1-2 Knockout

Thoughts

Over the course of the past few months, I've been increasingly asked for my thoughts on several econo-political topics, including, but not limited to "the bailout(s)," industry-specific solutions, regulatory overhaul, and others.

Those of you who've read my work over the course of the past year may also be wondering where or how I weigh in on these issues, and/or why I've remained relatively silent on issues which one would expect I'd be quite vocal.

To be honest, the only quasi-explanation I have to offer is that I just don't know.

Unlike professional writers, analysts, and pundits who depend on their words for sustenance, I have the convenience of not saying anything if/when I don't have anything good/useful/interesting to say.  The events that have transpired over the past year or two (including those preceding events over decades past) have been a bit overwhelming, in terms of the time and knowledge required to not only stay abreast of, but more importantly to understand.  While I'm hardly disappointed to still remain otherwise employed (knock on wood), I simply haven't had time to wrap my head around much of this information, at least not to the point where I would risk what little (if any) reputation I've managed to nurture by spouting off some uninformed nonsense the likes of which I've previously accused others. 

Thus, while I haven't yet developed a comprehensive solution to our various ills, there is a slightly smaller issue into which I've put some time and effort.

Like many people, as I see the news scroll by on my monitor, I'm often overcome by feelings of anger and disappointment.  I'm particularly enraged (although unsurprised) with the constant interference of pandering politicians and poorly-informed punditry presenting opinion as fact or careful analysis.  That every Joe and Jane Schmo with a keyboard gets to voice their often similarly uninformed opinions reminds me of Steve Carrell's character in Anchorman when he declares "I DON'T KNOW WHAT WE'RE YELLING ABOUT...LOUD NOISES!"  The complex, interrelated issues at hand seem to be way beyond the knowledge, experience, and understanding of virtually everyone, and yet everyone still has an opinion, everyone knows who was at fault, who we need to blame, and how we'll magically "fix the economy," whatever that means.

Various media participants and outlets have done their part to contribute to the hype and hysteria, often inciting outrage and chaos, when there is often little-to-no reason for doing so, other than to sell papers/eyeballs.  To be sure, much of my ire has been focused on the media, specifically, the part that  covers (or attempts to, as it were) business, finance, and economic happenings.  Even to those of us who are actually trained, experienced, and possibly still work in such fields, there is much disagreement over what/how/why things happened as they did, and perhaps more importantly, how to "fix it."  Yet we've seen the same sort of behaviour from virtually every media outlet that I described in the above paragraph, speaking very loudly and authoritatively on topics of which they don't appear to have the slightest understanding.  Just pick up any daily Newspaper or click on over to Fox News or CNN to see some of the ridiculous crap being peddled by the "fair and balanced" media.  (Just to be sure, the previous sentence applies to both sides, and everyone in-between.)

Despite a keen awareness that most reporting these days is unfortunately nothing but filler between advertisements, I've found it difficult to contain my immense dissapointment with the way inherently complicated concepts have been grossly over-simplified, mis-interpreted, and mangled over-and-over in popular media, of both the new- and main-steam varieties.  To be sure, its altogether unsurprising to witness such a non-phenomenon when sensationalism and incendiary "reporting" are - or are perceived to be - the largest drivers of revenue for most media outlets.  Contrarily, when there is - or there is perceived to be - little/no incentive to present  balanced, well-argued/researched, and transparent information, it comes as no surprise that such things are few and far between. 

In fairness, there are several media outlets who have found a way (not necessarily a profitable one perhaps) to practise what I'd call "responsible reporting" when it comes to these matters, and I applaud them for their efforts.  These are the outlets I visit on a regular basis, and its little secret who they are.  However, such outlets unfortunately represent a disproportionate minority, and are thus not nearly as popular as their sensationalist, more irresponsible brethren.  

Of course this is hardly the biggest problem at stake, but it is perhaps one of the few that we have any ability to affect.  Especially in such turbulent times, we should be extremely cognizant of the material presented to the general public, and the light in which this information is presented. 

