Quantitative Methods – Page 34

Don’t Confuse Stupidity with a Bear Market

Posted on 22 May 2009 by David Merkel

“So when are we coming out with a tasset fund?”

“A tactical asset allocation fund?” I replied. “Mmm, it’s worth a thought, but you know what it takes to add a new product.? How much demand would there be for this?”

“Are you kidding? In a bear market, people still want to make money.? We need someone smart who can decide when to be in the market and when to take shelter in cash.”

“If it were only that easy,” I replied, “Tell me, who is so reliably brilliant at market timing, and willing to trade for anything other than his own account?”

“You got me there, Dr. Merkel, but we really need a product like this.? It would sell like crazy.”? (Note: they called me Doctor there regularly.? I did not encourage it; I am not a Ph. D.)

“No doubt.? I will consider it, and get back to you.”

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I had that conversation back in 1994 with one of the better pension representatives of Provident Mutual.? As one of the actuaries there, I quickly realized that I had to boil any investment ideas down into very simple terms for the field force.? The best explanations were rich and simple, like a fairy tale, one of Aesop’s fables, or one of the parables of Jesus Christ.? That is a challenge — one worthy of the best investment minds.

The thing is, there is a constant war between two views of the market:

Buy and Hold — Bull Market
Trade, trade, trade — Bear Market

I don’t think either view has permanent validity.? Of course in a bull market the buy and holders will crow; they are making money.? And in a bear market, those with less exposure to the market will crow.? Big deal.? Those that are accidentally correct boast while their strategy is in favor.

So, when I read this NY Times article about diversification, I yawn.? After a bear market, you decide to reduce equity exposure?? That’s just fear expressing itself in stupidity.? Even worse is this WSJ article, where the author is giving into his fears, and reducing equity exposure.

My point here is a simple one.? Don’t confuse brilliance with a bull market.? Don’t confuse stupidity with a bear market.

Very few people are good traders, such that they can manuever the pulses of the market.? For those that understand how the market works in the long run and on average, the best thing to do is to ride bear markets out.? Own the best companies you can find, and adjust your asset allocation such that you can survive something worse than a bad recession.? Many people over-own stocks, implicitly trusting in the naive view that they always outperform bonds.? Stocks do outperform bonds, but by much less than advertised, say 1-2%/year.

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When I look at the risk cycle now, I am inclined to reduce risk, and add to safe investments.? That said, I might wait a while to see if the positive momentum persists.? I am gratified by the rally in lower-rated corporate bonds, but think that the risk there is growing.? I am presently inclined to do an “up in quality” trade, sacrificing yield for safety.? There.? That is the way to go now.? Reduce risk, and take the loss in yield.

Book Review: Quantitative Strategies for Achieving Alpha

Posted on 20 May 2009 by David Merkel

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

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:

Profitability
Valuation
Cash Flow
Growth
Capital Allocation
Price Momentum
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.”

The Zero Short

Posted on 13 May 2009 by David Merkel

Wrong

Something for nothing.

Intellectual and financial achievement.

We showed those losers.

Hey, it’s free money!

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Possibly Right

Don’t play for the last nickel.? It may cost you a buck or more.

Shorting is not the opposite of being long, it is the opposite of being leveraged long.? You don’t control your trade in entire, and the margin desk, or fear of the margin desk can make you leave a trade prematurely.

Pride goeth before a fall.

Would you rather be right, make money, neither, or both?

Free money in the market exists until too many people start searching for it.

Whom God would destroy, He makes overconfident.

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Though I do risk control different than many people, risk control is behind much of what I do in managing money.? Avoid risks that I am not being paid to take, and take risk where I am getting fair compensation or better.

Now, I can think of several companies where I think the common is an eventual zero.? Fannie, Freddie, AIG, GM, and Ford (I am less certain about the last one).? My calls on GM and Ford were ones made long ago.? The same for Fannie and Freddie.? AIG is more recent.

Now, I rarely short, because my risk control methods are not designed to work with shorting.? But one thing I would almost never do is try to “zero short” — short a stock to zero.? As I have said before, seemingly free money brings out the worst in people, and makes them play more aggressively than they should.

Don’t underestimate the power of control.? There is an optionality there that is underappreciated.? With the right offer management can sell assets, change the capital structure, get a bailout, etc.

