism was superior to the Soviet system of state-driven Communism, GDP became even more important to national prestige and global image.” (pp. 50-51)

GDP is an intrinsically flawed number, but its flaws are nothing in comparison to those of the trade balance. The author argues that “it is possible that if trade numbers measured more accurately how products are made, there would be no [US] trade deficit with China.” (p. 170) According to the current rules of origin, “a product is assigned to the country where that product has undergone its final and ‘substantial transformation.’” Each product thus has a single country of origin. The iPhone “acquires its ‘substantial transformation’ in China and, hence, shows up as a US import from China. In fact, every iPhone that is sold in the United States adds $229 to the US-China trade deficit, and each iPad adds $275, at least according to the calculations of three economists who looked at the issue in 2010. That means that by 2013, Apple’s sales of the iPhone in the United States had added as much as $4 billion to the trade deficit with China every year.” (p. 172)

Karabell, as should be evident from these snippets, translates econ-speak into language that the layman can understand and appreciate. He gives historical context to economic indicators even as he points out their limitations, especially their state-centric nature (the fact that in a global economy “almost all indicators are based on the idea that an economy is a closed system with physical boundaries that define a nation-state” [p. 79]). The Leading Indicators is a thought-provoking read. I thoroughly enjoyed it.

Wednesday, February 12, 2014

Fung, Ko, & Yau, Dim Sum Bonds

Let’s start with a definition. Dim sum bonds are, as the subtitle says, “the offshore renminbi (RMB)-denominated bonds.” Since 2007 they have been issued in Hong Kong and, as such, are available to investors worldwide. Dim Sum Bonds, coauthored by Hung-Gay Fung, Glenn Ko, and Jot Yau (Wiley, 2014), offers a “panoramic view of [this] bond market that has played a pivotal role in China’s grand scheme of making the RMB a global reserve currency.” (p. xii) The offshore RMB market also serves two other major goals of the Chinese government: to “control smooth cross-border capital flows to China so as to harness the inflation in mainland China” and to tap foreign capital. (p. 4)

The RMB bond market serves not only the Chinese government and Chinese financial institutions. Foreign firms operating in China who need RMB funding “can raise longer maturity RMB funding through the dim sum bond market instead of relying on shorter-term borrowings from Chinese banks.” (p. 18) The first foreign company to take advantage of the RMB bond market was McDonald’s; since then Caterpillar, Ford, Unilever, BSH Bosch, and Siemens have also issued bonds. Foreign corporations account for 6.15% of the total number of issues and 8.84% of the total RMB amount. They are, as one might suspect, dwarfed by banks (predominantly Chinese), which make up just over 50% of the total RMB amount.

Who invests in the nascent dim sum bond market? The major holders are investors based in Asia, but the authors predict that interest in this market will become more global. It’s too early to say whether dim sum bonds can be considered an asset class and whether they play an efficient diversification role in portfolios. Between 2011 and 2013 the Bank of China (Hong Kong) Dim Sum Bond Index showed relatively low or, in a few cases, negative correlations with other assets such as the JPM Global Aggregate Bond Index and Barclays U.S. Aggregate Bond Index, the Nikkei 225 in equities, and the Japanese yen, Brazilian real, and British pound sterling in exchange rates.

Even though individual investors are unlikely to buy dim sum bonds in the near future, this book is still worth reading. It sheds light on Chinese currency issues as well as on Asian investor sentiment. And it is vital for anyone who wants to know more about the offshore RMB bond market.

Monday, February 10, 2014

Horan, Johnson, & Robinson, Strategic Value Investing

The three authors of Strategic Value Investing: Practical Techniques of Leading Value Investors (McGraw-Hill, 2014)—Stephen M. Horan, Robert R. Johnson, and Thomas R. Robinson—are all Ph.D.s with ties to the CFA Institute. Their credentials shine through in this cogent, comprehensive book.

The authors advocate strategic value investing, where by “strategic” they mean “being thoughtful about the characteristics of a particular security rather than blindly applying some sort of trading or classification rule.” (p. 21) There are no magic formulas to successful strategic value investing. Each investor has to find his own style, do his own leg work, and remain patient and disciplined.

The book is divided into three sections—introduction, measuring value, and value investing styles and applications. In the section on measuring value the authors discuss concepts of value, dividend discount models, free cash flow models, asset-based approaches, residual income models, and relative valuation. The most interesting section, at least for someone with a grasp of the principles of value investing, is the third. There the authors address value investing styles, choosing the right style and valuation model, distressed investing, and applying value investing to the market.

They introduce the chapter on value investing styles with an apt quotation from Christopher H. Browne: “Value stocks are about as exciting as watching grass grow. But have you ever noticed how much your grass grows in a week?” (p. 227) Here they examine the styles of nine noted value investors—Benjamin Graham, Warren Buffett, Seth Klarman, Bill Ruane, John Neff, Tweedy Browne Company, Wally Weitz, Charles Brandes, and Bill Miller. Bill Miller is presented as a “cautionary tale”: “Confidence is a positive quality in an investment manager. On the other hand, overconfidence can be lethal. Value investors often see falling prices as buying opportunities. If you like the stock at $30 per share, then you should love it at $20 per share. Miller underestimated the depth of the financial crisis and kept purchasing shares of financial stocks as prices continued to weaken. This overconfidence was exemplified by his remark that ‘the only way he would stop buying more when a stock’s price fell was when we can no longer get a quote.’” (p. 243)

Although, over time, value stocks outperform growth stocks and small stocks outperform large stocks, the authors point out one major downside to value investing—that “value stocks tend to have greater variability in returns than growth stocks, and small stocks have greater variability in returns than large stocks.” (p. 250) Value investors therefore have to decide how much volatility they can tolerate in their portfolio at every stage of their investing career.