I say this because frankly, I'm not quite sure how to properly enunciate my fear that the various braintrusts  (legislatures, the SEC, FDIC, Board of Directors of most banks, the general populace, etc) will, in trying to "stabilize" the economy, actually send us further into the abyss.  If there were an ETF or other instrument to short the testicular fortitude of our Congressional and other "leaders" tasked with addressing our economic woes, I would be into that trade in serious size.  I have little-to-no faith in their ability to understand the issues in front of them, and even less faith that the group as a whole will make the tough choices conducive to long-term sustainability and economic health.  If what we've seen from both sides is any indication, we should expect more of the same short-term "solutions" which have generally failed to address any underlying issues, and quite likely prolonged the pain, and simply delayed confronting the real issues until a later date.

Showering the masses or individual companies with money (the exact faucet, pressure, and distribution pattern used is irrelevant here) may seem like the most politically expedient option, but as many others far more informed than I have argued, is actually counter-productive at a certain point.  Eventually, we have to pay the piper and reduce leverage across the board to sustainable levels.  (I'll leave it to 1-2 to discuss this in greater detail if he feels compelled to do so, since going down that path is a far-longer discussion than I'm interested in having here.)

So, perhaps if we can find a way to incentivize the media to be more careful about what information they present, and how it is presented, perhaps we can affect public opinion, and thereby affect the decisions made by the powers that be. 

I realize that this is far easier said than done, but to oversimplify, I believe that those of us who "know" have a civic duty to share that knowledge with those who do not, especially when it just so happens that doing so may very well be critical to ensuring our future employment. 

Some have argued that trying to improve the quality of business reporting is a fools errand, a futile effort.  One follower on Twitter pointed out that if one possesses a functional understanding (or even capacity to understand) the material, they one will most likely pursue a more-lucrative career in the field rather than reporting on it.  This may be true for many people for whom money is the primary motivator, however I know several people who forgo financial gain to report upon and analyze business and business news (for example, I don't do this for the money).  Some of these people even have undergraduate or even advanced degrees in the fields which they cover, as shocking as that might seem.  

The other solid criticism seems to be that news outlets and reporters wouldn't have much, if any incentive to comply with our requests.  Judging from traditional media's well-documented aversion to change, this is a legitimate criticism for which I don't have a fantastic response.  It would seem that any concerted effort to affect change would have to first gain sufficient visibility and popularity so as to make our stamp of approval an important sales/marketing tactic, or on the other hand, such that not having our support was perceived to be sufficiently detrimental to that outfit's credibility that they comply out of perceived necessity.  This is a bit of a catch-22, as 1-2 was quick to point out when we spoke about this a few days ago, but one that I don't think is insurmountable.

I envision a largely-volunteer Non-Profit, at the core of which is a proprietary, secure database of business professionals and academics willing to make themselves available to whatever degree they're comfortable with to reporters and journalists.  There are enough of us who make our thoughts, opinions, and analysis available for free already that I don't think this is asking too much.  Think of something along the lines of Linkedin, except with the added ability of anonymity for those who need to remain so for professional concerns.  These volunteers would be able to create a profile with whatever level of detail on their background, knowledge, experience, etc they feel comfortable providing.  Reporters and journalist members would then be able to search the database for those with knowledge/experience on the subject matter they're covering. 

Additionally, the website would allow volunteer members (like FT Alphaville's Long Room) to post corrections, criticisms, etc, on poor business/financial/economic reporting.  This could even be extended to a ranking of various media outlets.  In turn, this could be used to present awards each year for the best, most improved, etc ones, and also highlight repeat offenders so that the general public could be made aware which outlets they should avoid or take with a grain of salt.

Perhaps I'm delusional, perhaps I'm insane, but to me, this seems like a worthwhile cause.  There's virtually no overhead besides maintaining the website, plenty of business professionals with newfound time on their hands, and a general politico-economic state of affairs that makes today a more important time than ever to put our knowledge and experience to good use.

