Sunday, May 1, 2016

Peterson, Trading on Sentiment

We all know that sentiment is a critically important ingredient in the pricing of tradable assets. But it is extremely difficult to move from this general and somewhat amorphous principle to a trading/investing edge. Richard L. Peterson takes up this challenge in Trading on Sentiment: The Power of Minds Over Markets (Wiley, 2016).

Peterson is the CEO of MarketPsych, a firm that in 2011 joined forces with Thomson Reuters to produce the Thomson Reuters MarketPsych Indices (TRMI), sentiment data feed covering five asset classes and 7,500 individual companies that Thomson Reuters distributes to its clients. As the Thomson Reuters website explains, these indices use “real-time linguistic and psychological analysis of news and social media to quantify how the public regards various asset classes according to dozens of sentiments including optimism, fear, trust and uncertainty.”

Odds are that, unless you’re a bank or hedge fund employee, you won’t have access to TRMI. Peterson’s book is the next best thing, although you have to realize that if you want to incorporate sentiment (not some proxy for sentiment) into your trading decisions and can’t do big data analysis yourself, you’re working with one hand tied behind your back.

Trading on Sentiment is divided into five parts: foundations, short-term patterns, long-term patterns, complex patterns and unique assets, and managing the mind.

To give a taste of this book (and to address something that affects everyone’s investments) I’ll focus on the chapter on sentiment regimes. As Peterson writes, “Context matters in financial markets. In the academic literature, differences in context are said to be a product of market regimes. A market regime is—in its most simplistic terms—a bull or a bear market. Recent academic research demonstrates that the performance of common investment strategies differs across market regimes, and these differences may be rooted in the divergent mental states of traders in each context (e.g., optimism in a bull market versus pessimism in a bear market).” (p. 270)

Regime-dependent performance may result from shifts in liquidity available to portfolio managers. “The profitability of published market strategies rises and falls in 3- to 5-year cycles based on liquidity. … The alpha to be harvested from such price patterns exists when they are largely ignored, but as capital is attracted to them, the excess returns dry up or even reverse.” (p. 272)

Peterson summarizes “the effects of sentiment regimes on the predictable returns of several market anomalies.” For instance, high-beta stocks outperform low-beta stocks “only following months of negative news sentiment.” As for post-earnings announcement drift (“the tendency of stock prices to continue moving in the direction of an earnings surprise after the event”), such drift is “significantly greater when market sentiment is opposite the direction of the earnings surprise.” (p. 273)

Trading on Sentiment will undoubtedly be seen in time as a seminal work. Much more research remains to be done on the identification and measurement of sentiment and its impact on financial markets, both on a macro and a micro level. But, even so, investors can use whatever measures they have of sentiment as potentially profitable filters in placing and managing their trades. Peterson’s work can serve as a useful guide.

Tuesday, April 19, 2016

Ericsson and Pool, Peak

If you’ve been living under a rock for the last couple of decades you may not have heard of deliberate practice. Anders Ericsson, who along with Robert Pool, a science writer, has just published Peak: Secrets from the New Science of Expertise (Houghton Mifflin Harcourt, 2016), was an early advocate of the notion that, within limits, extensive deliberate practice is what separates expert performance from run-of-the-mill performance. Malcolm Gladwell subsequently popularized (and bastardized) this notion in Outliers, calling it the 10,000-hour rule.

Peak is Ericsson’s own popularized version of his research. As such, it doesn’t break new ground, but it sets the record straight in an accessible, engaging way.

Natural talent, Ericsson argues, plays “a much smaller—and much different—role than many people generally assume. … While people with certain innate characteristics … may have an advantage when first learning a skill, that advantage gets smaller over time, and eventually the amount and the quality of practice take on a much larger role in determining how skilled a person becomes.” (pp. 178, 198-99) And, by the way, there’s no magic number of hours of practice that divides peak performers from the rest of us.

