Category: Quantitative Methods

“There doesn’t seem to be a fundamental reason why.”

“There doesn’t seem to be a fundamental reason why.”

Posted on by David Merkel

Until I read the last sentence of this Wall Street Journal article on AIG’s risk models, I felt somewhat sympathetic for the guy who developed the models.? Having developed many models in my life, I have seen them misused by executives wanting a more optimistic result, and putting pressure on the quantitative analyst to bend the assumptions.? Here’s the last paragaph:

On a rainy morning last week, Mr. Gorton briefly discussed with his Yale students how perplexing the struggles of the financial world have become. About 30 graduate students listened as Mr. Gorton lamented how problems in one sector caused investors to question value all across the board. Said Mr. Gorton: “There doesn’t seem to be a fundamental reason why.”

When I read that, I concluded that the poor guy was in over his head for years, and did not have the necessary expertise for what he was doing at AIG.? All good credit models contain something for boom and bust.? Creditworthiness of borrowing entities is highly correlated, especially during the bust phase of the credit cycle.? That said, to get deals done on CDO-like structures, the modeler can’t assume that correlations are as high as they are in real life, or the deals can’t get done.

But to my puzzled professor, there are fundamental reasons why.

  • Overlevered systems are inherently unstable.? Small changes in creditworthiness can have big impacts.
  • Rating agencies undersized subordination levels in order to win business.
  • Regulators allow regulated financials to own this stuff with low capital requirements, partially thanks to Basel II.
  • Much of the debt was related to Financials, Housing, and Real Estate, and all of those sectors are under pressure.
  • When financials ain’t healthy, ain’t no one healthy.

Now, for another look at the problem from a different angle, consider this New York Times article on Wisconsin public schools buying CDOs for teach pension plans.? As a kid, I played against a number of the schools mentioned in sports, etc., so many of these names bring back old memories for me.

Again, what is clear is that the guy advising the school one of the school districts barely understood the ABCs of what he was doing, and the district trusted him.? I’ll say it again, if you don’t understand it, or you don’t have a trusted friend on your side of the table who does understand it, don’t buy it. Also, relatively high yields on seemingly safe investments typically don’t exist.? Beware the salesman that offers high yields with safety; there is usually one of four things involved:

  • Financial leverage
  • Options sold short
  • Low credit quality of the underlying debt instruments
  • Foreign currency risks

These deals fall far short of the “prudent man rule” in my opinion.? Not only is the salesman culpable in this case, so are the board members that did not do proper due diligence.? For something this complex, not reading the prospectus is amazing, even though it might not have helped, given the complexity of the beast.? At least, though, a board member should read the “risks and disclosures” section of the prospectus.? There is usually honesty there, because that is what the investment bank is relying on to protect themselves legally if things go bad.

The districts should have accepted a lower rate of return on their investments, and asked the taxpayers for contributions to the pension plans, etc., to make up any deficits.

We will probably see many more stories like this over the next year.? Politicians and bureaucrats are often short-sighted, and look for “that one little thing” that will magically close a gap in the budget.? It’s that little bit of fear of the taxpayers and other stakeholders that caused “that one little thing” to become so tempting.? But now they have to live with the bad results; heads will roll.

What is the Value of Market Dividend Yields?

What is the Value of Market Dividend Yields?

Posted on by David Merkel

Blogging is often a cooperative venture, so this piece begins with thanks to three people:

When I read the piece at The Capital Spectator, my response was “Huh, neat article, wonder how it would look with a larger data set?”? Given Eddy’s help, I had that data set, and so I got to work.? Here is the main result:

The results at The Capital Spectator went from 1995 to 2003. My results go from 1871 to 2003. His results give a tight relationship, while mine indicate a loose relationship.? His R-squared was far? higher than my 7%.? Why?

In aggregate, many relationships in finance are tenuous.? Do interest rates mean-revert?? Yes, but the tendency is weak.? In this case, high dividend yields foreshadow high five-year total returns, but that tendency is weak.

