If it wasn’t enough to have Bloomberg sue the Federal Reserve, now we have Fox Business News suing the US Treasury for refusing to disclose information asked for under the Freedom of Information Act [FOIA].

I don’t have much to say here (for now) because I have not seen the complaint yet, but I would say that American citizens are entitled to know the details of the bailout plans because they are a large part of the Federal budget, supported by our taxes.  The same is true for the actions of the Federal Reserve, because they are messing with the value of the US Dollars we hold.

What does the Treasury have to hide?:

  • How were the amounts of relief chosen?
  • Who qualifies for relief, and why did you turn some away?
  • Why did AIG get special treatment?
  • Why didn’t you bail out Lehman?
  • What Constitutional authority do you have for doing any of this?
  • Why do you think that auto companies can get relief here, given the terms of the bailout bill?

This is a mess, though less of a mess than the one at the Federal Reserve.  Our choices are hard today because of previous choices where we relaxed monetary/credit policy at points where it would have been painful.  We are facing far more pain today as a result.

It;s a pity that the incoming administation doesn’t get it.  Reducing leverage slowly should be priority number one.

1) There are firsts for everything.  Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952.  America has always been a pro-debt and pro-debtor nation.  It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period.  But, the Pilgrims did extinguish the debt.  Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity.  With the decline in housing values, the fall in the ratio was inevitable.  The low ratio puts downward pressure on home prices, because it means that more homes are underwater.  Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector.  Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble?  Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more.

5) Now these same low yields whack Treasury money funds. How many will close?  How many will cut fees?  How many will break the buck, and credit negative interest?  An unintended consequence of monetary policy.  Another unintended consequence reduces liquidity in the repo markets.  Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates.

6) Brave Ben Bernanke is fighting the Depression.  If his theories are right (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy.  But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle.

7) Inflation is the lesser evil at this point.  It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go, and Elizabeth Warren now confirms it for the Treasury.  My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.”  So it is for the TARP bailout.  Policy made hastily rarely works.  Spend more time, get it right.  The market won’t die as you work it out.

9) But will AIG die, or the automakers?

10) Even VCs are looking at the survivability of their portfolio holdings.  Who can survive and become cash-flow positive in a tough environment.  Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers.  Watch the loan covenants, so that you can get good recoveries in a default.  If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults.  For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices.  Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss.  This is a tough time for anyone taking credit risk.  That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics.  I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers.  He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes.

16) You can give the banks funds, but you can’t make them lend.  Would you lend if you didn’t have a lot of creditworthy borrowers?

17) The export boom is dead, for now.  Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed.  Sorry, but the secret to changing the residential real estate market is not lowering interest rates, but writing-off  portions of loan balances.  Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater.  Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?

19) On commercial property, when do you extend on a loan vs foreclosing?  In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan.  More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position.  With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now.  (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar?  As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever.  Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized?  The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming.  As the interest rate differentials narrow in real terms, the US Dollar should improve.

But, there are complicating factors.  Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates.  Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply.

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies.  For now, put your macroeconomics books on the shelf, because they won’t be useful for some time.

Many people have asked me what to do in this market environment, and I have sat and thought about it.  My own personal portfolio is around 60% equities, 15% my home, and 25% cash.

I think probabilistically.  I don’t focus on just one scenario.  I try to balance across a wide number of scenarios, and ask what will do the best.  In a foggy situation like today, that answer is not easy.

I will give you an example.  8.5 years ago, the leaders of my church came to me and said “Would you invest the money for our congregation’s building fund?”  My initial answer was “no.”  I don’t like investing money for friends, generally.  They came back again, and said, “Please?”  I felt ashamed, and said, “Okay, fill out this risk questionnaire.”  They gave me a series of answers that essentially said, “We don’t know when we need the money, but get a good return for us.”

Ugh.  In May of 2000 went back to Ben Graham’s 50/50 (stocks/bonds), and then adjusted it, taking 10% from the area of the market that I liked worst, and added it to the area I liked best.  I took growth stocks and sold them and bought long term corporate bonds.