When you’re learning and practicing a new skill—say, dissecting corporate balance sheets or detecting patterns in price fluctuations, you are changing the structure of your brain. This was clearly evidenced in a 2011 study of the MRI brain scans of London taxi drivers. They had much larger than average posterior hippocampi, the areas of the brain “particularly engaged by spatial navigation and in remembering the location of things in space. … Furthermore, the more time that a person had spent as a taxi driver, the larger the posterior hippocampi were.” (p. 42) But there can be too much of a good thing. “Pushing too hard for too long can lead to burnout and ineffective learning. The brain, like the body, changes most quickly in that sweet spot where it is pushed outside—but not too far outside—its comfort zone.” (p. 51)

What are the characteristics of deliberate practice? First of all, it should be noted that deliberate practice is normally overseen by a teacher or a coach. Self-coaching is tough, especially since deliberate practice “demands near-maximal effort, which is generally not enjoyable.”

Ericsson lists seven traits of deliberate practice. Among them, it “involves well-defined, specific goals and often involves improving some aspect of the target performance; it is not aimed at some vague overall improvement.” It also “both produces and depends on effective mental representations. Improving performance goes hand in hand with improving mental representations; as one’s performance improves, the representations become more detailed and effective, in turn making it possible to improve even more.” (p. 94)

The notion of mental representations is fuzzy. But “in essence these representations are preexisting patterns of information—facts, images, rules, relationships, and so on—that are held in long-term memory and that can be used to respond quickly and effectively in certain types of situations. The thing all mental representations have in common is that they make it possible to process large amounts of information quickly, despite the limitations of short-term memory.” (pp. 65-66)

The quality and quantity of mental representations are, in fact, the most important characteristics that distinguish the performance of novices from that of experts. “Through years of practice, [experts] develop highly complex and sophisticated representations of the various situations they are likely to encounter in their fields… These representations allow them to make faster, more accurate decisions and respond more quickly and effectively in a given situation.” (p. 66)

I have chosen snippets from Peak that distill some of the book’s main points. But Ericsson and Pool flesh out these points with case studies. We learn, for instance, how Benjamin Franklin set about becoming a good writer, how Paganini wowed his audiences by breaking one violin string after the other and still playing beautiful pieces of music (some, of course, that he wrote specifically for the purpose), how the Polgár sisters became world-class chess players, how Steve Faloon was (after more than 200 training sessions) able to remember 82 digits.

The upshot is that there’s no substitute for hard work. But this work has to be smart and focused, pushing boundaries. Otherwise, you condemn yourself to accomplishing much less than you’re capable of.

Sunday, April 17, 2016

2016 Valuation Handbook—Guide to Cost of Capital

A team from Duff & Phelps, a global valuation and corporate finance advisor, authored the imposing 2016 Valuation Handbook—Guide to Cost of Capital (Wiley, 2016). The book, part of an ongoing series, is “designed to assist financial professionals in estimating the cost of equity capital for a subject company. Cost of equity capital is the return necessary to attract funds to an equity investment.” Or, put differently, it is the “expected return appropriate for the expected level of risk,” also known as the discount rate. The book’s intended readers are CFOs and investment bankers as well as, more generally, those who are involved with M&A, IPOs, and private equity financing or who for one reason or another are called upon to value a corporation, including conscientious value-oriented investors.

Let me say something I rarely say here: this book was beautifully produced. Printed on high quality, heavy stock and measuring 8 1/2” x 11,” it is well designed, with a font size that doesn’t produce eye strain and with clean, easily readable tables with red accents that match the display type. I can’t easily say how long the book is because it isn’t paginated consequently but rather section by section.

Back to the content of the book. It analyzes the basic building blocks of the cost of equity capital: the risk-free rate and equity risk premium, the size premium, betas and industry risk premia, and company-specific risk premia. Using data from the Center for Research in Security Prices (CRSP), the authors compare the CRSP deciles size premia studies and the risk premium report studies. They offer examples of CRSP deciles size premia and provide general information about the risk premium report exhibits, as well as examples of the same.

