Wednesday, July 30, 2014

Scheinkman, Speculation, Trading, and Bubbles

To pay tribute to one of its most famous graduates, Kenneth J. Arrow, Columbia University launched an annual lecture series dealing with topics to which Arrow made significant contributions—and there were many. Speculation, Trading, and Bubbles stems from the third lecture in the series given by José A. Scheinkman, with adapted transcripts of commentary by Patrick Bolton, Sanford J. Grossman, and Arrow himself. I’m going to confine myself here to a few excerpts that encapsulate some of the lecture’s key points, ignoring the often perceptive commentary.

Scheinkman offers a formal model of the economic foundations of stock market bubbles in an appendix to his lecture, but he lays out its basic ideas in the lecture proper. The model rests on two fundamental assumptions—“fluctuating heterogeneous beliefs among investors and the existence of an asymmetry between the cost of acquiring an asset and the cost of shorting that same asset. … Heterogeneous beliefs make possible the coexistence of optimists and pessimists in a market. The cost asymmetry between going long and going short on an asset implies that optimists’ views are expressed more fully than pessimists’ views in the market, and thus even when opinions are on average unbiased, prices are biased upwards. Finally, fluctuating beliefs give even the most optimistic the hope that, in the future, an even more optimistic buyer may appear. Thus a buyer would be willing to pay more than the discounted value she attributes to an asset’s future payoffs, because the ownership of the asset gives her the option to resell the asset to a future optimist.” (pp. 15-16)

This framework leads Scheinkman to define a bubble as “the difference between what a buyer is willing to pay and her valuation of the future payoffs of the asset—or equivalently, the value of the resale option…. An increase in the volatility of beliefs increases the value of the resale option, thus increasing the divergence between asset prices and fundamental valuation, and also increases the volume of trade. Hence, in the model, bubble episodes are associated with increases in trading volume.” (p. 16)

Scheinkman is concerned with modeling bubbles, not with policy recommendations about bubbles. But concluding his lecture with some final observations, he addresses a question he left unanswered in the lecture—“whether one could use the signals associated with bubbles, such as inordinate trading volume or high leverage, to detect and perhaps stop bubbles. One of the difficulties in using these signals is that we know next to nothing about false positives.” And, he continues, “Even if we could effectively detect bubbles, it is not obvious that we should try to stop all types of bubbles. Although credit bubbles have proven to have devastating consequences, the relationship between bubbles and technological innovation suggests that some of these episodes may play a positive role in economic growth. The increase in the price of assets during a bubble makes it easier to finance investments related to the new technologies.” The one recommendation that flows directly from his model is that “to avoid bubbles, policy makers should consider limiting leverage and facilitating, instead of impeding, short-selling.” (p. 35)

Monday, July 28, 2014

Gogerty, The Nature of Value

Nick Gogerty sets his book within a by now familiar framework, thanks in large part to the cross-disciplinary work carried out over the past thirty years at the Santa Fe Institute.* In its baldest outline, it states that economies are nonlinear complex adaptive systems that can be fruitfully compared to evolving biological ecosystems.

The framework might be familiar, but The Nature of Value: How to Invest in the Adaptive Economy (Columbia University Press, 2014) takes the reader into unexplored and underexplored territory. The book moves seamlessly between theory and practice and adds substantially to our understanding of both.

It might seem obvious that price is not value, but ordinary investors as well as financial modelers tend to forget this. For instance, many asset valuation estimates rely on models like Black-Scholes or the efficient market theory that use flawed inputs such as historical prices. They assume that economic risk is measured by price volatility. (No, says Gogerty, economic risk is “the chance that you permanently lose the capacity to generate or receive future economic value.” [p. 11]) They justify a firm’s stock price using dubious metrics to compare it to a competitor’s stock price. (“If firm X is priced at 120 times revenue, then seemingly similar firm Y must be a bargain when priced at 80 times revenue. This dangerous analytical shortcut—in essence, using a price-based model to compare apples to oranges—was popular during the Internet bubble of 1997-2000. In that case, both the apple and orange turned out to be rotten pieces of fruit. Being less rotten doesn’t make something more edible.” [pp. 12-13])

