Sunday, December 27, 2015

Newport, Deep Work

Cal Newport, an assistant professor of computer science at Georgetown University, moonlights as an author of advice books. (Actually, “moonlights” is the very wrong word because he keeps his evenings work free.) In addition to three books for students—How to Be a High School Superstar, How to Win at College, and How to Become a Straight-A Student, he wrote So Good They Can’t Ignore You: Why Skills Trump Passion in the Quest for Work You Love. Now he is out with Deep Work: Rules for Focused Success in a Distracted World (Grand Central Publishing, 2016).

Although I admit that reading a book about deep work may itself be a distraction from actually doing deep work, it’s a worthwhile distraction. Newport’s book is a quick, inspiring read, although consistently implementing its rules is much, much tougher to do. Because, let’s face it, most of us spend the bulk of our time in the shallows, a word Nicholas Carr memorialized in his 2010 book. When I read Carr’s book I vowed to do something about my penchant for being distracted. Instead, five years later I may be even more distracted. And so, like a yo-yo dieter, here I go again, with good intentions and a new guidebook to turn those intentions into best practices.

Newport defines deep work as “professional activities performed in a state of distraction-free concentration that push your cognitive capabilities to their limit. These efforts create new value, improve your skill, and are hard to replicate.” (p. 11) By contrast, shallow work refers to “noncognitively demanding, logistical-style tasks, often performed while distracted. These efforts tend not to create much new value in the world and are easy to replicate.” (p. 13)

By and large, to thrive in the new economy a person must have the ability to quickly master hard things as well as the ability to produce at an elite level, in terms of both quality and speed. (p. 28) And these abilities depend on the person’s ability to perform deep work.

Routines and rituals help foster a deep work habit. These routines and rituals must fit the individual’s circumstances, personality, and type of project being pursued. The author himself adapted the 4DX framework from the book The 4 Disciplines of Execution to his personal work habits. The four disciplines he embraced were: focus on the wildly important, act on the lead measures (as opposed to lag measures), keep a compelling scorecard, and create a cadence of accountability. And his own fifth habit, regularly rest your brain. “When you work, work hard. When you’re done, be done.” (p. 107)

To avoid the siren call of email or Google searches, Newport recommends that people schedule Internet blocks, both at work and at home. It is important to learn to resist switching to an online distraction at the slightest hint of boredom. The author also recommends that people give up time-consuming social media. Instead, he suggests they put more thought into their leisure time, offering themselves a quality alternative. Like reading a book.

Scheduling is a recurrent theme in this book. In fact, Newport recommends that people schedule every minute of their day. Well, not minute by minute of course, but in blocks.

And the reward for following this path? “A deep life is a good life, any way you look at it.” (p. 69)

Wednesday, December 23, 2015

Dampier, Effective Investing

Some books don’t translate well. In the case of Mark Dampier’s Effective Investing (Harriman House, 2015) the problem is not language. Since 1998 the author has been head of research at Hargreaves Lansdown, the UK’s largest independent brokerage firm. He writes in perfectly clear English. Rather, the problem is that he is writing for the British investor, especially those who are interested in buying British funds and successfully navigating the British tax system. And his references are sometimes a tad alien, at least to this American investor. For instance, in explaining his choice of Darwin Leisure, a kind of family unit trust that invests in a portfolio of caravan parks, he says that they attract “a more upmarket kind of visitor—more Center Parcs than Carry On Camping, if you like.” (p. 97)

The author himself invests primarily in funds rather than in individual stocks. And “when it comes to buying accumulation or income units,” he “generally prefer[s] to opt for the income units.” That way, he always has “some new money coming in” which he can invest where he sees the best value. (p. 94)

Although Dampier warns the reader not to get trapped in his own “personal history and experience” because nothing stays the same in finance, I thought it might be useful to share a table that shows the real returns on investment in various British instruments over four time intervals.

Sunday, December 20, 2015

Dempster and Tang, Commodities

Commodities, edited by M.A.H. Dempster (University of Cambridge) and Ke Tang (Tsinghua University), is part of the CRC Financial Mathematics Series. Over 700 pages long, it contains 31 papers written mostly by academics. It is organized into four parts: oil products, other commodities, commodity prices and financial markets, and electricity markets.

Recently, most commodities have been cratering. Natural gas hit a 14-year low, oil prices collapsed from $105 down to $35 in a little over a year with Goldman Sachs standing by its prediction of a low of $20 a barrel, even milk is selling at only about 60% of its peak in the late summer of 2014. Understandably, investors have sold down their positions. Commodities have lost their appeal as a way to diversify a portfolio.

At some point, of course, commodities will rebound, even if not fully. While they wait for a better entry point, investors can use their time to learn more about the ins and outs of some of these markets. For the quantitatively inclined, the Dempster-Tang book is a perfect way to gain valuable insights.

I can’t, of course, survey the entire book here. Instead, I’ll simply share some bullet points from the section on commodity prices and financial markets that I think may be of general interest.

First, oil price shocks are the only variable with forecasting power for stock returns at horizons of one to three quarters. (That may be an overstatement, but if we get rid “the only” it’s a hypothesis worth studying.)

Second, oil prices lead oil volume, and S&P 500 trading volume leads S&P 500 prices. Moreover, over a 28-year period of study, “there is a persistent positive association between crude oil futures prices and S&P 500 futures prices.” (p. 354)

As for portfolio diversification, adding the spot commodity “considerably improves the value of the portfolio.” (p. 433) But investing in calendar spreads, using distant futures contracts in conjunction with the near end of the commodity term structure, gives poor results.

Long-short commodity funds are meaningful portfolio diversifiers.

Finally, from a paper on the dynamics of commodity prices that especially interested me, some findings on volatility in the six major commodity markets and the S&P 500. “[W]ithin the stochastic volatility framework, the models that allow for jumps provide a considerably better fit to the data than those that do not, although there is little to choose between the models allowing for jumps in returns only and those allowing for jumps in both returns and volatility.” In the relationship between returns and volatilities for various commodities the signs are “negative for crude oil and equities, close to zero for gasoline and wheat, and positive for gold, silver, and soybeans.” The intensity and frequency of jumps varies considerably among commodities, “although all commodities are found to exhibit more frequent jumps than the S&P 500.” (p. 502)

These are just a few of the many intriguing takeaways from this thoroughly researched book. Commodities gives investors with quantitative skills an opportunity to study a range of modeling tools. It gives commodity traders some unexpected ways to seek alpha. And it offers portfolio managers ideas for improving their returns. All in all, a wealth of information.

