July 2010 – Page 2 – The Aleph Blog

Book Review: Fortune’s Formula

Posted on 17 July 2010 by David Merkel

When I reviewed the book Priceless, I thought I had reviewed “Fortune’s Formula,” because I had written several pieces on the Kelly Criterion at the blog and at RealMoney (free at TSCM).? But I found that I had not, so I offer you this review of a book I greatly enjoyed:

The book asks a simple question: in making a bet, investment, or business decision, what is the optimal amount of capital to allocate?

But the author, William Poundstone, is not going to give you the answer immediately.? He is going to take you on a journey where you can meet many odd personalities from the ’50s to the early ’00s, and how they came to look at the problem.

Ed Thorp was fascinated with Blackjack, and originated card-counting to improve the probability of winning, to what the card counter had and edge versus the casino.?? He meets John Kelly, Jr. while working together at Bell Labs on Information Theory.? He discovered that an economic actor with an edge could size his bets as a ratio of his edge in? betting divided by the odds received on the bet.

Thorp eventually published a paper, “Fortune’s Formula: A Winning Strategy for Blackjack,” which led to a torrent of interest from gamblers.? With the aid of several backers, Thorp tried out the methods with some success in Reno, with two wealthy gamblers as backers.? That tale was hairy, to say the least, but they more than doubled their money.

Thorp later applied himself to the sleepy market for stock warrants in the 1960s. He developed delta-hedging along with a colleague.? As the book progresses, gambling ceases to be the focus, and advanced strategies for making money on Wall Street with little risk becomes the rule.? And, as in Vegas, as they took steps to lessen the edge in blackjack, on Wall Street competition itself eroded the edge.? But Thorp set up a hedge fund to take advantage of securities mispricing.

One odd sidelight is the number of parties that came up with the option pricing formula known as Black-Scholes, long before B-S wrote their paper.? Life reinsurance actuaries had a version of it in the ’60s, Bachelier had a version of it around 1900. And there were others, but the point was that no one took advantage of the knowledge, except in rough ways, prior to the B-S paper.

Yet option theory could be applied to a wide number of situations, convertible bonds and preferred stocks, even corporate bonds themselves, in addition to warrants and options.? Those that did it early made a lot of money.

A more generalized version of the Kelly Criterion says to focus on the choice that offers the highest geometric mean return.? This led to a conflict with academic economists who insisted the optimal strategy was derived from utility maximization.? What is not disputable is that the Geometric mean will maximize terminal wealth, a result found by Bernoulli and Latane.

The book takes us through financial crisis after crisis, showing how bet sizes were too large relative to the results.? It also takes us to the end where a number of the protagonists end up decidedly wealthy from their attempts to beat the market.

Quibbles

Though Poundstone’s aim is the Kelly Criterion, more of the book is dedicated to finding edges, whether beating the dealer in blackjack, or arbitrage of securities.

If you want to buy the book, you can buy it here:? Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

Who would benefit from this book

Many people would enjoy this book, written in 2005.? Poundstone tells a good story and illustrates how a number of clever men found edges, pursued them, and triumphed.? The reader may not be able to beat the world after reading this, but it may teach him about how bright men found ways to pursue their advantages.

Full disclosure: I bought my copy with my own money.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

The Education of a Corporate Bond Manager, Part I

Posted on 16 July 201016 July 2010 by David Merkel

In 2001, I became a corporate bond manager by accident.? I had been the mortgage bond manager and risk manager of a unit managing the assets of a medium-to-large life insurer, when the boss left to take another job in the midst of a merger.

The staff and I got together, and the credit analysts told me that I should lead the organization during the merger.? When I asked why, they said they trusted me, appreciated my growing bond skills, that I was the only one who understood the client, and said that I had a better call on credit than the boss had.? I was surprised by that last comment, but upon meeting with the management of our parent company that was selling us, along with the life insurance company that we managed, they told me that yes, I should lead the unit until the merger closed, but rely on the high yield manager in our group to advise me for the duration, which was going to be three months.

The first thing that I did was a bond swap, trading away an older bond of a company for a new issue.? There was some hurry in the matter, so I entered into the swap before I could consult the high yield manager.? After I could talk with him, he pointed out that I had offered terms more favorable than I should have.? On a $5M swap, I ended up losing $20K.? We worked through the swap a number of different ways, which solidified my knowledge of corporate bond pricing.? I did not make that error again.

In the corporate bond market, new deals come frequently.? My former boss would do almost all of his bond buying on new deals, and almost never in the secondary market, because he knew that new deals almost always came cheap.? There is a price to be paid by corporations to gain liquidity.? The life company that I managed money for was growing like a weed (their products were perpetually underpriced), so I had a lot of money to put to work.

But, I already had a large portfolio of corporate names.? I was familiar with many of them to some degree because of my stock investing.? How could I go through the whole portfolio to look for bombs that might be lurking? Ask the credit analysts to give me a review on every name?? I did not want to kill them, or me for that matter.

I took the idea home , and thought about it, and then it struck me.? Thinking of bonds as having sold a put option to the equity, why not look at the amount that the stocks of the companies issuing the bonds had fallen in price since issuance of the bonds?? I set a threshold of 50%, and that gave me a list of about 30 names to hand to the analysts.? Manageble.? Cool.? (Oh, and tell me briefly about these 20 private bonds where there is no stock price.)