If investors are inclined to reduce value to price, many economists incorrectly reduce what is inherently an adaptive process to a mechanistic one. Keynes was one of the greatest offenders. He anticipated that within two or three generations the economy would plateau and reach equilibrium, which he described as “bliss.” But, Gogerty argues, “the only economic systems found today that are truly at or close to equilibrium are nearly dead economies. A cow that achieves equilibrium is called a steak, and the economy closest to achieving equilibrium today is probably North Korea.” (pp. 21-22)

Gogerty’s model of the economy as an adaptive, networked system begins with its fundamental building block, the ino (informational unit of innovation). Inos, which are analogous to genes, are expressed as capabilities, giving organizations the potential to deliver value if they are properly nurtured. These inos need not be original; “more often, big ino-enabled chunks of functional knowledge and capabilities are borrowed, shared, and mixed.” (p. 61)

Companies create value by having multiple advantaged capabilities. Gogerty cites the work of The Doblin Group, which identified ten categories of business innovation capabilities, and gives examples of firms that excelled in this regard and those that fell short. He contends that “the more types of unique capabilities a firm’s goods and services offer, the longer it may dominate competitors. To use a biological metaphor, it is one thing to be the fastest frog in the pond. It’s another to be the fastest, healthiest, best-looking, strongest, most fertile, and most metabolically efficient frog in the pond. Ideally, a firm should have long-term advantages in each of the ten innovation capability categories, with each capability impossible to replicate by competitors for the foreseeable future.” (p. 90)

At the next level of the economic hierarchy are clusters, competitive spaces in which firms fight for “the scarce resource of customer value flow.” (p. 102) Gogerty does a masterful job of describing four broad types of clusters (Lollapolooza, cash cow, lottery, and Red Queen) and their life cycles. ETF investors would do well to pay special attention to this section of the book. As Gogerty later explains, “people forget that a sector ETF allocation is actually a bet on the distribution of value capture among competitors in a cluster. Anticipated revenue growth means increased value will flow through the cluster—but does not guarantee sustained profits for any single firm, much less the aggregate cluster of firms. Competition and cluster instability can limit the cluster’s retained profits and the sector’s ability to retain value or build wealth.” (p. 307)

Followers of Warren Buffet know about the value of moats, but Gogerty goes deeper into the weeds and devotes an entire part of the book (three chapters) to this topic.

Finally, Gogerty analyzes the nature of various kinds of economies, those that are investable and those that are better left alone. He also discusses monetary shocks and their implications for the allocator, a term he prefers to ‘investor’.

The Nature of Value is a well-reasoned, thought-provoking book that belongs in the library of every investor, professional and retail, value and growth.
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*The Santa Fe Institute has some free online courses starting in September—introduction to complexity (a re-offering), mathematics for complex systems, and nonlinear dynamics. For those relatively new to the field, I can recommend the introduction to complexity course as well as Scott Page’s MOOC on Coursera, Model Thinking.

Wednesday, July 23, 2014

Baldwin, The Copyright Wars

Intellectual property is an ever growing contributor to the global economy; today, it comprises over 40% of the market value of American companies. With its growth has come the need for legally clear, enforceable intellectual property rights. Drafting and enforcing these rights across a global economy, where emerging nations were understandably inclined to follow “the same low road of piracy that the currently industrialized ones—none more shamelessly than the United States—had themselves travelled during the previous two centuries,” has proved to be a daunting task. (p. 19)

A subset of intellectual property—original works of authorship such as books, art, music, films, and computer software—is ostensibly protected by copyright law, although at times that protection seems to be more the exception than the rule. In the 1990s there was a valiant effort to codify and enforce copyright protection internationally (the Berne Convention), but subsequent advances in digital technology have raised new legal challenges and prompted yet another round in the long-standing battle over just what it is that should be protected.

In The Copyright Wars: Three Centuries of Trans-Atlantic Battle (Princeton University Press, forthcoming September 21) Peter Baldwin meticulously traces out the conflict between the Anglo-American and the continental European traditions. The Anglo-American approach puts the notion of copyright front and center whereas the continental European approach (with France being its most outspoken proponent) stresses authors’ rights.