Wednesday, December 16, 2015

Kumar, Short Selling

In Short Selling: Finding Uncommon Short Ideas (Columbia Business School Publishing, 2015) Amit Kumar, a portfolio manager at Columbia Threadneedle Investments and adjunct professor of finance at Rutgers Business School, shares valuable insights from his career as well as the careers of three top investors.

Short selling is notoriously difficult. Kumar doesn’t recommend it for the average individual investor; “it is geared more toward institutional investors with sophisticated research and risk management resources.” (p. 218) But even they can go badly astray. Keurig Green Mountain, for instance, looked to many like a promising short until, boom, it got an insanely generous buyout offer and the stock skyrocketed 72% in a single day.

Kumar helps investors navigate the treacherous waters of short selling, introducing them to the kind of research necessary to come up with potential targets and illustrating his points with case studies. In 2010 Office Depot was a classic case. As Kumar writes, “It is hard to find shorts with as many negative catalysts as Office Depot: losing market share, structural issues with business model, high debt levels, share dilution, and poorly aligned management incentives.” (p. 50)

For this book Kumar interviewed value investor Jean-Marie Eveillard , activist investor Bill Ackman, and researcher Mark Roberts. In response to the question of whether it is inherently more difficult to generate alpha on shorts than longs, Ackman said: “It is harder and creates more brain damage than you can imagine. Will we do it again? … We waited five years after closing the MBIA short investment before we built our Herbalife position. We may wait another five, ten, or twenty years to do the next one. Who knows, we may never get involved in shorts in the future. If and when Herbalife plays out the way we expect, perhaps the next time we will just say the name of the company without taking a short position and wait for it to go to zero.” (p. 149) Ackman’s frustration is palpable in these sentences.

Kumar’s analyses are worth studying, even if one is a long-only investor. He explains how to expose chinks in the armor of companies. And he also shows how, through an analysis of a potential short, the investor can flip and make an informed decision to go long. His analysis of Netflix in 2012 is a case in point.

Investors who buy stocks should subject the underlying company to a stress test: what, given the company’s financials, its management, its position in the market, could go wrong? It is even more critical for investors looking to short stocks to subject their thesis to an analysis of what could go right with the stock (and hence wrong with their position). Kumar provides investors with an excellent guide to engaging thoughtfully and rigorously in the debate over whether or not to go short.

Sunday, December 13, 2015

Josse, Dinosaur Derivatives and Other Trades

Jeremy Josse’s Dinosaur Derivatives and Other Trades (Wiley, 2015) is by turns amusing and illuminating. He addresses big questions, asking what is value, uncertainty, a contract, a financial instrument, financial innovation, ownership, money, taxation, fraud, regulation, and a bankrupt. But instead of tackling these philosophical puzzles, as he calls them, head on, he eases into them by way of stories. “Each story is,” he suggests, “a thought experiment in the laboratory of the philosophy of finance.” (p. xv) Some of the stories are true, some come from literature, some are utterly apocryphal. But they all shed light on conceptual dark corners in finance.

The first chapter, from which the book takes its title, describes an auction for an option to buy, among other things, a Megalodon, a prehistoric shark that had become extinct many millions of years previously. “(In small print on the auction list, it did state that the option could be exercised only in the event that a Megalodon ‘should become available.’)” Another item up for bid was “a letter of credit presentable on the coming (or second coming—which ever turns out to be first) of the Messiah.” (pp. 3-4) This account of the frenzied auction for presumably worthless items leads into an insightful discussion of markets, value, liquidity, and manias.

The puzzle of uncertainty is introduced with the story of Joseph’s prophetic powers, his ability to interpret the pharaoh’s dreams in economic terms—that seven good years would be followed by seven bad years. Through his power of prophecy (call it a tip from God) Joseph removed the element of uncertainty from financial prediction. Subsequently chosen by the pharaoh to be “the equivalent of the Egyptian Treasury Secretary,” Joseph saw to it that during the good years the Egyptian state stockpiled grain and crop holdings. During the bad years, Joseph used this stockpile “to buy up everything he could. He vastly increased the state’s cash reserves” and bought up “land, livestock, and ultimately labor. In fact the story indicates he acquired more or less the whole economy of the then known world. Joseph and the Egyptian state effectively cornered the whole Fertile Crescent.” (p. 19)

Josse skillfully uses these stories to explain, in a way that a person with some knowledge of the financial markets and perhaps a penchant for philosophy could easily understand, some of the thorniest concepts in finance. For instance, he shows in what sense a financial instrument is a legal fiction, describes how John Rawls’s theory of justice is connected to “the wondrous workings of the convertible bond,” and exposes the gap (which can occasionally become blurred) between inalienable human rights and inalienable ownership.

This is definitely a book worth reading—and pondering.

Tuesday, December 8, 2015

Best books of 2015, an idiosyncratic list

As I surveyed the books I reviewed this year, I looked for ones with broad appeal that I personally enjoyed reading. Herewith my idiosyncratic list, with apologies to the authors of quite fine books, usually specialized, who aren’t recognized here. I compile these lists reluctantly (and not even annually), only because I have been asked to do so by readers of this blog. I don’t relish being a prize committee of one.

The books are listed in alphabetical order by author, and each one is linked to my review of it.

François Bourguignon, The Globalization of Inequality

Bill Browder, Red Notice

Robert Carver, Systematic Trading

Wesley R. Gray et al., DIY Financial Advisor

Greg Steinmetz, The Richest Man Who Ever Lived

Richard Teitelbaum, The Most Dangerous Trade

Philip E. Tetlock & Dan Gardner, Superforecasting

Richard H. Thaler, Misbehaving

Sunday, December 6, 2015

Parness, The Art of Trend Trading

Michael Parness’s claim to fame is having turned “a relatively small amount of money into over $4 million” in 1999/2000 and roughly $13,000 into $3.8 million in 2008/2009 using mostly options and some futures and taking pretty big risks. Less publicized is the fact, to which he admits in this book, that he blew up his account on more than one occasion. The Art of Trend Trading: Animal Spirits and Your Path to Profits suggests a more “modest” goal for the reader, making about 1% a day. Compounded, that’s about a 500% annual return on your investment. Move over, all you hedge fund billionaires!

