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.

Fran├žois 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)