Archive for January, 2011

Now, it’s an Expansion

January 31, 2011 Leave a comment

Friday’s report that US GDP grew an annualized 3.2% in Q4 is by now common news. Less commonly reported: Real GDP officially past its 2007 peak—the economic “recovery” can now be called an “expansion.” Also, according to Thomson Reuters, 71% of S&P500 companies have beaten 4Q earnings estimates so far, and the one year forward P/E of the market is 13.3.

These facts were overshadowed by Egypt news last week. But we note that January was a fairly turbulent geopolitical month (Jasmine revolution, Chinese President visits US, Egypt, Moscow bombings, Ivory Coast, et al), and yet global markets absorbed those body blows pretty well, not to mention renewed inflation fears in China/Brazil, and a nasty UK GDP report, and the ongoing PIIGS problems.

Fisher Investments Analyst’s Book Review: End the Fed by Ron Paul

January 28, 2011 Leave a comment

Congressman Ron Paul is now chair of the Monetary Policy subcommittee, which means he’s effectively chief antagonist to Ben Bernanke. Paul is a pure-form libertarian (read: pure-form tea partier), an ardent student of Austrian economics (read: laissez faire, free market capitalism), and has staunchly voiced his opposition to the very existence of the Federal Reserve every chance he gets.

With the new Congress fully installed, now seems the right time to have a look at Paul’s short but well-executed 2009 book, End the Fed. Of course, this is a political document, and on that basis it’s easy to see why Paul’s been around so long and did better than most expected in his 2008 presidential run—he’s a gifted communicator, able to exude down-to-earth everydayness, good humor, prudence, and practicality, but coupled with that eagle-eyed vision, intellect, and steadfastness that are the rhetorical hallmarks of most great public executives (be they CEO or president). Everything he writes sounds sensible, trustworthy, wonderful. You’d so like to have a drink with this gentleman.

This means, to really get value out of End the Fed, you have to work hard to be constantly vigilant of this layer of political rhetoric, especially when he relates stories about how he learned about money and saving as a kid from his father, as well as his encounters with economist Ludwig Von Mises and curmudgeonly philosopher Ayn Rand.

Past that, it turns out End the Fed is a great primer on how money, money creation, and central banking works. On some level, it’s refreshing to read a high-profile legislator write in such learned fashion on the issues he must, you know, legislate on.

Paul operates from the basic philosophical position that principles are more important than practicality. This is the crux of pure libertarianism. That is, panic of 2008 be darned, the Fed/Treasury/Congress had no business bailing out beleaguered banks—to a libertarian such intervention is morally wrong. In fact, in Paul’s view, liberty and freedom are antithetical to the way markets and banking are set up today. Because of moral hazard and the now-inextricable relationship between banks and the government, there really isn’t much true capitalism anymore. Instead, he describes today’s banking as a kind of public-private entity. Financial markets are really largely beholden to central planning of the government (he says), and the government has been manipulating the economy for many decades—from inflation to savings rates and basically all in between. He’d rather see the world do away with central banking altogether and return to the gold standard. (But he’s not really a “gold bug” per se. Paul says very clearly he doesn’t care if it’s gold or something else money is directly tied to—he just doesn’t want the government to control money supply.)

Mostly, Paul says the recent recession and most other banking crises are not the fault of capitalism but of the government—Fannie and Freddie, artificially low interest rates from Alan Greenspan, and so on. This all seems very compelling. But hidden in the sensible rhetoric is a classic mistake pure free marketers and socialists alike consistently make: Economic cycles can’t be “solved,” yet they prescribe and proselytize as if they can. We had depressions, bank runs and panics long before the Fed existed, and we’ve had them long after too—and will again. Fact is, we are in a more highly regulated world than ever before, but there’s still quite a lot of capitalism out there too. And as such, we’re not going to do away with economic cycles—ever. They’re part and parcel of markets. If you mitigate the downturns, you mitigate the economic growth. Efficient allocation of capital is of course beholden to short-term psychology, and corrections can be swift and devastating. But any good economist knows economic readjustment is usually better done with relative alacrity than drawn out for years, letting uncertainty fester. One can argue central banks exacerbated the recession/panic unduly; but maybe sometimes they helped avoid ruin too. But their existence won’t change the basic mechanics of capitalism, which is by nature destructive, cyclical, and ultimately wealth-creating for society. Cycles are here to stay.