Parness outlines several paths to potential profit, most involving intraday trading. His model is the power trader , “someone who is capable of trading the market successfully throughout the entire day, and when desired, before and after regular market hours as well.” (p. 26)

His favorite plays, which he describes in some detail and from various perspectives, are gap fades, earnings runs, earnings straddles (long), FOMC fades, and the 10 a.m. rule (if a stock gaps up you should not buy it unless it makes a new high after 10 a.m.; if it gaps down, you should not short it unless it makes a new low after 10 a.m.).

Parness is at heart a trend trader because “trading in harmony with current trends rather than against them provides an additional edge that can result in a higher percentage of winning trades.” (p. 194) And so, although he often closes out all his trading positions at the end of each day, trading only intraday trends, “when a good reason justifies it,” he will “hold a stock or option position over a longer period of time.” (p. 40) Trends, he explains, are psychologically driven, which is why he hasn’t read very many books on the stock market but reads psychology books instead.

Although Parness’s firm, Affinity Trading, not only offers trader education but also sells stock and option plays of the week, this book is not an infomercial. And it’s evidence that reports of the death of day trading have been greatly exaggerated.

Wednesday, December 2, 2015

Newport, So Good They Can’t Ignore You

I recently finished reading and drafting a review of Cal Newport’s new book, Deep Work, scheduled for publication in early January. Since I won’t post my review until publication is imminent, I decided to dip into his earlier work, So Good They Can’t Ignore You: Why Skills Trump Passion in the Quest for Work You Love (Business Plus, 2012), which I can write about now, though I’ll be brief.

Newport debunks the passion hypothesis—that you should do what you’re passionate about because only then will you be happy in your job/career/calling. The problem, in a nutshell, is that for most people this hypothesis puts the cart before the horse. Passion is a side effect of mastery, not a precondition of it.

The craftsman mindset, Newport argues, is the foundation for creating work you love. The craftsman mindset focuses relentlessly on the value you’re producing in your job. By sorry contrast, the passion mindset focuses on the value that your job offers you. (The distinction is reminiscent of the famous words from John F. Kennedy’s inaugural address: “ask not what your country can do for you, ask what you can do for your country.”) In the former case, the craftsman mindset, you’re the subject of the sentence and are acting; in the latter, the passion mindset, you’re the object and are being acted upon.

As Newport writes, “put aside the question of whether your job is your true passion, and instead turn your focus toward becoming so good they can’t ignore you. That is, regardless of what you do for a living, approach your work like a true performer.” (p. 56)

Sunday, November 29, 2015

Hirsch, Stock Trader’s Almanac 2016

The new year will soon be upon us, and with it comes the continuation of a long tradition. The Stock Trader’s Almanac is now in its 49th edition. Well, not quite the track record of The Old Farmer’s Almanac, which launched in 1792, but presumably a tad more data driven.

The spiral bound, green lexotone-covered almanac opens flat for easy access to its information or for jotting down notes. The format remains essentially the same as that of recent editions, with a calendar section, a directory of trading patterns and databank, and a strategy planning and record keeping section. The calendar section has on facing pages historical data on market performance (verso) and a week’s worth of calendar entries (recto). January’s verso pages, for example, give the month’s vital statistics, January’s first five days as an early warning system, the January barometer (which has had only eight significant errors in 65 years, one of those in 2014), and the January barometer in graphic form since 1950. Each trading day’s entry on the recto pages includes the probability, based on a 21-year lookback period, that the Dow, S&P, and Nasdaq will rise. Particularly favorable days (based on the performance of the S&P) are flagged with a bull icon; particularly unfavorable trading days get a bear icon. A witch icon appears on options expiration days. At the bottom of each entry is an apt quotation. There’s about a five-square-inch space in which to write.

The Stock Trader’s Almanac pays particular attention to the presidential cycle, and its message is mixed for 2016. On the one hand, “election years are the second-best year of the four-year cycle and sixth years of decades have been up double digits four in a row, so 2016 has some solid history behind it.” On the other hand, “eighth year of presidential terms represent the worst of election years since 1920. In eighth years, DJIA and S&P 500 have suffered average declines of -13.9% and -10.9% respectively.” Admittedly, there are only six data points in this eighth year series (new to this edition), but of them only 1988 was positive.

What other seasonals are powerful? The best six months is still “an eye-popping strategy.” Since 1950 the best months are November, December, January, March, and April. Add February, “and an excellent strategy is born!” These six consecutive months gained 17,883 Dow points in 65 years, while the remaining May-through-October months lost 1066 points. In the last two years this pattern has been less “eye popping.” The DJIA gained 4.8% in 2013 and 4.9% in 2014 between May 1 and October 31 and 6.7% and 2.6% between November 1 and April 30.

As always, this year’s almanac is chock full of data that will delight traders who believe that past is prologue.

Thursday, November 26, 2015

The turkeys arrived for their Thanksgiving dinner

I took this picture of deer and wild turkeys feasting in my back yard at dawn yesterday. A couple of turkeys flew into the vegetable garden, eating who knows what in the garden paths. When it was time for the turkeys to move on, one of birds in the garden was stymied. He/she had no idea how to get out and instead paced up and down along the fence, inevitably ending up in the corner. The turkey’s family briefly showed some concern but then abandoned the dullard. I finally went out to open gates, hoping that this might prove an avenue of escape. Obviously my presence and the clanging of metal was frightening enough to inspire the turkey to “get wings.”

Benjamin Franklin might have called wild turkeys “birds of courage” and proposed that the wild turkey, not the bald eagle, be the official animal of the United States, but this particular wild turkey exhibited neither courage nor any problem solving skills.

Sunday, November 22, 2015

Mellon & Chalabi, Fast Forward

I just received my copy of next year’s Stock Trader’s Almanac. The page I normally turn to first is the editor’s choice of best investment book of the year. I don’t think I’ve ever agreed with the choice, but I always note it in my review. This year it turned out that I hadn’t read the top pick, so I felt I needed to remedy that state of affairs. I set some time aside to read Fast Forward: The Technologies and Companies Shaping Our Future by Jim Mellon and Al Chalabi (Fruitful Publications, 2015). And although I admit I read it in a manner befitting its title, it was definitely worth the time I put in, and probably considerably more.