Since then I have made further adjustments.  The current portfolio is:

  • 5% Energy stocks (VGENX)
  • 5% Gold stocks (VGPMX)
  • 25% International stocks (VINEX)
  • 25% TIPS (VIPSX)
  • 20% Intermediate Investment Grade Corporates (VFICX)
  • 20% High Yield (VWEHX)

Much as I like Vanguard, I am not endorsing any of their funds here; they are example for asset allocation.  I am very light on US stocks here, and intentionally so.  This portfolio has an anti-inflation bias, and will do better against a weaker dollar.  The corporate bonds, both investment grade and high yield, replace equity exposure.  Corporates are cheap relative to common stocks, and they have better protective characteristics as well.  Though I don’t have any closed-end corporate floating rate funds here, they could be interesting if their leverage was low enough, which isn’t common.  As for the international developed market stocks, a basket of different countries will likely do better than a simple US exposure, even if the dollar continues to fall.

TIPS have been a fatal attraction for me, and I hope to have a post  out in the near term explaining their value in this environment where inflation is negative for now.  My view is that the Fed will eventually monetize the debts they are incurring.  Also, as the dollar gets weaker, inflation will get imported back into the US.

What could go wrong here?  We could have a trade war, or the US government could take actions to protect the value of debt held by foreigners (not likely).  If the equity markets rally, investment grade corporates and high yield will not be far behind, but this portfolio would lag.

No portfolio is perfect.  This one certainly isn’t, but it is my attempt to position for what I view as a lousy economic environment that will eventually yield inflation.

Full disclosure: long VIPSX, and my church long what is listed above

There have been a lot of articles recently about the poor performance of hedge fund of funds, and hedge funds generally.  I’ve written before on this topic, so if you have a subscription to RealMoney, and want to peruse my earlier pieces on market structure, here they are (with their odd titles, I wanted something more consistent):

Many investment managers seem to not think globally about their businesses.  It becomes: “Follow my process.  Buy and sell securities that my process reveals.  Succeed.  Rake in more money to invest, if my marketing guy is competent.”

Market environments like this reveal the weaknesses inherent in balance sheets of all sorts.  Every investment enterprise, every company, and even you have a balance sheet.  During times of stress, those balance sheets get tested.  Many of them are found wanting, if one can read the writing on the wall. 😉

An investment manager thinking globally, using logic from a source like Co-opetition, or Michael Porter’s Five Forces considers not only his actions, and the actions of securities that he has bought or sold short, but considers in broad the actions of other managers, and companies that he does not own.  He also considers the affairs of his investors, and the stresses they are under.  What if they are under stress, and need to redeem funds at an inopportune time?  What if they pour in money in a frenzy during good times?

It is important, then, to think about how a manager should structure the cash flows of his fund.  How liquid/fungible are the assets?  As with a money market or stable value fund, how much can the book value (what investors can withdraw) differ from the market value (best estimate of what the securities are worth)?

With some open-end real estate funds, they limit redemptions to the amount of cash that can be realized at each withdrawal date, and investors stand in line for the portion of their money that they will receive.  Or, consider hedge funds with illiquid positions.  Many funds, including the famed Citadel, are restricting withdrawals in order to avoid fire sales (or forced buy-ins) of assets.

But there is more to the Co-opetition framework here.  Shouldn’t managers try to estimate if there are too many other managers following their strategies?  With all of the adulation over managing the endowments at Harvard and Yale, isn’t it possible that too many endowment managers got Swensen-envy, and decided to allocate to “alternative assets” at the worst possible time?  That ‘s a reason to be cautious on illiquid alternative asset classes.  You can’t undo the decision without significant costs.  Also, there is greater freedom to mess up, as happened with Calpers on real estate.

