Thursday, April 24, 2014

Fox, The Myth of the Rational Market

Justin Fox’s The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street (Harriman House, 2009) isn’t exactly hot off the press, but I discovered it only recently. It’s a fast-paced history, replete with interesting (sometimes chatty/catty) details, of theories about the financial markets from Irving Fisher to Robert Shiller.

The cast of characters is huge. I list them here to give a sense of the scope of the just shy of 400-page book: Kenneth Arrow, Roger Babson, Louis Bachelier, Fischer Black, John Bogle, Warren Buffett, Alfred Cowles III, Eugene Fama, Irving Fisher, Milton Friedman, William Peter Hamilton, Friedrich Hayek, Benjamin Graham, Alan Greenspan, Michael Jensen, Daniel Kahneman, John Maynard Keynes, Hayne Leland, Robert Lucas, Frederick Macaulay, Burton Malkiel, Benoit Mandelbrot, Harry Markowitz, Jacob Marschak, Robert Merton, Merton Miller, Wesley Mitchell, Franco Modigliani, Oskar Morgenstern, M.F.M. Osborne, Harry Roberts, Richard Roll, Barr Rosenberg, Stephen Ross, Mark Rubinstein, Paul Samuelson, Leonard “Jimmy” Savage, Myron Scholes, William F. Sharpe, Robert Shiller, Andrei Shleifer, Herbert Simon, Joseph Stiglitz, Lawrence Summers, Richard Thaler, Edward Thorp, Jack Treynor, Amos Tversky, John von Neumann, and Holbrook Working.

The unifying theme of the book is the rational market hypothesis, but don’t worry if you’ve read more about efficient and inefficient markets than you yourself can rationally justify. Don’t worry if you’re bored with CAPM or option pricing or if you can, practically in your sleep, recount the demise of LTCM in all its gory details. You won’t be able to put Fox’s book down. He combines journalistic prowess with academic rigor to tell a captivating, and important, tale—one that investors and traders ignore at their peril.

Monday, April 21, 2014

Cooper, Money, Blood and Revolution

George Cooper’s Money, Blood and Revolution: How Darwin and the Doctor of King Charles I Could Turn Economics into a Science (Harriman House, 2014) is a quick read but a much longer think. I’m still in the thinking process.

Thomas Kuhn’s landmark work, The Structure of Scientific Revolutions (1962), provides the theoretical underpinning to Cooper’s book. In Part I Cooper recaps Kuhn’s hypothesis and illustrates it (as well as the paradigm shift he proposes in economics) with the work of four scientific revolutionaries: Copernicus, Harvey, Darwin, and Wegener. “In all cases, the path to scientific progress required overturning the equilibrium paradigm and moving to a dynamic, usually circulatory, paradigm. Copernicus made the earth circulate around the sun. Harvey made blood circulate around the body. Darwin made species evolve and Wegener made continents move, pushed by circulating currents within the earth’s core.” (p. 76)

Economics, Cooper argues, is not yet a science; instead, it “exhibits all of the symptoms of being in one of Thomas Kuhn’s states of pre-revolutionary scientific crisis.” (p. 81) For instance, it has fractured into too many incompatible schools of thought with incommensurable paradigms. Cooper analyzes—and criticizes—the most widely recognized of these schools: classical, neoclassical, libertarian, monetarist, Keynesian, Austrian, Marxist, institutional, and behavioral. Moreover, although the mathematical models of economics are proliferating and their complexity growing, “their predictive ability is not obviously improving.” (p. 82) Economics, in brief, is ripe for revolution.

The first ingredient of economics, if it is to be truly scientific, must be Darwin’s notion of competition. Unfortunately, if human beings are Darwinian competitors rather than neoclassical optimizers, the basic tenets of neoclassical economics (individualism, maximization, and equilibrium) crumble. People do not make their decisions based on their own self-interest, independently of one another, and these decisions are not always designed to maximize their own welfare. Once the first two principles fall, the principle of equilibrium—that “the result of all of these individual optimizing decisions is a stable system in optimal equilibrium”—falls as well.