As Baldwin explains the distinction (and editorializes in the process), “copyright has focused on the audience and its hopes for an expansive public domain. Authors’ rights, in contrast, have targeted creators and their claims to ensure the authenticity of their works. … Copyright sees culture as a commodity. Its products can be sold and changed, largely like other property. But the authors’ rights, especially their ‘moral rights,’ run counter to the market. Inalienable claims, they remain with the creators or their representatives even if they conflict with the commercial ambitions of the rights owners. The authors’ rights ideology sees itself speaking for high culture. It is elitist and exclusive, while copyright is democratic and egalitarian. Copyright gives authors a limited economic monopoly over their work to stimulate their creativity, eventually enrich the public domain, and thereby serve the public interest. Private interests are thus subordinate to the public good. Authors’ rights, in contrast, make no attempt to serve the public good as such, except tangentially insofar as happy authors better society.” (pp. 15-16)

Baldwin describes the conflict between audience and author against the backdrop of intellectual, ideological, political, and legal history. He invokes Kant and Fichte, romanticism, Nazism, Napoleonic and case law. A rich tapestry indeed.

He also shows how this conflict played out in real time. For instance, in nineteenth century America “British writers did not realize the profits of full copyright protection. Both their property and reputations, British authors complained, were injured by cheap knock offs. “ (p. 118) American authors suffered as well. “Given royalty-less British works of proven mettle, why take chances on an unknown local author? Washington Irving struggled to help a young colleague get published. ‘The country is drugged from one end to the other with foreign literature which pays no tax,’ he complained. American writers competed against ‘substantially all the European authors, in editions sold at the price of stolen fruit.’” (p. 120)

Over the past three centuries the Anglo-American and continental European models have traded positions of dominance. In the 1990s victory went to the continental ideology even though “the 1990s spasm of intellectual property legislation may … have testified more to rights owners’ frustrating inability to hold on to their property than to the actual enforceability of their claims.” (p. 317)

Where do we go from here? Baldwin comes down on the side of the audience. Take digital recordings, for instance. He writes: “Ironically, that industry that today most loudly laments digital pilfering on its turf was built a century ago on the legal evisceration of sheet music. But if sheet music was not sacrosanct property in 1909, why should digital recordings be so today? What the law gives, it can take away.” (p. 409)

He concludes: “That we want to keep present and future authors happy and productive is clear. But why rights holders’ claims to intellectual property should expand indefinitely, while those of other owners are ever more restricted by social concerns, is not. And that a vast existing cultural patrimony, already paid for and amortized, sits locked behind legal walls, hostage to outmoded notions of property, when at the flick of a switch it could belong to all humanity—that is little short of grotesque.” (p. 409)

I agree.

Monday, July 21, 2014

Jevons, The Mystery of the Invisible Hand

Wittgenstein, a passionate reader of detective stories, famously said that “more wisdom is contained in the best crime fiction than in conventional philosophical essays.” Marshall Jevons’ The Mystery of the Invisible Hand (Princeton University Press, forthcoming September 7) may not measure up to Wittgenstein’s lofty standard since it imparts knowledge rather than wisdom, but it’s still a worthwhile, enjoyable read.

Marshall Jevons is the pen name of William L. Breit and Kenneth G. Elzinga, professors of economics at Trinity University and the University of Virginia. They write mysteries that mix economics lessons with murder. I’m not sure what this hybrid genre is called, but let me—for lack of a better term—dub it didactic detective fiction. The reader learns some basic principles of economics as he sorts through motivations for murder. In this case, the Coase conjecture takes center stage.

This is the third Henry Spearman mystery. The fictional Spearman, a professor of economics, is the incarnation of Kenneth Arrow’s (somewhat dubious) statement that “an economist by training thinks of himself as the guardian of rationality, the ascriber of rationality to others, and the prescriber of rationality to the social world.”

Spearman speaks the language of economics: “That doesn’t seem to fit any rational cost-benefit analysis” and “… everybody’s better off, no one’s worse off. Sounds Pareto-optimal to me.” He explains to his dismissive neighbor: “… the term ‘dismal science’ was coined by Carlyle, and he didn’t mean that the subject was dismal to learn. Carlyle disliked economics because he saw free markets as a threat to the social structure in England that kept blacks and others in their place. He was a bigot who worried that a market economy would reduce the authority of the English ruling class.” And he thinks such unromantic thoughts as “In his case, marriage was a husband and wife having interdependent utility functions: one spouse deriving more utility by increasing the utility of the other.”

