Wednesday, August 27, 2014

Brooks, Once in Golconda

John Brooks (1920-1993), a financial journalist best known for his contributions to the New Yorker, was also the author of ten nonfiction books on business and finance. The three most famous were Business Adventures, The Go-Go Years, and Once in Golconda. Open Road Integrated Media is reissuing all three books this year.

The title of Brooks’s 1969 book, Once in Golconda: A True Drama of Wall Street 1920-1938, needs some explanation. “Golconda, now a ruin, was a city in southeastern India where, according to legend, everyone who passed through got rich. A similar legend attached to Wall Street between the wars.”

Brooks is a captivating writer who is adept at both setting the stage and portraying some of the leading actors. He can also step back to poke fun at the entire drama. For instance, in addressing the issue of speculation, he quotes the British sociologist Elias Canetti who “has a rather more engaging and original explanation” for the urge to speculate than the normal reply that “it is rooted in human venturesomeness, acquisitiveness, and love of risk for its own sake.” Canetti suggests that “the essence of trading is the giving of one object in exchange for another. The one hand tenaciously holds on to the object with which it seeks to tempt the stranger. The other hand is stretched out in demand towards the second object, which it seeks to have in exchange for its own. As soon as it touches this, the first hand lets go of the object; but not before, or it may lose both…. The trader remains on his guard during the whole transaction, and scrutinizes every movement of his opposite number. The profound and universal pleasure men take in trading is thus partly explained by the fact that trade is a translation into non-physical terms of one of the oldest movement patterns. In nothing else today is man so near the apes.” (p. 69)

Brooks continues: “In Wall Street in the later 1920s, where speculation in stocks reached a degree of intensity and subtlety and an extent of public participation probably not matched anywhere before or since, it is doubtful that it occurred to any of the speculators that they were recapitulating the movement patterns of their subhuman ancestors swinging from tree to tree. Nor did this occur to the explainers and defenders of speculative activity. On the contrary, these explainers and defenders, led by the authorities of the New York Stock Exchange, emphasized as lyrically as their gifts would allow, the creative, human, even almost superhuman accomplishments of speculation and speculators.” Princeton economist Joseph Stagg Lawrence went so far as to make the (fortunately hedged) claim that “it is probable that upon this stage [the NYSE] can be discovered the aristocracy of American intelligence.” (p. 70)

Fed policy was impotent to stem the tide of speculation. In 1928 “it progressively reversed its easy-money policy. In three steps it raised the discount rate from 3.5 to 5 percent; at the same time bank reserves available for lending were reduced by Federal Reserve sales of government securities on an unprecedented scale. At the beginning of the year the Fed held $616 million in such securities …; a little more than a year later, in the early part of 1929, constant and vigorous selling had reduced the portfolio to below $150 million.” (p. 98)

“The effects of the new Fed policy began to be felt in the second half of 1928 and were to be felt in full force early in 1929. Nationwide, interest rates rose and the classic concomitants of dear money followed: building construction fell off, the borrowings of state and local governments were postponed, small businesses starved for the want of new funds. And meanwhile stock speculation—the chief target of the policy—went its merry way as if harassed by nothing more than a persistent mosquito. … In short, the new Fed policy was an instant and spectacular failure.” (p. 99)

New York bankers thrived in this environment. They could borrow from the Federal Reserve at 5 percent and lend to speculators at 10 or 12 percent. “[B]oth transactions were cut and dried, requiring no business initiative and involving practically no risk, and although starting in early February [1929] the Federal Reserve Board officially disapproved of the practice, it continued to be done. Bankers, like royalty in a constitutional monarchy, were in the position of being handsomely paid simply for existing. A plum tree had been grown, tended, and brought to fruit just for their shaking.” (p. 100) The Fed might announce that “the Federal Reserve Act does not … contemplate the use of the resources of the Federal Reserve System for the creation or extension of speculative credit” (or, as Brooks paraphrases, “please don’t shake the plum tree any more for a while”), but this prohibition was unenforceable. Speculation continued apace.