This seems to be the fifth book that Mellon and Chalabi have written. Their earlier efforts are Cracking the Code, Wake Up!, Top 10 Investments for the Next 10 Years, and Top Ten Investments to Beat the Crunch!

Fast Forward analyzes technologies in eight areas: robotics and automation; life extension; the internet of things; transportation; energy; payment processing; 3D printing; and media, publishing, education. Much of what they write is a summary of material that has been covered extensively in the media. But what is new and valuable is that the authors describe companies, both private and publicly listed, that are engaged in these technologies. It is therefore an idea book for technology investors. In the third appendix to the book they list the public companies chapter by chapter, along with the exchange on which they trade as well as their ticker and market cap.

Although I wouldn’t put Fast Forward among the best books I’ve read this year, for those who want to explore investing in burgeoning technologies it is a useful starting point.

Friday, November 20, 2015

Grimes, Quantitative Analysis of Market Data: A Primer

Adam Grimes’s brief book, Quantitative Analysis of Market Data (only 35 pages of text), which kindleunlimited subscribers can read for free, is indeed a primer. He starts with the formulas for percent return, both simple and logarithmic, and shows how we can standardize these returns for volatility, using ATRs, historical volatility, or the standard deviation spike tool (measuring each day’s return as a standard deviation of the past 20 days’ returns). He describes normal distribution, running mean, and running median for Cauchy-distributed random numbers.

The bulk of the book consists of an explanation of “three simple tools that should be part of every trader’s tool kit: bin analysis, linear regression, and Monte Carlo modeling.”

Traders who are familiar with the most rudimentary mathematical principles of finance will learn nothing from this book. But it’s a good place for the mathematically uneducated to start and a quick review for those whose grip on statistical modeling is tenuous.

Wednesday, November 18, 2015

Baker, The Trade Lifecycle, 2d ed.

Retail investors and traders are for the most part blissfully ignorant of how their orders are processed. They buy, sell, and see their account balance either increase or decrease. Or they track open profits and losses. Some days even this seems like far too much information. And, if we are to believe Nicolas Darvas (How I Made $2,000,000 in the Stock Market), it may well be.

For people who work in the capital markets, however, understanding the anatomy of a trade is of vital importance because it sheds light on how banks and trading firms are structured. Where do risk managers fit in? What does the back office do? It is this kind of understanding that Robert Baker aims to impart in The Trade Lifecycle: Behind the Scenes of the Trading Process, 2d ed. (Wiley, 2015).

He pays special attention to the role of technology in the trading progress, which makes perfect sense since it’s an increasingly important part of finance. For instance, as of this past April, of about 33,000 full-time employees at Goldman Sachs, 9,000 of them were engineers and programmers. Goldman had more tech employees than Facebook. As the Business Insider article which reported these figures noted, “The massive on-boarding of tech talent shows just how seriously investment banks regard technology as a means of security and infrastructure.”

Baker’s book may not be a page turner, but it is a useful outline of how firms develop, arrange, test, approve, monitor, report, and audit trades.

Sunday, November 15, 2015

Ursone, How to Calculate Options Prices and Their Greeks

Those option traders who care about the Greeks (and not all do) normally rely on trading platforms for their calculated values. Why do the calculations yourself when an algorithm can do it for you? Just as no adult works out a long division problem on paper, almost no option trader bothers to use the Black Scholes model to solve for a value that he can find by plugging a few numbers into an online calculator.

The problem with taking this shortcut is that most option traders don’t understand how their positions can change prior to expiration. They don’t know what’s under the hood. And, unlike driving a car from point A to point B, where the road is relatively straight, the car is reliable, and you can arrive safely at your destination in blissful ignorance of how the parts of the car work, trading options without any knowledge of how the Greeks affect both one another and the price of options can be lethal.

Pierino Ursone’s How to Calculate Options Prices and Their Greeks: Exploring the Black Scholes Model from Delta to Vega (Wiley, 2015) sets out to fill this void. It requires no advanced math skills (though occasionally it invokes Excel to make the reader’s life easier) but instead offers mostly back of the envelope calculations.

For instance, the 20% to 80% delta region is almost linear. “This linearity promotes working with a lot of rules of thumb and easy derivations for the Greeks. It is a strong tool for being able to come up with values for the Greeks without applying the option model.” (p. 79)

The book is not for beginning option traders, but at the same time I don’t think one should wait too long before tackling the material it covers. I personally learned quite a bit from it, much of practical value. And it’s book I’ll keep around for when I need a refresher course.

Thursday, November 12, 2015

Support your local sheriff / blogger

With the holiday shopping season nigh upon us, I think it’s an appropriate time to thank those readers from the United States who have used this blog as a launch pad for their Amazon shopping. I would also like to encourage readers (U.S. only; I don’t have bank accounts elsewhere) who haven’t already done so to consider joining my supporters.

In case you don’t know how the system works, I get a small referral fee for anything you buy during your shopping session after you’ve clicked on one of my book links or used the Amazon search box on the right-hand side bar—it could be electronics, clothing, pet supplies, you name it. It costs you absolutely nothing, and it gives me another incentive, however financially modest, to keep on blogging.

Thanks very much. I really appreciate your support.

Wednesday, November 11, 2015

Brown et al., Make It Stick

I trust that if you read this blog you are engaged in a course of lifelong learning. But how much do you remember of what you allegedly learned? Peter C. Brown, Henry L. Roediger III, and Mark A. McDaniel offer suggestions for improving retention in Make It Stick: The Science of Successful Learning (Harvard University Press, 2014).

Among their claims,

“Learning is deeper and more durable when its effortful. Learning that’s easy is like writing in sand, here today and gone tomorrow.”

Rereading text and massed practice [the single-minded, rapid-fire repetition of something you’re trying to burn into memory] are among the least productive study strategies.

Retrieval practice—recalling facts or concepts or events from memory—is a more effective learning strategy than review by rereading.”

“When you space out practice at a task and get a little rusty between sessions, or you interleave the practice of two or more subjects, retrieval is harder and feels less productive, but the effort produces longer lasting learning and enables more versatile application of it in later settings.”