Economics is central to solving The Mystery of the Invisible Hand, but inevitably it also gets in the way of free-flowing prose. I suppose that’s just the nature of the hybrid beast. Still and all, for anyone wanting to nail down some basic principles of economics, and have fun doing it, it’s a “rational solution.” It would make superb supplementary reading for an introductory econ course.

Thursday, July 17, 2014

Brooks, Business Adventures

Resurrecting a 45-year-old book, Bill Gates included Business Adventures: Twelve Classic Tales from the World of Wall Street on his 2014 summer reading list. His enthusiasm (“Warren Buffett recommended this book to me back in 1991, and it’s still the best business book I’ve ever read”—and claims it’s Warren Buffett’s favorite business book, too) was contagious. With prodding by Gates’s team, the out-of-print book was reissued as an e-book by Open Road, and as I write this post it’s Amazon’s #1 best seller in commerce and #2 in books.

John Brooks originally published these business stories in The New Yorker, so it goes without saying that they are well written. Describing the stock market as “the daytime adventure serial of the well-to-do,” Brooks devotes the first chapter to a blow-by-blow account of the “little crash” and rapid recovery that occurred in the last week of May 1962. On Monday the Dow dropped more than it had on any day except October 28, 1929. By Thursday, after the Wednesday Memorial Day holiday, it closed “slightly above the level where it had been before all the excitement began.”

The infrastructure in place at the time could not cope with the overwhelming trading volume. On Tuesday, May 29, “there was something very close to a complete breakdown of the reticulated, automated, mind-boggling complex of technical facilities that made nationwide stocktrading possible in a huge country where nearly one out of six adults was a stockholder. Many orders were executed at prices far different from the ones agreed to by the customers placing the orders; many others were lost in transmission, or in the snow of scrap paper that covered the Exchange floor, and were never executed at all. … By a heaven-sent stroke of prescience, Merrill Lynch, which handled over thirteen per cent of all public trading on the Exchange, had just installed a new 7074 computer—the device that can copy the Telephone Directory in three minutes—and, with its help, managed to keep its accounts fairly straight. Another new Merrill Lynch installation—an automatic teletype switching system that occupied almost half a city block and was intended to expedite communication between the firm’s various offices—also rose to the occasion, though it got so hot that it could not be touched. Other firms were less fortunate, and in a number of them confusion gained the upper hand so thoroughly that some brokers, tired of trying in vain to get the latest quotations on stocks or to reach their partners on the Exchange floor, are said to have simply thrown up their hands and gone out for a drink. Such unprofessional behavior may have saved their customers a great deal of money.” (p. 17)

The first chapter alone is worth the price of the e-book, but Brooks has eleven more. He writes about the fate of the Edsel, the federal income tax, insiders at Texas Gulf Sulphur, Xerox, the Haupt crisis, non-communication at GE, a company called Piggly Wiggly, David E. Lilienthal, annual meetings and corporate power, the trial of Goodrich v. Wohlgemuth, and the pound sterling.

I admit that I haven’t quite finished reading the book, but since any review I could write would pale in comparison to Gates’s and Buffett’s endorsement, I considered it sufficient to add my voice to those calling attention to these essays.

Wednesday, July 16, 2014

Carey, How We Learn

Benedict Carey, a science reporter for The New York Times, has written a fast-paced, well-structured book that should have broad appeal. How We Learn: The Surprising Truth About When, Where, and Why It Happens (Random House, forthcoming September 9) not only summarizes a wide range of research findings that challenge traditional views but offers useful tips for both teachers and students.

For instance, most people do better if they break out of routines—if, for example, they vary their study or practice locations. Distributed study time is more effective than concentrated study time. Mixing multiple skills in a practice session sharpens our grasp of all of them. Forgetting is critical to learning. And sleep—well, we all know the value of sleep to learning and creating.

Of particularly interest to traders may be the chapter entitled “Learning Without Thinking: Harnessing Perceptual Discrimination.”

