Econ graphs

For those whose life is not complete without reviewing economic graphs here are a couple you may not have seen: monetary policy decisions (Australia, Indonesia, Japan, Europe, UK, Philippines); U.S. non-manufacturing PMI, consumer credit, and nonfarm payrolls; and Australian employment. Compliments of Econ Grapher.

Buytendijk, Dealing with Dilemmas, part 1: big-picture issues

As readers of this blog know, I often look for insights in books that were not written with investors and traders in mind. Most of the time my search comes up empty. But now and again I hit pay dirt. Frank Buytendijk’s Dealing with Dilemmas: Where Business Analytics Fall Short (Wiley, 2010) is my latest discovery. I’ll devote two posts to his ideas.

Buytendijk, currently a vice president and fellow at Oracle responsible for “thought leadership,” sets out to counter the obsession with analysis. Why, he asks, are there so many analysts and no synthesists? Especially since synthesis is particularly useful in dealing with “something more fundamental than a straightforward problem—such as a dilemma.” (p. xv)

“A dilemma can be defined as a situation requiring a choice between equally undesirable or unfavorable alternatives. It is a state of things in which evils or obstacles present themselves on every side, and it is difficult to determine what course to pursue. … Whatever decision you take, there is an unacceptable downside.” At the same time, “a dilemma is an opportunity to fundamentally solve a problem, as understanding the dilemma lifts you to another dimension of insight” (p. 3)—an echo, duly noted, of the thesis-antithesis-synthesis process of Hegelian dialectic.

Buytendijk focuses on strategy management (formulation, implementation, and performance measurement). A strategy, understood informally, is “an action plan to achieve the organization’s long-term goals.” (p. 14) Does this mean that strategy is about making big choices? The author suggests that a better way to think about strategy is to view it as “creating a portfolio of options,” somewhat akin to a portfolio of stock options. “Options, as opposed to choices, do not limit our flexibility in the future; they create strategic flexibility.” (p. 16)

Creating options, of course, does not preclude making choices. “You cannot have a contingency plan for every possible future; not making any choices at all, while trying to go along with everything that passes by, leaves you unfocused and most probably unsuccessful. The trick is to make the strategic choices that create the right options.” (pp. 32-33)

Buytendijk describes six quintessential strategy dilemmas that businesses face: value/profit, inside-out/outside-in, top-down/bottom-up, listen/lead, optimize/innovate, and long-term/short-term. He then introduces the image of a strategy elastic to visualize how businesses are dealing with these dilemmas. “Creating strategic stretch is very much like working with an elastic band. If you pull it from only one side, the other side will move along in the same direction. You can stretch it only if you pull it from both sides. And the harder you pull in multiple directions at the same time, the more space you create, which is the objective of strategic management. The metaphor of an elastic band is particularly appropriate because it implies you cannot stop pulling; otherwise, the elastic band goes back to its neutral position” which translates into average results for the organization. (p. 69)

These are some big-picture issues that managers in every kind of business face, whether it be manufacturing or financial, large or small. If you haven’t given them any thought, perhaps it’s time to reevaluate how you’re managing your business.

Robert Engle’s FT lectures on volatility, part 5: global financial volatility

This is the final installment of my notes on Robert Engle's FT lectures. As I wrote earlier, the transcripts of these mini-lectures are available on the FT website.

Global volatility over time is very similar to S&P volatility. Some more detailed findings from Engle’s study:

The larger the stock market (i.e. the more companies listed) the lower the volatility.

The faster the GDP is growing, the lower the volatility. When GNP is declining, the volatility will rise.

When you have high inflation rates you tend to have high volatility. When there’s a lot of fluctuation in short-term interest rates or short-term real output this macro economic volatility contributes to financial market volatility.

Peterson and Murtha, MarketPsych

Traders, especially discretionary traders, have long recognized the importance of psychology to their endeavor—trying to fathom not only what’s in their own heads but what’s in the heads of those on the other side of their trades. As a result, there is a fairly extensive bibliography of books and articles on trader psychology. Not so with investor psychology, at least not outside the world of academe. Richard L. Peterson and Frank F. Murtha, co-authors of MarketPsych: How to Manage Fear and Build Your Investor Identity (Wiley, 2010), seek to help fill that void.