Don’t overestimate the uniqueness of the reasoning involved.? Zero shorts attract parties wanting to short to the bitter end; they think that zero is inevitable.? No risk here.? One decision.

I would look at the borrow.? Can I borrow a lot more stock easily, without paying a premium either directly, or indirectly through the cost of some derivative instrument? (options, swaps, etc…)? If I can, perhaps I don’t have to worry so much about losing control of the trade.? If not, it may be time to close out the trade (for a little while, then re-evaluate), or at least evaluate how high the price could go in a short squeeze.? As we have seen recently, some lousy companies in a short squeeze can double or triple.? Would I have enough capital to carry the trade under such adverse conditions?

At least I should estimate short-term upside versus downside for that position versus others in the portfolio.? After a successful short, it may not employ a lot of capital; perhaps I should close it out.

What’s that you say?? The borrow is plentiful, and I should short more?? After all, it is going to zero.? I would not do it because the upside/downside ratio is worse than when the? trade began.? Figuratively, playing for that last nickel could cost me several bucks.

What if the position moves against me and the borrow is plentiful?? Should I short more?? After all, it is going to zero.? Sigh.? Review the thesis.? I might look for someone who doesn’t always agree with me, and ask him what he thinks.? If the thesis does not change, I would short a little more once the momentum against the position has stopped.

One more note: I review pricing across the capital structure.? Where does the bank debt trade?? Where are Credit Default Swaps [CDS] trading?? Yields of senior unsecured notes across the maturities?? Junior debt, trust preferreds, hybrids, preferred stock, etc…? These are all relevant bits of data to tell whether the common stock will indeed zero out.? If the next most senior class of capital to the common is trading above 50% of par, I would do more research on my thesis.? If it is over 80% of par, the zero short is not a good idea.

Risk control wins in the long run.? To me shorting all the way to zero is a risky way to do business, and so I am very unlikely to do it.? There is a pride element involved, and all good investing relies on having control over your attitude.? If you decide to zero short, be very careful.? It is not as easy as it looks, even if in the end, it does go to zero.

Stressing Bank Tests

Posted on 11 May 200911 May 2009 by David Merkel

Perhaps we have it easy in the life insurance industry. Solvency is defined on two criteria: risk-based capital, and a variety of cash flow testing schemes, both contingent and noncontingent. Truth is, it’s not that easy, but the life insurance industry has been more proactive on risk management than the banks.

I have not talked much, if at all about the “bank stress tests” for one major reason: in life insurance, there are detailed rules for performing cash flow analyses. With the bank stress tests, the adverse scenario posited higher unemployment, lower residential housing prices, and lower real GDP than “baseline” estimates.

Okay, that’s nice, but as is often said, the devil is in the details. Did the banks get relief from the scenarios? It seems so. Why? When I first saw the adverse scenario, I said to myself, “Not adverse enough. Aside from that, how do you translate the adverseness into actual credit losses?”

The latter question is a critical assumption, particularly for complex financial institutions. There is no immediate good answer, so how did the US government simplify matters? We do not know, but we do know that the financial institutions pushed back.

What concerns me the most is that the stress scenarios did not explicitly consider weakness in commercial mortgage pricing. This is a process that is in its early phases. Much as REIT stock prices have fallen, and CMBS prices have fallen, the impact has yet to be realized on commercial whole loans on bank balance sheets.

It is very difficult to transform the macroeconomic assumptios of the stress test into usable credit loss data. Reasons:

Differences in bank lending practices makes uniformity tough.
Attempts at getting accurate on a company-specific basis introduces the ability of the company to tilt the analysis their way. Also, company specific loss estimates lack credibility.
Loss estimates on new lending classes also lack credibility.
Estimates of how sensitive loss estimates are to unemployment, GDP and residential housing prices lack credibility for most lending classes. We don’t have enough data.

Now I have done stress tests at life insurance companies. You estimate how much you can take in credit losses without having to dip into surplus assets over a 1, 3, 5, 10, etc-year periods. You compare those statistics to worst few credit losses over 1, 3, 5, 10, etc-year horizons to get an idea of the likelihood of such large losses. That has its troubles, but it is better than nothing. The life insurance industry keeps pretty extensive statistics on its asset losses.