In the graph above I tried to highlight the eras for different alignments of dividend yields and future five-year returns.? Depending on the era, the relationship of dividend yield to future returns differed.? In the long run, there is a weak positive relationship between dividend yields and total returns, but in the short run, many other factors predominate.

So what does this tell us?

  • Use larger data sets when possible.
  • Realize that many relationships in finance are not stable.? Indeed, that is a strength of Capitalism.? It adjusts to changing conditions, and is not stable.
  • When dividend yields are high the market is attractive.? Of course, factor in how high bond and cash yields are at the time.
  • Beware relying on intermediate-term relationships in quantitative finance.? They last for less than a decade.
  • Beware trusting correlation coefficients calculated over short intervals.
  • In finance, we know less than we think, so we should be cautious in our conclusions.
  • The best forecasts come when we are at extreme values of the system.? In the middle, everything is a muddle.

I am a firm believer in dividends. My portfolio has an above average dividend yield.? In general, high dividend yields pay off in investing, subject to credit quality.? But, the payoff varies over time; a heavy reliance on the dividend yield of the market as a sole indicator is not advised.

Recession or Depression?

Recession or Depression?

Posted on by David Merkel

Back to the crisis.? I want to be a bull, really.? I read what Barry wrote on 10 bullish signals, and I think, yes that’s what history teaches us.? I have used that for profit in the past.? I even have a few more.

Here’s my knockoff of S&P’s proprietary oscillator:

That’s the lowest reading ever, with statistics going back to 1990.? For more, consider the discounts on closed-end funds — they are lower than ever.? Or, consider that the IPO market is closed.? Or consider that every implied volatility measure under the sun is through the roof in ways that we haven’t seen since 1987.? The yield curve of the US is wide.? Fed policy is accommodative; don’t fight the Fed.? Consider that well-respected value investors like Marty Whitman are finally excited about the market.? Credit spreads are at record highs in the money markets and in the corporate bond markets.? Finally, consider that the lack of insider transactions indicates a potentially bullish situation:

I have a hard time accepting the bullish thesis at this point because of troubles in most of the major banks, and the disappearance of all of the major investment banks.? I have a saying that when you have a major market malfunction, there tend to be many things going screwy at the same time.? I don’t like to say that it is different this time, but rather, we have to be careful whenever there is a significant hint of depressionary conditions.? If that is the case, we should see many abnormalities:

This is a global crisis, affecting most governments and firms.?? Our most severe crises, aside from the Great Depression, tended to be local, or limited to just a segment of the world.

Final notes: I warned about this disaster in advance, though I am not as prominent as a George Soros or Jeremy Grantham.?? I can dig up the references at RealMoney if necessary.? Last, as in the Great Depression, some moves by the government exacerbated the crisis, that may be true here as well.

With that, I conclude that we are back to the one key question: are we facing a recession or a depression?? If a recession, we should be buying with both hands, but if a depression, there will be better bargains later. At present, given the condition of the banks and the global scope of the problem, I lean toward the depression side of the argument, but I am not totally sold on the idea. There are bright people on both sides of the question. That said, I am not jumping to buy at present, even with many indicators that are favorable. The state of the financial system matters more.

Let the Current Bailout Die

Let the Current Bailout Die

Posted on by David Merkel

I’m starting out tonight’s post with two stories, to try to help illustrate my position on the bailout. Recently I did some consulting for a financial institution that held the single-A tranches of several trust preferred CDOs that had CMBS, REIT debt, and a lot of junior debt from bank, mortgage, and housing related names. They wanted to know where I would market the bonds at year end 2007. I created a really complex simulation model with regime-switching for credit migration, to simulate how creditworthy the underlying bonds would be.

These bonds were on the cusp; the value of the bonds would vary a lot depending on the assumptions used. The bonds below the single-As in the securitization were all likely to eventually default. All they are worth is the value of interest they will get paid before the securitization shuts them off, plus the warrant value if things improved dramatically. The bonds above the single-As were very likely money good. Losses to the AA and AAA bonds were a remote possibility.