Another way to think about it, is that when too many managers pursue the same strategy, in absolute terms, it does not matter if you are the best manager of the strategy.  If too much money is being thrown at the strategy, it will underperform, and the best manager will be carried down with the worst.  The relative performance will be better, but there will still be a likely loss of assets in the “bust phase” of that market.

But in the present environment, we have had the challenge of many managers seeking returns off of every market anomaly that we collectively can imagine.  When a market anomaly gets saturated with enough assets, returns become market-like.  Risk becomes market-like as well, because the investors are subject to needs/fears for cash flow.  In the recent past most anomalies have been saturated.

That is one great reason why so many seemingly unrelated asset classes have become so correlated.  The investor base as a whole diversified, and all of the asset classes are subject to their greed and fear.

Now, there will always be new entrants with novel and profitable theories, but their success will attract imitators, and their returns will decline.  Aleph will give way to Beth, oops, Alpha will decline, and the new methods will correlate with the market as a whole (Beta).

As for hedge fund-of-funds, they suffer from the conceit I described yesterday.  They look at past uncorrelatedness, and presume that past is prologue.  Thus someone with a positive alpha, and uncorrelated returns can get a big allocation, like Mr. Madoff.

As investors, we need to think about the markets as a whole.  We can’t afford the luxury of ignoring the broader picture, as some stock pickers might.  Instead, we need to consider the macro and the micro factors, and when we can find them with any accuracy, the technical factors.

This is not easy to do, and I often fail.  But I would rather be approximately right than precisely wrong.  May it be so for you as well.

The Federal Open Market Committee decided today to lower its establish a target range for the federal funds rate 50 basis pointsof 0 to 1/4 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

Since the Committee’s last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.  Financial markets remain quite strained and credit conditions tight.  Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters to levels consistent with price stability.

Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee Federal Reserve will monitor economic and financial developments carefully and will act as needed to promoteemploy all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.  As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.  The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.  Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.  The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice ChairmanChristine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 5075-basis-point decrease in the discount rate to 1-1/4/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.

The Upshot

  • We’re done with Fed Funds in entire.
  • On to quantitative easing.  (Japan had the advantage of running a current account surplus… how will it work for us with a deficit?)
  • The princely rate of 1/4% gets paid on all reserve balances at the Fed, both required and excess.
  • The Fed is looking at deflation, not price stability.
  • The Fed will possibly invest more into long Treasuries, with uncertain prospects.
  • The Fed will continue to make it up as it goes, and keep expanding its balance sheet, adding liquidity where it wills, and replace functions of the private lending markets in the name of fixing the lending markets.

Time again for another underwhelming FOMC meeting.  As I said before the last FOMC meeting, in The Fed Funds Target Rate is an Exercise in Futility, we are so close to the zero bound that further easing will do little.  Here’s a graph of effective Fed funds:

That is not to say that the Fed is out of options, but the FOMC and what it has to say, matters less and less.  The various lending programs of the Fed are where the action is, where they monopolize liquidity for the markets they deem worthy of service, while starving everything else of liquidity.

As others have commented, and I can’t remember where, the low Fed funds rate reduces the powers of the regional Federal Reserve banks, and raises the power of the NY Fed and the Board of Governors, because the regional Federal Reserve banks don’t have much play in the new lending programs.

The low fed funds rate affects high credit quality money market funds, many of which will close to new investments (and/or reduce fees).  Otherwise, the low rates may cause them to “break the buck.”  As it is, rates will be near the zero bound for a long-ish time, unless we get a spate of inflation due to dollar depreciation.

I’ll be back with a redacted version of the FOMC Statement after it is issued.

When I think about the present market difficulties, I think about both the situation as a whole, and the personalities involved.  We might look at Bernie Madoff as a poster child for the current distress, but back during the Great Depression. we might have considered Richard Whitney.

Though the conditions are different, when conditions move from boom to bust, cheaters get revealed — those who were relying on good times in order to make good on promises gone wrong.  Both Madoff and Whitney had sterling reputations as well, and they both played a significant role in the trading of the market.