I didn’t get too encouraged by the results of the stress tests. They were easy tests to pass for many because:

The stress scenario isn’t that severe. I give it better than 50% odds of occurring. A real stress test has perhaps a 5% chance of occurring.
The stress scenario isn’t very prolonged, like the Great Depression.
Creating the models that connect the economic assumptions to the loss costs is problematic. Errors are unlikely to be on the conservative side — both the banks and the regulators are incented to be aggressive, because they don’t want to cause specific panic over their company, or general panic over the banks. Remember, their is a large number of people who think this panic is merely confidence/liquidity, and not solvency. (Then why are we raising capital or selling assets?)
There are many new lending classes that have not gone through a full asset default cycle, so their default loss properties in an era of debt deflation won’t be calculable. We don’t have the data.

When I look at the modest cost of $75 billion of capital to raise, I think of all the capital raised prior to this — and now a measly $75 billion will assure the future solvency of the system. This is only an opinion, but I think that number is too low, particularly with the troubles in commercial real estate being so early in its cycle. Remember 1989-92? The degree of overbuilding now is greater than then. The losses should at least be proportionate.

My simple bit of investment advice is to underweight the securities (bonds, preferred and common stocks), of the companies that failed an easy test. That means underweighting:

Bank of America
Citi
Fifth Third
GMAC (debt, there is no public common)
Keycorp
Morgan Stanley
PNC
Regions Financial
SunTrust
Wells Fargo

At least, this will be worth watching as a basket from 5/8 on. It may give us clues to the economy as a whole. I expect that it will underperform, but I am more certain that it will covary very highly with the market as a whole. Let’s see what happens.

One Dozen Notes on our Current Situation in the Markets

Posted on 8 May 20098 May 2009 by David Merkel

I’m leaving for two days.? I might be able to post while I’m gone, but connectivity is never guaranteed, particularly in southwestern Pennsylvania.? (Sometimes I call it “the land that time forgot.”) Apologies to those that live there — Pittsburgh is the capital city of Appalachia.

Here are a few thoughts of mine:

1) Many have been critical of Buffett after a poor showing in 2008.? Much as I have criticized Buffett in the past, I do not do so here. The mistake that many make in analyzing Berky is forgetting that it is first an insurance company, second an industrial conglomerate, and last an investment vehicle for Warren Buffett for stocks, bonds, derivatives, etc. With most of his investments, he owns the whole company, so you can’t tell how Buffett’s investing is doing through looking at the prices of the public holdings, but by reading Berky’s financial statements. By that standard, 2008 was not a banner year for Berky — book value went down — but it was hardly a disaster. Buffett remains an intelligent businessman who deserves the praise that he receives.

From The Investor’s Consigliere, he agrees with me.? Berky is more like a special private equity shop than like a mutual fund.

2) I’m past my limit for cash for my broad market portfolio.? I have sold bit-by-bit as the market has risen.? I’m planning on buying more of my losers, or finding a few new names to throw in.? Will the current “bull market” evaporate?? There are some sentiment measures that say so.? Also, when cyclicals lead, I get skeptical.

3) As correlations rise, so does equity market risk.? Are we facing crash-like risks now?? I don’t think so, but I can’t rule it out.? My opinion would change if I knew that major foreign investors were willing to “bite the bullet” and recognize the losses that they will experience from investing in Treasuries.

4) My initial opinion of Ben Bernanke, which I repudiated, may be correct.? My initial opinion was that he would be a disaster.? Now that the transcripts of the 2003 Fed meetings are out, he was among the most aggressive in loosening policy, which was the key blunder leading into our current crisis.? It also explains the novel policies adopted by the Fed over the last 18 months.

5) Investors are geting too excited about a recovery in residential housing.? Such a recovery is not possible while 20%+ of all residential properties are under water.? Foreclosures happen because of properties under water where a random glitch hits (death, disaster, disability, divorce, debt spike (recast or reset), and disemployment).

6) I have long had GM and Ford as “zero shorts.”? Sell them short, and you won’t have to pay anything back.? Though Ford is prospering for now, GM is declining rapidly.? In bankruptcy the common is a zonk.? With dilution, the common will almost be a zonk.