After estimating likely cash flow streams, I tried to estimate where a single-B bond would trade in that environment; that is, if it would trade. I estimated that it would need a 20% annualized return, leading to a dollar price around $35 on a par of $100. The bank pushed back in two ways, suggesting that my discount rate was too high, suggesting that I use 10% (price $65), and they trotted out another analysis from one of the subsidiaries of the rating agencies that was incredibly lightweight, suggesting a price of $85.

Now, did these beasties ever trade? Rarely. But they had traded two months earlier between $25-30, and at year end there was one unusual trade, for which I will give you a fictionalized version of how I think it happened:

Bond Owner: I need a bid for my bonds; you brought this deal to the market. Bid on my bonds.

Investment Banker: There is no market for those bonds; no one knows what they are worth. No one is bidding for them in this environment.

BO: You have a moral obligation to bid on my bonds; you brought the deal to market.

IB: So what, at this point almost no investment bank is willing to honor that.

BO: (begging) Look, I’ll take anything, anything, offer me a cruddy “back bid.” I just need to sell these to realize a tax loss.

IB: (long pause, feeling disgusted, and wanting to tell the guy to go away through a too low bid) Okay then, I’ll offer you $5.

BO: (Happy) Done. Sir, you have those bonds at $5!

IB: Done. (Ugh, what will the risk control desk say?…)

What did I tell my client? I said that I would tell them what my model yielded under their assumptions, but that my recommendation was that they mark them at $35.

Okay, so what’s the right price? $5, $35, $65, $85, $100. The bank marked them down to $75, average of the 10% discount rate and the rating agency’s view, because they could not take the full hit.

Now apply this lesson to the current bailout, and what do we learn?

  • The hold-to-maturity price mentioned by Bernanke is the $75, a value that has no basis in fact.? They don’t want to have the bank take losses.
  • The price that a clever investor would pay if he could buy-and-hold is below $35.? Where?? Not sure, thing have gotten worse since my analysis.
  • The security is worth at least $10, if it pays interest for three years (highly likely).
  • The investment bank that bought the bonds can’t re-sell them.
  • Most bond owners ignore the $5 trade, and ignore the $25-30 trades also.? They mark the bonds much higher, because they can’t take the losses.? They are eating an elephant.? How do you eat an elephant?? One bite at a time.? They can’t take a full loss this year, but will use flexible accounting rules to take those losses over the next three years.
  • A clever bailout would start sucking in these bonds in the teens, quietly.? We’re not doing that, but that is what Buffet would do, and maybe Bill Gross.
  • But these bonds are unique, as are most credit sensitive bonds.? The idea of holding reverse auctions is ridiculous, because I have given you one example, and there are hundreds of thousands, maybe a few million different bond tranches to evaluate.? Only the originally AAA-rated tranches have any size to them.? For any party, even PIMCO, to say that they can come up with the proper pricing for all of them is ludicrous, regardless of whether we go for the panic price, theoretical current “fair price,” or the price at which it is on the bank’s books.
  • This also discourages banks from taking writedowns.? Why write down, when the government will pay you book value?? Or at least, the lowest book value that is common….

Well, that’s one story.? Here’s one more: As a bond manager, I would occasionally come up with unsusal theses that would translate into inquiries after unusual assets.? in late 2002, I began buying floating rate trust preferred securities.? Junior debt — not as safe as senior debt, but because they were floating rate, they did not have the same call provisions as the fixed rate securities.? There could be a lot of profit if the credit market rallied.? So, I started buying slowly, because it is not a thick market, using three brokers to mask my actions.? By the time, I reached 90% of my goal, two things happened.? First, the chief investment officer called to ask what I was doing buying such low yielding securities.? My comment back was that I was earning more than a 5-year senior bank bond, and that it improved the asset-liability match for our insurance client.? He said that he didn’t want much more of them, and I said that I wanted $20 million more.? He agreed, and we were done.? Second, one of the three brokers, the one that I used the least, called me and said that their bank thought there was a buyer in the market, and that prices would rise from here.? I asked what they had left in inventory, and he named a few names that I did not have so much of.? I bought those bonds, and then (after a few weeks) the market repriced dramatically tighter, i.e., higher prices.? We never cleared less than a 10% gain on any of those bonds, which is a “home run” in bond terms.