Baseball stars (hitters) and chess masters both have what Carey calls a good eye, and none of them is able to describe exactly what that is. “Their eyes, and the visual systems in their brains, are extracting the most meaningful set of clues from a vast visual tapestry, and doing so instantaneously.” (p. 152)

Carey takes the reader back to the doodle experiment of Eleanor Gibson and her (unnamed) husband. Gibson showed that the brain perceives to learn; “it takes the differences it has detected between similar-looking notes or letters or figures, and uses those to help decipher new, previously unseen material.”

As Carey clarifies a key passage from Gibson’s 1969 book Principles of Perceptual Learning and Development, perceptual learning “is active. Our eyes (or ears, or other senses) are searching for the right clues. Automatically, no external reinforcement or help required. We have to pay attention, of course, but we don’t need to turn it on or tune it in. It’s self-correcting—it tunes itself. The system works to find the most critical perceptual signatures and filter out the rest. Baseball players see only the flares of motion that are relevant to judging a pitch’s trajectory—nothing else. The masters in Chase and Simon’s chess study considered fewer moves than the novices, because they’d developed such a good eye that it instantly pared down their choices, making it easier to find the most effective parry.” (pp. 156-57)

And good traders? They presumably have developed a similarly good eye. For those who want to train future traders Carey describes how to construct a basic perceptual learning module to build perceptual intuition. Success not guaranteed; by definition, in every field there are only a handful of people at the top of their game.

Monday, July 14, 2014

Lombardo, Better Than Perfect

Perfectionism as it is usually understood can be a terrible curse, especially for a trader. It leads a person to act out of fear rather than passion—and sometimes not to act at all (why bother? I’ll botch it anyway). The perfectionist has both an “incessant drive to control the future” and “the unsatisfying feeling that, no matter how hard [he tries, he] will always come up short.” (p. 7)

In Better Than Perfect: 7 Strategies to Crush Your Inner Critic and Create a Life You Love (Seal Press, forthcoming September 23) Elizabeth Lombardo, a clinical psychologist and author of the national bestseller A Happy You, tackles the problems perfectionists create for themselves and suggests ways to overcome them.

For the most part Lombardo’s solutions involve reframing attitudes and motivations. Take the fear/passion dichotomy. “When you are fueled by fear, you focus on what you don’t want. Your goal is to do everything in your power to reduce the possibility of an undesired outcome. … Just by switching your perspective from one of fear to one of passion—working toward a desired outcome instead of avoiding an unwanted result—you can begin to feel more motivated, engaged, positive, and hopeful.” (p. 50)

Perfectionists are inclined to compare themselves to others and to judge themselves negatively. Of course, it’s not only perfectionists who do this; they are simply more intensely competitive. As Lombardo says, “Perfectionists don’t just want to ‘keep up with the Joneses,’ they want to kick the Joneses’ butts!” (p. 185) Well, that sounds more like trader talk; maybe a dose of perfectionism is actually a good thing, at least professionally. Lombardo admits that “many champion athletes, prominent scientists, and celebrities demonstrate perfectionist traits.” (p. 6)

I have the feeling that there are in fact a lot of perfectionists in the trading world—not basket case, paralyzed perfectionists but highly driven, competitive perfectionists. Consider the following excerpt, which in its broadest strokes is a reasonable trading strategy, at least if the tradeoff is favorable. “Comparisons affect not only how we feel but also what we do to try to feel better. People will actually give up something positive in order to have someone else receive less. In one experiment, for example, participants were given the opportunity to get rid of other participants’ money—though if they did they had to give up some of their own money, too. The result? More people chose to have others lose money, resulting in the depletion of their own funds.” (p. 187)

Lombardo’s world has limitless possibilities—limitless potential for money, health, prosperity, and abundance. By contrast, “perfectionists have a scarcity perspective: me vs. them.” (p. 186) In some markets perfectionists have it right; they’re playing a zero sum game.

I started Lombardo’s book believing that perfectionism (and, I admit, I have it in spades) is on balance a negative that should somehow be transcended. But by the end I was feeling pretty good about myself (although Lombardo might conclude that I’m in denial). Some perfectionist traits may get in the way of optimal performance, but others propel people to extraordinary heights.