Wednesday, August 20, 2014

Brooks, The Go-Go Years

It is fitting that Michael Lewis wrote the foreword to an earlier reissue of John Brooks’s 1973 book The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s (just republished by Open Road Integrated Media). Like Lewis, Brooks was a skilled writer with a nose for compelling financial stories.

Brooks’s most famous book, Business Adventures, has stood the test of time; it was on Bill Gates’s 2014 summer reading list—45 years after it first appeared. Time has not treated The Go-Go Years quite so kindly, although the book is still an interesting, if sometimes pained, commentary on a troubled era of change, both in society at large and on Wall Street in particular.

“In the nineteen twenties,” Brooks wrote, “it was in a real sense what Wall Streeters always cringed to hear it called, a private club—and not just any private club but probably the most important and interesting one in the country, a creator and reflector of national manners and a school for national leaders. In the nineteen sixties, despite declining aristocratic character and political influence, it was still those things, playing out week by week and month by month its concentrated and heightened version of the larger national drama. But after the convulsion with which the decade and that particular act in the drama ended, its days in the old role seemed to be numbered. … If the certificate and the floor go, Wall Street will have moved a long way toward transforming itself into an impersonal national slot machine—presumably fairer to the investor but of much less interest as a microcosm of America.” (pp. 314-15)

The late sixties were a time of social and political unrest. But “all through the stormy course of 1967 and 1968, when things had been coming apart and it had seemed that the center really couldn’t hold—the rising national economic crisis culminating in a day when the dollar was unredeemable in Paris, the Martin Luther King and Robert Kennedy assassinations, the shame of the Chicago Democratic convention, the rising tempo of student riots—the silly market had gone its merry way, heedlessly soaring upward as if everything were O.K. or would surely come out O.K., as mindlessly, maniacally euphoric as a Japanese beetle in July. Or as a doomed man enjoying his last meal. One could only ask: Did Wall Street, for all its gutter shrewdness, have the slightest idea what was really going on?” (p. 17) Obviously not. By the end of the decade and into 1970 the stock market “had gone into a sickening collapse,” interest rates were at near-record highs, and one hundred or more Wall Street firms were near failure.

Not that the early part of the decade was exactly tranquil. The stock-market collapse of 1962 sent the Dow down more than 25 percent. Brooks writes of it: “Diabetic coma, the preventable catastrophic crisis of a human disease, comes on slowly; the sinister lassitude it induces neutralizes the rational alarm that would otherwise lead the patient to take measures to head it off. So it is with stock-market crashes.” (p. 55)

The Dow reached a high just shy of 735 at the turn of the year, after which “a gradual, fairly consistent decline began. But experts who a year earlier had been sounding prudent warnings of the dangers of speculation were now victims of the very euphoria they had warned against; in January and February, 1962, they pointed out that business was good, spoke of a ‘healthy correction,’ and recommended the continued, if cautious, purchase of stocks.

“What a falling market needs to become a diving market is not a reason but an excuse, and in April it found one when President Kennedy chose to engage in a to-the-death confrontation with the steel industry and its bellwether, U.S. Steel, on the matter of a price increase.” The steel industry eventually capitulated, “but at what a cost! Investors, who had profited so handsomely from the ‘Kennedy market’ of the previous year, suddenly decided that the energetic young man in the White House was an enemy of business, after all. Whether or not Kennedy, in the heat of confrontation, had actually said in private, ‘My father always told me that businessmen were sons of bitches,’ was not the point; the point was that a good proportion of the 17 million American owners of corporate shares believed he had said it. For several weeks in succession, the market slumped ominously, until the week of May 21-25 saw the worst decline for any week in more than ten years. And then, on May 28, the day that has gone down in Wall Street annals as Blue Monday, the Dow average dropped 34.95 points, a one-day collapse second in history only to that of October 28, 1929, when the loss had been 38.33. Moreover, the decline took place on the then-fantastic volume of 9,350,000 shares.” (pp. 55-56)

Brooks recounts how the late sixties became, “for a shockingly brief moment, the heyday of the young prodigy, the sideburned gunslinger. … He came from a prospering middle-income background and often from a good business school; he was under thirty, often well under; he wore boldly striped shirts and broad, flowing ties; he radiated a confidence, a knowingness, that verged on insolence, and he liberally tossed around the newest clichés, ‘performance,’ ‘concept,’ ‘innovative,’ and ‘synergy’; he talked fast and dealt hard (but unlike the back-office people he seems to have seldom used drugs, including marijuana); and, if he was lucky, he made 40 or 50 percent a year on the money he managed and was rewarded with personal earnings that often exceeded $50,000 a year.” (p. 189) Alas, “the look of eagles became a vacant stare once the ever-rising market began to plunge,” and “many of the gunslingers who had touted [the glamor stocks] would leave, or be fired from, the securities business.” (p. 192)

Monday, August 18, 2014

Oliveira, Traders of the New Era

According to a 2011 study that used data from the Taiwan Stock Exchange over a 15-year period (1992-2006), less than one percent of day traders are profitable two years in a row. “But,” the researchers note, “the stock picking ability of these investors is remarkable. Top day traders (based on prior year ranking) earn gross (net) abnormal returns of 49.5 (28.1) bps per day on their day trading portfolio, while the tens of thousands of day traders with a history of losses in the prior year go on to earn gross abnormal returns of -17.5 (-34.2) bps per day.”