7) I worry over our government’s involvement in the markets.? First, I am concerned over contract law.? The bankruptcy code in the US strikes a very good balance between the needs of creditors and debtors.? I worry when the government tampers with that.? I fear that the Obama administration does not grasp that if they attempt to change certain regulations, it will have a disproportionate effect on the economy.

8) I have almost always liked TIPS.? Do I like them now?? Of course, particularly if they are long-dated.

9) Much as I do not trust it, we have had a significant rally in leveraged loans and junk bonds.

10) Did major banks support subprime lenders?? Of course many did.? No surprise here.

11) The EMH exists in a dynamic tension with its opposite.?? Because many, like me, are willing to hunt out inefficiencies, the inefficiencies often get quite small.? So it is that those that come into investing with no hint that the EMH exists think it is ridiculous.? Coming from a household where the EMH had been stomped on for many years (thanks, Mom) made me ill-disposed to believe it, and not just because we subscribed to Value Line.

12) He who pays the piper calls the tune.? To the degree that the government gets involved in business, it will intrude into lesser details that should only be the province of shareholders.? What this says to management teams is “don’t let the government in in the first place,” which should be pretty obvious.? Major shareholders with secondary interests are often painful.? With the government, that secondary interest is regulation, which makes them a painful shareholder.

With that, I bid all of you adieu for a time.? May the Lord watch over you.

Analyzing the Current NASDAQ Composite Streak Upwards

Posted on 5 May 20095 May 2009 by David Merkel

When I saw this piece from Barry, and this piece from Jason Goepfert on the eight-week Nasdaq streak, and read some of the questions, I said, “Hey, maybe I can help.”? After struggling with what defines a week (close of business for the week, Friday, or Thursday if the market was closed on Friday, or Monday in the second week of September 2001), I ran the numbers, and here is what I found:

Up Streaks

I used data from the Nasdaq Composite Index from inception in February 1971 through last Friday.? (Dividends not included in performance.)? Streaks longer than seven weeks are rare, but they tend to be associated with good performance in the next twelve weeks.? Again, the momentum effect is showing its face.? Interesting that intermediate length streaks of five and six weeks have done poorly over the next 12 weeks, whereas shorter streaks are just noise.? The frequency of streaks seems to follow an exponential decay pattern that is essentially coin-flip random, decaying at a rate of around 50%.

Down Streaks

Hey, if I have the data, shouldn’t I do the other side even if it is not immediately relevant?? The market was in a bull phase from 1971 until the present, so it doesn’t surprise me that after streaks downward that the market tends to rally, and after streaks upward the market meanders?? But long down streaks tend to bounce back hard (few observations, be careful), while the results after middling streaks are weak, and short downward streaks are stronger.? Again, there is exponential decay of streaks, near coin flip levels here as well.? Not surprising.

What does this tell about the current eight-week streak upwards?? With weak confidence it tells us that there is more room to move up.? Perhaps the Nasdaq Composite could be over 1900 by the end of July.? Given the lack of confidence in the rally, that is a genuine possibility.

Whether you run out and buy a bunch of QQQQs is your own business, but momentum tends to persist.? I don’t plan on buying the QQQQ.

Book Review: Trend Following (5)

Posted on 30 April 200930 April 2009 by David Merkel

There are many places where I agree with Michael Covel.? Here are two:

Trend following, or, price momentum, is a good strategy.
Most investment advisors charge a lot, and on average deliver suboptimal performance.
The weak form of the efficient markets hypothesis doesn’t work.

Most of the Wall Street establishment, and those trained by universities and the CFA program believe that the weak form of the efficient markets hypothesis works.? I.e., You can’t make money from past price and volume information. This is why most of them don’t use price momentum.? They would get laughed at.? The weak form of the EMH is holy stuff.

Beyond that, the fund manager consultants try to cram every manager into a simplistic risk control model, leaving managers little room to hold cash, or invest in promising places that don’t fit the narrow pigeonhole that the fund manager consultants use to simplify their work.? Someone who rotates styles, sectors, domestic versus international, or who simply raises cash when opportunities don’t seem so good are anathema to the fund management consultants, no matter how good their performance is.