Wednesday, February 5, 2014

Halsey, Trading the Measured Move

David Halsey throws out the old notion of a measured move: that you copy an AB move up (or down) and paste it on a retracement low (or high) of C to get your price target D. In Trading the Measured Move: A Path to Trading Success in a World of Algos and High Frequency Trading (Wiley, 2014) he substitutes Fibonacci levels.

He uses three trade setups: the traditional 50% retracement measured move (MM), the extension 50% MM, and the 61.8% failure. When a trade is entered, its target is 123% from a swing high or low (and sometimes from a breakout) that is followed by a retracement (50% in the traditional setup). That is, the target is AB + 23%. Halsey shows both successful and failed MM trades on charts—unfortunately usually grey bars on a black background, which makes them hard to decipher.

The measured move trade setups are not stand-alones. Halsey discusses the use of multiple time frames, seasonality, NYSE tools, tick extremes and divergences, and gaps. He also discusses how to manage positions and take profits, advanced (actually, pretty basic) risk management, trading psychology, and having a trading plan and journal.

The virtue of this book is that it touches on almost everything a short-term trader needs to consider when devising a trading plan. Some things will eventually be discarded, others will be tweaked. And even though Fibonacci levels are not necessarily the best ways to organize price data, they do bring some order, real or imaginary, to price fluctuations.

Trading the Measured Move can be supplemented with educational videos on the author’s website,, although much of the material there is for members only.

Monday, February 3, 2014

Roose, Young Money

You’re a college student with a yen to go to Wall Street and become a master of the universe. Well, you might want to rethink your dream. In Young Money: Inside the Hidden World of Wall Street’s Post-Crash Recruits (forthcoming, Grand Central Publishing, 2014) Kevin Roose profiles eight of the seemingly lucky ones. Most of them got two-year contracts as analysts in the investment banking divisions of major Wall Street firms. Although they knew the work would be demanding, they started off full of excitement and determination. Soon enough reality set in.

The problem wasn’t simply the long hours first-year analysts are expected to put in. It was the lack of control of the hours. “At-will scheduling is the bane of the young analyst’s existence. It means that every evening activity is subject to last-minute cancellations, that stress-free vacations and personal trips out of town are impossible, and that work-issued phones function as permanent third limbs.” (p. 40) Why the hundred-plus hour weeks of on-call work? They are, people told Roose, “one half of a grand, unspoken social contract that had existed on Wall Street for decades. As part of the basic bargain, analysts were asked to demonstrate full loyalty to the firm by becoming a slave to its demands. In order to fully belong, the first-year analyst had to realign his priorities, replacing his own with his bank’s. And seen in this light, all the young banker’s cancelled dinners and broken relationships aren’t just unpleasant externalities—they were central to the process.” (p. 107)*

Another problem the young recruits faced was that “Wall Street … makes its workers feel expendable; many entry-level bankers conceive of themselves as lumps of flesh who perform uncreative and menial work. “ (p. 43) They are nothing like those senior investment bankers described in the 1976 book The Financiers who have lavish offices and dress in expensive suits and who are the “richest wage earners in the world.” Today the offices of the young bank analysts “are covered in moldy takeout containers and pit-stained undershirts. They dress in whatever is left in the clean laundry bag from last week, and haven’t seen sunlight in two months. They make pitch books for clients who will never read them, and get yelled at for improperly aligning cells in Excel, all in hopes of a year-end bonus number that won’t make them want to jump in front of the 4 train. They are the young investment bankers of Wall Street, and they just want some sleep.” (pp. 43-44)

Some of these young analysts became almost morbidly depressed. One coped with the help of a countdown clock which he set for 336 days—the amount of time between the day that his equally miserable Goldman friend gave him the clock and when he estimated the following year’s bonuses would be paid. Although he might not be able to handle an entire career at Goldman, he figured he could make it through 336 days.

In some cases the unhappy analysts plotted their escape to ostensibly greener pastures, like Silicon Valley. In other cases they failed to make the grade and got their walking papers after their two-year stint. Still others decided to tough it out and remain in finance. In fact, according to one headhunter, “only 10 percent of young Wall Street workers ever leave to work in a completely different industry.” (p. 225)

Roose’s book focuses on the toll that Wall Street took on these young financiers. Over the three years that he tracked them, they changed in troubling ways. “I’d seen most of them become less happy and optimistic, more cynical and calculating. They were slower to smile and quicker to criticize. Many of them began to talk about the world in a transactional, economized way. Their worlds started to look like giant balance sheets, their appetite for adventure waned, and they viewed unfamiliar situations through the cautious lens of cost/benefit analysis. … There is, in other words, an enormous cost associated with our nation’s long-standing practice of sending huge numbers of our most promising college graduates into finance. These financiers form an elite class that will go on to become influential in the top ranks of government, technology, and culture. And if they all share the experience of having spent their formative years working as entry-level bank analysts, performing and internalizing the ethos of the financial sector, it means that, in a way, we’ve allowed Wall Street’s culture to enter our national bloodstream. It’s the consequences of that cultural contagion—and the genuine misery I saw Wall Street inflict on so many young people—that makes me glad that the financial sector is smaller and less dominant now than it was before the crisis.” (p. 234)

*James Surowiecki, in his January 27 “financial page” for The New Yorker, addresses the changing cult of overwork. He writes: “Grinding out hundred-hour weeks for years helps bankers think of themselves as tougher and more dedicated than everyone else. And working fifteen hours a day doesn’t just demonstrate your commitment to a company; it also reinforces that commitment. Over time, the simple fact that you work so much becomes proof that the job is worthwhile, and being in the office day and night becomes a kind of permanent initiation ritual. The challenge for Wall Street is: can it still get bankers to run with the pack if it stops treating them like dogs?”