The analysts came back with their opinions, and surprisingly they advised selling half of the bonds and keeping the other half.? That was more than I expected.? But I started selling away, and began to learn the art of price discovery.? When you want to sell a bond, you first have to look at what investment banks ran the books of the deal.? There is an unwritten rule that if they play that large role in origination, they have to make a market in the bonds thereafter.? So, I consulted the various investment banks and inquired about levels, and then said something to the effect of, “If there is a reasonable bid (naming the spread over Treasuries) we would be interest in losing a few million bonds.? If there is an aggressive bid, we could be induced into selling a few more.? We might even be willing to sell the whole wad if they make us the offer that we can’t refuse.”

If there were multiple banks that traded the bond, I would set the above up with just one bank.? You never wanted to make it look like there were two sellers out there, or bids would vanish.? Beyond that, it was bad etiquette to employ two banks without telling them that they were in competition with each other.? If not. you could end up with two orders to buy your bonds, and you would have a moral obligation to meet both orders, even if that was against your interests.

Usually the broker would ask for the total size of the wad available for sale.? The idea was to get the buyers to think economically.? Yes, they could get a small amount of bonds if they met the spread, but was it worth it to bid for more?? Also, if they bought the wad, they would know that there were likely no more bonds on offer, the selling pressure would be gone, and the bonds would likely trade up from there.

I sold away a decent amount of the bonds that the analysts wanted gone, and then 9/11 hit.? What a day.? Since we worked inside the insurance company that we manager money for, and we had two TVs on the corners of our trading floor, all of a sudden our area was flooded with people staring at the spectacle.? I almost felt like Crocodile Dundee as I had to maneuver my way around and over them.

I gathered my staff and told them to look at their portfolios, and e-mail me threat reports so that I could inform our client.? After that, take the rest of the day off, as there is nothing to do here; many of them wanted to mourn friends that might be dead (I lost two acquaintances).? I summarized the threat reports, and submitted them to the client by 4PM.? We repeated that process for the next eight business days, until the crisis was past.

I had worries over One Liberty Plaza, next to the former World Trade Center, which seemed to be leaning, and might fall.? We owned the AAA portion of the CMBS that contained the loan for that building.? As I scoured the web, I concluded there was no danger, the building only looked like it was leaning; the dark coloration was deceptive.

Eventually trading resumed.? If you remember Metcalfe’s Law, the value of a telecommunications network is proportional to the square of the number of connected users of the system.? Well, after 3 days, 2 of 12 major brokers were running, which meant that there was no trading.? After 4 days, 6 brokers were up, so I made an offer on some AA Manufactured Housing ABS, deeply below where there market was prior to the crisis.? I got hit, and I owned the bonds.? Some said to me, “Why not wait?? Why offer liquidity now?? I said that some had to make some bids to restart the market; my client had ample liquidity, and I was offering liquidity at a price; if someone was that desperate for liquidity, they could have it at my price.

After 5 days 8 of the 12 were up, and after 6, 10 of 12.? The last two took a while to re-emerge, but were back after 10 days.? Even so, things seemed sluggish.

I began to do the same with corporate bonds, doing a large auction offering liquidity, specifying bonds that I wanted at certain levels, and the amounts.? I ended up buying half of my list, and still my client had ample liquidity.? What a high quality problem to have.? More in my next segment.

Book Review: Complicit

Posted on 15 July 201010 December 2010 by David Merkel

I am not sure how many current economic crisis books I have reviewed.? I think I am getting close to a dozen and I am currently reading “Fault Lines.”? I’m not sure I want to do many more crisis book reviews.? Tonight’s review is Complicit, by Mark Gilbert of Bloomberg.

Bloomberg columnists are typically good writers, with detailed knowledge of their subject areas, and a no-nonsense approach to writing.? This book from Mark Gilbert is no different.? As Joe Friday often said, “All we want are the facts, ma’am.”

And for the most part, that’s what you get in Complicit.? It is not a long book at 173 pages, but it comprehensively chronicles the growth in leverage, and how it spread to many areas of the investment markets.

When bubbles grow, everyone is a friend.? Underwriting becomes lax, limits are stretchable, FICO scores are pessimistic approximations, etc.? Risk is transitory; we originate to sell.? Regulators don’t want to stand in the way of seeming prosperity.? Nor do politicians.

Leverage gets higher in explicit and implicit ways.? Credit spreads get tight as a drum.? It is a virtuous cycle… until it become a vicious cycle.

In the bust, credit spreads rise, cutting off the possibility of refinancing.? Then asset defaults come, and GSE and bank insolvencies.

Central banks did not view inflation broadly enough, focusing on goods price inflation, and ignoring the asset inflation that was distorting the economy.? They disclaimed an ability to see, much less deal with bubbles.

The high yield market became a frenzy for yield, with CDO equity bidding for lousy bonds and default protection on lousy corporations.? Debt spreads tightened to levels that indicated perfection had arrived.