The central character in Brooks’s book is Richard H. Whitney, who went from Wall Street hero to Sing Sing inmate. He was a hero on October 25, 1929, when the panic was at its height: “the Morgan broker strode to the post where U.S. Steel was traded and placed the most celebrated single order in Stock Exchange history—a bid for 10,000 shares at 205, the price of the last previous sale, although the stock was actually being offered at that moment at well below 200…. He then matched this grandly uneconomic gesture by proceeding to various other posts on the floor and placing similar orders for other blue-chip stocks—each in huge quantity, each at the price of the last previous sale. Within a few minutes his orders aggregated more than twenty million dollars, and everyone knew that the bankers’ consortium was in action and that Richard Whitney was its floor man.” (pp. 123-24)

But Whitney himself sustained considerable speculative losses, and even his vast borrowings (“well in excess of five million dollars” in early 1938) were insufficient to allow him to stay afloat and maintain his extravagant lifestyle. He resorted to embezzlement. In 1926 (although it wasn’t known until more than a decade later) this future president of the NYSE embezzled from the New York Stock Exchange Gratuity Fund, entrusted to his care. He later stole money from the New York Yacht Club and his father-in-law’s estate.

His misdeeds uncovered, he pled guilty, reading a mea culpa “in a firm, clear voice—almost with a certain joy.” Before sentencing, he was examined by the court’s psychiatric clinic and its probation officer. “The psychiatric clinic found his reactions to be ‘urbane and sportsmanlike,’” and the probation officer wrote: “Contributing factors in his delinquency are pride, obstinacy, unshakable belief in his own financial judgment, and a gambling instinct…. Egotistical to a marked degree, it was apparently inconceivable that he, a figure of national prominence in financial circles and one whose judgment in economic matters was considered that of an expert, should prove a personal failure.” (p. 262)

Monday, August 25, 2014

Dutton & McNab, The Good Psychopath’s Guide to Success

According to a controversial 2011 study by researchers at the University of St. Gallen, traders are more reckless and more manipulative than psychopaths. The traders in the study were intent on getting more than their opponents; in fact, “they spent a lot of energy trying to damage their opponents.” They behaved as though their neighbor had the same car, “and they took after it with a baseball bat so they could look better themselves.”

I suppose Kevin Dutton and Andy McNab would characterize these traders as bad psychopaths. They possess some character traits that could propel them to great profits, but if left unchecked these traits may lead to financial implosion instead.

The Good Psychopath’s Guide to Success: How to use your inner psychopath to get the most out of life (Apostrophe Books, 2014) is co-authored by a (good) psychopath and a psychologist. McNab is an SAS (British Special Air Service) legend who, as he himself claims, is “considered to be one of the top thirty writers of all time”—I assume by someone whose education was tragically cut short. Dutton, a research fellow at Oxford, has spent a lifetime studying psychopaths. The book, reflecting the penchants of the authors, illustrates self-help principles with rough and tumble adventure tales.

A psychopath has a distinct subset of personality characteristics, including ruthlessness, fearlessness, impulsivity, self-confidence, focus, coolness under pressure, mental toughness, charm, charisma, reduced empathy, and a lack of conscience. Depending on how these traits are dialed up, down, or omitted, the psychopath can be either good or bad.

I’m not going to try to construct a profile of the ideal trader (who presumably would be a good psychopath) using the book’s guidelines. Instead, let me give two examples of how a good psychopath would proceed.

The first, actually a negative example, comes from a London cabbie. Asked how business was, especially since it was a beautiful day and lots of people were about, he replied: “The sun brings them out all right. But no one wants to take a cab in this weather. All they want to do is sit about in parks and get pissed. I wanted to watch the football tonight but instead I’ll probably be working now. I have to make £200 a day just to cover the cost of hiring this thing. Then there’s the diesel on top of that. Give me the rain and the cold any day of the week. Once I’ve reached my quota I can knock off early.”