This loops us back to Paul’s hard-line position that practicality must always be trumped by principles—his world is a kind of “no relativism zone.” That’s a fine and noble political view and an easy place from whence to evoke the Founding Fathers and other pious mantras. But investors steadfastly hold to principles at their peril. Bull and bear markets happen in both Elephant- and Donkey-led eras; in socially dominant and “deregulated” eras. William James’ Pragmatism is a much better worldview for an investor. (Of course, the communists didn’t do so well with their capital allocation.) In investing, it’s the pragmatic who evolve and see the world with clear enough eyes to navigate the many market situations encountered over a lifetime.

The bottom line, though, is this book is darn near essential reading if you want to understand an important contemporary undercurrent in US politics and central banking today. This is not a work of inflammatory flim-flam; it’s thought-provoking, well argued, and a fine contribution to the conversation.

Wait a Week to Read

January 28, 2011 Leave a comment

For years I’ve made a practice of reading the Wall Street Journal daily. And to really do it, even for a very skilled skimmer, takes the better part of an hour. In any given week, I generally have a goal of reading the WSJ, FT, Economist, Bloomberg Businessweek, and The New Yorker. Then monthly (or bi-weekly), the New York Review of Books, Forbes, Fortune, and Foreign Policy.

That’s a lot of reading, but to my mind that’s what the investing job requires. I know people who do considerably more. I tried a tactic over the last month that’s worked beautifully so far: for daily newspapers, let them build up and then bang them all out one day each week. It’s simply amazing how many stories become generally irrelevant after just a couple days. Yet, it’s all still fresh enough that you stay informed and don’t miss an important op ed or editorial. It’s simply a myth that investors (except very specific types of jobs, like for traders) need to have up to the second information in most cases.

In the meantime, I’ll keep experimenting—reading is a skill set that needs to be continually honed and absolutely can be improved (both speed and comprehension). Most folks don’t bring much consciousness to how they read, but it matters.

A Wave of Bank Mergers?

January 26, 2011 Leave a comment

Something to keep an eye on this year: a handful of pros are expecting financials (mostly banks) to heavily consolidate in 2011. Past drivers through the decades had to do with high consolidation tied to the S&L crisis and eras of deregulation.

This time around, if there is a big wave of mergers, it won’t be from pure form deregulation; that much seems obvious. True, clarity on new regulation will come this year, and the dangers of even more regulation seem low, but neither of those serve as a real catalyst.

If a wave of bank M&A does happen it’ll probably be because, coming off the crisis, mid- and big-sized banks will find themselves better capitalized than they realized and looking for easy, accretive profits. If so, they can just start scooping up smaller assets at still very attractive prices.

As any good commercial banking exec knows, there’s always an investment banker waiting in the wings to find a way to get a deal done.

Emanuel Derman’s Metaphors, Models, and Theories

January 7, 2011 Leave a comment

Emanuel Derman’s My Life as a Quant is a fun autobiographical book about his personal experience in finance as quant funds became vogue, but does no justice to the sheer brainpower and creative intelligence behind the man.

Luckily, he penned a column recently for Edge that does. In Metaphors, Models, and Theories comes an essay that’s simply devastating to the current norms of theoretical and practical thought in finance. Thus, my guess is it’ll go largely ignored because it essentially means many if not most Wall Street analyst jobs today are useless. But Derman’s view is righteous and impossible to ignore once you’ve experienced it.