But as time has gone on, the behavioral finance folks have shown that valuation, price momentum, normalized operating accruals, and other factors have significant predictive potential on future returns.? Hedge fund managers, who have less of a tendency to listen to the fund management consultants, and a greater tendency to do what works, do use trend following, or price momentum in their investing.

What if Everyone Followed Trends?

Suppose everyone except Warren Buffett decided to follow trends.? The market would become very volatile, as was suggested in Investing by the Numbers.? (By his model, anytime momentum investors are more than 20% of the market, things go nuts.)? Buffett would make money hand over fist as he would sell holdings as they soared over fair value, and buy as they crashed well below fair value.? The valid strategy that is less employed makes more money.

There would be another effect.? There is a limitation on the ability to short on the market as a whole, if the borrow is enforced.? The whole world is 100% net long every night.? Shorts and leveraged longs are side-bets in the game of investing.? The more trend followers there are, the more that shorting capacity would prove to be a constraint, because once things start going down, the available shares to borrow would disappear.? The profitability of trend following in a bear market relies on a small enough number of parties selling short.? Everyone can’t sell short at the ame time.? Everyone can’t go to cash at the same time.? The assets must be owned by someone at the end of each day.

There’s only one strategy that could be followed by everyone — Indexing (and not fundamental indexing).? Returns to any strategy decrease as more pursue it.

On Audited Track Records

Bill Miller had a great audited track record, and it imploded in two years, largely because he did not understand the financial stocks that he owned.? While working at Provident Mutual, I interviewed a growth manager who used price momentum heavily, and had a tremendous track record.? I pointed out 10% of his portfolio that had poor earnings quality, and he gave me a “you don’t know the right things to look for” answer.? In the next week, a number of those companies preannounced earnings shortfalls.? The marketing guys came over to me and said, “You called that one.”

In truth, I didn’t.? Rarely do things happen that fast.? But that manager did disappear within a few years, despite his great past track record.

There’s a reason why we say, “Past performance does not indicate future results.”? Because it doesn’t.

I am not saying that I manage money better than Michael Covel, or anyone else.? He has done better than me, even though I have done better than 90% of all long only equity managers over the last nine years.

I do not have an audited track record, but only because I don’t want to pay for something that I don’t have use for.? I am not broadly advertising my services.? If an institutional investor would want to use me, I would get my returns audited.

I write my blog because I enjoy teaching, nothing more.? It fills a hole in my life, a part of a need to give back.

In closing, I can endorse “Trend Following” because its basic premise is true.? Follow price momentum and you will beat the equity market 80% of the time.? I just did not enjoy the lack of logic from Mr. Covel.? Correlation is not causation.? Making money in the past is not proof.? Picking and choosing trend followers does not constitute proof.? Take a more humble attitude, and you have a good book.

Book Review: Trend Following (4)

Posted on 28 April 2009 by David Merkel

While reading the book Trend Following, I was reminded of something that I read in The Intelligent Investor (I have the Fourth Revised Edition.)? These are two very different books.? What could be the same?

Fortunately, you don’t have to have a copy of The Intelligent Investor to see this.? Appendix 1 of the book is, the edited transcript of Warren Buffett’s talk that he gave at Columbia University in 1984 for the 50th anniversary of publication of Security Analysis can be found here.? The PDF version can be found here — it has the tables, but will take a while to load.

Buffett chooses 9 investors in the mold of Ben Graham, all value investors, and shows how they have soundly trounced the market over their tenures.? He uses that correlation to demonstrate that since they all used the same basic theory of investing, it is unlikely that their wonderful performance is due to mere chance.

In appendix B of his book, Michael Covel chooses 14 (or so) investors who are trend followers, and shows how they have soundly trounced the market over their tenures.? He uses that correlation to demonstrate that since they all used the same basic theory of investing, it is unlikely that their wonderful performance is due to mere chance.

See the similarity?? Now, I think that both approaches work to some degree, though not all of the time.? I have known a number of managers that have married the two approaches, usually with some success.? (As Humble Student Cam Hui points out, marrying the two may be more difficult than it seems.? I’m going to have to dig up that copy of the Financial Analysts Journal.)

