The Financier's Roar

Finance is not generally considered a stirring subject. Interesting, maybe. Remunerative, certainly. Complicated, definitely (and don't believe anyone who says otherwise). But stirring?

Well, not often, but occasionally.

2001 was not a great year for Berkshire Hathaway. The firm had experienced its first decline in book value per share (their chosen measure of performance) in their history. This was coming off the back of a very poor 1999 result where their growth in book value per share underperformed the S&P 500 by 20.5%. In 2001, at least everyone else did poorly too, but to a firm that prided itself on consistent results, this was a tough pill to swallow.

The proximate cause of this problem was that they run a huge reinsurance business, and September 11th caused them to have to pay out a ton. And Warren Buffet, in his 2001 letter to shareholders, had the job of fronting up to investors about what was going on.

He began by explaining what he called the three principles of underwriting, which he acknowledged that they had failed to live up to:

1. They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.

2. They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.

3. They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn’t work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.

The third one I'm less certain of than the first two. But they all fit a pattern - pick carefully which risks you want to take on. Make sure you can survive them, and pick the ones likely to be profitable.

But having done that, how should one approach the vicissitudes of fortune? How should one weather the storm?

Buffet's answer is perhaps my favourite line in finance. I call it 'The Financier's Roar'.

At Berkshire, we retain our risks and depend on no one.

Just so.

Risk and return are not just academic constructs, but the very stuff on which the economic world is built. The point is not to eliminate risks. If one wants to do that, buy treasury bills, accept a zero rate of return, and don't ever leave your house. You will earn zero, and you will never succeed.

The vast majority of good plans carry a risk of failure. The reason they do is that arbitrage is rare. Sometimes, life hands you a risk-free profit opportunity, but, like the proverbial $20 bill on the sidewalk, they don't stick around for long. And in the space of risky ventures, a similar mechanism holds. If an opportunity has a really high return and very low risk and everyone sees this, mostly the price will get bid up until the expected return has gone back down.

Mostly. But not always. Arbitrage may be very rare, but undervalued assets are more common. Figuring out what they are is the substantive part of the Buffet risk management. Identify things that are good risks, and buying enough that you can take on and survive.

The second part, the Financier's Roar, is the call to courageous decisions. Having selected the right risks to take on, retain them. Be willing to eat the possibility of loss and failure, and don't try to hedge everything out. Have the confidence of your own calculations to hold the portfolio of life's payoffs that you think will work out the best overall. As I have noted before, one does not eat the expectation, but the realisation. No matter how well you calculate, sometimes you will lose. That's life. But at least you won't lose in a stupid manner. Courage, when properly applied, is taking the right risks, though risks they be nonetheless.

The second benefit is the one that's easy to overlook, but is important. When one retains one's risks, one is an island. The universe may deliver success or failure, but the only thing that matters is one's calculations and the roll of the dice. By contrast, the more you hedge out risks by trading with others, the more you rely on the success or failure of others. If you're relying on a counterparty to pay up when the porridge hits the propeller, your risk management now depends on their risk management. Just ask the people who bought credit protection from Lehman Brothers.

Retaining risks leads to self-reliance. Retaining the right risks leads to success or failure with the only tools one has against the cold indifference of fate - one's own wits.

Retain your risks, and depend on no one.

The Drain Approaches

So, we're about at the halfway point since I made the following prediction, half in jest, as my version of the Julian Simon bet:

Shorting the rand against a trade-weighted basket of currencies will earn positive abnormal returns over the next ten years.

This was based on nothing more than my hunch that South Africa is a country circling the drain.

How are we doing so far? Well, ignoring the trade-weighted bask bit, here's a partial answer:

The saddest incorrect prediction in geopolitical terms is that it can't possibly get any worse. The Zimbabwe lesson is that it can always, always get worse.

It gives me no pleasure to say that I told you so.

Bun Arbitrage

It is left as an exercise to the reader to show that, under the law of one price and the absence of arbitrage, the market-clearing price of a hamburger bun in Heidelberg is zero.

Currency as a Paper Standard

People often make a distinction between asset backed currency, (where each dollar is a claim to some physical good, such as the gold standard), and fiat currency (where each dollar is simply a government printed piece of paper).

The distinction that people generally draw is that fiat currency can be produced in arbitrarily large amounts (i.e. printing tons of paper money), while asset backed currencies limit the sovereign's wealth to his stocks of the asset in question (unless he wants to dilute the currency, by reducing the amount of gold in each coin if it's literally a commodity currency, or reducing the amount of gold that each piece of paper is claim to for an asset backed currency).

In reality, all these arrangements are arbitrary - money works because people believe other people will accept it, and the gold and paper and whatnot are just coordination mechanisms to help us agree on what to accept.

The idea that the key distinction is the ability to print more money obscures a second aspect of asset-backed currencies that was less prominent historically but is actually more relevant today - the fact that people are accepting a notional instrument as a claim to some other less convenient instrument that they would say that they value more.

With gold, it was inconvenient to actually carry it around, so people were happy to carry around convenient pieces of paper that were claims to a fixed amount of gold, as long as everybody believed that the paper system was always going to work and be accepted. Eventually people got sufficiently used to the paper that the fiction of convertability was unnecessary. The Supreme Court took it away, and people barely noticed.

The parallel today is that we have a 'paper standard'.

The real money in today's society is ones and zeros in bank accounts, in SWIFT computers, and in Federal Reserve bank deposits.

Just like the gold standard before it, people are happy to transact in this fully abstract money because each digital dollar is a notional claim to a piece of paper printed by the US treasury. You can go to the bank and redeem your digital dollars for paper dollars whenever you want.

In the modern world, the digital dollar is vastly more convenient than the paper dollar, just as the paper dollar was more convenient than the gold bar. And while people do still withdraw dollars for some purposes, it's becoming increasingly rare. Can you imagine someone actually taking all their wealth out of the bank and leaving it in dollars under the mattress? The vast majority of the cash holdings for the vast majority of people are already in digital form.