Here’s my point: the Treasury, should it do the bailout, will find it hard to determine the proper prices for the bonds they want to buy. Why?

  • High prices bail out the banks.
  • Low prices protect taxpayers.
  • No one knows the correct price.
  • Anyone with a large amount of money to invest will artificially inflate the market, unless they are very careful.

The negotiations have broken down, and it is for a good reason.? There is little agreement over what costs the taxpayers should bear for matters that they had little say in creating.? I offer you the following articles that agree with my findings:

With respect to the central question, “Will the Bailout work?” my answer is no.? The assets are too fragmented, and the policy goals too uncertain to make the deal work.

We will see what happens tomorrow.? The Cantor plan may play some role in this, trying to restructure the bill as a reactive bill through an insurance mechanism, while making it sound proactive.? That is prefereable to me, because I think that the next administration whould take time to analyze the best options, rather than let an unaccountable lame duck President and Congress set the tone.? If bailouts are needed because of systemic risk before then, let them be done on a one-off basis.? We don’t need a systemic solution now.

What is the crisis at present?? It is mainly in the short-term lending markets.

That’s not good, because they are big markets, but on the other hand, the percentage losses aren’t large.? Again, I would call Congress to oppose the bailout, in order to let the next President and Congress consider the measure.? Until then, I would do one-off bailouts, like those done for AIG and Fannie, and Freddie.

That may not be optimal policy, and it might be messy, but it might minimize cost to the taxpayers, while causing those that would sell off liabilities to the government to think twice.? Bailouts shoud be painful.

Now We’re Talking Volatility

Now We’re Talking Volatility

Posted on by David Merkel

If the gyrations of the equity market today were not enough, we are in a historically unusual situation where 3 of the last five business days have had moves on the S&P 500 of over 4% in absolute terms.? Since 1928, how many times has that happened?? 69 times.? Dig this:

So, on average, you make money investing during volatile times, but the possibility of moderate-to-severe loss is significant.? Those losses came in the Great Depression era (as did the huge gains), but for those that have read me a long time, you know that I believe that a second Great Depression is not impossible.? I don’t care how much policymakers say that they have learned, the system has an odd way of mutating to create the same result through a new process.? The market always has a new way to make a fool out of you.

Aside from the crash in 1987, only the depression era has had similar volatility, and they had it for a long time.? Even 1973-74 did not rate under that measure (though it resembled the Chinese water torture).

Take this with a grain of salt.? A salt shaker even.? Eddy Elfenbein and Bespoke often do analyses like these, and they have a certain wisdom most of the time.? But data-mining is always dangerous.? The question that must be asked is whether there is a mechanism to explain the results.? In this case, there is.? Volatile markets scare investors away, and drive prices down, in general.? This causes stock to move from weaker to stronger hands, i.e., from the weakly capitalized to the strongly capitalized (now I get to send my electricity check to Mr. Buffett).

So, ask yourself this: are we heading into a depression?? If not, buy some stock.? Personally, I’m not certain about whether we aren’t heading into a depression.? I view it as a 25% chance now.? Perhaps my next article will help explain.? As for me, I am continuing my normal policy of having 70% of my net worth in risk assets.

Avoiding Doomed Sectors, Redux

Avoiding Doomed Sectors, Redux

Posted on by David Merkel

Those that have followed me for a while know that I rotate industries.? The idea is to buy:

  • Strongly capitalized companies that are at their cyclical trough, or
  • Moderate-to-strongly capitalized companies where pricing trends are under-discounted.? Often these companies have positive price momentum.