As McNab pointed out, the cabbie has things the wrong way round. “If it was me I’d be working my bollocks off on the good days and knocking off early on the bad days instead. Think about it. If you’re going to knock off early, why do it on a day when you’re coining it right, left and centre? It’s madness! On a day like that you should keep your foot on the gas and maximize your profits, surely? On the other hand, it actually makes sense to knock off early on a slow day because not only is your profit margin going to be jack shit anyway, you’ll be conserving energy for your next shift—which could turn out to be a good ’un.”

The second example comes from a study of how we make financial decisions. “The study took the form of a gambling game consisting of twenty rounds. At the beginning of the game each participant was handed a roll of $20 bills and, at the start of each new round, was asked whether they were prepared to risk the princely sum of $1 on the toss of a coin. A loss incurred the penalty of that $1 invested, but a win swelled the coffers by a cool $2.50. Now, it doesn’t take a genius to work out the winning formula. Logically, … the right thing to do is to invest in every round.”

The study participants were divided into two groups. One group had lesions to the emotion areas of their brains; the other had lesions in other areas. Predictably, “as the game unfolded, ‘normal’ participants began declining the opportunity to gamble, preferring instead to conserve their winnings. But participants with problems in their brains’ emotion neighbourhoods—participants whose brains were not equipped with the bobby-on-the-beat, everyday emotional police force that the rest of us take for granted—kept right on going. And ended the game doing quite a bit better than their thriftier, more cautious competitors.” As one of the researchers claims, “This may be the first study that documents a situation in which people with brain damage make better financial decisions than normal people.”

Wednesday, August 20, 2014

Brooks, The Go-Go Years

It is fitting that Michael Lewis wrote the foreword to an earlier reissue of John Brooks’s 1973 book The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s (just republished by Open Road Integrated Media). Like Lewis, Brooks was a skilled writer with a nose for compelling financial stories.

Brooks’s most famous book, Business Adventures, has stood the test of time; it was on Bill Gates’s 2014 summer reading list—45 years after it first appeared. Time has not treated The Go-Go Years quite so kindly, although the book is still an interesting, if sometimes pained, commentary on a troubled era of change, both in society at large and on Wall Street in particular.

“In the nineteen twenties,” Brooks wrote, “it was in a real sense what Wall Streeters always cringed to hear it called, a private club—and not just any private club but probably the most important and interesting one in the country, a creator and reflector of national manners and a school for national leaders. In the nineteen sixties, despite declining aristocratic character and political influence, it was still those things, playing out week by week and month by month its concentrated and heightened version of the larger national drama. But after the convulsion with which the decade and that particular act in the drama ended, its days in the old role seemed to be numbered. … If the certificate and the floor go, Wall Street will have moved a long way toward transforming itself into an impersonal national slot machine—presumably fairer to the investor but of much less interest as a microcosm of America.” (pp. 314-15)

The late sixties were a time of social and political unrest. But “all through the stormy course of 1967 and 1968, when things had been coming apart and it had seemed that the center really couldn’t hold—the rising national economic crisis culminating in a day when the dollar was unredeemable in Paris, the Martin Luther King and Robert Kennedy assassinations, the shame of the Chicago Democratic convention, the rising tempo of student riots—the silly market had gone its merry way, heedlessly soaring upward as if everything were O.K. or would surely come out O.K., as mindlessly, maniacally euphoric as a Japanese beetle in July. Or as a doomed man enjoying his last meal. One could only ask: Did Wall Street, for all its gutter shrewdness, have the slightest idea what was really going on?” (p. 17) Obviously not. By the end of the decade and into 1970 the stock market “had gone into a sickening collapse,” interest rates were at near-record highs, and one hundred or more Wall Street firms were near failure.