At the moment though, people still like the fiction that they might convert all their digital dollars to paper dollars. If things were entirely on computers, what would happen if the computers crashed?

In reality, that ship sailed decades ago. If the computers crashed, the rich would be left with their houses and that's about it. But most people don't worry about this, just like most people in the 90s in America didn't worry about the government printing zillions of paper dollars, even though people in 1800 would have viewed this insouciance as insane naivete.

It seems likely that eventually the fig leaf of paper convertability will be removed. Young people already would be comfortable with this - they barely use cash, it's all credit cards. Eventually, the anachronism of paper money will be removed altogether.

When that happens, it will raise a number of intriguing economic possibilities.

The biggest of these is that there will no longer be any binding zero lower bound on interest rates. The biggest obstacle to negative interest rates is that people have the option of just hanging onto their dollars and earning zero. When the dollars are only in the bank, that's trivial to change. Every dollar in your account is depreciating at a continuously compounded interest rate equal to 3% per year.

If you could do that, the 2008 recession might have been a damn lot shorter. You don't want to spend and are trying to deleverage and hoard liquid assets? Does your answer change if those liquid assets are earning you -8% a year? Hell, even a Porsche doesn't depreciate much more than that - why not just enjoy the car instead? Hey presto, spending is back.

Don't get me wrong, there will likely be a huge psychological obstacle to negative interest rates. People will view it as the government or the bank taking their money (in a way that they don't view it as the government giving them money with positive interest rates). If the fed wants to do it, there's not much choice though - where are you going to take your money instead when there's no paper to redeem it for? If probably would fuel asset inflation, as people rush to put their assets into anything that will hold its value.

In addition, the difference between fiscal and monetary policy becomes much harder for the average person to see. If the government is taking out 1% per month from your account, does it really matter whether that amount is getting transferred to the government's account (under a tax) or destroyed altogether (under a negative interest rate)?

The eventual disappearance of paper money seems like it will only be forestalled by civilisational collapse or a massive change of governing arrangements. When the first government has the balls to announce negative nominal interest rates is another question.

I suspect that you and I may well live to see this reality.

Bravo, Mr Fama!

So Eugene Fama was finally awarded the Nobel Prize in Economics, along with Lars Hansen and Robert Shiller. All of them are thoroughly deserving. I suspect in part that the committee might have felt like a parent finally caving to their child's demand for chocolate - it was easier to give Fama the prize than keep dealing with the implicit mockery when his name topped the list of prospective prize winners year after year after year.

I've written about the excellence of Mr Fama before. What I will note, however, is the interesting nature of the prize. It was awarded to the three economists for "for their empirical analysis of asset prices". Both Hansen and Shiller did their most famous work in this area - the Generalized Method of Moments in the case of Hansen, and the excess volatility of prices with respect to dividends in the case of Shiller.

But curiously, Fama's most famous work is developing the idea of market efficiency - that an efficient capital market is one where prices fully reflect all available information. This can work at several levels - weak form, which covers all past price and volume information, semi-strong form, which covers all public information, and strong form, which covers all information, both public and private.

Simple, right? But people hadn't thought about it in that way.

Market Efficiency was a Nobel Prize worthy insight. More importantly, it was a Nobel Prize worthy insight even if markets are not, in fact, efficient. This is because the concept of market efficiency crucially changed the way the debate was framed and the evidence understood. The people that bang on about how markets obviously aren't efficient because of the 87 crash, or the financial crisis, or whatever, still implicitly accept the framework that Fama laid down. It is very difficult to conceive of what asset pricing would look like without Fama.

Of course, people confuse the real contribution of market efficiency with the related point that markets are actually mostly efficient (which Fama has made statements in support of, though by no means universally or dogmatically). But this is the secondary part - the real genius is the idea, regardless of whether efficiency is 'true' or not. The better way of phrasing the question is how efficient markets are, rather than the boo-hiss pantomime of 'all efficient' or 'all inefficient'.

If you come up with a brilliant idea simple enough for people to understand, they'll dismiss it as obviously wrong and unimportant. If you're like Lars Hansen and do something totally brilliant that nobody outside economics will ever understand the importance of, people will assume that your reputation is deserved.

And hence they didn't give Fama the prize for market efficiency directly - they gave it for his body of work on empirical asset pricing. Which is fair enough, as it gets to the main point. By including Shiller, they also added someone whose work tends to suggest that markets may not be efficient, although again by performing novel tests to examine this question. Don't get me wrong, Shiller is a totally deserving recipient. But it still seems to me that Fama's work is the most central of the three, in the same way that Leonid Hurwicz was arguably the most central in the mechanism design prize of 2007. It seems like the addition of a behavioral person in the empirical asset pricing prize was partly a way of saying that the committee doesn't necessarily think markets are efficient (a totally fair opinion), and also, along with the prize label, to insulate themselves somewhat against clowns who misunderstand the importance of market efficiency.

Still, this is all by the by. A great day for Chicago.

It's been a while since anyone has been inducted into the Shylock Holmes Order of Guys Who Kick Some Serious Ass, but Eugene Fama is most deserving of the honour. Congratulations! Apparently some guys in Sweden rate your work too, but that's not so important.

Odd Hedges Against Modern Worst-Case Scenarios

File this one under “it’s probably still a bad idea, but it’s not clear exactly why”.

The idea of a hedge is to take steps that are (typically) costly today in order to get better payouts in bad states of the world. Unemployment insurance and health insurance are classic ones, well understood by most people.

But there are plenty of other disasters in life that people don’t think much about how to hedge.

There are, for instance, plenty of possible states of the world where civil society breaks down altogether. Frankly, the best argument for gun ownership is for the eventuality of some extended civil emergency where government disappears for weeks or months on end. If the police aren’t coming to save you any more, you’ll probably wish you’d bought that shotgun. And antibiotics. And water. Lots and lots of water. You’re laughing at the preppers now, but that’s to be expected – until the disaster comes, they’re the weirdos buying insurance that never pays out.