Also, the idea is to avoid:

  • Sectors where valuation metrics are cheap, but the indutries are in terminal decline.
  • Weakly capitalized companies and industries where product pricing is weak.

The sectors to avoid are what I term “doomed sectors” though it applies better to the first example of the two.? My favorite example of a doomed sector is newspapers.? I don’t care how cheap they get, I am not buying.? They are obsolete.? As for the second example, think about depositary financial companies, or companies that take a lot of credit risk.? Eventually they will bounce back, but it will take a while.

Here’s my current industry ranks:

IndustryRanks-9-12-08
IndustryRanks-9-12-08

So, why don’t I dig through Hotels/Gaming, Air Transport, and Homebuilding?? Hotels are overbuilt.? Air Transport is a losers’ game; there are always romantic male entrepreneurs willing to invest at subpar prospective returns, because they like to see the planes fly.? Homebuilding?? There is a glut of homes.

If you can avoid bad sectors, your performance will be pretty good.? That has helped me over the past eight years.

I like investing in the green zone, in industries that I think have a future.? Good picks there can last for years.? There is another way to play my industry model, though.? Put money in the top ten industries, and keep it there as the berst industries change.? The trouble is, it is a high turnover strategy, though it beats the index by about 6%/year.? I’m not sure what trading friction would do to the return advantage.

That’s my view on industry rotation.? I prefer playing for longer periods and slower trading, but the system can be used in a momentum mode.

Another Look at My Investment Screening Methods

Another Look at My Investment Screening Methods

Posted on by David Merkel

Recently I received an e-mail from one of my readers on my investing methods.? I thought it might be useful for all of my readers, so I am going to answer it here.

I liked your post of your 8 investing rules and also your 4/16/08 post where you list your metrics for ranking potential stocks.? I too believe that a disciplined investing style that adheres to certain rules and metrics is very important in controlling the emotions that lead to subpar returns, and have been trying to develop a set of metrics for my own quantitative investing methodology. I noticed that some of your metrics are different that the common ratios I’ve usually come across while developing my methodology.??I was wondering?if you could answer a few questions regarding?them.

Note: the links are to posts that I think he meant.? If not, my apology.

P/E:??You use?three different P/E criteria, which makes P/E very important in your strategy.??Why do you?use P/E as opposed to P/Cash flow, which many believe is more telling than P/E???Do you have any concern in using forward P/E ratios, considering that analysts are notorious for being wrong with their earnings predictions (David Dreman?discusses this in his books)?

Ideally, we want an accurate forward estimate of free cash flow.? No one knows that, so I have to compromise.? P/E did have three spots in my April post, but that gave it a weight of 3/13ths.? Why not cash flow?? I’m open to the concept, and I have used it in the past.? In tough markets where M&A is not happening, CFO and EBITDA measures tend not to work as well.? I give forward P/Es higher weights when we are in the beginning of a recovery, with corporate bond spreads starting their rally.? Once the rally is established, and spreads have tightened, that is when M&A heats up, that is when EV/EBITDA, and P/CFO metrics have more punch.? During bear phases, I give more weight to P/B and P/Sales.

I’ve talked with a lot of different investment managers, and some like trailing P/Es and others, forward P/Es.? In general, the sell side is optimistic, but there is an advantage to using their estimates.? They provide a control mechanism.? Their estimates drive stock performance in the short run and they provide a gauge to how results are tracking against expectations.? I think that their estimates reflect the view of the market as a whole usually.? I try to balance optimistic and pessimistic indicators in my valuations, so as not to overplay either side.

Net Operating Accruals:? Do you use this metric based on the research done by Sloan and used in Piotroski’s Z_score?

No, I got this through Hirshleifer and a number of other financial economists.? That doesn’t mean that it might not be the same thing researched by Sloan and Piotroski.? Piotroski’s Z-score has a lot to commend it; the only trouble is that very few companies get those high scores.