“When you’re adept at extracting the underlying principles or ‘rules’ that differentiate types of problems, you’re more successful at picking the right solutions in unfamiliar situations.”

“People who learn to extract the key ideas from new material and organize them into a mental model and connect that model to prior knowledge show an advantage in learning complex mastery.”

These are just a few bullet points from an altogether excellent book. It’s well worth reading, and remembering.

Sunday, November 8, 2015

Zweig, The Devil’s Financial Dictionary

Jason Zweig’s The Devil’s Financial Dictionary (PublicAffairs, 2015) is a book that probably every reader wishes he had been clever enough to write. Following in the satiric tradition of Ambrose Bierce (The Devil’s Dictionary, 1906), Zweig has compiled a marvelously witty set of definitions and explanations of financial jargon. Part exposé, part elucidation, it is almost always savagely amusing.

Three examples:

“QUANT, n. A trader or investor who relies primarily or exclusively on computer software and mathematical formulas without the noisy distractions of human judgment. The results, of course, can only be as good or bad as the judgment of the human who designed the computer software and the mathematical formulas.” (p. 142)

“VOLATILITY, n. The extent to which an investment’s short-term returns differ from its long-term average returns, technically known as standard deviation and colloquially known as Oh my God!” (p. 179)

HEAD AND SHOULDERS, n. A purported pattern in TECHNICAL ANALYSIS in which the price of a stock or other asset bounces up a little, down a little, up a lot, down a lot, up a little, then down a little—which is supposed to mean a lot about how the price will move in the future. If that reminds you of the lyrics to the children’s song,

  Eyes and ears and mouth and nose,
  Head, shoulders, knees and toes, knees and toes,

you might well be right, but you have no future as a technical analyst.” (p. 91)

Wednesday, November 4, 2015

Freeman-Shor, The Art of Execution

The Art of Execution: How the World’s Best Investors Get It Wrong and Still Make Millions by Lee Freeman-Shor (Harriman House, 2015) is a slim book. Its goal is to sear into the reader’s brain one key message: that investments need to be managed. In the words of the old saw, investors need to cut [or double down on] their losses and let their winners run.

The author manages over $1 billion in high-alpha and multi-asset strategies for Old Mutual Global Investors. From this position he was able to analyze 1,866 investments, representing a total of 30,874 trades, made by 45 leading investors from June 2006 to October 2013. He had given each of these investors between $20 and $150 million to invest for his Best Ideas fund, “with strict instructions that they could only invest in ten stocks that represented their very best ideas to make money.” (p. 6) Only 49% of these investments were profitable, and yet most of the investors still made a lot of money for the fund. The key to their success was knowing what to do when they were losing and what to do when they were winning. In brief, the bulk of their success came from wisely managing their positions.

When these investors had losing positions, they adopted one of three personae: Rabbits, Assassins, or Hunters. The Rabbits, whom the author wishes he had never hired, exhibited a buy and hope mentality. They did not adapt to changing circumstances; they did nothing to mitigate a losing situation. Of the 946 investments that lost money, 19 lost more than 80% and 131 lost more than 40%. Of those that fell by 40%, not one eventually produced the required returns to get back to breakeven.

The Assassins had stop losses in place, so that all losing trades would be killed when they were down by 20-33%. They were right to take action. Of the 946 losing investments, 41% saw their share price decline further. Of the stocks that subsequently rallied, only 37% returned more than 20%. So, the author concludes, “two-thirds of the time you are likely to be better off cutting a losing position.” (p. 33)

The contrarian Hunters pursued a Martingale approach, doubling down either when they thought that a bottom was in place on a stock in which they still believed or when its stock price had fallen between 20% and 33%. They too posted positive returns even though the odds were against them.

Investors who have winning positions can either be Raiders or Connoisseurs. “Raiders occupy a thin line between success and disaster. These are investors who like nothing better than taking a profit as soon as practical.” (p. 52) They don’t let their winners run. Furthermore, the author notes, “Raiders are often Rabbits when they’re losing—and the combination is fatal.” (p. 58)

Connoisseurs are the most successful investors even though, in the author’s sample, only a third of their ideas made money. What sets them apart? They invest in companies with a predictable growth of earnings and yet look for significant upside potential. They invest big and have focused portfolios. Up to 50% of their assets might be invested in just two stocks. They take small profits along the way but keep the majority of their positions in play, riding their winners. And, of course, when their positions turn into losers, they become either Assassins or Hunters.

Freeman-Shor’s message isn’t new, but it’s one that’s always worth repeating.

Sunday, November 1, 2015

Ip, Foolproof

Greg Ip, the chief economics commentator for the Wall Street Journal and author of The Little Book of Economics, has written an intriguing new book: Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe (Little, Brown, 2015). Drawing primarily from finance and secondarily from such diverse fields as forest management, sports, medicine, and transportation, he explores the tradeoff between innovation and crisis. Or, alternatively, though obviously not equivalently, between stability and disaster, between safety and danger, between fear and adventure.

The tension between these opposing forces “bedevils the people whose job it is to steer our economy and manage our surroundings. Philosophically, they fall into two schools of thought. One, which I call the engineers, seeks to use the maximum of our knowledge and ability to solve problems and make the world safer and more stable; the other, which I call the ecologists, regards such efforts with suspicion, because given the complexity and adaptability of people and the environment, they will always have unintended consequences that may be worse than the problem we are trying to solve.” (pp. 18-19)

In the first half of the book Ip demonstrates how “the pursuit of safety leads to behavior that makes disaster more likely.” (p. 125) Football helmets, designed to reduce injuries, became weapons for spearing opponents. Antilock brakes became an excuse to drive faster and brake harder. The global saving glut, a form of insurance, contributed to the financial crisis of 2008 as, of course, did portfolio insurance to the crash of 1987.

The second half of this book offers prescriptions for how to strike the right balance between safety and disaster.

One of Ip’s theses is that it doesn’t make sense to pay any price to avoid a disaster or crisis. “Not only is the price too high, but the nature of complex systems is such that if risk taking is repressed in one arena, it may migrate to another, and even more costs and damage may occur through other means.” (p. 130) For instance, shutting down nuclear power plants because there is a very small chance of a catastrophe (and, even then, the maximum number of deaths is probably in the hundreds) may not be justifiable. Each year deaths attributed mainly to pollution from the burning of wood and fossil fuels total more than 7,000 in the U.S. alone.