The most unorthodox life hedge that I’ve been musing about (only in abstract terms, of course) is that of faking low level symptoms of mental illness. Go to a doctor, and complain that you’ve been hearing voices. They’re not saying alarming or violent things, just other voices in your head. When you get referred to a psych, they can disappear. Maybe they come up again in a few years. Or if you’re worried about appearing crazy, complain about chronic sleepwalking and other dissociative states. 

What, you’re probably wondering, is this a hedge for?

Credibly establishing an insanity defense if you’re charged with a serious crime, particularly a capital crime.

Courts have a good ability to sniff out people who are bogusly claiming insanity to get out of prison sentences. It’s no good to just claim after the fact that you were mad. But if there’s a paper trail of psych evaluations starting several years earlier, it becomes much easier to run an insanity defense.

Obviously, as any good lawyer will tell you (and as I've written about before), you generally don’t want to plead insanity, since this means getting locked up in a psych ward forever, which may or may not be better than getting locked up in prison forever. It probably is better than the chair, though.

That’s where sleepwalking comes in. Some jurisdictions will accept various dissociative states (like sleepwalking, being concussed, that kind of thing) as indicating a lack of intent, but not indicating enough craziness to get you institutionalised. I don’t know how likely this is to work, but it’s a possibility.

Of course, the down side is that you will have a medical history of mental illness, which might cause all sorts of problems I don't understand. That said, for better or worse (and it's often for worse), modern society is reluctant to forcibly institutionalise mentally ill people who haven't committed a crime and aren't an immediate threat to other people's safety, so I don't know how big the costs of being diagnosed as schizophrenic would actually be. Of course, after you're charged, all bets are off.

These actions fulfill the big point of the hedge – if you find yourself being charged with a capital crime, you may well wish you’d done it. I personally doubt this will ever happen to me, so the chance of it paying off is low, and the potential other costs of being diagnosed as mentally ill are large. So it’s probably a bad idea. Plus, I don't want to lie in general, let alone commit fraud, so I wouldn't be doing it in any case. But it’s still interesting to think about.

Morgan Stanley is not your friend

Not if you are their client. Not if they're underwriting an IPO you're purchasing. And certainly not if they're just trading on the other side of the market against you.

What, did you expect something else? Is this surprising to you?

Then I have bad news for you. You have no business picking your own shares to day trade in equity markets.

The Greek sent me this interesting Atlantic article about the debacle surrounding the Facebook IPO.

It's rather long, and I have mixed feelings about it, so let me give you the quick version.

Facebook had a big IPO coming up. As the date neared, they realised that revenue projections were going to be lower than expected, because more people were switching to (low ad revenue) mobile services than they'd forecast. They released a form with the SEC that buried this news while meeting technical disclosure requirements. Institutional investors figured this out from their brokers and banks. Joe public did not.

There's an interesting story here, but I found it hard to get through, because it started in the following manner:

Uma Swaminathan tuned the television set in the living room of her ranch style home in the suburbs of East Brunswick, N.J. to CNBC. It was 9:00 a.m. on May 18, 2012, a day the retired schoolteacher thought might make her rich. She logged onto her Vanguard brokerage account on her computer and placed an order for 5,000 shares of Facebook at $42 a share.

Like a bad movie, I already knew how the rest of this was going to play out from the first paragraph. The author clearly has sympathy with the lady in question, and invites the reader to as well.

With short hair, brown skin, and few wrinkles, Swaminathan looks much younger than her 68 years. She spent most of adult life as a suburban mom, making tofu for her daughter's friends at theater rehearsals, taking her three sons to soccer practice and Boy Scouts, and volunteering in the local community. She served a term as president of the Indian American Association of New Jersey.

My immediate responses are threefold:

1. These sound like admirable things to do.

2. A similarly glowing list could be compiled about just about anybody.

3. If this is story about financial markets, what about the above listed background made her think she was an ideal candidate to start trading actively?

Her interest in the stock market didn't develop until her husband died about 13 years ago. Her four children had already moved out to attend college or to pursue their careers. Swaminathan was left with her late husband's 401(k) retirement account, when she started dabbling in the market, investing in stable companies like Microsoft. Not long after, she began to follow the news coverage of initial public offerings (IPOs) -- when private companies enter the public market -- and came to know of the phenomenon known as the first day "pop." On the day that companies would debut on the stock market, the price would tend to shoot up before stabilizing. A year earlier, she watched as social networking site LinkedIn's stock price closed up 109 percent on its opening day.

Okay, we're going to hear a lot of sympathetic stuff later in the article. But let's just unpack some of these statements. Roll the tape again:

[She] came to know of the phenomenon known as the first day "pop." On the day that companies would debut on the stock market, the price would tend to shoot up before stabilizing.

So IPOs historically go up, on average (we'll come back to that phase in a second) on their first day. So what? Do you think that you're somehow owed a large first day return? For what? What did you do to earn them?

And in a question that might be viewed as immensely patronising, except for everything revealed by her subsequent actions: do you think that positive average returns are the same as uniformly positive returns?

Financial markets combine two distinct roles. There is a positive sum problem of real resource allocation - prices send signals about which companies should be able to expand their operations, and what the economy should produce more of. But there is also a zero sum problem of trading - if I buy and the share goes up, I make money relative to the alternative case if I hadn't bought. But the guy I bought it off loses money relative to if he hadn't sold.

So this woman might have made money. But who would have lost? Whose story is not being told here?

Most of the time, the company who sold it to her. The standard answer in the finance literature is that IPO underpricing is about companies getting ripped off by their unscrupulous advisors. So finally, the academics get their way, and Facebook is definitively not ripped off with its IPO price. So instead the story gets written about the woman who bought the Facebook shares and lost money. But that's inevitable - if someone makes money, someone else loses.

[Diversion: Academics have written hundreds of papers on the reason IPOs are "underpriced" because of the first day pop. But really, do you think CEOs look at stories about the 'biggest IPO flop ever' and think to themselves, 'Wow, that's what I want! That Zuckerberg guy managed to get absolute top dollar for his worthless shares!'. And if they don't, can you really blame them?]