I won’t summarize the piece because that might mean you won’t read it. What it does, though, is take finance, theories of value, and economics generally, back from the rigid, reductionist fascist tendencies of today’s mathematics fanatics, and puts finance instead squarely into the territory of phenomenological experience, practicality, and complexity. It demands vigilance and creative insight—concentrated consciousness upon the problems of markets—and a lack of reliance on equations or black box solutions (as so many wish there was, and many will always quest for). Derman’s essay is a high-minded, and sometimes overly technical (Derman’s reference to Spinoza’s attempt to systematize the emotional spectrum is, at this point, less relevant than contemporary philosophical/psychological work in this area, but it’s still worth the slog).

Real knowledge about markets isn’t just rote logic and empiricism—it’s often visceral, intuitive (but then again almost totally counter intuitive until you’ve spent forever studying markets, their history, what they do, why, their anomalies, and their universalities), experiential, and phenomenological. It’s a breath of fresh air to hear Derman champion the study of market history. Market forecasting and understanding is explicitly about what happens in the real world, and thus logic and math are secondary and inferior things. Models and math should be used lightly, with simplicity viewed a virtue, to judge relative conditions and act as reductionist descriptors. What Derman is saying is that there’s a very good reason Economics has forever been lumped in with the social sciences and not hard sciences, and no amount of mathematical workmanship can change that. Finance wants to be different but mostly isn’t.

Hardcore finance wonks should read this thing twice, then put it aside, and read it twice more. Don’t let these lessons escape you. Below are some favorite passages. Happy New Year!

  • There is a gap between the model and the object of its focus. The model is not the object, though we may wish it were.
  • A model is a metaphor of limited applicability, not the thing itself. Calling a computer an electronic brain once cast light on the function of computers. Nevertheless, a computer is not an electronic brain. Calling the brain a computer is a model too. In tackling the mysterious world via models we do our best to explain the thus-far incomprehensible by describing it in terms of the things we already partially comprehend. Models, like metaphors, take the properties of something rich and project them onto something strange.
  • A model focuses on parts rather than the whole. It is a caricature which overemphasizes some features at the expense of others.
  • A model is a fetish in which the importance of one key part of the object of interest is obsessively exaggerated until it comes to represent the object’s quintessence, a shoe or corset standing in for a woman. (Is that perhaps why most modelers are male?). But the shoe or corset isn’t the woman, just the most important part of the woman for this model user.
  • Models are analogies, and always describe something relative to something else. Theories, in contrast, are the real thing. They don’t compare; they describe the essence, without reference. Every fact, as Goethe wrote, is a theory.
  • …A theory is the ultimate non-metaphor.
  • Theories tell you what something is. Models tell you only what something is more or less like. Unless you constantly remember that, therein lies their danger.
  • Intuition is a merging of the understander with the understood. It is the deepest kind of knowledge.
  • No model is correct – a model is not a theory – but models can provide immensely helpful ways of initial estimates of value.
  • There are no genuine theories in finance. Financial models are always models of comparison, of relative value. They are metaphors.
  • All concepts, perhaps all things, are mental. But there are no genuine theories in finance because finance is concerned with value, an even more subjective concept than heat or pressure. Furthermore, it is very difficult to find the scientific laws or even regularities governing the behavior of economies: there are very few isolated economic machines, and so one cannot carry out the repeated experiments that science requires. History is important in economics. Credit markets tomorrow won’t behave like credit markets last year because we have learned what happened last year, and cannot get back to the initial conditions of a year ago. Human beings and societies learn; physical systems by and large don’t.
  • The greatest conceptual danger is idolatry, imagining that someone can write down a theory that encapsulates human behavior and relieves you of the difficulty of constant thinking. A model may be entrancing but no matter how hard you try, you will not be able to breath true life into it. To confuse the model with a theory is to embrace a future disaster driven by the belief that humans obey mathematical rules.
  • Financial modelers must therefore compromise, must firmly decide what small part of the financial world is of greatest current interest, decide on its key features, and make a mock-up of only those. A model cannot include everything. If you are interested in everything you are interested in too much. A successful financial model must have limited scope; you must work with simple analogies; in the end, you are trying to rank complex objects by projecting them onto a low-dimensional scale.

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