Sometimes seemingly excessive risk taking turns out to be good for society. In the course of the dot-com bubble this was manifest not only in the overly indebted Amazon’s ability “to pull another financing rabbit out of its rather magical hat” and stay afloat. It was also manifest in the host of telecom companies that borrowed billions to lay fiber-optic networks between cities and continents –and that subsequently sank. Of the networks we now take for granted, 63% of transatlantic, 35% of trans-Pacific, and 39% of the capacity between the U.S. and Latin America were built by now-bankrupt companies.

We will never eliminate disasters and crises. “Nor,” Ip contends, “should we want to. Periodic crisis is the price we pay for an economic system that encourages, and rewards, risk. Periodic disasters are the price we pay for situating our cities in desirable, productive places.” And so, the book concludes, “Our goal should be to eliminate big disasters, not small ones, to accept a bit more risk and instability today in return for more reward and stability in the long run.” (p. 219)

Wednesday, October 28, 2015

Hung, The China Boom

Ho-fung Hung, a sociology professor at Johns Hopkins University, invokes history, sociology, and economics to explain why, in the subtitle to his book The China Boom (Columbia University Press, 2016), China will not rule the world.

In the first part of the book, Hung takes the reader back to the two centuries (1650-1850) in which China had a market without capitalism, where capitalism is understood to be the use of money to pursue a larger sum of money. He outlines China’s phase of primitive accumulation (1850-1980), followed by the capitalist boom (1980-2008). The flowering of Chinese capitalism, he argues, was not a radical break with the past. Rather, it was “built on the foundation laid in the Mao period, including a large, healthy, and educated rural surplus labor force and an extensive network of state-owned capital.” (p. 10)

The second part of the book looks at the present and paints possible future scenarios.

With its rise as a global economic powerhouse China took a “great leap backward to inequality.” In the Mao era, inequality was expressed not in income but in power. But after the 1980s income inequality became “the increasingly prevalent form of inequality through which other inequalities are expressed.” (p. 91) Inequality is now manifested in class inequality, the growing rural-urban inequality, and inequality among provinces.

China’s development model led to an imbalance in the Chinese economy, “characterized by tepid household consumption, excessive investment by the state sector, and reliance on the export sector” (p. 151), complaints we have heard frequently. Wage growth is lagging far behind the growth of the economy as a whole. Corporate profits are turned into corporate and government savings, which in turn fuel a credit boom that aggravates overinvestment. “The problem of overinvestment that accompanies worsening underconsumption in China is more severe than it was earlier for the Asian Tigers owing to the decentralized nature of the Chinese developmental stage.” That is, local states in China can act independently, creating “anarchic competition among localities, resulting in uncoordinated construction of redundant production capacity and infrastructure.” (p. 155)

So far China has been able to export its excess capacity. But how long can this last? Hung believes that “the imminent and inevitable readjustment of the Chinese economy is poised to create significant repercussions throughout the world.” (p. 176) Just what these repercussions might be Hung leaves largely to the reader’s imagination. He certainly doesn’t want to be a fear monger. In fact, he concludes:

In the end, China is far from becoming a subversive power that will transform the existing global neoliberal order because China itself is one of the biggest beneficiaries of this order. It will not be exonerated any time soon for its role in facilitating continued dominance by the United States in the world through its supply of low-cost export and credit to the United States. If U.S. global dominance is going to end, it will not likely be fostered by China but by some other forces. To be sure, China has been reshaping and will continue to reshape the context of development in the developing world…. Whether China’s net impact will be beneficial or detrimental to development will vary from country to country and will change from time to time. In the short run and from the perspective of specific individual countries, China’s capitalist boom might seem like a game changer that will bring new prosperity, empowerment, subordination, or crisis. At the global level and in the long run, nevertheless, China is set to disappoint many who hail or fear the prospect of its challenging the existing global order in any fundamental way.” (pp. 180-81)

Sunday, October 25, 2015

Turner, Between Debt and the Devil

Adair Turner, the former chairman of Britain’s Financial Services Authority and described by The Economist as a man for all policy crises, upends financial orthodoxy in Between Debt and the Devil: Money, Credit, and Fixing Global Finance (Princeton University Press, 2015). He argues that nothing regulators have done thus far has addressed the fundamental underlying cause of financial instability: that “modern financial systems left to themselves inevitably create debt in excessive quantities and in particular debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate. It is that debt creation which drives booms and financial busts: and it is the debt overhang left over by the boom that explains why recovery from the 2007-2008 financial crisis has been so anemic.” (pp. 3-4)

For 50 years private-sector leverage increased as “credit grew faster than nominal GDP. In the two decades before 2008 the typical picture in most advanced economies was that credit grew at about 10-15% per year versus 5% annual growth in nominal national income. And it seemed at the time that such credit growth was required to ensure adequate economic growth.” (p. 7) If that theory is in fact correct, we’re condemned to financial instability and crisis. But, Turner argues, we can develop a less credit-intensive growth model if we address the three drivers of credit intensity: (1) the increasing importance of real estate in modern economies, (2) increasing inequality, and (3) global current-account imbalances unrelated to long-term investment flows and useful capital investment.

One policy initiative we should be willing to use in moderation, although Turner admits it will horrify central bankers, is fiat money creation, “using central bank-printed money either to finance increased public deficits or to write off existing public debt.” (p. 12) This action, though reminiscent of a cautionary tale in Goethe’s Faust in which Mephistopheles tempts the emperor to print and distribute paper money, is necessary to escape the debt overhang.