Let me know what you think. 

Good idea?  Bad Idea?  I'm a stupid schmuck?  Whatever, just let me know.  If this turns out to be a horriffic idea, then so be it, however if enough of you are with me then I stand ready to make this (or something like it) happen.  Lets see how it goes.

 

Why MFs Ride the Failboat -- A response to MarketSci

This morning Mike at MarketSci pondered why mutual fund managers just can't seem to get it right, yet he can (he has an audited track you can check):

"...why the mutual fund industry, with such a low hurdle to clear, doesn’t reach out to folks like me to apply some of our concepts to their more fundamental approach to investing; in other words, why they don’t think outside their little box.

Can anyone honestly tell me that a developer who has produced as much positive consistent alpha as we have couldn’t apply those concepts to a mutual fund and produce that magical and much sought after 1-2% annual outperformance? I think not."

My humble response (please excuse grammar and typographical errors):

Even though I am in what I would call “the brunch” phase of my career (early in the morning, but well awake long enough to clear the sleep from my eye), I have worked in just about every facet of asset management, and I am consistently befuddled by the poor performance of professional money managers. That said, I posit a few ponderables about WHY they are so bad:

1) Incentives/Risk Aversion: as you know, most money managers are really asset gatherers, skimming their fees off the top of AUM, not performance. Unfortunately this leads to an asymmetric risk aversion model of money management. Rightly or wrongly people benchmark their manager’s performance against a well known benchmark (simple framing heuristic). Since I am sure you are familiar with the risk-aversion “S” curve I won’t get into the details, but suffice it to say the visceral reaction an investor (client) has to underperformance is far more pointed than their reaction to outperforming the benchmark. Money flows more swiftly out of funds that underperform by, say, 200bps, than it flows in for 200bps of outperformance. Gathering assets takes time; losing them doesn’t. Since there is little payoff for marginal outperformance (zero profit participation), and a heavy penalty for marginal underperformance, PMs manage towards an alpha of zero (after fees): hug the benchmark and your career is safe. Furthermore, a single drawdown of any magnitude is likely to stain ones reputation for years, whereas (again) a single positive year is likely seen as “lucky” or flash in the pan. (This is nothing new, but it’s still true).

2) Regulations: while there are some (albeit a minuscule number) of actively managed funds that actually manage concentrated or unique strategies, the majority of funds are boxed in by diversification rules, bans against shorting, etc. As you know, the greater diversity assets you hold the closer you are going to perform “as the market” (for the few novices in the crowd just look at the Dow and SPX correlations…they are incredibly high even though the two indices have different methodologies, weightings, sector exposures, etc) in fact, if i recall correctly, after about thirty stocks you are at a .8-.9 correlation and beta to the market. Today it is (near) impossible to run a portfolio that DOESNT act like the funds respective “market”, simply because of the forced diversification.

It is also incredibly difficult to change ones investment/trading strategy in a fund that requires are the requisit fillings, risk analysis, and BoD approval. Therefore it’s tough to be agile and “try new things”.

3) Assets kill performance: on top perverse misalignment of incentives “asset gathering” promotes, the game of “getting big and collecting fees” is antithetical to efficient investing. A) As you grow in size your trading agility decreases as your ideal position sizes are corrupted by a major exogenistic (non investment) factor: moving the market. The elasticity of prices with respect to liquidity severely hinders a funds actual investment universe and forces PMs down their “best ideas curve”. B) Since there are “upper bounds” in how much you can invest in any one stock (by virtue of point “A”) you are forced to go down your investment prospects list to simply have somewhere to park excess cash. PMs aren’t paid for holding cash (it’s seen as the client’s role to measure their risk tolerance and balance accordingly), and the presence of cash reserves may (rightly or wrongly) signal that the PM is out of ideas (a negative signal).