Every year new traders come on the scene, though certainly not the hordes who tried their luck in the dot.com era. They hope against hope that they will be among the top one percent. By definition, the odds are staggeringly against them.

Fernando Oliveira is a relatively new trader who struggled to achieve profitability. In search of answers, he set out to interview, as the subtitle of the book says, “a select group of day and swing traders who are still beating the markets in the era of high frequency trading and flash crashes.” Actually, not all of these traders are delivering alpha; one interviewee admits to struggling and another is described as a “former winner.”

Traders of the New Era is a surprisingly decent book, even if unpolished. The interviewees are not exactly household names—Flemming Kozok, Denis Dick, Jeffrey Goldman, Eric Scott Hunsader, Mitch Semon, Wayne Kulcheski (plus two anonymous traders and one who uses a nickname). But that may be the reason the book has a freshness to it.

Most of the interviewees are discretionary traders who rely on screen time rather than backtesting to develop informed instincts, who tend to look at order flow rather than technical indicators. They focus on the mechanics of order entry (type of order, routing, etc.), risk management, and emotional discipline. Most of what they know and what they have done is only in their heads, not in trade journals.

Traders of the New Era is not a particularly useful book for the rank novice. The main message he could glean from the book is to devote hours and hours (if not the “magical” 10,000) trying to get a feel for the way individual stocks and markets move. But those with some experience will find helpful pointers and occasionally insightful analysis.

For instance, one trader says: “I hate using market orders, because it’s just a blank check. It’s such a fast trading world right now, and I believe that some HFT participants can see your market order coming down the pipe, especially if your order is pinging multiple destinations. … I would rather use a marketable limit order. For example, if the offer was at $94.50 and I really wanted to own a stock, I would maybe put a $94.55 limit or something like that. I’d probably get filled at the $94.50 offer, but if the price changes rapidly, I’m not going to get filled at something crazy like $95.”

Another trader notes: “I’ve been more strategic about getting in and out of positions. The way to think about [it] is that HFTs are like parasites and you’re the host. They do not want to a buy a stock unless you want to buy it. They don’t want to sell it unless you want to sell it. So just know that when you send an order, it will have three or more times the impact on the market than it used to have. So buying 100 shares is like buying 300 shares.”

Monday, August 4, 2014

Roberts, Saving the City

Seemingly countless articles have been written comparing 2014 to 1914—politically, economically, socially, every which way. Richard Roberts’ Saving the City: The Great Financial Crisis of 1914, published last year by Oxford University Press, has a different agenda. First, and most important, it sets out to acquaint the reader with a financial crisis that remains largely unknown and, second, it draws parallels between the events in London at the start of World War I and the most recent financial crisis.

On July 31, 1914—more than a month after the assassination of Archduke Franz Ferdinand in Sarajevo and about a week after the ultimatum from Austria to Serbia, after a few days of “the weirdest prices” as London became, in the words of The Economist, “a dumping ground for liquidation for the whole Continent of Europe”—the London Stock Exchange closed, with the NYSE following later in the day. (p. 14) London would not reopen for five months, on January 5, 1915. The NYSE resumed trading “in the full list … with restrictions” on December 15, 1914, “and on a pre-crisis basis on 1 April 1915.” (p. 223)

“The financial crisis of 1914,” Roberts writes, “was the most severe systemic crisis London has ever experienced—even more so than 1866 or 2007-2008—featuring the comprehensive breakdown of its financial markets. The 1914 crisis was not a ‘typical’ financial crisis…. There was no preceding credit expansion, speculative mania, asset bubble, or ‘Minsky moment’. However, there was a very clear ‘displacement’ moment [the Austrian ultimatum] that transformed risk perceptions of the possibility of a major European war. … As fear supplanted greed there was a universal dash for cash, preferably gold. All sellers and no buyers meant that markets quickly ceased to function.” (p. 5)

It was not only the stock and bond market that broke down but the foreign exchange market and the discount (money) market as well. “The scramble for liquidity broke the markets’ mechanisms.” (p. 22) And there was a run on the banks, although, as commentators were quick to note, not a panic. Depositors withdrew their money (asking for gold but getting notes instead) and then flocked to the Bank of England to change these notes for gold.

Roberts details, and lauds, British efforts to stem the crisis. “Remarkably,” he writes, “there were no failures among major financial institutions, casualties amounting to just a dozen London Stock Exchange firms, a minor discount house and some small savings banks. … The avoidance of significant failures was an important achievement of the authorities’ measures—which is not to overlook individual tragedies, with more than a score of bankrupt brokers and 145,000 impoverished depositors at National Penny Bank. There were at least six suicides attributable to the crisis in the City.” (p. 232)

Although there are several parallels between the crises of 1914 and 2007-2008 and how governments dealt with them, the greatest difference is that the earlier crisis did not morph into a recession. World War I provided ample economic stimulus to prevent this consequence, perhaps the only positive thing one can say about what most people today regard as a futile conflict.

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.
____

*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.