Demonstrating the increasing complexity in the financial system, Turner points to the shift in typical bank balance sheets. In the U.K. in 1964, more than 90% of aggregate bank balance sheets were made up of loans to the real economy plus government bonds and reserves at the Bank of England. By 2008 “much more than half the balance sheets of many of the biggest banks in the world … were accounted for by contractual links, whether in loan/deposit or in financial derivative form, between these and other banks, or between them and other financial institutions, such as money market funds, institutional investors, or hedge funds.” This shift, he notes, reflected in part the dramatic rise in trading activity. “The value of oil futures trading has gone from less than 10% of physical oil production and consumption in 1984 to more than 10 times that of production and consumption now. Global foreign exchange trading is now around 73 times global trade in goods and services. Trading in derivatives … now dwarfs the size of the real economy; … the total notional value of outstanding interest rate derivative contracts had soared by 2007 to more than $400 trillion, about nine times the value of global GDP.” (p. 25)

I could go on and on (and in fact I have pages of notes), but there is no space here. Turner’s book is tightly argued and is packed with insights about the financial markets as well as the real economy. For example, he lists five factors that explain why market bubbles and subsequent crashes are inevitable and five features of debt contracts that make them potentially dangerous. He explains why fixing the banks will not fix the economy. He argues that, if it is to succeed, the eurozone must become a complete currency union and hence a political union and that if this cannot be done, “eurozone breakup is likely to be inevitable and is preferable to sustained stagnation.” (p. 159) He explains in what sense less liquid and less complete markets can be good. And these examples represent but a tiny fraction of the issues Turner tackles in his book.

We know that we still have a long way to go to recover from the financial crisis and that we’re slipping back into some of the practices that gave rise to it in the first place. Turner’s book is both a critique of the status quo and a set of suggestions for getting out of the morass without precipitating yet another crisis. It will, and should, be controversial, but Turner is a worthy adversary.

Wednesday, October 21, 2015

Lowenstein, America’s Bank

Whenever Roger Lowenstein writes a book it’s a newsworthy event in the financial media. He already has five under his belt—The End of Wall Street, While America Aged, Origins of the Crash, Buffett, and perhaps his best-known, When Genius Failed. His latest book, America’s Bank: The Epic Struggle to Create the Federal Reserve (Penguin, 2015), is yet another tour de force. As over sixty pages of endnotes indicates, he did extensive research, but he writes gracefully, as if telling a familiar story.

In its broadest outlines, the founding of the Federal Reserve Bank is a familiar story, at least to anyone who has a passing interest in U.S. financial history. But Lowenstein shows just how critical, difficult, and in the end miraculous it was.

The American financial system in the late nineteenth and early twentieth centuries was rudderless and fragile, with frequent crises and panics. Paul Warburg, who would be one of the early promoters of the Federal Reserve, likened the currency system “to that of Europe ‘at the time of the Medicis’” (p. 56) and said that “it suffered in comparison with that of the ancient Babylonians.” (p. 74)

Although monetary reform was essential if the country’s rickety banking system was to survive, there was little consensus about the form it should take. How much power should the government, Wall Street, East Coast banks, Midwest banks have? How centralized should the system be? America had already experimented with two national banks and, even though these banks were successful on balance, it didn’t want a third.

The birth of the Federal Reserve was long and arduous. Initially, the very idea of substantive banking reform seemed stillborn. Two Republican administrations (Theodore Roosevelt, William Howard Taft) came and went. One of the key advocates and framers of banking reform, Senator Nelson Aldrich, himself a slow convert to the idea of a Federal Reserve, saw his political clout erode amid scandal. Congress was splintered. The media balked. The Washington Post, responding to the Glass bill, “warily predicted that the power to be lodged in the new Federal Reserve Board could be ‘greater in some respects than the power now wielded by the President of the United States.’” (p. 214)

The Glass-Owen bill was a compromise, addressing the concerns of the time. “No onlooker in 1913 could have predicted that one day the Fed’s most well-advertised duty would be setting interest rates. The bill’s primary purpose was to mobilize reserves, the better to avert a crisis, and to modernize the banking system. … However, an intriguing clause stated that interest rates should be adjusted ‘with a view to accommodating the commerce of the country and promoting a stable price level.’ Buried in that phrase was the suggestion of what became, through a subsequent act of Congress, the Fed’s dual mandate.” (p. 218)

Woodrow Wilson, who eventually signed the Federal Reserve Act into law, had to fend off threats from bankers and deal with a revolt in the House Banking Committee. “The latter in particular upset him. Intraparty strife was the virus that had undone Taft, and Wilson was determined not to give factionalism any quarter.” (p. 224) In the end Glass-Owen passed the House 285-85, with all but three Democrats voting in favor. The Senate, after lengthy wrangling, passed its own bill 54-34, with six Republicans joining a united Democratic front. The gap between the House and Senate bills was “unusually large,” but the conferees managed to produce a conference report that was overwhelmingly accepted by both the House and the Senate. “In twelve short months, Wilson had wrung from a party steeped in devotion to Andrew Jackson, and to the crudest anti-banking stereotypes, the filaments of a central bank.” (p. 252)

Lowenstein explores the hopes and dreams of the men who were instrumental in the creation of the Fed, and he shows how the sausage was made. America’s Bank is an engrossing story.

Sunday, October 18, 2015

Superforecasting: 5 master classes

If you were intrigued with Philip Tetlock’s Superforecasting, you can get a lot more at, a wonderful site. There he offers five master classes for a high-powered group of round-table participants, including Danny Kahneman and Dean Kamen.

Sekerke, Bayesian Risk Management

Matt Sekerke’s thesis in Bayesian Risk Management: A Guide to Model Risk and Sequential Learning in Financial Markets (Wiley, 2015) is important and, even if not unassailable (just ask all the frequentists), readily defensible:

[T]he greatest obstacle to the progress of quantitative risk management is the assumption of time-invariance that underlies the naïve application of statistical and financial models to financial market data. A corollary of this hypothesis is that extreme observations seen in risk models are not extraordinarily unlucky realizations drawn from the extreme tail of an unconditional distribution describing the universe of possible outcomes. Instead, extreme observations are manifestations of inflexible risk models that have failed to adapt to shifts in the market data. The quest for models that are true for all time and for all eventualities actually frustrates the goal of anticipating the range of likely adverse outcomes within practical forecasting horizons. (pp. 4-5)

Sekerke wants to replace the normally overly complex risk model of classical statistics with a set of models, which are evaluated on their ability to generate useful predictions and which are penalized for complexity. “Though common practice routinely works exclusively with a single model, Bayes factors will always be computable for the chosen model relative to any conceivable alternative specification, so long as informative priors are used. … If one is seriously interested in knowing when models are in danger of breaking down—or equivalently, when the dynamics of markets are undergoing a significant change relative to recent history—the information contained in the Bayes factor is crucially important.” (p. 50)

Bayesian methods are superior to classical methods in numerous ways. One notable difference is that Bayesian inference not only captures the distinction between risk (measurable randomness) and uncertainty (which recognizes that randomness cannot be definitively measured) but “makes visible and quantifiable one element of generalized risk that has been deemed inaccessible to analysis. In fact, the possibility of making model comparisons between models with different discount factors makes it possible to speak of the degree of uncertainty in a meaningful way.” (p. 84)

Sekerke’s book is written for quants, with the appropriate amount of math, but even non-quants can learn something from it. In nine chapters it covers models for discontinuous markets; prior knowledge, parameter uncertainty, and estimation; model uncertainty; introduction to sequential modeling; Bayesian inference in state-space time series models; sequential Monte Carlo inference; volatility modeling; asset-pricing models and hedging; and from risk measurement to risk management.