4) Client representatives/Buyside advisors: these geniuses love to take complex situations and boil them down to nothing more than a series of comps from traditional style-box analysis. If you can’t be bucketed into a well defined style pension/insurance/RIA advisers won’t even look at you. God forbid they have to take the time to understand products and explain a complex subject to their clients. Rather they prefer to simply have a matrix by which they can punch in return streams and holdings then say “XYZ is best, look at their Sharpe!” When I launched one of those fabled HF Replication products the toughest hurdle to clear was figuring out how to “box” the fund–not the mechanics, not the methodology, they only asked “what box would this go in?”

5)Finally, to sum everything up, MF companies are big, slow moving organizations. On top of the regulatory hurdles most funds are seen not as alpha generators, but as product shelf fillers. A “good” mutual fund shop has a product for every “box” and they need to keep their presence in each category regardless of performance or rationality. If a PM on, say, a large cap value fund underperforms heavily then the PM is simply replaced because every platform needs a LCV fund. To the contrary, should you outperform your market, but exhibit any kind of style drift, you can just as easily be canned because people will complain “they dont know what they’re buying”. And god help you if you come up with a new investing metric to base your analysis on—you’ll have to prove it works to your handy dandy risk department for well over 6 months, but which time it’s probably arbed out anyways.

At the end of the day it’s the structure of the system that has set portfolio managers up to fail–all in the name of “protecting” retail investors. The only places you see demonstrable alpha is in the HF community because they can trade nimbly, react quickly, generally aren’t big enough to move markets, and have an aligned incentive structure. Is it perfect? No! But you are never going to eliminate all principal-agent problems, which is what this REALLY comes down to. HFs are just allowed to act as better agents.

Merry Christmas!

excuse the crappy blackberry pic, too much espresso!

Incomplete, Incoherent Rambling on (the Role of) Quantitative Investing

Long story short I was reading about the ever=fascinating and slightly irritating Ray Kurzweil earlier, and per Wikipedia, apparently he began a venture in 2006 to use Artificial Intelligence to drive quantitative investment programmes, dubbed FatKat (Financial Accelerating Transactions from Kurzweil Adaptive Technologies).

What got to me though, was this:

 "...he predicted in his 1999 book, The Age of Spiritual Machines, that computers will one day prove superior to the best human financial minds at making profitable investment decisions."

Ray has a history (and a slight ego to boot) of making predictions for technological change, many of which have turned out to be both prescient and accurate.  One cannot help but wonder how colored his judgment may be from his successful past experiences applying technical and scientific thought advances to other fields such as education and healthcare though. 

Finance, and more specifically profitable investing, presents a variety of challenges which have brought down virtually every systematic strategy over any significant period of time, going back as far as such things have been recorded.  Until the past year or two one had to go back an entire decade (whoa!) to the spectacular chronology of When Genius Failed , but over the past 24, or really 12 months we've seen the 'new breed' of quant geniuses getting crushed as badly, if not worse, than their non-quant brethren.

I think if Kurzweil, himself, cared to contribute to this rambling, his argument would hinge on the fact that the failure of quantitative investment schemes (or lack of relative success) of late is due to the human element, not necessarily the technological, although the two are inevitably and inextricably linked whether they like it or not.

The most historically spectacular investing failures, regardless of the system (or lack thereof) employed by their practitioners, have shared many a characteristic, among them ego, hubris, pride, arrogance, and intractability rank at or near the most frequent and serious offenders.  My inclination, one I believe is supported repeatedly by history, is that there is not one single investing strategy which (out)performs in any and all circumstances.  I realize this is not necessarily the claim of many quant funds, however, in the grand scheme of things, it seems to be the ultimate aspiration, or at least nerdy wet dream of many.  

The quants' search for the ultimate algorithm, for the AI that's always one step ahead of mere mortals may very well be an impossible task, or even a fool's errand.  That there is a very public, multi-party game being conducted, where each party believes that, utilizing essentially the same set of tools as the other parties, they will outsmart them, seems inherently ridiculous to me.  Of course, this can also be said for the larger investing game as well, although the number and variety of approaches (not to mention the "quality" of many participants) opens up the odds some, although the point is hardly lost on me.  Much in that same vein, what we've seen is that rather unsurprisingly, the proliferation of quantitative investing has created an even more profound feedback loop in various markets than already existed just with the more 'traditional' methods and participants. 