This is not a book for the casual investor, but for those interested in careful corporate valuation it’s a treasure trove. The book is not currently available through Amazon but only directly from Wiley.

Thursday, April 14, 2016

Scheve & Stasavage, Taxing the Rich

Taxing the Rich: A History of Fiscal Fairness in the United States and Europe (Russell Sage Foundation and Princeton University Press, 2016) lends some perspective to what is today a burning question, at least in some camps. Kenneth Scheve and David Stasavage, the co-authors, set out to show that “societies tax the rich when people believe that the state has privileged the wealthy, and so fair compensation demands that the rich be taxed more heavily than the rest.” (p. 4)

The most powerful compensatory arguments over the last two centuries have involved military conscription. The rich benefited from the mass wars of the twentieth century in two ways. “First, labor was conscripted to fight while capital was not. Second, owners of capital benefited from high wartime demand for their products. Heavy taxation of the rich (owners of capital) became a way to mitigate these effects and to restore at least some degree of equality of treatment by the government.” (pp. 6-7) In an era of limited warfare where mass armies are no longer necessary this form of the compensatory argument is irrelevant.

Democracies have not increased taxes on the rich just because inequality is high, nor have they done so only when “the rich are unable to use their wealth to capture the political process.” (p. 16) Moreover, the ability to pay argument usually falls on deaf ears. Democracies are inclined to default to a “hands off” position, moved by arguments that levying high taxes on the rich is either self-defeating (they will work less, invest less, or shift their wealth abroad) or flies in the face of the equality of citizens under the law.

The authors contend that it will be possible to raise taxes on the rich only where “it is clear not just that the rich have been lucky, but that their luck has involved privileged treatment by the state.” And, they continue, “convincing compensatory arguments cannot simply be invented out of thin air. They emerge in response to concrete political and economic conditions that make such arguments credible and convincing.” (p. 47)

At the moment there isn’t much support in the U.S. for adopting the kinds of high rates that prevailed in the immediate postwar era. “Building such support would require the construction of a new compensatory argument, outside of a wartime context, which would suggest how the rich have benefitted from state privilege while others have sacrificed.” Pointing to the bank bailouts zeroes in on only a fraction of the rich. “To put it differently, it is not clear why Silicon Valley should be taxed just because Wall Street was bailed out.” (pp. 213-14)

The authors address across-the-board tax increases, not tweaks to the system, such as closing the carried interest loophole (though they do mention it in the context of the capture hypothesis). But even there it is evident how difficult it is to make any change to the tax system that negatively affects the very wealthy.

Sunday, April 10, 2016

Benmosché, Good for the Money

Of the troubled companies in the wake of the financial crisis AIG was the most troubled. It received a staggering $182.3 billion in bailout money, and few people believed it would ever be able to pay the country back. But it did. The government even turned a $22.7 billion profit on its investment. Steering the company back to health even as, by the end, he himself was fighting a losing battle with lung cancer was Robert Benmosché, the company’s fifth CEO in as many years.

Good for the Money: My Fight to Pay Back America
(St. Martin’s Press, 2016) is Benmosché’s posthumous autobiography, written with Peter Marks and Valerie Hendy. As the title indicates, the book focuses on his time at AIG. But his success at AIG would be hard to understand without knowing where he came from, how he developed his ability to say “Fuck you, I’m going to do what I want whether you like it or not.”

As a 12-year-old child he learned what it was like to live without a bailout plan when his father died suddenly, leaving behind a debt in today’s dollars of about $2.2 million that he had borrowed to build a motel in Monticello, New York. Keeping up with the payments became a family affair, and Bob, the eldest of four children, helped out managing the motel and stocking shelves in a local supermarket. A rambunctious boy with little interest in school, in his sophomore year he was shipped off to military school—the same school Donald Trump attended, a year behind Benmosché. “With hand-me-down threads, a job in the academy’s dining room and a restless spirit,” he started a new chapter in his life, though with the same aversion to academics. What interested him was making money, achieving financial freedom. What he became good at was tackling complex business issues and pointing employees in the direction of a positive outcome.