Volatility, RSI, Neglect:? These are metrics that I have seen few people discuss. ?What is?your basis for using them? I believe I read an abstract to a?study that found that low volatility stocks outperform high volatility stocks- is this what you are trying to take advantage of???What is the measurement for neglect anyway???Sorry for my lack of knowledge on this subject.? When I read this post I was suprised that, as a contrarian fundamental investor,?you used so many technical metrics.? Do you try to use metrics that have?very little following because?methodologies lose their?effectiveness when?they becomes popular (like the small cap effect)?

What is a technical indicator?? I don’t read charts.? I do try to look for stocks that are off the beaten path, and there are some non-price measures that indicate that.? As for volatility, I would point you to this article at the excellent CXO Advisory blog.? Yes, low volatility tends to outperform.

It’s not that I am looking at technicals, but anomalies.? I believe in the Adaptive Markets Hypothesis, which says that inefficiencies exist in the markets, but only for a while because when they are big enough, investors take advantage of them, and compete them away.? The markets are only mostly efficient, and I try to take advantage of what is “on sale” when I reshape my portfolio.

The neglect measure is what fraction of the company’s shares trade.? In general, companies with lower share turnover tend to do better.

As for RSI, that is one area where I have changed.? I used to use momentum as “buy what’s falling” metric.? There’s too much evidence for the contrary, and so I have flipped RSI so that weight is given to stocks with positive momentum.? Positive momentum tends to generate positive returns, because people are conservative in their estimates.? Buying momentum makes sense except when many are doing it.? After things have been running hot for a while, I would drop the metric.

What helps me go where others will not are my industry models.? One of my core beliefs is that industries are under-analyzed.? Also, Industry behavior is more basic to the market than size and value/growth distinctions.? If I analyze industries that are out of favor, and buy financially strong names in those industries, it is difficult to go wrong.

When I look at anomalies, I look for things where retail and professional investors tend to err.? Those are places where human nature tends to encourage people to make wrong decisions.? People like to play controversial stocks — they tend to be overvalued.? People like to play well-known stocks.? They are overvalued as well.? Momentum?? The market as a whole is slow to react to new data.

I don’t aim for metrics with small followings.? I aim for things that have worked over time.? Before the calculation of the metrics, my industry models toss in a number of out-of-favor names.? After the calculation of the metrics, I look at earnings quality, frequency of beating estimates, a more detailed look at the balance sheet, etc.

I view my non-fundamental variables as measures that complement the valuation side of the analysis.? (Valuation is most important, but it is not everything.)? They help in avoiding value traps (net operating accruals), and point at stocks that other investors are ignoring.? They aren’t perfect, and if they were perfect, I am sure that I don’t use them perfectly.? The object is to tilt the odds in my favor of having a successful investment.? That is what my screening methods (rule 8 ) intend to do, as well as the rest of my eight rules.

In Defense of the Rating Agencies — III

In Defense of the Rating Agencies — III

Posted on by David Merkel

After writing parts one and two of what I thought would not be a series, I have another part to write.? It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.? (That said, small investors are often, but not always, better of with the summary advice that bond rates give.? Institutional investors do more complete due diligence.)? The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.? Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.? Markets are faster than any qualitative analysis process.? But regulators need methods to control the amount of risk that regulated financial entities take.? They can do it in three ways:

  1. Let the companies tell you how much risk they think they are taking.
  2. Let market movements tell you how much risk they are taking.
  3. Let the rating agencies tell you how much risk they are taking.
  4. Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.? There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.? The fourth option underestimates what it costs to rate credit risk.? The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.? Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.? As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.? As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.? Ratings should not be like stock prices — up-down-down-up.? A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Have the rating agencies made mistakes?? Yes. Big ones.? But ratings are opinions, and smart investors regard them as such.? Regulators should be more careful, and not allow investment in new asset classes, until the asset class has matured, and its prospects are more clearly known.

With that, I lay the blame at the door of the regulators.? You could have barred investment in novel asset classes but you didn’t.? The rating agencies did their best, and made mistakes partially driven by their need for more revenue, but you relied on them, when you could have barred investment in new areas.