Investors chased risk, seeking returns.? There were too many parties willing to make fixed commitments, because they needed to earn a lot.? Balance sheets were ignored, and income statements were everything.? History being bunk, was thrown out the window, because it was different this time, we were in a new era.

The crash in Shanghai was the first warning in February 2007, followed by the equity quant crisis in August 2007, and the breakdown in the money markets.? All of the clever ways parties used to lever up short-term credit blew up, forcing banks to take credit back onto their balance sheets.? At that point, everyone should have dumped the banks, but few did; leverage was too high, and asset prices were falling.

The critical decision was bailing out Bear Stearns.? I agree with Gilbert; either both Lehman and Bear should have been bailed out or neither.? I think not bailing Bear and Lehman out would have led to the best outcome.? After Bear failed, other banks would have moved to straighten themselves out.? We might not have had as much failure had as we eventually did. The inconsistency of regulation, as well as the unwillingness or regulators to be tough added to the crisis.

The book covers the September 2008 climax well, but takes us past that, offering possible solutions.? I particularly liked the ideas of limiting the number of academics in important regulatory posts, and having more regulators with practical experience.? I also liked central bankers being proactive on bubbles, and the asset/liability matching inherent in paying those that make long term decisions with financial instruments that last for the term of the decision, and are contingent on the credit quality of that decision.? An example would be paying securitization originators with pieces of the subordinated tranches.

I liked the book; for those with limited time, the book is particularly suitable, because it is brief.

Quibbles

Gilbert’s style is hard-hitting; though many financial companies took advantage of government largesse, few practically considered the possibility of bailouts while the boom was going on; they were pursuing profit with little thought of systemic risk. There was a lot of greed, but in my opinion, few expected bailouts, but took them when they were offered.

Who would benefit from this book?

Most people would benefit from this book on the crisis.? The book is available here: Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable (Bloomberg)

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.? I review about 80% of the books that get sent to me.

A Baker’s Dozen of Notes on the States

Posted on 14 July 2010 by David Merkel

When I wrote my piece Watch the State of the States, I did not expect the degree that it would be picked up by other blogs and media.? I still think the states are critical to watching the well-0being of the nation, and I want to point out a few more items here:

1) There is some good news.? Tax receipts are increasing.? It would be better if the states were getting ahead of spending, excluding recent subsidies from the Federal Government.? When the states get there, unemployment will stabilize.

2) Though conditions in Real Estate are not good in general, there are some bright spots, like condo activity in Miami.? Though renting now, that can plant the seeds of stabilization, because it means there is some bottom-line demand for the space.? It doesn’t have to be torn down to turn it into orange groves. 😉

3) I agree with Felix, muni bond defaults will not prove to be a source of systemic risk.? They are too broadly held; defaults will hurt individuals more than institutions, and it is quite possible that municipalities may make up lost interest payments and become current on their debts again.? Unless defaults cascade, and there is a change in the ethics of municipalities not subject to Chapter 9, the effect should not be large, except on the taxpayers who get milked to pay, and the government employees that get laid off.

Now there are some banks with outsized holdings of munis, but they are not the majority of banks.? And, though I respect David Goldman, I don’t think the default severities will force the Federal Government to bail out municipalities.? The Federal Government may do so anyway, out of intellectual and moral weakness, until its wings get clipped by the global debt markets.? But they don’t HAVE to do it.

4) One last bright spot: more states are looking at hybrid pension plans.? Hybrid plans combine defined contribution and defined benefit plan attributes.? It is one of the few ways of trying to reduce legacy pension promises, if you can get unions and participants to go along with it.

5) But on the negative side, when DB pension funding gets tough, what do plans do?? Stretch for return through alternative investments.? As I have pointed out on endowments, this is not wise unless you are getting more than compensated for the illiquidity risk.

Illiquidity risk is hard to measure, and only the best risk managers know how to handle it.? It comes down to an analysis of illiquid assets versus liabilities, and the need for cash generation for current use.? In my experience, most investors trade away liquidity for illiquidity far too cheaply.

6) Now, the worries are inclining many to shy away from muni bonds.? I would agree with this, though carefully chosen revenue bonds will do well, as will the states that hold good on their promises.

7) Most states are in trouble, so it should not surprise us that Texas is having problems.? It’s in bad shape, but not as bad as many other states.

8 ) Though this is dated, that six states were delaying tax refund payments in June was notable.

9) Five states are getting aid from the Federal Government because they are the worst hit by the fall in housing values.

10) The deficits of many states on a deficit/GDP ratio are worse than Greece; that said, their debts are not nearly as high even if pension deficits are factored in.

11) But states may default anyway to play for time because they are not insolvent but illiquid.? Many just need to get their political will together, and times have not gotten tough enough to force that.? Oh, who knows, maybe they will sell off some state parks?? Or, threaten to cut police rather than less critical spending, in order to force acceptance of tax increases.

12) States are laboratories for policy ideas.? One stinker came out of Massachusetts on health care, and now the Feds are imitating it.? Read this story to see the problems.? Better in my opinion to move the whole country to HSAs.? Costs will drop like a stone, and insurers will starve.