Perhaps big frauds require seemingly upright men who command trust from their peers.  Practices that can be gooten away with during a bull phase of the market will fall flat during the bear phase.

Aside from the Whitney story, Once in Golconda tells the story of boom and bust for the financial economy as a whole.  Taking chances ramped up, supported by a too-easy monetary policy.  After the peak, opportunities were few, and few had the spare capital to invest in ventures that were seemingly rich, as measured against boom conditions.  Such is the nature of scarce liquidity after a boom.

This is a fun book.  You can see the gathering storm as liquidity grows, and markets boom.  You can see the increasing furor nearing the peak.  At the peak, you can’t hear much.  During the fall you can hear investors go through the five stages of grieving as they watch their investments die.

This is a good book, well-written, and appropriate for our era.  I recommend it.

If you want to, you can buy it here: Once in Golconda (Wiley Investment Classics)

PS — Remember, I don’t have a tip jar, but I do do book reviews.  If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra.  Such a deal if you wanted to get it anyway…

One of the great conceits in investments is trying to earn above average returns with low variability of returns.  Yet, when you consider the Madoff scandal, it is what can attract a lot of money from credulous investors.

One of the glories of a capitalistic economy is that markets are unstable, they adjust to point out what is no longer needed.  Often the adustments occur violently, because businessmen/consumers chase trends, which can lead to bubbles and bubblettes, until the cash flows of the assets cannot bear the interest flows on the debts that have been created to buy the assets.  Attempts to tame this, such as Alan Greenspan’s aggressive provisions of liquidity just build up more debt for an economywide bubble, followed by a depression.  We got the Great Moderation because of trust in the Greenspan Put.  The Fed would only take away the punchbowl for modest amounts of time, so speculation on debt instruments, real estate, financial institutions, etc., could go on to a much greater degree.  Boom phases would be long; bust phases short and low-impact.

There have been problems with lax regulation of bank underwriting, and investment bank leverage, but the key flaw was mismanagement of the money/credit supply.  Had the Fed held credit tighter during the ’90s and 2000s, we would not be here now.  The Fed could have kept the fed funds rate high, rewarding savings, perhaps leading to a lower cuurent account deficit as well.  Debt growth would have slowed, and securitization, which hates having an inverted or flat yield curve, would have slowed as well.  GDP growth would have been slower, but we would not be facing the crisis we have now.

Or consider housing, and how it became overbuilt because of lax loan underwriting, accommodative monetary policy, and a follow-the-leader mania.  Here’s an old CC post from the era:

David Merkel
Pensions, Energy and Housing
8/18/2005 3:32 PM EDT

1) For those with stable businesses that throw off a lot of earnings and cash flow, and want to dodge the tax man, here’s a possible way to do it, courtesy of the Wall Street Journal: start a defined benefit plan. Disadvantages: complex, relatively illiquid and expensive. Advantages: you can sock away a lot, and defer taxes until you begin taking your benefit, possibly (maybe likely) at lower tax rates.

(This message brought to you courtesy of one actuary who won’t benefit from the message itself… but hey, it helps the profession.)

2) Sea changes in the markets rarely take place in a single day or week. Tops, and changes in leadership tend to take place over months, and feel uncertain. Though Jim is pretty certain that it is time to shift out of energy, I am willing to hang on, and get my opportunities to average down if they come at all. My rebalance points are roughly 20% below current prices anyway, so I’d need a real pullback in order to add.

Though there may be temporary inventory gluts, the basic supply/demand story hasn’t changed, and energy stocks still discount oil prices in the 40s, not the 60s.

3) Contrary to what Jim Cramer wrote in his housing piece today, you can lose it all in housing. Granted, it would be unusual to see homeowners in multiple areas in the country lose their shirts all at the same time; that hasn’t happened since the Great Depression, and we all know that the Great Depression can’t recur, right?

Thing is, local hot real estate markets often revert; if the reversion is bad enough, it leads to foreclosures. Think of Houston in the mid-80s, and Southern California in the early 90s. For that matter, think of CBD real estate in the early 90s… not only did that threaten real estate owners, it did in a number of formerly venerable banks and insurance companies.