But it's more than that - the woman wasn't buying shares in the IPO from Facebook, but in the open market. She was buying them off some other investor. Maybe she was buying them from Goldman. Maybe she was buying them from some other small investor who doesn't get an Atlantic story written about them. Who knows.

The point is, suppose she'd made money. Someone else sold too low immediately on the open. Would you feel equally sorry for them? Maybe if they'd gotten a glowing article written about how they volunteer at their local soup kitchen or whatever, but ordinarily, no, you wouldn't.

As the grievance studies professors are fond of saying - some narratives are privileged, and others are not.

Let's jump back to a statement at the beginning.

[O]n May 18, 2012, a day the retired schoolteacher thought might make her rich.

You thought you'd get rich trading IPO stocks as a retired schoolteacher.

The Greeks have a word for the feeling I experience reading those words, and it is catharsis.

She'd never placed such a big bet on just one stock, but she felt a personal connection to Facebook. She had been using the site to connect with family and friends since 2009, and almost everyone she knew had an account.

...

Facebook shares hit the market at an opening price of $38. Minutes later, Swaminathan's online order was executed, and the retired schoolteacher had just spent approximately half her life savings.

You put half your God damn life savings into a single stock? And an IPO stock at that? Are you out of your mind?

First of all, this shows that you have absolutely no idea about even the very basics of finance. Idiosyncratic risk? Diversification? Anyone? Anyone at all?

Second, it shows that you don't even understand the strategy you're implementing. IPO underpricing is a statement about average returns to a strategy of buying a ton of IPO stocks. It is not  a strategy for putting all your money into a single stock. If you are counting cards in blackjack, you want to place lots of bets over and over because the odds are in your favour. You do not want to put all your money on one hand. If you don't understand this, again, you don't understand the very basics of finance. 

I want you to remember this, reader. Because there's an entire article about how this is all JP Morgan's fault, and Vanguard's fault, and NASDAQ's fault, and FINRA's fault.

Madam, I submit to you the following - your belief that you would make tons of money by putting half your life savings into Facebook stock was not something you learned from JP Morgan, or Vanguard, or NASDAQ, or FINRA. It was not something you got from financial academia, or textbooks, or even moderately sophisticated blogs. I don't know where you got it. I suspect from naive extrapolation.

Don't get me wrong. There is another side to the story, one about investment banks giving selective advice to their favoured clients and the game being rigged against small investors. This is all true. But you don't need me to tell you that story - the whole article is about that. We can argue about what, if anything, should be done to fix this problem.

But to my mind, this is just a smokescreen. Why?

Because if you're putting half your life savings into a totally fair and not rigged IPO stock, there's a large chance that the story would still have the same ending. That's what happens when you take a huge bet on a single volatile asset. If I had to hazard a rough guess without looking at the actual data, I'd say it's a bit less than a 50% chance for a one-off bet, since IPO stocks do rise on average on the first day. But if you're doing this strategy multiple times, it starts becoming way more likely.

Financial markets are like a circular saw. You can use them to fashion a beautiful oak table if you know what you're doing.

You can use them to chop your own leg off if you don't.

You may think this is all rather harsh. Some poor woman still lost a ton of her life savings. Don't I feel sympathy for her?

Of course I do. It's a tragic story. She clearly had no idea what she was doing, and got fleeced by Wall Street.

As the great Theodore Dalrmpyle put it, people can both be figures of sympathy and also acknowledged as being significant architects of their own misfortune.

One can, in other words, be a victim, but also partly responsible. The two are not at all contradictory.

And this is worth mentioning, because this is not really a human interest story. It is, after all, a policy story. The author wants you to believe that this unfortunate woman's losses are primarily the fault of Wall Street Greed and Crony Capitalism.™ More taxes on crooked banks! More regulation!

The real problem here is the one that the author doesn't want to talk about - there are plenty of individuals investing in financial markets who have not the vaguest clue what they are doing, and a number of them are going to lose a lot of their life savings.

One way to deal with this is to load up on paternalism - only let sophisticated people with demonstrated knowledge trade. This might solve the problem. Then again, it might not. It would also come with a number of undesirable side effects.

The other way to deal with this is reflect on the sad and imperfect universe we live in, and the wisdom that the Gods of the Copybook Headings would have told us, much more in sorrow than in scorn:

"A fool and his money are soon parted."

Don't tell them it's also linked to tax revenues in the City of London which finance their existence

The BBC has a classic case of 'English Majors Trying To Write About Finance', with this clanger of a headline:

Black-Scholes: The maths formula linked to the financial crash

Bravo! Never mind that the 'financial crash' is nearly universally recognised as being about a crisis in:

-Banks and Bank Runs

-Housing

-Sub-Prime Leverage

-Counter-party Risk

-Contagion

-Over-leverage

none of which have anything  to do with options or the Black-Scholes formula. It's like the Black Scholes formula has become the Economic Whipping Boy that SMBC hilariously described.

Here's a fun game - identify other scary sounding 'linkages' that the BBC may be interested in exploring:

-Chemotherapy linked to patients having cancer

-SAT scores linked to students failing to get into college

-Cars linked to increase in bank robberies

etc.

Did I mention I also help little old ladies across the street on my way to Mensa meetings?

I was going to write about this piece at the New York Times where this guy called Greg Smith writes about how he's leaving Goldman Sachs because it no longer has the vibrant service culture of putting clients first that it had when he started (no really, stop laughing). He also wrote to say that all you darn kids have no respect any more, and you keep listening to that damn rap music, and back in his day politicians cared about the public interest.

I was going to write about that, but then David at Popehat nailed it so perfectly that you should really just read his post instead. Comedy gold!

Why I Don't Read the Financial Press Much

Pity low-level financial journalists.

The big names get to write important opinion pieces on the financial crisis and the banking system.

The low-level guys, on the other hand, every day they have to write garbage about financial markets. Prices went down today? Hmm, what could explain that? How about 'fears of a weakening economy'? Sure, that sounds plausible. Prices went up today? Investors were bargain hunting after yesterday's price decline. Etc.