13) This piece argues that the Feds should subsidize some state on a one time basis.? I think not.? If the Feds do subsidize the states, it will become a habit. It has with every other federal involvement in state politics, so we should not do it. It is a good thing that states are being forced to radically trim their budgets. They grew them at far greater than the rate of GDP growth, which was unsustainable. After we cut state services by 20-30%, we should be back to GDP trend. It will force us to prioritize and focus on the things government does well, e.g. justice, security, etc.

Now, I take no delight in the cuts, but states presumed too much out of their tax increases when they were disproportionate the growth in their state economies.? Along with financial firms they rode the leverage bubble up.? It is only fiar now that they ride it back down.? They presumed wrongly that every rise in their tax base was theirs to keep.? Sorry, but it ain’t so.

The Rules, Part XVI

Posted on 13 July 2010 by David Merkel

Governments are smaller than markets; markets are smaller than cultures.

This rule has always had a special place in my heart.? It is an attempt to explain what drives human action in our world.? Though I think economic reasons for action are important, they are not the dominant reason for human action.? Human actions are dominated by the religious and philosophical views of each culture.? That is what men will sacrifice for.? Economics is how they fund those ideals.

Homo Oeconomicus does not exist.? Few live to merely maximize their personal enjoyment of life, narrowly described.? Yes, if one broadens the paradigm to say that enjoyment of life means achieving the unique goals that one might have for influencing society, that might make the two similar, but there is no way for that to be true for all men at the same time, because views differ there.

Cultures are not Neutral with Respect to Economics

Let’s take a step back.? The embedded beliefs of cultures affect what can be done by its inhabitants economically.? Does the culture permit/encourage:

Borrowing and lending with interest? (In non-stilted ways)
Taking risks?? Having a bankruptcy code that is not too punitive?
Avoiding big risks, that might harm parties two or three links removed?
Education of children, such that they are motivated to learn.? (Note: only parents can do this effectively.? Teachers will try, but school cultures depend on parenting cultures.? Lazy parents –> lazy kids.? This applies to children in public, private and home schools.)
Education, so long as we don’t get too many people in any area where there is not enough demand.? (I am thinking of the science and math deficit here.)
Labor flexibility; will a significant subset of people retrain when their area of the economy is no longer in so much demand?
Basic honesty in business dealings?? Business is based on trust.
A strong view of the value of time?? Time is money, and cultures that say “tomorrow” will not prosper as much.
Allowing freedom to business within the basic boundaries of ethics?
Government officials don’t commonly take bribes, or political action committee contributions?
People to have an interest in building something through their lives, and free to pass on the benefits as they wish?
Charity, not welfare, to those who have had a rough go of it.
Fair courts that will adjudicate rights and claims impartially.
Legislatures that will be restrained?
Executive officers and bureaucrats that will balance the varying needs of society in accordance with the laws, and not become pseudo-dictators?
Honest money, where a stable unit of account is maintained, rather than trying to trick people into doing more or less through monetary policy.
And more, I hope you get the idea.

Cultures set the backdrop for what men will value and do.? More than laws and regulations, cultures have the soft power such that it is difficult for a man to imagine other ways to do things rather than the accepted norms of the culture.

Cultures are not contiguous with nations; it is more of a tribal thing.? Some cultures exist inside a single nation, some exist across nations.? I think it boils down to a similar view of life that gets propagated through families sharing a similar world view.

Each nation has a meta-culture that is a weighted average of the influences of the cultures inside it.? The weightings depend on size, and willingness to exert effort.

Over the long haul, I think that culture has a bigger impact on the growth of GDP/person than natural resources of an area.? Hong Kong and Singapore are small examples of successful meta-cultures.? Russia and Venzuela would be examples of a resource-rich places that did not capitalize on its opportunities because of the lack of honesty in government.

Governments Have Limits Relative to their Economies

The present time helps show the limits of governments.? Yes, governments have taken bold actions to prevent a banking crisis.? And, it may have worked, but who can tell two years out?? But the governments took on a lot of debt to do so.? Debt-based systems are inherently less flexible than equity-based systems.? As such, the governments of our world are less capable of meeting a significant crisis than they were ten years ago.

Governments that try to do too much run the risk of growing beyond their meta-culture’s willingness to fund them.? It makes sense for governments to focus on the few things that they should do well: internal security, defense, public health, justice, etc.? Beyond that, the effectiveness of governments breaks down.? Governments that try to favor/disfavor a wide variety of actions through tax and stimulus policies don’t typically achieve what they wish for.? Instead, they get populaces that get a minority of clever people who milk the legal code to their advantage, and pay lobbyists to continue the practice, while the average person is frozen out through barriers to entry.

There is something similar to the Laffer Curve that applies to governments, though the shape is unknown to me.? At some point, increasing tax rates stops leading to an increase in revenues, and at some point beyond that increasing tax rates leads to a decrease in revenues.? Those break points will vary, but the clever rich forever reduce their taxes through loopholes.? For the second break point to be hit, taxes have to rise such that the middle class starts to seek shelter from taxes.

Conclusion

Governments can’t dominate economies or meta-cultures.? If they do, they will enforce relative poverty on their countries.? They have to reflect the basic ethics of their meta-cultures, or they won’t survive for long.? Economies will only grow to the degree that their meta-cultures allow them to do so.? Willingness to take and fund risk are culture-driven.