I would criticize one aspect of Buffett’s logic, and the same would apply to Covel.? I’ve known my share of bad value investors.? Usually they overemphasize cheapness, and forget “margin of safety” as the key intellectual concept of value investing.? It’s easy to come up with a group of great managers following a certain strategy in hindsight.? Where is the grand study of all investors of that class, be it value investing or trend following?? Almost any strategy could be made to look good if one can cherry-pick the investors with the advantage of hindsight.

So, what would qualify as a valid study?? You’d need a relatively complete census of the group following a given strategy, including those that failed and dropped out.? After that, audited returns would help, as Mr. Covel likes to point out.? An alternative would be to follow a smaller closed cohort of managers following a certain management style.? The problem with that is you yourself might have a really good eye for management talent apart from the investment style.

Another alternative would be an academic-style study where the researcher defines the buy and sell criteria and then sees if the method beats the market, whether adjusted for risk or not.? Now, regarding risk, that is one of many places where I agree with Mr. Covel.? Standard deviation does not measure it; beta doesn’t measure it; tracking error doesn’t measure it.? Maximum drawdown, or maybe some obscure statistic from extreme value theory would probably be the best measure.

Why drawdown?? It best measures the ability of a manager to continue his strategy without panicking.? Most of us would question our sanity after a certain level of loss, and give up.? For different investors, the number is different.? For those managing external money, it is more important, because normal investing processes get destroyed when investors pull their money.? Where is that maximum level where investors will stay on board?? It depends on how they were sold on investing their money with the manager.

What are the problems with doing an academic-style study?

Often does not include costs of commisions, market impact, etc.? Liquidity is implicitly free, while in the real world, it is costly, particularly for undervalued oddball securities.
Data-mining may allow anomalous result that are noise to be reported as signal.
Managers using the style being modeled argue that it does not truly represent what they do.
Some studies get skewed by using calendar-year-end dates, where trading is often unusual.

Does that mean doing? definitive studies of trading strategies is impossible?? No, but it is quite expensive to do, so those interested in questions like this often resort to shortcuts, such as academic studies, limited peer group studies, etc.

Now, fairly comprehensive studies for things like growth and value managers exist (tsst… value wins), and some studies for CTAs exist.? But I’m not aware of any comprehensive studies for trend followers.? The academic studies show that price momentum is an important factor in market returns, and many investors with good returns use momentum.

It begs the question, if price momentum, or trend following is a panacea, why is it not more broadly embraced by the money management community?? That is tomorrow’s essay.

Book Review: Two Books on Options by Anthony Saliba

Posted on 23 April 2009 by David Merkel

I’m usually pretty open to reviewing books.? Sometimes I get books that I can’t do justice to in reviewing.? The following two books may be examples of that:

Option Spread Strategies: Trading Up, Down, and Sideways Markets

Option Strategies for Directionless Markets: Trading with Butterflies, Iron Butterflies, and Condors

I’m not an options trader.? Do I understand the math? Largely, yes.? Do I understand how they can benefit investors?? Also yes.? I occasionally use options to enhance income, but for the most part, I avoid using them for personality reasons.? I fear that I would make bad decisions while working at a higher level of leverage.? I don’t trust myself.

As for the books, they are clear and well-written, giving both the common view of options, and the view using the “greeks” a la Black-Scholes.? The chapters explain, and then offer tests at the end to see how well you have understood.? These could be textbooks in a business school.

The books explain how you can make money in any environment if your view of the world is correct.? That’s the catch, though.? Few of us get it right within the length of time before an option expires.? Be wary of the correctness of your opinions.

Now, my opinion is not of the highest value here.? Better to consult Adam Warner or Bill Luby, who have far more practical experience on a retail level.? My experience is largely institutional with respect to options.

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.? If you wanted to get it anyway, it is good for both of us?

Sell Stocks, Buy Corporate Bonds (II)

Posted on 27 March 2009 by David Merkel

After a sharp bear market rally, people are feeling better about stocks.? But corporate bonds have not bought into the stock market rally.? Aside from noises from the US government, whose actions may or may not pan out, there is little reason for optimism in the real economy, as GDP continues to shrink.

At a time like this, I reissue my call to sell stocks and buy corporate bonds, even junk bonds.? When the advantage of corporate bond yields are so large over the earnings yields of common stocks, there is no contest.? When the yield advantage is more than 4%, bonds win.? It is more like 6% now, so enjoy the relatively stable returns from corporate bonds.