Monday, December 22, 2014
Most of the characters in this book are familiar: Ray Dalio of Bridgewater Associates, Tim Wong and Pierre Lagrange of Man Group/AHL, John Paulson of Paulson & Co., Marc Lasry and Sonia Gardner of Avenue Capital Group, David Tepper of Appaloosa Management, William A. Ackman of Pershing Square Capital Management, Daniel Loeb of Third Point, James Chanos of Kynikos Associates, and Boaz Weinstein of Saba Capital Management. Adding to the luminaries, Mohammed El-Erian wrote the foreword and Myron Scholes the afterword.
Many of their stories are familiar as well. So why does this book remain a compelling read?
It introduces us to a very bright, hardworking, resilient group of people. We see how their research leads them to formulate hypotheses, how they translate these hypotheses into market positions, how they push their advantage, and how they bounce back when their hypotheses don’t pan out.
In chapter after chapter we begin to see what it takes to be an alpha master (or, as Scholes would have it with a nod to Ohm’s law, an omega master, “where omega is the varying amounts of resistance in the market”). It matters not where you start or what niche you carve out for yourself. But it matters enormously that you mold your fund to fit your own interests and expertise, that your research is relentless and subject to constant testing and potential revision, that you understand (and respect) risk. It matters that you can see things in available data that other people don’t, that you or your team have a set of skills that can offer a fresh perspective when weighing potential investments.
If your goal is to become a master investor/trader, this book may inspire you to work harder and smarter than you ever thought necessary.
Wednesday, December 17, 2014
Sears focuses on the “make or break” things most investors blithely ignore, such as risk and when/how to sell. With respect to the latter, he writes: “Selling is Wall Street’s essence just as surely as buying is Main Street’s. … If you don’t learn to be a disciplined seller, you risk losing more money than you make. … Selling is not about timing the stock market. It is about managing the risk of your own investment portfolio, and tempering your decisions.” (pp. 23, 24) There’s no single right philosophy of selling, although Bernard Baruch’s timeless advice to “sell while the stock still is rising or, if you have made a mistake, to admit it immediately and take your loss” (p. 35) remains a good place to start.
At home in both the stock and options markets, Sears contrasts the two, saying that “the options market is driven by fear” and “the stock market is driven by greed.” He admits that “this is an oversimplification—but not by much.” (p. 89) The SKEW Index, an option-based indicator that measures the risk of 30-day S&P 500 returns two or more standard deviations below the mean, can be a useful guide for the risk-conscious stock investor. “When the SKEW Index is at 100, it means that the probability of a steep stock market decline is minimal. When it rises above 100, the odds of a sharp decline increase.” (p. 90) Its all-time low was on March 21, 1991, as the recession that had begun in July 1990 was winding down. Its all-time high—146.88—was in October 1998 during the Russian debt crisis and the unexpected Fed move to lower interest rates. It was also high in March 2006, shortly before the housing bubble burst. Using the SKEW Index in conjunction with the VIX can be especially helpful.
Sears also describes an alternative approach to asset allocation, relying on the work of Mark Taborsky, then at PIMCO. This was a strategy that Mohammed El-Erian’s Harvard team tried to execute but found very difficult to quantify and optimize. As El-Erian outlined the strategy in When Markets Collide, “The ideal situation is to come up with a small set (three to five) of distinct (and ideally orthogonal) risk factors that command a risk premium. The next step is to assess the stability of the factors and how they can be best captured through the use of tradable instruments.” (p. 233) Instead of relying on historical asset class performance patterns and assuming that markets are mean reverting, Taborsky explained, PIMCO looked at factors such as risk, volatility, correlation, interest rates, or even time.
These short takeaways from The Indomitable Investor offer only a glimpse into the richness of Sears’s book. Investors who are serious about managing their money and who want to be among the few who succeed can learn a great deal from Sears.
Monday, December 15, 2014
The third edition of Being Right or Making Money (Wiley, 2014) showcases the firm’s guiding principles and some of its research. Although I have neither the first (1991) nor the second (2000) edition of this book, I think we can safely discard the idea that the 2014 edition is merely an update. The simple fact that the second edition was 150 pages long and the new edition runs some 231 pages is probably sufficient to disavow anyone of that notion. Chapters that deal with current topics, such as a potential bear market in 2014 and the game-changing nature of U.S. energy independence, are another tip-off.