When you consider international investing, examine the culture that you are investing in and ask whether it will be fair to foreign shareholders.? Ask whether they will have standards of governance as good or better than in your home country.? Ask whether they will be motivated to do their best for themselves and their owners.

Don’t underestimate cultural effects in economies.? Men are not the same everywhere; their cultures lead them to think differently.

We Might Be Dead In The Long-Run, But What Do We Leave Our Children?

Posted on 10 July 201011 July 2010 by David Merkel

One of the problems with Neoclassical economics is that it assumes that the economic system tends toward stability.? In all of my years of doing quantitative analyses of equity and debt markets, as well as the economy as a whole, my models have shown me that there is a tendency toward mean-reversion, but it is a very weak tendency that is swamped by shocks to the system in the short run.? The further we are away from the mean, the stronger the tendency toward mean-reversion.

But, as I have often said, the beauty of Capitalism is its ability to handle instability.? There is creative destruction as some economic concepts are no longer as useful as they once were — e.g. fixed-line telephones, newspapers, buggy-whips, everyone should own a home, residential real estate is an easy road to riches, etc.

It is dangerous to try to stabilize that instability, to create a great moderation of volatility, to keep marginal concepts from failing, whether through fiscal means (tax incentives and subsidies), or monetary policy (lower the policy rate or some banks will fail).

It’s good to see bad economic concepts fail, along with those who finance them, particularly when a society is not so dependent on debt finance that the failures will not cause a cascade of more failures.? Failures allow resources to be redeployed to more productive uses, and keeps capital focused on the best opportunities.? Unemployment stays cyclical.

But when failures are quickly bailed out through overly easy monetary policy, as well as a fiscal policy that favors debt over equity, debt grows like crazy, because there is little to restrain it.? Why should the politicians care?? Easy money means prosperity today.? Bureaucrats don’t argue with the politicians; that is suicide.

Debt issuers crave stability.? Credit spreads fall when conditions are stable, until enough marginal borrowers take on debts that they can’t afford, and the bust phase of the credit cycle kicks in.? If the central bank eases too soon, as was true for the Greenspan/Bernanke era, then the bust doesn’t get to do its job.? Marginal concepts survive.? The marginal efficiency of capital falls.? Asset prices stay inflated.

This process can continue until the central bank’s policy drives the economy into a liquidity trap, because they can’t drop rates lower than zero.? (Though I wonder, couldn’t the Fed go negative, and require the banks to pay them interest on reserve balances?? Perverse, I know, but what isn’t perverse today?)? The central bank can further lower rates, a subsidy to bad decisions, by buying long debt, and maybe credit-sensitive debt (not yet, but wait and see).

That’s where we are today.? Now there are two competing theories for why we are in this mess.

Aggregate demand has failed, so the government needs to step in and spend to keep growth going in the short-run.
Our economy is too levered.? We need to adopt policies that reduce indebtedness, and also expect that these policies will cause some pain in the intermediate-term, but that it will give us a healthier economy in the long run, that is, for our children, even if we are dead.

My view is that neoclassical economists are wrong.? Aggregate demand has failed for four reasons:

Overleveraged consumers will not readily buy.
Citizens of overleveraged governments will not readily spend, for fear of what may come later from the taxman, or from fear of future unemployment.
Aggregate demand is mean-reverting.? It overshot because of the buildup of debt, and is now in the process of returning to more sustainable levels.? The same is true of private debt levels, which are being reduced to levels that will allow consumers to buy more freely once again.
When the financial system is in trouble, people get skittish.

The thing is, we are not in a liquidity trap, as much as we are in a broken financial system.? Ordinarily, savings in a bank lead to investment.? The bank lends the savings.? When the banks are impaired, or forced to put up more capital against their operations, as financial reform properly will do, lending is light.

If we give it enough time, willingness to lend will recover, without government help.? That implies that debt levels mean-revert across the economy down to levels where people aren’t concerned about their own debt, or the debts of the government.? We are in a process now where the private economy is properly trying to reduce debt levels, and the government is interfering through monetary policy, deficits, and tax credits for borrowing, in order to support the economy of the 1990s, where we needed more houses and cars, and all who created/serviced them.

Thus I will tell you that the current set of policies is not only useless, but unproductive.? Don’t keep interest rates artificially low.? It punishes savers.? Savings are what lead to sustainable investment.? Don’t stimulate the economy via fiscal policy; it never rewards the economy of the future, only that of the past.

Here are my solutions:

Make interest non-deductible, and dividends tax-deductible.? Phase this in over five years.? Yes, the prices of houses would fall, and many other asset prices.? Venture capital would get whacked.? But the system that would emerge by 2020 would be delevered, more profitable, and much more stable.? It would grow more rapidly as well.
Issue coupons to taxpayers? that can be applied to repay debt.? That would delever the economy rapidly, aside from the government.? (A weakness of the idea.)
Bar the Fed from running overaggressive policies.? Fed funds can never be more than 1.5% below the 10-year rate, or 0.5% above the 10-year rate.? Constrain the madness of unelected bureaucrats that see no problem in weakening the credit of the economy.? Also, eliminate section 13:3, so that the Fed can’t do bailouts.? Let Congress, who we elect, sign off on every bailout, so that we can kick them out thereafter.
Worst case scenario: Inflate the currency, such that it passes into goods prices.? That will lower the value of old debts, making them not as much of a burden to the economy.? But try the other three strategies first.

