Day: May 20, 2009

Book Review: Quantitative Strategies for Achieving Alpha

Book Review: Quantitative Strategies for Achieving Alpha

In order to do this book review, I have to compare the book to five others that I have reviewed.

  1. Trend Following, (2), (3), (4), (5)
  2. Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell
  3. The Fundamental Index
  4. The Alchemy of Finance, and Soros on Soros
  5. What Works on Wall Street

I chose these five, because they deal with factors that affect stock performance.? With 1 and 4, you can learn a great deal about price momentum.? With 4, you learn how price momentum and mean reversion interact, and even get taste of why even fundamentalists should grab onto this.

Today’s book, Quantitative Strategies for Achieving Alpha, takes a mix of factors, including price momentum, and attempts to show how investors can achieve above average returns.? That is similar to what was posited in books 2 and 3 in rudimentary ways, and in book 5 in more sophisticated ways.? The book that is most similar to this book is What Works on Wall Street.? More on that later.

The author has seven “basics” that must be applied to all investments:

  1. Profitability
  2. Valuation
  3. Cash Flow
  4. Growth
  5. Capital Allocation
  6. Price Momentum
  7. Red Flags

These are the building blocks of good investment strategies, and the best strategies use 2 or more of the “basics.”? This is consistent with the book What Works on Wall Street.? The most important “basics” are Profitability, Valuation, Cash Flow, and Price Momentum.? Good strategies will look at most of them.

Quibbles

  • The data period for the analyses was short — a mere 20 years 1987-2006.? As time has gone on, data collection has gotten richer, but the 20 year period chosen was one of a big bull market, and not necessarily representative of the next 20 years.
  • Data mining — when testing a wide number of similar hypotheses, data snooping is a problem.? If theory A works well, why not test theories A’, A+, A-, A*, etc?? That happens in this book, but it does not make the error of What Works on Wall Street, because it does not make claims that the best strategies from the sample period will be the best strategies for the future.
  • Also on data mining, in the price momentum section, analyses are done to see which momentum strategies did best over the sample period, and then those strategies are applied.? Someone starting out in 1987 would not have had the benefit of that knowledge.
  • Strategies that favor increasing debt worked well, but that is a relic of the Greenspan era, where overages of debt were never punished.
  • Cash flow was an important variable, and there were variables for capital allocation, but there was not much discussion of earnings quality by itself, which has significant predictive powers.

The book is data and statistics heavy, but not equation heavy.? If your eyes glaze over from numbers and statistics, this is not for you.

Wrong way to use the book

Look for the strategies that gave the highest excess returns, Sharpe ratios, etc.? Follow those strategies religiously.? If you do this, you will mimic the excesses of the period 1987-2006.? Those won’t recur in the same way 2009-2028.

Right way to use the book

Use the book to guide your strategies.? Look at how you currently analyze stocks, and see if you aren’t missing significant factors that could improve your performance.? Look to balance your strategies such that all of the main factors get some representation.

Also, the summaries of each chapter are simple, and give the main thrust for those who get tired.? Tortoriello does a good job boiling it down for those needing a summary.? He also does not overpromise; the book is free from overselling, in my opinion.

If you want to buy it you can buy it here: Quantitative Strategies for Achieving Alpha (McGraw-Hill Finance & Investing)

Remember, I read the books that I review.? Not all do.? Those entering Amazon through my site, and buying anything, I get a small commission, and their prices do not rise at all.? This is my version of the “tip jar.”

One Dozen More Notes on the Economic Scene

One Dozen More Notes on the Economic Scene

1) I may as well start out the evening with some predictions. I’m not an expert on this, but Chapter 9 of the bankruptcy code applies to municipalities, but not states. Given the problems with state & municipal pensions, we will probably see chapter 9 modified over the next two decades to allows states to default. There will also be some modification to retirement funding laws as applied to municipalities, states, and maybe the US Government, to allow for retroactive negotiation of pensions and healthcare benefits for an insolvent government.

2) California will lead the parade of states in trouble.? They want the US to guarantee their municipal debt.? Schwartzenegger did all he could to try to pass the referenda that might partially close the budget gap, but from what I see now, it looks like most of the important ones have failed.? Having been a California resident for seven years, I went though my share of referenda; the referendum process makes the politicians of California lazy… they pass the tough stuff off to the electorate, who then get to decide off of voters’ guides and soundbites.

3) California is an exaggerated version of the troubles that other states are having.? Social program spending rises, while taxes on wages, corporate profits, real estate, real estate transfers, etc., all fall.? If you can’t print your own money, and must balance your budget, life is tough, kind of like it is for most Americans.

4) Another municipal issue — can financial guarantors split in two?? I have argued “no,” but who cares what I think?? We do care about those that use the courts, and banks are suing to prevent the MBIA split.? It is a simple issue of fraudulent conveyance.

5) One last municipal issue: pension placement agents.? This is very similar to what I experienced in Pennsylvania regarding municipal pensions there.? Pension consultants would gain business through campaign contributions, and the Democratic and Republican consultants would collaborate and share to control the profits jointly.? Insurance companies providing pension services would pay? compensation to the consultants in exchange for business.? It’s a dirty business, and when I raised ethical objections to it, I was told that I was naive.? Perhaps I have more company now.

Anytime you have opaqueness of compensation, politics, and uncertainty of results (investing), there is always room for corruption.

6) Asset allocation.? The belief in a large equity premium led many to overweight stocks.? I have argued against that.? Now there are many who are finding the they have to start over, after bad equity returns.? There is no magic in any asset class.? Yes, equities do better than bonds in the long run, but only by 1-2%/yr, not 5-7%.

As for the arguments of Ayres and Nalebuff, only the most emotionally dead investors can live with levering up 1.9 times perpetually.? Most people panic.? They can barely deal with the volatility of the S&P 500, much less double that.

7) Mmmm… is it time to take on Bill Miller again?? Yeh.? Overweighting financial stocks?? That is quite a bet, and probably irresponsible again.? Here is my free advice — analyze your estimates of intrinsic value with commercial real estate prices 30% lower than today.? Aside from short-tail insurers, I don’t think you want to be overweight financials.

8 ) On the same note, many small and intermediate-sized banks face troubles under stress, particularly from commercial real estate lending.

9) I think we are in the second inning for declines in prices for commercial real estate, but perhaps the seventh inning for residential real estate.? So long as residential properties sell for less than their mortgages there is downward pressure on prices, because negative events lead to foreclosures, not sales.

10) How will derivatives be regulated?? That is the question.? Will it be as transparent as TRACE?? I doubt it.? The market is not that liquid.

11) Will the US Government likely get full value back on TARP buyouts? No, because they lack expertise at analyzing these situations.? They don’t know what a warrant is worth.

12) Will low-rate mortgages rescue the economy?? No, but many middle class people with equity will breathe easier after they refinance.? Also, some will buy homes, but who will have the downpayment necessary to qualify now that underwriting has tightened?? Not many.

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