Not that the early part of the decade was exactly tranquil. The stock-market collapse of 1962 sent the Dow down more than 25 percent. Brooks writes of it: “Diabetic coma, the preventable catastrophic crisis of a human disease, comes on slowly; the sinister lassitude it induces neutralizes the rational alarm that would otherwise lead the patient to take measures to head it off. So it is with stock-market crashes.” (p. 55)

The Dow reached a high just shy of 735 at the turn of the year, after which “a gradual, fairly consistent decline began. But experts who a year earlier had been sounding prudent warnings of the dangers of speculation were now victims of the very euphoria they had warned against; in January and February, 1962, they pointed out that business was good, spoke of a ‘healthy correction,’ and recommended the continued, if cautious, purchase of stocks.

“What a falling market needs to become a diving market is not a reason but an excuse, and in April it found one when President Kennedy chose to engage in a to-the-death confrontation with the steel industry and its bellwether, U.S. Steel, on the matter of a price increase.” The steel industry eventually capitulated, “but at what a cost! Investors, who had profited so handsomely from the ‘Kennedy market’ of the previous year, suddenly decided that the energetic young man in the White House was an enemy of business, after all. Whether or not Kennedy, in the heat of confrontation, had actually said in private, ‘My father always told me that businessmen were sons of bitches,’ was not the point; the point was that a good proportion of the 17 million American owners of corporate shares believed he had said it. For several weeks in succession, the market slumped ominously, until the week of May 21-25 saw the worst decline for any week in more than ten years. And then, on May 28, the day that has gone down in Wall Street annals as Blue Monday, the Dow average dropped 34.95 points, a one-day collapse second in history only to that of October 28, 1929, when the loss had been 38.33. Moreover, the decline took place on the then-fantastic volume of 9,350,000 shares.” (pp. 55-56)

Brooks recounts how the late sixties became, “for a shockingly brief moment, the heyday of the young prodigy, the sideburned gunslinger. … He came from a prospering middle-income background and often from a good business school; he was under thirty, often well under; he wore boldly striped shirts and broad, flowing ties; he radiated a confidence, a knowingness, that verged on insolence, and he liberally tossed around the newest clich├ęs, ‘performance,’ ‘concept,’ ‘innovative,’ and ‘synergy’; he talked fast and dealt hard (but unlike the back-office people he seems to have seldom used drugs, including marijuana); and, if he was lucky, he made 40 or 50 percent a year on the money he managed and was rewarded with personal earnings that often exceeded $50,000 a year.” (p. 189) Alas, “the look of eagles became a vacant stare once the ever-rising market began to plunge,” and “many of the gunslingers who had touted [the glamor stocks] would leave, or be fired from, the securities business.” (p. 192)

Monday, August 18, 2014

Oliveira, Traders of the New Era

According to a 2011 study that used data from the Taiwan Stock Exchange over a 15-year period (1992-2006), less than one percent of day traders are profitable two years in a row. “But,” the researchers note, “the stock picking ability of these investors is remarkable. Top day traders (based on prior year ranking) earn gross (net) abnormal returns of 49.5 (28.1) bps per day on their day trading portfolio, while the tens of thousands of day traders with a history of losses in the prior year go on to earn gross abnormal returns of -17.5 (-34.2) bps per day.”

Every year new traders come on the scene, though certainly not the hordes who tried their luck in the era. They hope against hope that they will be among the top one percent. By definition, the odds are staggeringly against them.

Fernando Oliveira is a relatively new trader who struggled to achieve profitability. In search of answers, he set out to interview, as the subtitle of the book says, “a select group of day and swing traders who are still beating the markets in the era of high frequency trading and flash crashes.” Actually, not all of these traders are delivering alpha; one interviewee admits to struggling and another is described as a “former winner.”

Traders of the New Era is a surprisingly decent book, even if unpolished. The interviewees are not exactly household names—Flemming Kozok, Denis Dick, Jeffrey Goldman, Eric Scott Hunsader, Mitch Semon, Wayne Kulcheski (plus two anonymous traders and one who uses a nickname). But that may be the reason the book has a freshness to it.