I write this not because I get any kick out of austerity, but because I think the present set of solutions will not only not work in the long-run, but make things worse.? There will be no recovery without some pain.? People always want something for nothing, and that never works in the long run.? If we want to have two or three lost decades, like Japan, well, keep following the status quo.? But if we want to get this over with, follow my solutions, and stop interfering with the economy.

As it is, there are limits to borrowing for any government in real terms, and the present set of policies will test those limits.? Perhaps Greece or Japan will be the canary in the coal mine for the US, but will we learn the lesson early enough to avoid default or a severe inflation?

Brief Reviews of Three Books

Posted on 10 July 201012 February 2011 by David Merkel

These three book reviews are for books that I scanned, and did not read in depth.

Quantitative Equity Investing

The first book: Quantitative Equity Investing, is a book for practitioners with strong math skills, not average investors.? It reviews basic econometrics and factor analysis, and then applies these tools in an effort to sort out anomalies in investment markets, tease out important factors driving markets, and find workable trading strategies, considering execution costs, slippage, etc.? It has a brief section on algorithmic and high frequency trading.

On the whole, I didn’t find anything that new or amazing in the book.? Though there were a few things in the book that I hadn’t seen before, they were trivial things that I looked at and said, “Oh, yeah, of course.”

The book is generic in the way that it deals with the topic.? It is no going to give you ideas to pursue, but only tools that you can use if you have ideas tht you want to analyze, and turn into strategies.

Who would benefit from this book?

You have to have a very strong math background, including the type of Matrix Algebra that one would use in graduate-level Econometrics.? To that end, this book would be most useful to grad students wanting an introduction to how to apply their math skills to the markets.

The book is available here: Quantitative Equity Investing: Techniques and Strategies (The Frank J. Fabozzi Series)

The New Science of Asset Allocation

This book uses Modern Portfolio Theory in order to analyze asset allocation decisions.? Those that have read me for a while know that I think that is a flawed paradigm, in need of replacement.? For those that want a reasonable understanding of that paradigm in a short space, the book does that very well.

That said, the book has its virtues.? The chapter on the “Myths of Asset Allocation” shows that the authors have some depth of insight into the foibles and misunderstandings that surround asset allocation.? The book also goes into the importance of qualitative analysis of managers, looking up from the numbers so that you can avoid allocating money to the next Madoff.? It also describes the use of derivatives in order to control risk exposures.

Each chapter ends with a short summary of the takeaways from the chapter, which serves to reinforce the points of the book.

Though the book has the word “new” in the title, I did not find much new in it.? If one is looking for novel implementation methods for asset allocation, best to look elsewhere.

Who would benefit from this book?

This is not a book for average investors.? It is for professionals who want to brush up their asset allocation skills, and young professionals wanting insight into asset allocation.

The book is available here: The New Science of Asset Allocation: Risk Management in a Multi-Asset World (Wiley Finance)

The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

To me, this was the most interesting book of the three, but I feel it was mistitled.? A better title would have been: “Fueled: The Effects of? Using Food for Fuel” or something like that, because the central question of the book is to what degree has using crops to produce biomass for fuel production (usually ethanol) affected the costs of food and fuel.

I found the book is very even-handed, to a fault.? It argues that the use of crops for fuel production had little impact on food costs, and that there were many other factors that made food prices rise when ethanol production was going gangbusters.? Weather, domestic and foreign demand and many other factors had a role in moving food prices, not just ethanol.

After reviewing the book, I have a better sense of the complexity of the question, and that it will not admit easy answers.

Who would benefit from this book?

Anyone who wants a basic understanding of food economics, and how that is impacted by a wide number of factors including using crops for the production of fuel would benefit from this book.? The book is well written, and seemingly balanced.

The book is available here: The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.? I review about 80% of the books that get sent to me.

Book Review: Priceless

Posted on 9 July 2010 by David Merkel

I really enjoyed the book Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street (review forthcoming), so when I learned the William Poundstone had written a new book, I went out and bought it.

This book, Priceless: The Myth of Fair Value (and How to Take Advantage of It), covers rationality in decision making, and how markets and marketers take advantage of the deficiencies in rationality in average people.

There are many in the investment community that admire behavioral finance, and many who say that it might be true, but where are the big profits to be made from it?

This book doesn’t cover behavioral finance per se, but it does cover its analogue in pricing and marketing.? In a negotiation, the first person to put a price on the table tends to push the final price agreed to closer to his price.? Leaving aside no-haggle dealerships, why do car dealers post high prices for vehicles?? Because only a minority does the research to understand what the minimum price is that a dealer will accept.? The rest pay more, often a lot more.? Personally, I do a lot of research before I buy a car, and it helps me spot dealer errors in pricing.

The book is replete with examples of how there is no “fair” way to price things out.? What are the proper damages for a jury settlement?? The attorney for the plaintiff is incented to come up with the highest believable amount for the jury, because they will render a verdict less than that.? Make the ceiling as high as possible, and the plaintiff will get more.