In summary, I still don’t see a proposal that meets my five realities:

  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
  • Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

And because of that, I think that solutions to the rating agency problems will fail.

Book Review: Investing By The Numbers

Book Review: Investing By The Numbers

Posted on by David Merkel

I’m going to be reviewing a few books on quantitative investing.? Many of these will not be suitable for everyone, and as I do these reviews, I will try to indicate what level of math skills you will need in order to benefit from the book.? For today’s book, you can get most of it if you can remember your Algebra 1, and understand basic statistics.? Knowing regression helps, and a little calculus wouldn’t hurt, but this book is mainly qualitative.? It describes,and there are many graphs, but formulas are not on every page.

Investing By The Numbers has been out a while (1999), and though it is a good book in my opinion, it never sold big.? Oddly, a lot of investment actuaries bought the book because of a review in the Investment Section newsletter, Risk and Returns.? I have one of the few signed copies.? When I met Jarrod Wilcox when he gave a talk to the CFA Society of Washington, DC, he was genuinely surprised when I asked him to sign my copy of the book.

Jarrod Wilcox, Ph.D., CFA, held important roles at PanAgora Asset Management and Batterymarch Financial Management.? He runs his own shop now, focusing on liability-driven investing, something that I have written about at RealMoney, and at this blog.? What do I mean by liability driven investing?? Just that your asset allocation should reflect when you will most likely need the money.

This book does not have one big overarching idea to guide it.? Instead, it has many models to share from different situations in the market.? There is something for every quantitative equity investor here, and I will mention the areas where I benefited the most:

  • Along with a few other books, including some from the Santa Fe Institute, this book confirmed to me that one has to look at investment using an ecological framework.? Many strategies are competing for scarce returns.? Often the best strategy is the one that has few following it, and the worst one is the crowded trade.
  • Why do value methods tend to work?
  • How do you avoid traps in calculating models?
  • How do investors with different goals and expectations affect the market?? What happens when you get too many momentum investors?? Too many growth investors?
  • Difficulties with the Capital Asset Pricing Model [CAPM] and Arbitrage Pricing Theory [APT].
  • If the market tends toward equilibrium, the forces guiding it are weak.
  • Behavioral finance as a means of bridging investment theory and reality.
  • Market microstructure: how do we minimize total trading cost?? Minimize taxes?
  • How is the P/B-ROE model derived?
  • How to model market anomalies?
  • When do different valuation methods pay off well?
  • How does international diversification help?? (Bold in 1999, but a bit dated now.)
  • How to manage foreign currency risk in an equity portfolio?
  • How do neural nets work and what challenges are there in using them?

As a young investor using quantitative methods, I found the book useful, and still use a number of its findings in my current investing. Again, this is not a book for everyone — you have to want to do quantitative investing from primarily a fundamental mindset in order to benefit for this book.

Full Disclosure: Anytime anyone enters Amazon.com through any link on my site and buys anything there, I get a small commission.? This is my version of the tip jar, but best of all, it doesn’t cost you a thing, if you needed to buy it through Amazon already.

Current Industry Ranks

Current Industry Ranks

Posted on by David Merkel

Just a quick post to give a mid-quarter view of my main industry rotation model.? The recent moves in the market have knocked many energy sector industries out of the hot zone (red), but any bounce in financials has not knocked them out of the cold zone (green).? I’m still not ready to play in the depositary and credit sensitive financial companies, my insurance exposure is cheap, and earning money with low-ish risks.? That said, this is the type of environment that reveals which insurers have been taking on too much risk with marginal bonds.

industry-ranks-8-21-08
industry-ranks-8-21-08

Remember that my industry ranks can be used in two modes: momentum mode (look at the red zone), and value mode (green zone).? I spend most of my time in the green zone, looking at industries where I think pricing power will return.? For me, the red zone is more useful for sale decisions.? When an industry is running hot, I delay selling out in entire, and content myself with trimming positions in order to limit risk when the eventual turn happens.

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