What has remained the linchpin of all three editions is Ned Davis’s own investment philosophy. Even here there has been one major change: “the evolution of my belief that the most successful money managers are risk averse.” (p. xv)
Davis maintains that the four keys to making money in a business characterized by making mistakes are objective indicators, discipline, flexibility, and risk management. There is, of course, a dynamic tension between discipline (“remaining faithful to [one’s] systems through good and bad times”) and flexibility (the ability to change one’s mind when the evidence shifts). Davis readily admits that “there are periods, historically, in which model indicators tend to fail or stay wrong against a major move.” (p. 35) Risk management-–in the simplest terms, being willing to take small losses but avoiding big losses—helps to resolve this tension. And hence “the bottom line at Ned Davis Research is that our timing models, at every stage of development, are designed with one thought foremost in mind, and that is controlling big mistakes.” (p. 36)
Three chapters of this book are devoted to model building. The first describes the process of model building; the next two offer a stock market model and a simple model for bonds.
In building a timing model, the investor should first make sure he has clean data. He must then investigate “which data series, out of the innumerable possible sets out there, are the most useful or relevant for asset-allocation and market-timing purposes. Some data is best suited for aggressive, short-term trading, while other data is best suited for long-term asset allocation and risk control. Finding out what is useful is the biggest challenge the investor faces….” (p. 42)
NDR employs both internal and external indicators in its timing models. Internal indicators include such things as the slope of a moving average, breadth-thrust, and momentum. External indicators include interest rates as well as sentiment and valuation. Numerous charts illustrate indicators NDR has found useful in its models.
The final three chapters of the book—the first by Ned Davis, the second by Alejandra Grindal, and the final one by John LaForge—are examples of the kind of research NDR does. They are chock full of graphs, some comparing data that might not seem to be obviously connected such as the U.S. petroleum trade deficit and the goods deficit with China.
Being Right or Making Money is a tribute to the kind of research that can help the investor make money, even if he’s not always right.
Wednesday, December 10, 2014
The relationship between the partners was often fractious. Managers “remembered the two locked in sulfurous glares, faced off like the Monitor and the Merrimac, Lynch’s forehead knotted in fury, Merrill’s blue eyes turned into ice fields. The debates were bare-knuckled, and both were capable of extended, loud, and imaginative invective. At the root of these disagreements were fundamentally different approaches to life. Merrill was the visionary, Lynch the realist—but only Merrill recognized that a business needed both.” (p. 73)
Initially, the brokerage business was secondary to the investment banking business at Merrill, Lynch & Co. The firm’s bread and butter was underwriting stock issuances in expanding chain stores such as McCrory’s, Kresge’s, Penney’s, Kinney Shoes, and eventually Safeway.
After Lynch died in 1938, the company began to shift direction. At the urging of Win Smith, a partner of the ailing brokerage firm E. A. Pierce, Merrill merged the two firms. This “would be the realization of Merrill’s dream of a ‘department store of finance’ operated in the chain-store mold—a high volume of transactions with a small return on each to maintain profitability.” (p. 139)
Americans didn’t trust brokers; their main complaint was that brokers churned accounts in order to generate commissions. Merrill Lynch decided to offer a new model, where brokers were paid a straight salary, “with annual bonuses to reward special contributions to the firm.” … “This approach,” Smith notes, “lasted into the 1970s when competitive pressure forced the firm to change its method of compensation back to a commission-based one.” (p. 143)
The new Merrill model embraced ideas that were radical at the time: the customer’s interest would come first, the firm would advertise extensively, it would publish an annual report, its brokers wouldn’t give investment advice unless asked for it. But, despite efforts to cut costs and boost sales, in the early 1940s the brokerage firm was flailing financially. “The firm had an average income per transaction of $10.17 and an average cost of $14.29. According to Merrill, ‘When you figure that one of our clients, the Carnation Milk Company, can content the cow, milk it, pasteurize the milk, put the milk in the can, put a label on it, put it in a box, advertise it, and ship it all over the world, and sell the can of milk for five cents, then you realize how perfectly frantic these figures make me feel.’” (p. 158)
Smith recounts the subsequent successes of Merrill, and exposes its warts, with the fondness of an insider and the objectivity of a reporter. His anger about the course the firm took after Stan O’Neal became CEO (and after he resigned) is, however, barely contained.