We call placing the first price on the table “anchoring,” because it pulls the final result toward itself.? The book is filled with experiments dealing with anchoring.

The book also spends a lot of time on the “ultimatum game,” where a person gets $10, and must offer some of it to a second person, but if the second person turns him down, the first person gets nothing.? The main lesson here is that pride is stronger than greed.? Yes, it can be construed as a question of fairness, but when someone gives up money to deny money to someone else, it is not fairness but envy.? Why pay to make someone else worse off?? To teach him a lesson?? What an expensive lesson.

Much of this book was a walk down memory lane for me.? I discovered Kahneman and Tversky in the Fall of 1982, and I found their ideas to be more cogent than much of the “individuals maximize utility” cant that was commonly heard from most professors teaching microeconomics.? People are far more complex than homo oeconomicus.? Small surprise that most tests of microeconomics as a system are not confirmed by the data.

Kahneman and Tversky showed via a wide array of examples that the decisions people make are affected by the way they are presented to them.? People can be manipulated in limited ways in order to affect the decisions that they make.

The book deals with many marketing tricks, particularly the powerful word, “free,”? and how it dupes people into buying something to get something for free.? For another example, why companies sell really expensive items that few will want, because people will buy the next most expensive item with greater probability, versus less expensive items of the same class.

Changes for David — II

Posted on 8 July 2010 by David Merkel

Well, it has been a month since the demise of Finacorp.? I don’t know for sure why the company died, but I suspect that it overexpanded, and could not support its larger size.

As for me, I have been mulling over the possibilities and have settled on two main courses of action:

Setting up my own asset management shop
Setting up my own consulting business on investment, business, and insurance matters

I have left aside the idea of outside employment for now, whether in the private sector or the government.? I have also shelved the idea of writing a book.? I am still reluctant to write a newsletter, because of my experiences in writing about individual stocks.? I was right more often than I was wrong, but when I was wrong the response from readers was disproportionate.

Asset Management

With asset management, I have a great track record with my own portfolio going back to 8/31/2000, complete with all of the brokerage statements to back it up, and a consistent operating philosophy.? I need to get a number of legal matters straightened away before I can start up, though I would consider plugging in to some other firm to provide the?? infrastructure that I need.? If you have an interest in that, let me know.? In the early phase, minimum investment amounts will be lower.? Not sure on where that will be yet.

I will likely offer my strategy in two forms: long only, and market-neutral.? Between the two funds, you can express your own bullishness, while I hopefully continue to outperform the S&P 500.

As it is, I have a few nibbles as far as larger investors go.? If any of them hit, that will propel me forward faster.

Consulting

With consulting, I have a few clients already.? I call my consulting applying math to complex business and investing problems.? As it is, when I worked for Finacorp, many of my projects were consulting for clients, providing tailored research to meet a need.

In the past that has involved:

Analyzing complex securities to ascertain value, or lack thereof, whether fixed income, equity, or whatever.? I am happy as a clam when digging through complex legal documents.? (I know, that is perverse.)
Analyzing portfolios of equities or debts in order to improve performance.
Being a second opinion on complex investment questions.? I can provide the contrary opinion on investments that are moving against you.
Complex insurance questions.? I am a life actuary, and more than able to analyze tough questions there.

The future could involve:

For small municipalities: do you need someone on your side?? I am not able to be fooled by Wall Street investment banks that will pitch you all manner of complex products.? I will tell you he truth, and be on your side in complex negotiations.
The same applies to DB plans and endowments.? Is your consultant giving you a bum steer?? Are you wondering if you should fire him?? I can help with that.
And more.? I have many skills with data mining, setting compensation schedules for salesmen, and other complex business questions.
But most controversial: you can hire me on the question of whether you need a consultant or not.? Most of the time, the answer is no, unless you have a small staff with no experience in the area in question.? Most of the consultants that I dealt with in corporate America were less competent than the middle management of the firms engaging the consultants.? Would that managements would trust their middle managers.

Look, I shoot straight.? If I can’t solve a business problem, I will refuse it.? If I try and find I cannot get to a solution, I will not take payment.? My rule is that I don’t get paid until my client is happy with my work.? I never want to live with negative word of mouth; I want a bevy of clients very happy with my consulting work.? That fits with my work attitude, because I look for the success of my clients first.

That is what I am up to.? I am open to other ideas, feel free to e-mail me.? Please understand that I get a flood of e-mail everyday.? I read it all, but I can’t respond to all of it.

Thanks to all of my readers.? You make my blog better.

Sincerely,

David

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

Posted on 6 July 20107 July 2010 by David Merkel

Aggregation of economic variables is required for macroeconomic modeling.? One of the largest problems with macroeconomics is whether that aggregation makes sense, or conceals a more dynamic and diverse economy.