Real estate is not a one way street, any more than stocks are. We have never financed as much real estate with as little equity as today before. We have not used financing instruments that are as back-end loaded before. Finally, this speculation is being done on a basis where renting is far cheaper than owning, leaving little support for property prices if the incomes of leveraged homeowners can’t be maintained in a recession. (Oh, that’s right. No more recessions; the Fed has cured that.)

Look, I’m not pointing at any immediate demise of housing in the hot markets. I still think that any trouble is a 2006-7 issue. But this is not a stable situation; if you have a large mortgage relative to your income, make sure your employment situation is really stable. If you can make the payment, prices on the secondary market don’t matter. If you can’t… those prices matter a lot.

One more note: an average investor can sell all of his stocks in the next 20 minutes, with little effect on the market. This is true even in a bad market. In a bad real estate market, you can’t sell; buyers are gunshy — it is akin to what I went through as a corporate bond manager in 2002. There are months where there is no liquidity for some bonds at any reasonable price. So it is for houses in some neighborhoods when half a dozen “for sale” signs go up. No one can sell except at fire sale prices.


Well, that’s the macroeconomic problem with stability.  When it gets relied on, after a self-reinforcing boom, it goes away.  Trust in stability is dangerous in other contexts, though.  From another CC post:

David Merkel
Oil and Economic Strength (and a Rant on the Sharpe Ratio)
8/31/2005 3:13 PM EDT

I haven’t really talked about the issue of whether high oil prices portend economic strength or weakness for a good reason. No one knows. There are too many moving parts, and separating out the different effects is impossible; opinions here come down to more of one’s personality (optimist/pessimist) or investment positions (stocks/bonds/energy).

Even if someone did tests using Granger-causality, I’d still be suspicious of the result, whichever way it would point, because of the high probability of finding spurious correlations.

And, speaking of spurious correlations, since Charles Norton brought up the Sharpe ratio, I may as well say that it is a bankrupt concept as commonly used by investment consultants. First, variability is not risk. Losing money over your own personal time horizon is risk (which implies that risk varies for each investor). Second, there is not one type of risk, but many risks. Systematic risk may be measurable in hindsight, but never prospectively.

Third, any measure going off historical values is useless for forecasting purposes, because the values aren’t stable over time. When managers get measured in order for clients to make decisions, they are using the figures for forecasting purposes. It is no surprise that they don’t get good results from the exercise.

Why do figures like a Sharpe ratio gets used, then? Because consultants like simple answers that they can give to their clients, even if the answers yield no insight into the future. (It makes the math really simple, and allows a large number of strategies to be rapidly compared. It eliminates real work and thought.) Investment is a far more messy process than a few simple ratios can illustrate, and those that use these ratios get the results that they deserve.

Finally, an aside. Why am I so annoyed by this? Because of money lost by friends and clients who have been led along this path by investment consultants. There is a real cost to bad ideas.

Position: none

And this CC post as well:

David Merkel
Time Series Regression and Correlation (for wonks only)
7/12/2007 3:11 PM EDT

We’ve had a few discussions here recently involving correlation, so I thought I might post something on the topic. First, it is easy to abuse statistics of all sorts. Few on Wall Street really understand the limitations of the techniques; I have seen them abused many times, often to the tune of large losses.

When comparing multiple time series of any sort, the results can vary considerably if you run the calculation daily, weekly, monthly, quarterly, annually, etc. As you use fewer and fewer observations, the parameters calculated will change. The best estimate will be the one using all available observations, that is, assuming that the underlying processes that generated the time series will be the same in the future as in the past.

It gets worse when comparing the changes in time series. Here moving from daily to weekly to monthly (etc.) can make severe differences in the calculations, because two data series can be almost uncorrelated in the short-run, and very correlated in the long run. My “solution” is that you size your time interval to the time interval over which you make decisions. If daily, then daily, annually, then annually. Again, subject to the limitation that that the underlying processes that generated the changes in time series will be the same in the future as in the past.