Realistically, they should just be reporting 'today, the coin landed on heads!', because at a daily level, stock returns are pretty damn random. Over long horizons there's more predictability, but on a daily basis, it's just noise.

Making up this kind of junk tends to erode the intellect (and the spirit). And sometimes this spills over into further sloppy thinking.

The Greek passed on this gem from CNN Money:

At $400 billion, Apple is worth more than Greece

Apple's market cap is higher than the gross domestic product of Greece, Austria, Argentina, or South Africa.

Yeeeeaah...

So it's clear this guy doesn't understand the difference between a stock and a flow. Market Cap is a stock measure - not in terms of the 'stock' market, but meaning that it captures the total amount of something. GDP is a flow measure - it represents an amount that occurs each period.

In other words, GDP is analogous to your income for this year and market cap is analogous to your total net wealth. (It's an imprecise analogy, because net wealth represents income you've already earned, whereas market cap represents the estimate of the money you'll earn in the future).

But the point is that comparing these two numbers and saying that 'Apple is worth more than Greece' is absurd. It's like saying that the guy who works in a factory and owns a $600,000 house is richer than the guy who worked at an investment bank, because the investment banker's income this year was only $500,000. The comparison is meaningless.

Not only that, but the whole thing is a non-story.What even happened to justify writing this junk? Apple's market cap increased slightly? Quick, better write a puff piece of meaningless comparisons, because the rubes just love reading stories about Apple!

Remember kids - these are the people telling you why the market moved yesterday.

Pass the salt, please.

Markets Will Clear...

...whether you like it or not.

Tickets to the Coachella music festival went on sale today at 10am. Last year, I figured I had a while to dither about the decision as to whether to go, and after a week, they were sold out. Bam! Your $300-odd ticket is now a $500-odd ticket.

Okay, so this year I'd learned my lesson - I was going to buy it straight away. They went on sale at 10, by 10:15 I was online trying to buy tickets to the first weekend.

Nope, couldn't get them. They were gone. Apparently friends who tried even earlier, even at a few minutes past ten, weren't able to get them. The website would still list them as being available, but you'd try to buy without success. There were some still available for the second weekend, but I couldn't make it then.

It makes you wonder why the promoters don't set the price higher. I have some sympathy - this year, they increased the length from one weekend to two weekends, thus doubling supply. Didn't help - at the face value of  $330 or whatever, there was still a shortage.

It's always surprising how promoters end up leaving money on the table for scalpers. If the market-clearing price is $400, you're just giving free money to scalpers by setting the price at less than this. Granted, firms only get a small number of guesses at the market-clearing price. But surely it wouldn't have been hard to look at the secondary market prices from last year, hire some whizz-bang economist specialising in estimating demand curves, and figure out the correct price.

Nope, that would be too hard.

I did however make one very stupid error, which I now regret.

Once I saw that weekend 1 was effectively sold out, my instinct was 'Oh well, guess I'm buying on the secondary market. Let's read some other websites'. What I should have been doing is trying like crazy to buy tickets to the second weekend. It's a pretty damn good bet that if the first weekend is sold out in 20 minutes, the second weekend will be sold out pretty quickly as well. What you've got is a very strong signal that the tickets are underpriced. As a result, you ought to be buying weekend 2 tickets with the plan of re-selling them, doing this as a hedge against the likely price you're going to have to pay in the secondary market for your weekend 1 tickets.

Sure enough, on Stub-Hub,  weekend 1 passes start at $550, and weekend 2 passes start at $500. It would have been a pretty good hedge indeed.

Which just goes to show - mispricing doesn't hang around long. It's not enough to recognise it, you have to recognise it quickly and act on it. The race goes not always to the swift, but the arbitrage usually does.

Eugene Fama - So Full of Win

Check out but a mere handful of Eugene Fama's quality quotes in his mini autobiography of his life in finance:

My grandparents emigrated to the U.S. from Sicily in the early 1900s, so I am a third generation Italian-American. I was the first in the lineage to go to university.

Fans of linear extrapolation confidently predict that his children and grandchildren will soon be solving friendly AI and proving the Reimann Hypothesis.

I went on to Tufts University in 1956, intending to become a high school teacher and sports coach.

Huh! Given the guy is likely to win a Nobel Prize in Economics, I would not have guessed that.

Vindicating Mandelbrot, my thesis (Fama 1965a) shows (in nauseating detail) that distributions of stock returns are fat-tailed: there are far more outliers than would be expected from normal distributions – a fact reconfirmed in subsequent market episodes, including the most recent. Given the accusations of ignorance on this score recently thrown our way in the popular media, it is worth emphasizing that academics in finance have been aware of the fat tails phenomenon in asset returns for about 50 years.

Two points:

1. Spot on with the last part. When people start telling you that all of finance is disproved because returns aren't in fact normally distributed, this should be taken as fairly strong evidence that they are a) a moron, or b) a crank.

2. I love the self-deprecation in the 'nauseating detail'. The unstated implication is 'I have so much kick-@$$ work that I can disparage half of it and nobody will think any less of me.' This assumption has the virtue of being both hilarious and completely true.

The simple idea about forecasting regressions in Fama (1975) has served me well, many times. (When I have an idea, I beat it to death.)...In a blatant example of intellectual arbitrage, I apply the technique to study forward foreign exchange rates as predictors of future spot rates, in a paper (Fama 1984a) highly cited in that literature.

Again, Eugene Fama can say this about Eugene Fama without detracting in any meaningful way from Eugene Fama.

In 1976 Michael Jensen and William Meckling published their groundbreaking paper on agency problems in investment and financing decisions (Jensen and Meckling 1976). According to Kim, Morse, and Zingales (2006), this is the second most highly cited theory paper in economics published in the 1970-2005 period. It fathered an enormous literature. When Mike came to present the paper at Chicago, he began by claiming it would destroy the corporate finance material in what he called the “white bible” (Fama and Miller, The Theory of Finance 1972). Mert and I replied that his analysis is deeper and more insightful, but in fact there is a discussion of stockholder-bondholder agency problems in chapter 4 of our book. Another example that new ideas are almost never completely new!