The authors, by training a psychiatrist and a psychologist, are also the co-founders of MarketPsych LLC, a company that “trains financial advisors, portfolio managers, traders, and executives in emotion management and intuitive decision skills.” Its website offers free personality tests for investors and traders.

Throughout the book the authors draw on the findings of research in behavioral finance. For instance, in one chapter the authors identify ten investor blind spots (or mental traps), some of which should be familiar to those who have read (or read summaries of) the work of Kahneman, Tversky, Thaler, and their colleagues and followers. The traps are: win/lose mentality, down with the ship syndrome, anchoring, mean reversion bias, endowment effect, media hype effect, short-termism, overconfidence, herding, and hindsight bias. The authors profile hypothetical investors, each of whom falls into between two and five of these traps. We meet the Wicked Gardener, Corporal Clinger, Mr. Magoo, the Roulette Player, and Maxwell Smart. Let your imaginations run wild trying to match them up!

Topics covered in the book run the gamut from the genetics of risk taking to the pitfalls of self-affirmation. (“…some studies show that people who think they need affirmations—the insecure and the doubtful—typically have a negative response to affirmations. The people who benefit from daily affirmations are positive, confident, optimistic people—exactly those whom you wouldn’t expect to need them.”) (p. 182)

The authors also dig into investor values. I particularly enjoyed the set of questions a top financial advisor asks his clients. They include: What about money is exciting (stressful) for you? What are three things you lie to yourself (to others) about when it comes to your money? (p. 112)

MarketPsych offers case studies, exercises, planning templates, and down-to-earth advice. All are designed to take the investor from being an underperformer to being an achiever. And for those who think that being average is good enough, here is a stunning statistic. $100,000 invested in the S&P 500 index on January 1, 1989, would have grown to $292,329 by 2009, after accounting for inflation. The average equities investor, by contrast, would have ended up with $82,288 over the same 20-year period!

I personally didn’t learn a great deal from this book, but then I’ve read thousands of pages on behavioral finance and trading psychology. For those who need help managing their investing selves but have no intention of ensconcing themselves in the library or laying out countless dollars, MarketPsych is a quick yet wide-ranging 240-page read.

Phillipson, Adam Smith

Back when I received the galleys of this book I wrote a post entitled “Who Was Adam Smith?” Now that Nicholas Phillipson’s Adam Smith: An Enlightened Life (Yale University Press, 2010) is being officially released today it’s time to revisit the book.

First, for those who care about such things, it’s a handsomely produced book—from the coated dust jacket to the color plates to the sewn binding. Second, and of course much more important, the work is skillfully crafted. Phillipson not only explores the interconnectedness of Smith’s moral, political, and economic ideas; he also demonstrates that the Scottish Enlightenment was far more than a backdrop for Smith’s work.

Adam Smith is a compelling, albeit difficult, subject for an intellectual biography. He viewed himself as a philosopher. He had wide-ranging interests: ethics, aesthetics, rhetoric, jurisprudence, history, politics, and economics. And yet, as one reviewer noted, we tend to disregard his “far greater and nobler … intellectual goals” and reduce him to “the hard-nosed high priest of self-interested capitalism.”

Admittedly, Adam Smith defended the Humean principle that “Till there be property there can be no government, the very end of which is to secure wealth, and to defend the rich from the poor.” (p. 174) But this principle is not as crass as it appears. Just as virtue is the goal of morality so opulence is the goal of political economy. In both cases Smith invoked the idea of improvement “which lay at the heart of the culture of enlightened Scotland….” He showed that “commerce and improvement were natural to human beings, a function of their natural indigence, their need for society and their love of the satisfactions improvement brings.” (p. 179)

Smith bemoaned the slow progress of opulence in Europe. “For Smith the root cause of the slow progress … was the feudal system. As he had shown in his lectures on jurisprudence, the feudal system had encouraged landowners to extend rather than improve their estates, reducing their tenantry to a state of dependency and even slavery—always in Smith’s reckoning the least productive form of labour. What is more, it was a system that had been artificially preserved by means of primogeniture and a system of tenures and entails which were as offensive to a people’s sense of natural justice as to the cause of economic efficiency.” (p. 223)