Friday, October 16, 2015

DiPietro, Day Trading Stocks

When a book begins

Caution! Alone, this manual will not adequately teach you my intra-day trading and swing methodology. Your mastery of my system will only come about through formal hands-on training. … This book is your introduction. It’s meant to reveal why my training program lasts for one full year. … Do not attempt to trade with this system without formal training from me.

my first instinct is to cast it aside. I don’t use this site to promote training programs.

But in this case my curiosity got the better of me. Was there anything in Josh DiPietro’s Day Trading Stocks the Wall Street Way: A Proprietary Method for Intra-Day and Swing Trading (Wiley, 2015) worth sharing? The author himself would say no, since he stresses that the book must be read sequentially, no skipping around allowed. So if I write about something from p. 100, I will have violated his reading rules. And he is a man of many rules—primarily trading rules, of course—that are not meant to be broken.

I therefore gave up. I’ll say only that he advocates a fusion of day and swing trading, a countertrend system that endorses averaging down based on “real price levels.” One of its basic tenets is that “You need to get comfortable with being in the red.” (p. 147)

Wednesday, October 14, 2015

Morris, Wall Streeters

Edward Morris sets out to do for American finance what Paul de Kruif did for biology (The Microbe Hunters) and Robert Heilbroner for economics (The Worldly Philosophers). Through the stories of fourteen influential men, he traces “the development of financial innovations, the growth of financial markets, and the causes of financial crises.” For a variety of reasons having nothing to do with the quality of Morris’s book, Wall Streeters: The Creators and Corruptors of American Finance (Columbia Business School Publishing, 2015) will probably not attain the stature of the works he emulated. But it puts a human face on Wall Street as few finance textbooks do. After all, finance is not simply numbers; it’s also, and even more so, people.

Morris starts with J. Pierpont Morgan. He then profiles three reformers: Paul M. Warburg, Carter Glass, and Ferdinand Pecora. Two democratizers follow: Charles E. Merrill and John C. Bogle. Then come three academics: Georges F. Doriot, Benjamin Graham, and Myron S. Scholes. And three financial engineers: Alfred Winslow Jones, Michael R. Milken, and Lewis Ranieri. And finally, two empire builders: William H. Donaldson and Sanford I. Weill. Each chapter is about twenty pages long.

Just as history can’t be carved up into discrete periods, so Morris’s “lives” don’t always begin and end in the chapters that bear their names. Morris isn’t writing birth-to-death biographies. His focus is on the effect these fourteen people had on the financial world, and effects linger and overlap.

It’s not that he ignores personalities. Morris writes, for instance, that “Milken and Ranieri had little in common. Milken was taut and slender, with a no-nonsense, scholarly mien; except when the subject turned to business, he had little to say and his social life seldom veered from small family affairs. Ranieri, on the other hand, had a Rabelaisian personality and was loud and generally uncouth. He was infamous at Salomon as the perpetrator and subject of outrageously elaborate and sometimes profane practical jokes among his fellow bond traders—while Milken, when the Drexel traders hired a stripper to dance on his desk for his thirty-eighth birthday, simply retreated under the desk with his phone and continued trading.” (p. 252) But the bulk of the chapter on Milken deals with junk bonds; Ranieri’s chapter, with the MBS machine that he started and the rise of quantitative finance. “Mortgages are math” was one of his mantras.

Experienced Wall Streeters will enjoy this book. Students of finance should be required to read it.

Sunday, October 11, 2015

Steenbarger, Trading Psychology 2.0

Brett N. Steenbarger is always worth reading, no matter where you are in your trading career. If you’re just beginning, he lays out the highs and lows you can expect, the work you’ll be required to do, and the commitment necessary to sustain you. If you’re stuck, he counsels you—prodding if necessary, praising if warranted (and it usually is)—with a view to getting you back on a profitable path. If you’re doing well, he cautions that this too will pass, unless you remain adaptable to changing market conditions.

Trading Psychology 2.0: From Best Practices to Best Processes (Wiley, 2015) is Steenbarger’s best book to date. In four chapters and over 400 pages he tackles adapting to change, building on strengths, cultivating creativity, and developing and integrating best practices—57 in all (think Heinz, but not just varieties, distinctly different best practices).

Steenbarger is a felicitous writer, able to blend ideas from psychological and market research with stories from the field. He is also self-reflective. He not only analyzes his own behavior; the book itself is a case study in what he advocates. He himself has adapted his way of thinking about trading to changes in the field. As he writes, “The old trading psychology emphasized planning your trades and trading your plans. The new trading psychology—Trading Psychology 2.0—stresses the changing nature of markets and the need to develop fresh plans for new contingencies. The old psychology placed a premium on controlling emotions. Trading Psychology 2.0 is about cultivating positive emotional experience through the exercise of signature talents and skills. The ideal trader, according to the old trading psychology, is a disciplined rule follower. The ideal trader V.2.0 is a creative entrepreneur, uncovering and exploiting fresh patterns and rules.” (p. 199) I personally like the new trader a lot better.

Readers of Steenbarger’s TraderFeed and Forbes blogs will recognize many of the themes in this book. But he has integrated them into a book that reads, to echo Kahneman, “fast and slow.” The reader can be turning pages at a good clip only to be hit with a passage that stops him cold and demands careful reflection. And for me, at least, there were many such passages.

I like books that keep me engrossed (and expectant) as well as books that challenge me. Trading Psychology 2.0 is a happy combination of both attributes. Kudos to Dr. Brett on a job well done. Now, as he would be the first to point out, it’s my turn.