Translation - Michael Jensen's ideas are almost never completely new [you thieving @#$%].

Though not about risk and expected return, any history of the excitement in finance in the 1960s and 1970s must mention the options pricing work of Black and Scholes (1973) and Merton (1973b). These are the most successful papers in economics – ever – in terms of academic and applied impact. Every Ph.D. student in economics is exposed to this work, and the papers are the foundation of a massive industry in financial derivatives.

I guess some papers are completely new after all! Unlucky, Jensen. (Actually he's generous to Jensen later, but it's still funny.)

What are the state variables that drive the size and value premiums, and why do they lead to variation in expected returns missed by market β? There is a literature that proposes answers to this question, but in my view the evidence so far is unconvincing.

To what extent is the value premium in expected stock returns due to ICAPM state variable risks, investor overreaction, or tastes for assets as consumption goods? We may never know. Moreover, given the blatant empirical motivation of the three-factor model (and the fourfactor offspring of Carhart 1997), perhaps we should just view the model as an attempt to find a set of portfolios that span the mean-variance-efficient set and so can be used to describe expected returns on all assets and portfolios (Huberman and Kandel 1987).

Make sure you point out this passage next time you're forced to sit next to some boring mediocrity droning on about how everyone at Chicago naively and dogmatically assumes that markets are always efficient.

Gold, gold, gold.

(Via Marginal Revolution).

Paging Dunning and Kruger...

There are few things more irritating than popular journalists who try to take on an academic orthodoxy by pretending to be soooo much smarter than those ivory tower pinheads, and try to mask their poor understanding of the subject with bluster and scorn. Many academic ideas are wrong, but it's odd that a whole profession is comprised of morons.

Over at Forbes, Steve Denning has an article entitled "The Dumbest Idea In The World: Maximizing Shareholder Value". Right off the bat, you can tell from the title that it's going to be a howler. (I know titles are sometimes chosen by sub editors, but it's not unrepresentative). Maximizing shareholder value is the dumbest idea in the world? Dumber than witch burning, or the modern flat-earth movement, or communism, or astrology, or... okay, so nobody with half a brain can actually believe that, they're just being provocative.

The author is positing an underlying argument that's actually quite reasonable, namely that CEOs should focus on improving earnings, rather than focussing on exceeding market expectations. Personally, I tend to agree. But it's not enough to just make this point, Denning has to pretend that anyone who ever said anything to the contrary is a disingenuous fool.

Take this hilarious quote from the article:

Martin says that the trouble began in 1976 when finance professor Michael Jensen and Dean William Meckling of the Simon School of Business at the University of Rochester published a seemingly innocuous paper in the Journal of Financial Economics entitled “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.”

The article performed the old academic trick of creating a problem and then proposing a solution to the supposed problem that the article itself had created. The article identified the principal-agent problem as being that the shareholders are the principals of the firm—i.e., they own it and benefit from its prosperity, while the executives are agents who are hired by the principals to work on their behalf.

Yes, read that again. This imbecile is actually claiming that Jensen and Meckling (1976) created the principle/agent problem! Because until they pointed it out, no manager in history had ever thought to further their own interests instead of those of the shareholders. This article was like the poison apple in the Garden of Eden, and once managers were finally told 'hey, you know you can jack up your pay at the expense of shareholders?', then the age of the philosopher-king managers was over.

Honestly, I'm just baffled by this claim. The principal agent problem in J&M relies on the following assumptions:
1. Shareholders are the owners of the company, and they appoint the board, who hire managers on the shareholders behalf.
2. Shareholders will seek to maximise the value of their shares.
3. Managers, once appointed, will seek to act in their own self-interest.
4. The interests of shareholders and managers will sometimes be in conflict.

Seriously, which of these four assumptions wasn't true before 1976? It's just bizzarre. Denning wants to claim that managers never tried to maximise shareholder value before 1976. Well call me crazy, but I'm pretty sure that managers who weren't at least trying to do that got fired pretty quickly, and this had nothing to do with Michael Jensen. The author may not like the J&M solution of paying managers in equity, but that's completely different from smugly saying that J&M "created" the principal agent problem.

Let's just say that not only is maximizing shareholder value not the dumbest idea in the world, it's not even the dumbest idea in the article. And if Jack Welch and Roger Martin (Dean of the Rotman School of Management at the University of Toronto) feel differently, then so much the worse for them.

Steve Denning, you are an arrogant, pontificating fool.

Gift Card Arbitrage

GiftRocket has this interesting post examining what the average secondary resale value of a $100 gift card is.

Apparently there's quite a spread. At whole foods, the value is $91. At 1-800-Flowers, it's as low as $50. The average resale value is $72.

So here's the question - what should they be trading at?

Well obviously the upper bound is $100, as cash weakly dominates a gift card for all consumers. (The logic is that if I gave you $100 and you would like to spend it all at Starbucks, you would be indifferent between the cash and a Starbucks Gift Card. If you were going to spend even some of it elsewhere, you'd prefer the cash).

The standard explanation for a discount is shipping/hassle costs. If it costs me $2 to get it sent to me, and $5 of time to hassle around on E*Bay, I'm only going to pay $93. But this doesn't explain why there's such a big spread across retailers. The shipping costs are the same for all cards. And even the estimated cost of people's time doesn't make sense - people who shop at Whole Foods (value = $91) will probably have a higher cost of their time than people who shop at Baja Fresh (value = $70), in which case the price patterns should be reversed.

Another potential reason for the existence of a discount is the estimated probability that the card is fraudulent. But unless some stores are easier to scam than others, it's not clear how you end up with a cross-section of prices.

GiftRocket notes that the discount is related to how popular the merchant is - popular stores trade at a lower discount.

So what's the profitable trade here? The real question is why people who aren't planning a big purchase at one of these stores anyway don't stock up on gift cards. Doing so is getting you a 50% discount on flowers! I guess most people don't think to do this trade.