The paradox of thrift as proposed by Keynes assumes that all saving is similar.? People invest excess monies in some simple depositary instrument that earns interest.? As people panic over bad economic activity, they save more, driving interest rates lower.? But wait.? What if they don’t place their money in depositary instruments?? What if they pay down debt, whether secured or unsecured?? In that case, banks will find themselves more willing to lend, as the surplus/assets ratio rises.? The liquidity crunch at the banks will lessen.? Or, people may save in a different way, by:

Buying gold, commodities, or non-perishable consumables
Enhancing their homes, cars, etc., making them cheaper to operate, or giving them longer lifespans
Investing in foreign debt instruments

Saving can take many forms, some of which may look like consumption or investment.? The main idea is to direct your excess assets to the place that will give you the best long term benefit.

Even corporations will want to save during a tough environment.? Building up cash balances gives flexibility for the future, and gives options to buy assets cheaply if competitors crater.? Some firms even borrow long-term to have cash on hand.? It’s a negative arb, but it gives the firm flexibility.? But even firms may have alternative ways to save:

Investing in labor-saving or waste reducing technology.
Stockpiling needed nonperishable commodities, or locking in long-term supply agreements, at attractive prices.
Retiring stock or debt through buybacks at attractive prices.

Saving need not be in money markets or banks.? There are many ways to save, and there are always alternative uses for money.? Each economic actor has to find the most fitting savings method for his needs.

Now, recently I ran across a paper called The Paradox of Toil.? The abstract:

This paper proposes a new paradox: the paradox of toil. Suppose everyone wakes up one day and decides they want to work more. What happens to aggregate employment? This paper shows that, under certain conditions, aggregate employment falls; that is, there is less work in the aggregate because everyone wants to work more. The conditions for the paradox to apply are that the short-term nominal interest rate is zero and there are deflationary pressures and output contraction, much as during the Great Depression in the United States and, perhaps, the 2008 financial crisis in large parts of the world. The paradox of toil is tightly connected to the Keynesian idea of the paradox of thrift. Both are examples of a fallacy of composition.

This paper does the same simplifications that Keynes did to produce his paradox of thrift.? There is only one type of labor.? Well, certainly if everyone does the same thing, there are diminishing marginal returns to scale.? Big deal.

But labor is different.? We have the ability to choose different firms to work at.? Not all work is equal, and there are often better and worse opportunities available for labor.? Recessions occur partially because capital and labor are misallocated.? Look for the firms that are showing promise in the recession, and angle to work for them.

But beyond that, workers have one more option: work for yourself; start your own firm.? Find a problem that irritates many, and solve it.? Create a product or service that meets the needs of many.? In a deflationary environment that might mean finding a cheaper way to do things.? But it could be creating a new product that meets needs that people or businesses did not know they wanted.? Go for a Blue Ocean Strategy.

The best businesses are often created in recessions.? Flip the paradox of toil, and work many hours for yourself and your ideals.

Summary

I don’t believe in the paradox of thrift or the paradox of toil.? They are bogus results of oversimplified models that do not reflect reality.? As an investor and an economic historian, I know of many times where massive amounts of money were allocated to a single asset class or a single sector of the market.? If everyone follows a mania strategy, whether due to greed or panic, I can guarantee that there will be a bad result.

The dot-coms of the late ’90s
The one decision stocks of the ’60s.
Gold in the ’70s.
Railroads in the late 1800s.
Buying stocks in the 1920s.
Selling stocks in the 1930s.
Selling bonds in the early ’80s.
The mercantilist era — exporting cheaply to get gold, then getting less in return when liquidating the gold.

I could go on to various manias in earlier eras, less well-known manias, or individual stocks, but that wouldn’t help make my case any more than I have already.? The main point is the same.? Anytime everyone does the same thing, it is foolish.? It would be stupid for everyone to save using T-bills, or sell their excess labor to agricultural day labor.

I trust intelligent people to seek their best advantage in the markets.? That does not mean that foolish people will not get hosed.? That’s the nature of being foolish.? But bright people see recessions as a time to reorient and look ahead, to see what the new economy will want, and ignore what the old economy wanted.

So, I don’t see any value in:

Stimulus programs that don’t produce economic value.? If it only pays a wage, that is destructive.? For stimulus to be effective it must produce infrastructure that lowers the costs of the economy.? Think of all the useless projects built in Japan.
Paying extended unemployment benefits.? Additional consumption today, plus debt tomorrow is a recipe for economic lethargy.
Running large deficits.? If the money is not being spent on something that will produce future growth, it is a loss.
Bailouts of large financial institutions.? We have too many of those.
Housing tax credits.? We have too many houses.
Bailing out auto companies.? Too many autos are made in our world today.
Bailing out the GSEs.? They are deadweight losses.? Let them die, and let the senior bondholders feel the pain.? Let the junior bondholders be wiped out.
Monetary policy that steals from savers, thus depriving the private capital markets of a supply of private capital for productive investments, rather than the government absorbing most of the capital at low rates, and wasting the money on less productive projects.

Don’t listen to the fools that insist that we must run huge deficits and run a loose monetary policy.? A “big bang” would be preferable to the “Chinese water torture” that we are now undergoing.? Far better to take a short dose of sharp pain, where asset prices fall, some more banks fail, and bad debts are purged from the system, than to endure another lost decade, where the ability to employ capital productively is difficult.

As it is, we are pursuing the Japan solution to our overleverage.? They have had two lost decades, and are starting on their third lost decade.? Is that what we want?