As Cooper recapitulates: “If human decision-making is fundamentally a competitive process, then decisions of individuals become dependent upon those of their peers. This implies that behaviour at the aggregate level of the economy cannot be reliably modelled as the sum of individual behaviours. Nor can it be safely assumed that the behaviours of individuals in competition will lead to an equilibrium situation. Indeed it is likely that competitive actors will always seek to disturb any equilibrium.” (p. 133)

The second element in Cooper’s paradigm shift, with a nod to William Harvey, is a circulatory model of economic growth. This model comes from marrying the competitive Darwinian economic system with the democratic political system. Capitalism pushes wealth up the social pyramid while democracy, with its progressive taxation, acts in the opposite direction to push it back down, “causing a vigorous circulatory flow of wealth throughout the economy.” (p. 152) This model, sure to rile people on both sides of the political aisle, suggests that income inequality is essential for economic growth and that taxation and government spending are contributors to economic progress. That is, “economic progress is associated with both income inequality and large government.” (p. 157)

Cooper concludes by using the circulatory growth model to help explain the causes of the financial crisis and “why the policy mix applied after the crisis has failed to restore normal levels of economic growth.” (p. 169) He offers three suggestions for dealing with the current economic stagnation: “1. Stop the policies designed to promote further private-sector debt-accumulation” such as student debt, “2. Shift from monetary to Keynesian stimulus” because quantitative easing “puts the money into the wrong position within the circulatory system,” and “3. Rebalance the burden of taxation between labour and capital—less tax on labour, more tax on capital.” (p. 191)

Cooper may not be the Darwin of economics, but I suspect that he (and the many researchers who are exploring complex adaptive systems) will help point the way.

By way of a footnote, readers who are interested in learning more about complex systems science might want to check out Melanie Mitchell’s course, Introduction to Complexity, part of a project being developed by the Santa Fe Institute and funded by a grant from the John Templeton Foundation.

Wednesday, April 16, 2014

Friedman, Fortune Tellers

I just finished reading Walter A. Friedman’s Fortune Tellers: The Story of America’s First Economic Forecasters (Princeton University Press, 2014), which I highly recommend. Readers will probably be familiar with some of the main characters, but in a depersonalized form—for instance, Babson action/reaction lines and Moody’s Investors Service. Other characters, such as Herbert Hoover and Irving Fisher, are rescued from the one-sided simplifications of history—failed president during the Great Depression, false prophet who claimed just prior to the 1929 crash that the stock market had reached “a permanently high plateau.”

Friedman accomplishes two main tasks in this book. First, he brings his characters to life, recounting their personal, intellectual, and entrepreneurial successes and travails, their pet social and political ideas—some that now seem appalling, and the battles they did with one another. Second, he describes the dominant styles of forecasting (and, by extension, investing) of the period, which remain with us today—“historical patterns, mathematical models, expectations, and empirical analogies.” (p. 210)

The book is a darned good read and belongs in the library of every investor and trader. After all, despite all protestations to the contrary, we are fortune tellers too.

Monday, April 14, 2014

Sandford, Goals to Gold

Lee Sandford left school at the age of sixteen to become a footballer—or, more precisely, an apprentice footballer. He turned pro the next year. When he was in his mid-thirties he retired from the game and decided to focus on trading, in which he had dabbled, along with real estate, for a number of years. He recounts this journey in the first part of Goals to Gold: Trading the Football Pitch for the Financial Markets (Harriman House, 2014).

The second part of the book deals with trading basics. Sandford’s preferred trading method is spread betting, legal in the U.K. but not in the U.S. (Spread betting firms bear an uncanny resemblance to bucket shops, which flourished in the U.S. from the 1870s until the 1920s.) For those unfamiliar with spread betting, Sandford explains: “you are betting a certain amount of money per point or pip that a product moves up or down. … we’re not buying anything, we are just betting on the movement of the price of something. … You never own anything, so there is no capital gains tax, and it is not seen as income so it is not taxable. The government still classes it as betting.” (p. 114) The spread bet has an expiration date; for instance, the wager may specify that the price of a stock will rise over a period of three months. Since spread betting firms don’t charge commissions, spreads on these trades are normally wide, the farther in the future the wider.

Spread bets are often levered; you need deposit only a small fraction of a trade’s total value in advance and you can potentially reap much higher returns than in the stock market proper. Let’s say, to use the author’s example, you firmly believe that shares in Lee’s Boots will rise and you are willing to wager $10 per point. When the stock is trading at $10 per share, you place your bet at the offer price of $9.98 and set a stop loss at $9.90. If the stock price goes up to $11 per share, you make $1000; if it falls, you lose $100. Sounds good, doesn’t it?

Well, spread betting firms make money not only because they normally demand wide spreads but because most of their customers lose money. (Some firms trade against their own customers.) Sandford describes basic technical analysis techniques, such as MACD divergence, and positioning guidelines that are designed to change these odds. He also takes the reader through a series of illustrative trades, many drawn from the forex market.