Colonial America, with its rapid progress, stood in stark contrast to Europe. In The Wealth of Nations he explained that “the root cause of the American colonies’ progress was simple enough: ‘plenty of good land, and liberty to manage their own affairs their own way.’ American land was cheap, and inheritance—in some colonies at least—was unencumbered by primogeniture, entails and high taxes. The colonists themselves appeared educated, frugal, tractable and hardworking. They were natural Smithian improvers who invested their stock in agriculture and simple manufactures and, because labour was relatively scarce, paid their labourers high wages, which encouraged them to set up on their own. Above all, they possessed a spirit of equality that encouraged a ‘republican’ attitude to government.” (p. 228)

I have teased but a single thread from Phillipson’s sympathetic yet balanced portrait of Adam Smith the man and the thinker. It’s an opulent biography.

Fullman, Increasing Alpha with Options

Scott H. Fullman’s Increasing Alpha with Options: Trading Strategies Using Technical Analysis and Market Indicators (Bloomberg Press, 2010) is not a book for option traders. Its intended audience is money managers who want to improve their equity returns and smooth out their P/L curve by adding options to their portfolios. The strategies are sufficiently elementary that I see no reason the individual investor couldn’t learn from Fullman’s book as well. That said, the investor or money manager who wants to implement any of the author’s strategies should have a solid understanding of option fundamentals, which this book was not designed to provide. A foundation in technical analysis would also be a plus.

Fullman concentrates on directional option strategies--calls and puts (and he’s not squeamish about being naked) and vertical spreads. He outlines a series of scenarios in which it could be advantageous to buy or sell options rather than stock, to replace stock with options, or to hedge a stock position or a portfolio with options.

Here are a couple of examples that use simple option strategies in not so simple ways. The first is a pairs trade that keys off of the relative strength of stocks within an ETF. Assume that you own XLB, the materials ETF, and that it is outperforming the S&P 500. Of the ETF’s 29 component stocks IFF, a former leader, is experiencing weakening relative performance and its momentum is turning lower. Consider the following two possible trades, both seven weeks to expiration. First, with IFF at $30.48 buy the 30/25 bear put spread on IFF. Second, write 30 strike IFF calls. A variation on this theme occurs when a sector “appreciates past the point at which its initial leaders begin to lose upward power, pushed by lagging stocks that often appreciate for longer than the leaders—though not necessarily for an extended time period.” (p. 97) In this case a fund manager could sell the XLB stock and buy a call on a laggard in the ETF.

One of Fullman’s favorite strategies is the covered combination in which “managers use a margin account to purchase between one-quarter and one-half of the manager’s normal position in the underlying shares, then write an equivalent number of out-of-the-money calls and out-of-the-money puts.” (p. 81) This strategy makes money if the stock goes up or remains unchanged. If the stock drops below the strike price of the put and the contract is assigned, “the manager buys the remaining one-half or one-quarter of the position, depending on the number of contracts sold, yielding a lower average purchase price than that offered by the stock’s original value.” (p. 82) Of course, some people would consider this an example of the often dangerous practice of doubling down.

Readers of books on investing and trading often complain that they are long on theory and short on practice. Fullman’s book offers specifics. It’s up to the manager to decide what kinds of strategies fit the risk profile of his fund and what he personally is comfortable with.

Robert Engle’s FT lectures on volatility, part 4: long run risk

When we are measuring volatility using the GARCH model we’re using high frequency data. This measures only short-term volatility—over the next few days, for instance. The options market, using implied volatility, estimates volatility over various time horizons.

The two-year volatility measured in red versus the one-month volatility measured in blue oscillate—sometimes short-term volatility is predicted to be higher than long-term volatility, sometimes lower.

The above graph shows the period between 2004 and 2005. Here the long-horizon volatility in red is much higher than short-horizon volatility. This disparity is even more pronounced if you look at longer-term options which are traded only OTC.

What is the implication of having long-run volatility so much higher than short-run volatility? For one thing, the sophisticated investor is not going to put money into the market under these conditions because the odds of losing money in a higher volatility environment are greater.