Merrill is now 100 years old and no longer an independent legal entity. It, like so many Wall Street firms, was hijacked by a leader who did not understand the company’s principles and “unique culture” that had “allowed it to grow and prosper and survive in many challenging environments.” (p. 515)
Catching Lightning in a Bottle is not only an account of what was but a call for what should be. It’s a first-rate read.
Monday, December 8, 2014
Dayton, a clinical psychologist, sets a course for traders to follow that will, in the best case scenario, prevent them from being hijacked by their emotions. This is not to say that traders will be able to eliminate or control those emotions that undercut their trading success. In fact, trying to suppress, control, or eliminate feelings and thoughts usually only makes them worse.
Emotions are not only a necessary part of trading; they add to the quality of trading decisions. They are “a crucial component necessary in making decisions, especially in controlling and correcting reward-related and punishment-related behavior because these kinds of decisions always involve emotion.” Studies show, for instance, that people with frontal lobe damage cannot adapt their behavior to changing patterns of rewards. “[A]fter the experiment was over, the [brain-damaged] participants could accurately describe the tests, how the tests had changed, and also how they were incorrectly responding to the changes, signifying that they fully comprehended the tests, at least on an intellectual level. They could not, however, explain the dissociation between what they knew and what they did.” (p. 84)
So, the trader must provide room for emotions yet not permit them to wreak havoc on his trading. The key to walking what seems to be a fine line is, Dayton argues, mindfulness. As he writes, the “three characteristics of mindfulness—a heightened clarity of the market environment, focus on the here and now, and an understanding that thoughts and feelings are merely temporary events and not necessarily reality—can help the trader take action in the direction of what matters most in a given trade, as well as what matters most to him or her as a trader.” (p. 106)
Normally we fuse with our thoughts and emotions. That is, “thoughts and feelings are generated automatically by the mind and we don’t have much say over what thoughts and feelings occur. … The environment and the situations we are in highly influence what the mind tells us. … When fused, we uncritically believe the mind and become entangled in its story. This causes us to lose contact with the present. … When fused with our thoughts and feelings, we lose focus with the trading task at hand. … The mind can be remarkably shameless in the stories it will tell. When we are fused, we can’t tell the difference between what is truly useful and what is not.” (pp. 152-54)
The remedy for fusion is defusion, “the ability to accept thoughts exactly as they are for what they are (just words and feelings), not what they represent themselves to be (e.g., the truth).” For instance, ‘I am going to have a loss’ is a fused thought; its defused alternative is ‘I am having the thought that I am going to have a loss.’ “Letting thoughts go is possible by developing the skill of defusion.” (p. 158)
Trading is a stressful business, even if you’re an old hand at it. Will the stress of trading take a toll on our lives? Not necessarily, research shows. Premature death seems to be linked not to stress itself but to the perception that stress is harmful to our health. A study of 28,000 adults showed that people who experienced high levels of stress and who believed that it affected their health had a 43% increased chance of premature death. Those highly stressed people who did not believe that their stress was harmful to their health had the lowest risk of dying, even lower than people with low stress. My hunch is that in the first group were an outsize number of people who acted on their perceptions by engaging in harmful allegedly stress-reducing behavior, thus sabotaging themselves, and that in the second group were a good number of highly successful (and, yes, stressed) people who tend to live longer than folks lower down on the socioeconomic ladder. Whatever the case, believing may not necessarily make it so, but beliefs do shape actions and outcomes, for better or worse.
Dayton makes a strong case for mindfully accepting and defusing unwanted thoughts and feelings so that attention can remain on the task at hand. With practice, the mindful trader will be able focus on his trade rather than on, for instance, his fear that he’s going to lose money. The fear won’t go away, but it will no longer be the force that guides his actions.
The final part of the book, “Maximizing Your Trading Performance,” moves from the psychology of negative emotions and erratic behaviors to the positive psychology that can help enhance performance. Central to performance psychology is the Before-During-After process. “Preparing for trading in a high-quality way, taking our preparation into trading to maximize our trading abilities, and assessing our trading performance and results with the intent to improve our preparation and execution is the royal road to developing, advancing, and enhancing our trading.” (p. 273)
Friday, December 5, 2014
The guiding metaphor of the book pits the hunter against the farmer. Once the farmer (and Gutsche’s farmer is, of course, a stylized construct) figures out how to produce a harvest, each year he repeats the chain of decisions that led to the last harvest. He is complacent and wants to protect the status quo. The hunter, by contrast, is insatiable, curious, and willing to destroy. In Gutsche’s world the farmer is likely to become irrelevant or worse—think Smith-Corona or Blockbuster—while the hunter forges ahead.