Most of the interviewees are discretionary traders who rely on screen time rather than backtesting to develop informed instincts, who tend to look at order flow rather than technical indicators. They focus on the mechanics of order entry (type of order, routing, etc.), risk management, and emotional discipline. Most of what they know and what they have done is only in their heads, not in trade journals.

Traders of the New Era is not a particularly useful book for the rank novice. The main message he could glean from the book is to devote hours and hours (if not the “magical” 10,000) trying to get a feel for the way individual stocks and markets move. But those with some experience will find helpful pointers and occasionally insightful analysis.

For instance, one trader says: “I hate using market orders, because it’s just a blank check. It’s such a fast trading world right now, and I believe that some HFT participants can see your market order coming down the pipe, especially if your order is pinging multiple destinations. … I would rather use a marketable limit order. For example, if the offer was at $94.50 and I really wanted to own a stock, I would maybe put a $94.55 limit or something like that. I’d probably get filled at the $94.50 offer, but if the price changes rapidly, I’m not going to get filled at something crazy like $95.”

Another trader notes: “I’ve been more strategic about getting in and out of positions. The way to think about [it] is that HFTs are like parasites and you’re the host. They do not want to a buy a stock unless you want to buy it. They don’t want to sell it unless you want to sell it. So just know that when you send an order, it will have three or more times the impact on the market than it used to have. So buying 100 shares is like buying 300 shares.”

Monday, August 4, 2014

Roberts, Saving the City

Seemingly countless articles have been written comparing 2014 to 1914—politically, economically, socially, every which way. Richard Roberts’ Saving the City: The Great Financial Crisis of 1914, published last year by Oxford University Press, has a different agenda. First, and most important, it sets out to acquaint the reader with a financial crisis that remains largely unknown and, second, it draws parallels between the events in London at the start of World War I and the most recent financial crisis.

On July 31, 1914—more than a month after the assassination of Archduke Franz Ferdinand in Sarajevo and about a week after the ultimatum from Austria to Serbia, after a few days of “the weirdest prices” as London became, in the words of The Economist, “a dumping ground for liquidation for the whole Continent of Europe”—the London Stock Exchange closed, with the NYSE following later in the day. (p. 14) London would not reopen for five months, on January 5, 1915. The NYSE resumed trading “in the full list … with restrictions” on December 15, 1914, “and on a pre-crisis basis on 1 April 1915.” (p. 223)

“The financial crisis of 1914,” Roberts writes, “was the most severe systemic crisis London has ever experienced—even more so than 1866 or 2007-2008—featuring the comprehensive breakdown of its financial markets. The 1914 crisis was not a ‘typical’ financial crisis…. There was no preceding credit expansion, speculative mania, asset bubble, or ‘Minsky moment’. However, there was a very clear ‘displacement’ moment [the Austrian ultimatum] that transformed risk perceptions of the possibility of a major European war. … As fear supplanted greed there was a universal dash for cash, preferably gold. All sellers and no buyers meant that markets quickly ceased to function.” (p. 5)

It was not only the stock and bond market that broke down but the foreign exchange market and the discount (money) market as well. “The scramble for liquidity broke the markets’ mechanisms.” (p. 22) And there was a run on the banks, although, as commentators were quick to note, not a panic. Depositors withdrew their money (asking for gold but getting notes instead) and then flocked to the Bank of England to change these notes for gold.

Roberts details, and lauds, British efforts to stem the crisis. “Remarkably,” he writes, “there were no failures among major financial institutions, casualties amounting to just a dozen London Stock Exchange firms, a minor discount house and some small savings banks. … The avoidance of significant failures was an important achievement of the authorities’ measures—which is not to overlook individual tragedies, with more than a score of bankrupt brokers and 145,000 impoverished depositors at National Penny Bank. There were at least six suicides attributable to the crisis in the City.” (p. 232)

Although there are several parallels between the crises of 1914 and 2007-2008 and how governments dealt with them, the greatest difference is that the earlier crisis did not morph into a recession. World War I provided ample economic stimulus to prevent this consequence, perhaps the only positive thing one can say about what most people today regard as a futile conflict.