My guess is that it's also related to the length of time it will take you to spend the money. The two highest are a supermarket (Whole Foods) and a giant retailer (Walmart), where people might conceivably spend the money in one or two weeks. Next is Starbucks, which is also likely to be bought fairly frequently. But it will probably take most people quite a while to buy $100 worth of burritos. And as for flowers, if you weren't buying $100 of them at once, it could be a long time before you spend the rest.

Either way, I may look into this next time I'm thinking of buying at one of these places.

Why was the Greek default "voluntary"?

Marginal revolution links to this piece in the UK Daily Telegraph:

But perhaps the biggest sin of the lot was effectively to render all credit default swaps (a form of insurance against default) on sovereign debt essentially worthless, or void, by making the Greek default "voluntary".

This has made it impossible to hedge against eurozone sovereign debt purchases, and thereby destroyed the market. Worse, it's made investors believe that the euro cannot be trusted, that it'll repeatedly find ways of reneging on contract. That's the point of no return. This is no longer a serious currency.

Tyler Cowen refuses to take a stand on the question of whether the stated claim (making the default "voluntary" was a big blow to the credibility of the Euro) is true. And I think it's not clear, although the argument is not unpersuasive.

But it does raise a something that I now wish I'd written about earlier when I thought of it at the time, namely this: I don't understand why on earth they insisted on making the default "voluntary". The quotation marks are deliberate, as it was about as "voluntary" as when Vito Corelone makes you an offer you can't refuse, complete with a decapitated horse head left on your pillow. But technically, the private debt holders just happened to agree to forgive half the Greek debt they held. You know, like debt holders always do! Call up your student loan company, they'll tell you all about it!

When investors in Greek debt have to take a haircut, somebody is losing money. In a simple world without credit default swaps, the holders of the debt lose money - easy enough, that's the risk they took when they bought it. In this case, it doesn't really matter if the default is voluntary or not, they lose the same amount of money.

But when you add in credit default swaps, now it does start to matter. For the non-finance audience, think of this as like an insurance policy for the case that the debt defaults. You make periodic payments in advance, and then get a payoff if there's a 'credit event' (default, delay in payment, reduction in principal or interest, and a bunch of other contractually specified events). Some people buy the CDS contract and the bonds, some people buy the bond but not the CDS, some people sell (i.e. write) the CDS.

In a typical default, the ordering goes like this: the best off are those who had the bond and the CDS - this is like when your house burns down, but you have an insurance policy. The next worst off are the guys who have the bond but not the CDS. They're like the people whose house burnt down without insurance, but they still at least have the land (i.e., whatever the recoverable value of the bond is). The worst off are the CDS writers (i.e. the insurance comapny) - they pay out on the policy, and get nothing.

In well-functioning financial markets, we tend to think that this kind of risk-sharing is welfare improving. The insurance company is better placed to bear the risk of my house burning down than I am, and I pay them a premium for this service. Everyone benefits in the long run, even if there's winners and losers in any given event.

So here, it's as if the EU governments decided to not only burn down the house, but also void all the fire insurance policies, since "voluntary" defaults don't trigger the CDS contract payments. The best off are the CDS writers (the insurance companies), who pay nothing. The second worst off are the guys with bonds but no CDS (the homeowner without insurance), who takes the haircut but that's all. And now the single worst off guy is the one who bought the bond and the CDS - he loses  out on the value of the bond, AND he's been paying premiums for all these years on the CDS! Essentially you're totally screwing over the guy who bought the Greek Bonds but was a bit nervous about the risk and tried to insure himself. Congratulations pal, you get to eat a sh*t sandwich!

Now, bear in mind this is the exact opposite  of what governments normally do in catastrophes. If anything, they like to pressure insurance companies to pay out in situations they might not have. Both September 11th and the Paris Car Burnings could arguably be considered acts of war or civil emergencies (respectively), neither of which tend to be covered in insurance contracts. But the insurance companies paid out anyway, perhaps because of actual (or implied) pressure from the respective governments. Obviously there are clear political reasons in those cases - lots of voters on one side, a couple of nasty insurance companies on the other - but still, it's the general rule for how things go.

So why the hell would they deliberately do the opposite in this case? Truthfully, I don't really know. The "voluntary" defaults were taken by private investors and banks, and the people who wrote CDS contracts were largely other banks. So it's not clear why the EU government should prefer one group over the other. Maybe the government had private information that the financial stability was more threatened by CDS writers going under than bondholders, but it's not clear why this should be the case - a lot of French and German banks stood to lose money by this deal, as they held the bonds and CDS contracts that got screwed.

So what's left? A symbolic 'we never defaulted!' victory? Seems like a pretty damn Pyrrhic victory to me, as investors are not going to be fooled at all next time they're thinking about investing in PIIGS government debt. And the article author is right - they're also going to rightly question whether they can even get proper CDS insurance on this debt, or whether the EU will choose to screw them over again. This might not cause the collapse of the Euro, but it sure doesn't seem to be adding to the desirability of EU sovereign debt.

I'm hoping there's a good reason they did this that I don't know about. But from reading around, I haven't uncovered what it is. I can think of a bunch of bad reasons (CDS writers were more politically connected, the EU had a hard-on about the idea of not actually defaulting). But if there's some higher purpose to the whole thing, you can put me in the same camp as Jeremy Warner at the Telegraph in not understanding what it is.

A Pre-Mortem Post-Mortem

Over at Hacker News, there's a fascinating article discussing the prospects of Raystream, a company that claims to have a new video compression technology. As their 'about' page describes their claims:

Using Raystream, the same one hour 720p video can be compressed up to 90% of its original file size, which makes it easily streamable over connection speeds ranging from 0.4 to 1.0 Mbs per second.

No playback modifications required (codec, browser player, set top box, smart phones, etc.)

Interesting, no?

Enter the description at 'Ihatelawyers3':

OK, at this point, if you know anything about video compression, you start to see a red flag waving in your face. The only way one can encode videos so that they (a) play on mobile phones, and (b) need no playback modifications (codecs, etc) is... if you use an existing codec.
But how can an existing codec compress to 10% of what it... already can do?