Okay, so let’s say you’ve vowed to be a hunter. What should you hunt for? Gutsche lays out six patterns of opportunity: convergence, divergence, cyclicality, redirection, reduction, and acceleration. Described in their simplest terms, convergence combines multiple products, services, or trends. Divergence opposes or breaks free from the mainstream. Cyclicality focuses on predictably recurring opportunities. Redirection channels the power of a trend instead of fighting it; for instance, redirection can refocus or reprioritize. Reduction simplifies or focuses an idea. Acceleration identifies a critical feature and dramatically enhances that element.
What I have laid out in one paragraph Gutsche spends over a hundred pages on, describing the patterns in more detail and giving multiple examples. I would hope that traders and investors could come up with their own examples of patterns of opportunity.
We’ve now reached the point in Gutsche’s book that, “armed with a knowledge of the patterns of opportunity and having awakened your inner hunter, you’re now better prepared to spot and hit those opportunities to find better ideas, faster.”
The first step is to narrow your focus to “zero-in on the opportunities that are just big enough to be profitable, but not so large and obvious that your competitors can already spot them.” (p. 161) Then find a cluster of products, services, or concepts that follow a similar idea. The third step is to search the perimeter for slightly related ideas and the fourth, to push your boundaries. Five, collect and cluster what you find, and then throw away your first clusters because “the human mind is great at finding trends and patterns by creating shortcuts or by falling prey to stereotypes, schemas, and bias. We try to lighten our mental load by referencing what we’ve seen before and what we know works.” (p. 168) Finally, use the six patterns to re-cluster your insights.
There you have it, folks, a game plan for better, faster ideas. It might just work.
Wednesday, December 3, 2014
The authors start with an 800-year historical perspective and then discuss trend following basics, theoretical foundations, trend following as an alternative asset class, benchmarking and style analysis, and trend following in an investment portfolio.
Here I’ll simply highlight a couple of ideas that are central to the book’s thesis.
Let’s start with the notion of crisis alpha. “Crisis alpha opportunities are profits that are gained by exploiting the persistent trends that occur across markets during times of crisis.” (p. 145) Viewed in the context of the adaptive market hypothesis set forth by Andrew Lo in 2004, “for both behavioral and institutional reasons, market crisis represents a time when market participants become synchronized in their actions creating trends in markets. It is only the select (few) most adaptable market players who are able to take advantage of these ‘crisis alpha’ opportunities.” (p. 73)
A key concept of the book is divergent risk taking. “Convergent risk takers believe that the world is well structured, stable, and somewhat dependable. Divergent risk takers profess their own ignorance to the true structure of potential risks/benefits with some level of skepticism for what is or is not dependable.” (p. 95) Investing in equity markets is a convergent risk-taking activity; investors “believe in both the existence of an equity risk premium over the long run driven by fundamental value and the efficiency of financial markets. … In distribution, this is also true. Equity returns are positive in expectation, yet negatively skewed with fat left tails.” By contrast, trend following is an obvious financial example of divergent risk taking. “Trend followers do not believe in anything but opportunity. … When they see a trend they follow it, they give no consideration to fundamentals. In fact, the distribution of trend following is positive in expectation with positive skewness.” (p. 97) That is, “Convergent trading systems generally focus on many smaller gains with the occasional extreme loss. Divergent trading approaches focus on smaller losses with the occasional extreme gains.” (p. 98)
Using the market divergence index (MDI), “a simple aggregate measure of ‘trendiness’ in prices taking into account the level of volatility (or noise) in the price series” (p. 109), the authors show, using six agriculture markets with substantial price histories, that market divergence is stationary—that is, that “occasional ‘trendiness’ in markets is a stable characteristic of markets over the long run.” (p. 115)
Some of the authors’ findings are things we already believed to be true but had no compelling grounds for believing. Their work provides us with the requisite quantitative underpinning.
For traders and investors who want to be challenged intellectually but not overwhelmed, this book is an illuminating read. And, let me repeat, it’s not just for those who invest in managed futures.