Fast forward through his years at Alfred University and various jobs at consulting firms, banks, brokerages, and eventually as CEO of MetLife. He retired at the age of 62 with the prospect of spending his golden years in the villa on the Dalmatian coast he had refurbished, tending to his vineyards in Dubrovnik and managing his investments via Yahoo Finance.

But then came AIG. That Benmosché managed to turn AIG around was something of a miracle. He had the government breathing down his neck, wanting him to sell assets quickly, even if at fire sale prices. He had an uncooperative board and a hostile chairman. The press was scrutinizing and criticizing his every move. AIG’s employees were demoralized, some had already left what they considered a sinking ship.

Benmosché called on his outsize personality (he was called crazy, scary, bombastic) and his keen business acumen to navigate the treacherous corporate and government waters. A more restrained CEO could never have made the company’s lenders whole.

Good for the Money is one of those books that has you cheering and booing. It is a fitting tribute to Benmosché’s life.

Wednesday, April 6, 2016

Venkat & Baird, Liquidity Risk Management

A book announcement, not a review. I requested a copy of Liquidity Risk Management: A Practitioner’s Perspective edited by Shyam Venkat and Stephen Baird (Wiley, 2016) thinking that it might, at least in part, address the problem of liquidity risk as it affects investors. But this is first and foremost a banking book. And ever since, long ago, I spent a Sunday afternoon at an outing of boring New York bankers I have sworn off learning anything about banking, at least beyond what a reasonably well educated person is expected to know. Consequently, I am in no position to pass judgment on this book. My apologies to the multiple authors, each a partner or director in the PricewaterhouseCoopers Financial Services Advisory practice.

Monday, April 4, 2016

Wucker, The Gray Rhino

There’s nothing like a good image to drive home a message. The black swan has become practically a household phrase, and now Michele Wucker introduces us to a new animal. In The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore (St. Martin’s Press, 2016) she tackles the “unknown known,” “the information we may have available in our heads but that we’ve refused to give its due.” (p. 54)

Wucker suggests that behind every Black Swan is “a converging set of highly likely crises.” (p. 8) These likely crises can be a source of opportunity for the few who are ready to act, a danger for those who do nothing. As she writes, “When facing a rhinoceros that’s about to charge, doing nothing is seldom the best option.” And yet “the impulse to freeze is hard to overcome. Sometimes the grip of denial is so strong that we do nothing at all; or, even worse, as in many market booms leading to bust, we do more of what was dangerous in the first place.” (p. 22) In some cases, “these Gray Rhinos have the potential to become herds… In the zoological world, a rhinoceros herd is called a ‘crash’; I cannot think of a better choice of words.” (p. 25)

Dealing with Gray Rhinos is not a straightforward enterprise. First, they have to be identified, which involves an element of prediction, and most predictions are wrong. Then, if there are multiple potential dangers, they have to prioritized and responses timed. “There are costs to acting too soon.” (p. 108) The list goes on, the complexities multiply.

But the upshot is that we should never simply stand still. “Muddle if you must, but, if you do, muddle strategically by preparing for the moment toward which procrastinating eventually leads. … If you can, make a plan ahead of time and use it. … Even better, create automatic triggers that will force you to act at times when panic might otherwise cloud your judgment.” (p. 228)

The Gray Rhinos Wucker writes about are for the most part big issues, such as water shortages, economic crises, and creative destruction. But all of us have Gray Rhinos in our lives. Some are crises waiting to happen that can be averted by the proverbial “stitch in time.” Others are crises that we may not be able to avoid but that we can nevertheless prepare for—for instance, by having an automatic trigger to sell a stock that is collapsing. Still others are potential opportunities, like shorting a company that seems fraudulent.

Gray Rhinos are out there. It is our job to think independently and critically to identify them, to devise a way of dealing with them, and to act either preemptively or in such a way as to mitigate their worst effects. It’s all about risk management.