So he decided to take their test video and compress it using off the shelf technology. And the results, as described in the hacker news thread:

If you encode their test-video with an off-the-shelf open source H264 codec on normal settings, you end up with a video that is smaller than their sample video. Their "amazing new technology" is just vanilla h264 compression.

 Or put another way:

It means the _normal.mp4 file was encoded in an absurdly high bitrate for no reason except to make their claim of 90% compression.

 Hmmm.

I don't know video compression. The hacker news discussion and the github site seem pretty compelling.

But I do know finance.

Here's Raystream's stock price over the last month:

Yeeeaaaaah. It sure looks like something fishy is going on.

It's an over-the-counter stock, so you can't short it. But let's put it this way - Shylock Money Management is not investing any of its proprietary trading money in RayStream, and would be interested in possible short exposure to the stock.

How Good is the Apple iPhone 4GS?

Apple unveiled the new iPhone 4GS today. Rather than pore through smoothly presented video presentations, let's answer the question with boring financial data!

Zooming in on the return today only:

Return on Apple Stock today: -0.56%
Return on the S&P 500 today:  2.25%
Beta of Apple: 0.87

Abnormal Return of Apple Stock today = -0.56 -2.25*0.87 = -2.52%
(taking the S&P 500 as my lazy man's market proxy)

i.e. It's disappointing. Given Apple's market cap of $345 billion, it's actually about $8.7 billion worth of disappointing.

You'd think that this kind of basic information would be easy to discern, but it took much more hassling around to find out a simple market-adjusted return than you might think.

Instead, the financial press reports useless and insipid descriptions like the following:

Investors were disappointed, too. Apple's stock fell more than 5 percent before getting a late bump.

That 'late bump' was entirely driven by the market movement, and tells you virtually nothing about Apple. Yeesh. No wonder people end up believing ridiculous folk tales like 'the market fell today as investors began to take profits from last week's rise'.

How to Fail in Business Without Really Trying

Over at Paco Enterprises, Paco has an interesting post on Solyndra, the glorious new bankrupt solar energy company that managed to finagle $500 million in loans from the government and proceeded to send the money (and the company) down the rathole.

The more that comes out about this company, the more it becomes apparent that this was a horrible investment of money to start with. From the Government! I know, you must be as shocked as I was. As Zero Hedge noted, when you're producing a low-margin commoditised product like solar panels, and you've got revenues of $58 million versus cost of goods sold of $108 million, that's a recipe for the fast track to insolvency. Coyote's description is almost right:

Even in the worst run late 90′s Internet company I ever encountered, they were not selling dollars for 50 cents.

True enough. My only quibble with this metaphor is that if Solyndra were actually selling dollar bills for 50 cents, it would be a big improvement, because at least the final product would be re-salable for a full dollar. Here, it's more like they took a dollar bill to the 7-11, got change in quarters, melted two of the quarters into a blob of metal and proceeded to flush the blob down the toilet.

There is only one silver lining that I can see in this whole mess. At least the company actually went bankrupt, and now hopefully will be liquidated. In other words, taxpayer losses appear limited to only (only!) $500 million of yours and my money. By contrast, had Solyndra managed to limp along long enough to become a large political constituency, we probably would have been on the hook for much larger ongoing bailouts. It could have been added to the pantheon of dollar-bill blast furnaces of General Motors, Chrysler, Fannie Mae, Freddie Mac and the Post Office that no matter how badly they perform, the government picks up the tab and nobody ever gets fired.

The best thing Solyndra did for us was to fail fast enough and spectacularly enough that even the most coked-out green energy fanboys in the government couldn't justify throwing more money its way. You'll forgive me for not celebrating this fact too highly.

Shooting the Messenger

There is no such thing as a riskless bond. Never was, never will be.

But if there were, it would not be issued by the United States Treasury. Today, S&P downgraded US sovereign debt from AAA to AA+.

Zero Hedge is having a field day with this. They linked to this piece noting that the White House challenged S&P's economic analysis, and that this was the thing that delayed the announcement slightly as S&P decided whether to sack up and call it the way they see it, or bend over and be the Government's toady.

The reaction of the administration is quite revealing. Because we all know that S&P is the real problem. S&P's models (and everyone else's) say that US debt is looking increasingly risky. The models must be wrong, because we at the Obama Administration just know that it's going to all be fine. Just ask Timmy 'TurboTax' Geithner, who as recently as April declared there was 'no risk' the US would be downgraded.

If you, like me, are tempted to conclude that he's a dumbass, (and you would not be short of evidence for this proposition), it's worth remembering that he might just be being dishonest as part of his job. In other words, he has to be the cheerleader for the US government, yelling furiously that the ship isn't sinking so that people don't get trampled on the way to the lifeboats.

The nature of the immediate problem, of course, is that things get a little tricky when US debt isn't considered risk-free, as a bunch of institutions are required to hold AAA securities as collateral for various reasons. And now they may have to start dumping treasuries, pushing yields up even further. Fun times!

The nature of the longer term problem, of course, is that S&P is exactly right - the debt ceiling debate is a mess, and nobody is interested in tackling the question of long-term "entitlements" (I dislike that word) in health spending and, to a lesser extent, social security. And S&P decided, again rightly, that since their job is to rate bonds, then by golly they're going to call a risky bond risky, because it's not their job to cover the government's ass for the government's own reckless behaviour.

It's exactly the same as with TARP. The banks yell and shout 'We're in a liquidity crisis, and need a temporary loan!'. Skeptics pointed out that what they actually had was a solvency crisis, which needs not a loan, but a giant equity infusion (i.e. a cheque they get to keep). Most of the banks were insolvent, and that was causing the liquidity crisis. You could throw liquidity at the problem (which is what TARP originally purported to do) , but until you made the politically unpalatable choice to actually bail them out (which is what TARP actually did), liquidity crises will keep returning.

It's the same now with the US government. Except they don't have anyone to bail them out, and so they're going with the only plan they seem to have, namely hoping that the inevitable market reaction happens later, rather than sooner. Ideally after they're out of office.

In other news, it's bullish for equities!