The final part of the book is entitled “Trading in Football Terms.” I must admit that I, who don’t follow soccer, didn’t quite connect with “play like you’re not going down” (and hence get out of the relegation zone). But most of Sandford’s analogies could have been drawn from practically any sport, or from life in general—for example, be patient and match your tactics to the situation.

Monday, March 31, 2014

Martin, Money

I can’t remember ever reading a book in which John Locke was a villain, nay perhaps the villain. But in Felix Martin’s Money: The Unauthorized Biography (Knopf, 2014) Locke is described as a “physician, philosopher, and, fatefully, monetary theorist.” (p. 116) “The old” and, for the author, the only defensible “understanding had been that money is credit, and coinage is just a physical representation of that credit. The new understanding was that money is coinage, and that credit is just a representation of that coinage. Lowndes and his ilk [the good guys] had believed that the Earth went round the Sun. Locke had explained that the Sun in fact revolves around the Earth.” (p. 131)

Martin’s work, written for the layman, is primarily a historical/geographical/philosophical account of the notion of money. He begins with the monetary system of the Pacific island of Yap whose coinage, as documented in 1903, consisted of fei, “stone wheels ranging in diameter from a foot to twelve feet.” (p. 8) He describes the accounting technology used in England from the twelfth to the late eighteenth century—the Exchequer tally, a wooden stick on which were inscribed details of payments made to or from the Exchequer. (In the nineteenth century the vast archive of tallies remaining in the Exchequer were incinerated in an “overgorged” stove in the House of Lords in an act that managed to reduce not only the sticks but both Houses of Parliament to ashes.)

Throughout Martin advances his view that money is a social technology, “a set of ideas and practices which organize what we produce and consume, and the way we live together.” (p. 30) This stands in stark contrast to Locke’s view that “economic value is a natural property, rather than a historically contingent idea.” (p. 193)

The author introduces us to the Aegean invention of economic value as well as to the sophisticated monetary theories developed at the Jixia academy in China during its heyday in the late fourth and early third centuries B.C. The Jixia scholars argued that “money’s value was directly proportional to how much of it was in circulation compared to the quantity of goods available. They wrote: “[i]f nine-tenths of the kingdom’s currency remains in the hands of the ruler and only one-tenth circulates among the people, the value of money will rise and prices of the myriad goods will fall.” If, on the other hand, the ruler chooses an inflationary policy, “[h]e transfers money to the public domain, while accumulating goods in his own hands, thus causing the prices of the myriad goods to increase ten-fold.” (p. 72)

Walter Bagehot, editor of The Economist and author of the 1873 classic Lombard Street, is one of the author’s heroes. He argued against the abstract, mechanical theories of Locke, Adam Smith, and John Stuart Mill. Instead, he focused on the empirical realities of money, banking, and finance where the social properties of trust and confidence reigned supreme. As he wrote, “Credit is an opinion generated by circumstances and varying with those circumstances”; “no abstract argument, and no mathematical computation will teach it to us.” (p. 185)

The “biography” part of Money, by far the longest, is also the strongest. When Martin turns to policy recommendations in his closing chapters, the argument flags. (Or perhaps we’ve just heard so much about how to fix our banking system that everything begins to sound banal.) But for anyone with even a passing interest in the history of money and banking, Martin’s book is a treat.

Sunday, March 30, 2014

Michael Lewis interview

Michael Lewis will be on 60 Minutes tonight talking about his most recent book on high frequency trading, Flash Boys: A Wall Street Revolt, due out tomorrow. I haven't read the book, but CBS offers a glimpse into it in its tease of the segment. Also appearing will be Brad Katsuyama, founder of the new exchange IEX that is designed to thwart high frequency traders, and David Einhorn, who has invested in the exchange.

Lewis wrote a lengthy piece last fall for Vanity Fair that reinvestigated the case of Sergey Aleynikov, the programmer who was sentenced to eight years for stealing code from Goldman Sachs. In a discussion with New York Times contributing writer Diana Henriques on Friday Lewis said: “It was curious to me that in the aftermath of the greatest financial crisis of modern times” — in which Goldman Sachs played a key role — “the only time someone ends up in jail is when it’s someone that Goldman Sachs wants to put in jail.”

Saturday, March 29, 2014

On big data and behavioral finance

Two links for your weekend reading pleasure. First, a piece by Tim Harford in the FT about the pitfalls of big data. And, from edge.org, reflections on the influence of Daniel Kahneman's research.