But often, the results aren’t stable, because there is no real relationship between the time series being compared. High noise, low signal is a constant problem. Humility in financial statistics is required.

As an example, calculations of beta coefficients often vary significantly when the periodicity of the data changes. People think of beta as a constant, but I sure don’t.

For those who want more on this, there are my two articles, “Avoid the Dangers of Data-Mining,” Part 1 and Part 2.

Enough of this. Back to the roaring markets! Haven’t hit the trading collars yet!

Position: none, but intellectually short Modern Portfolio Theory [MPT]

My point is this: investors look for stable relationships that they can rely on.  Those relationships are precious few.  Sharpe ratios aren’t stable; correlation coefficients aren’t stable; return patterns aren’t stable.  They shouldn’t be stable.  They rely on a noisy economy  which is prone to booms and busts, and industries that are prone to booms and busts.  Seeking stable returns is a fool’s errand.  Warren Buffett has said something to the effect of, “I’d rather have a lumpy 15% return, than a smooth 12% return.”  Though we might mark down those percentages today, the idea is correct, so long as the investor’s time horizon is long enough to average out the lumpiness.

So, if we are going to be capitalists, let’s embrace the idea that conditions will be volatile, more volatile on a regular basis, but given the lower debt levels across the economy because of regular shakeouts, no depressions.  But this would imply:

  • Higher savings rates.
  • Greater scrutiny of balance sheets.
  • Aversion to debt, both personally, and in companies for investment.
  • Less overall financial complexity, and a smaller financial sector.
  • Lower P/Es at banks.
  • Even lower P/Es in non-regulated financials.  It’s a violent world.

For further reading:

One of my commenters wrote in response to my piece Book Reviews: The Complete Guide To Option Pricing Formulas, and Derivatives, Models on Models:

  1. Kurt Osis Says:

    How can advocate people using these models which clearly don’t work? Estimating volatility is a suckers bet. Even if you could estimate the underlying “actual” volatility with 100% accuracy there would be sample error in your realized volatility. And of course the volatility isn’t just changing, the fundamentals of the underlying are changing.

    I once heard of a man named Mandelbrot who said volatility was infinite, in which case these sigmas and lemmas are a bit beside the point, no?

Kurt, I’ve met Mandelbrot, and have discussed these issues with him.  The two books that I recommended are also up on those issues.  Implied volatility estimates as applied to option pricing formulas are a fall-out.  No one thinks they are true, but they are a paramater used to keep relationships stable across options of similar expirations.

Intelligent hedgers hedge options with options; they don’t try to apply the theoretical equivalence that lies behind the traditional Black-Scholes formula and do dynamic hedging with the common stock itself.  That is the philosophy behind the books that I reviewed.

I’m on your page, Kurt.  Variance is infinite, and B-S blows up.  But within the options world, there has to be a way of calculating relative value, and these books aid us in that calculation.

If you think I am wrong here, go to your local library, and get these books via Interlibrary loan.  Read them, and you will see that we are all in agreement.

I am usually not crazy about books that propound a simple way to beat the market.  This is one of those books.  What makes me willing to write a review about this book, is that the writer, Charles Kirkpatrick is willing to incorporate some fundamental measures into his analyses, notably price-to-sales, which will help with industrial companies, but not with financials.

This is a simple book that reinforces the idea that one needs to pay attention to valuation (in a rudimentary way), and also to momentum.  While I don’t endorse the specific methods of the book, I will say that for someone with a low amount of time, and wanting to do a little better than the market averages, he could do so over the intermediate-term with the methods in the book.

Note: I am not endorsing the technical methods in the book, but most of the methods boil down to momentum, anyway.

If you want, you can find it here: Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell

PS — Remember, I don’t have a tip jar, but I do do book reviews.  If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra.  I’m not out to sell things to you, so much as provide a service.  Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books.  I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.