The logical action for the prudent quant is then to adjust the models to better account for the actions of others with similar strategies.  Throw in another factor here, tweak a little stochastic calculus there, no big deal.  Of course, if everyone (or a significant # of participants controlling a significant amount of money) makes these changes, then you run into the unsurprising eventuality where everyone is essentially second-guessing each other, and thereby second-guessing themselves, much in the same basic fashion even the most novice retail brokerage account holder approaches the investing game.

What then, is the purpose, besides to tout one's technical or mathematical acumen, if the results do not stand up to scrutiny, if it can't weather the storm better than say, going to cash.  Contrary to many a financial professional, being down less than your (bullshit) "benchmark" in a severely down market as we're currently in does not strike me as worthy of celebration.  When, in a severely down market, you've outperformed cash, well Sir, now we're talking!  Crack out the good shit, we're having ourselves a party tonight!

Now, back on track (one resembling the Nurburgring, perhaps).

As many an investor has acknowledged, in this game, being right, and being profitable aren't necessarily one-in-the-same.  While admittedly comparing apples to an orange grove, over the past year or two many technically advanced quant funds, with access to a virtually unlimited supply of data and analytical power, suffered serious losses.  During this same period, myself and several acquaintances, with significantly less resources (to say the least!), have achieved positive returns, all-the-time wondering how it was possible that everyone else could get it so wrong.  By "it", of course, I mean the basic conceptual bets.  For example, as I'd mentioned over the course of the past 9-12 months, the short Retail trade seemed completely obvious if one was willing to look at the body of evidence available.  When I shorted Lululemon (LULU) at around $36 (after recommending it months earlier as a short before I started @ 1-2 Knockout when it was trading over $60), the analyst estimates were based on entirely unreasonable growth rates, given what I saw was the inevitable shitstorm we were heading into, the same shitstorm in which we currently find ourselves.  I can't speak for every quant model of course, but of late it seems to me that many such funds failed to see the forest for the trees.  That is, the data was there, but when one is looking for very complicated relationships, perhaps its not too surprising that some very simple connections went relatively unnoticed.

My intent is not to highlight my genius (nor to even claim such a thing exists; hint - it doesn't), but to simply point out the fact that perhaps the most highly-correlated factor or driver of investment success is not the sophistication of the system, but the ability of the manager (whether man or machine) to stay curious, and informed, and to keep an open, and humble mind. 

Are quantitative strategies useless?  Of course not, don't be ridiculous! They are yet another tool in the prudent investor's toolbox, which, when used "wisely" can yield spectacular results.  However, just like with any other powerful tool, an over-dependence upon, or misuse of quantitative analysis can be, as we've seen, catastrophic.

Excuse the rambling, its 2am 3am for Christ's sake! 

Thoughts?  Discuss amongst yourselves in the comments.

Quote of the Day

Not trying to copy LoSC, but this quote - in an entirely unsuspected place - sums up what I've been trying to explain to several friends and colleagues who have yet to grasp the severity of our current economic woes.  From the NYT Digital Domain Section:

If the recession is severe, “eventually, everybody gets slaughtered at some point."
--Tavis McCourt, Analyst, Morgan Keegan

There will be firms that may benefit from the carnage over the long-term (Best Buy's inevitable dominance once Circuit City bites the bullet, hedge funds that successfully profited from the insane vol we've been seeing, etc).  However, a rising tide lifts all ships, and vice versa.  Watch out for beta, kids.

SEC, FASB, FAIL

Earlier today, the SEC and FASB issued a press release meant to address concerns about the effects of mark-to-market accounting, specifically FAS 157, as they relate to the current financial "crisis".  I’ve been working on this in much greater detail for the past week or two (check out the re:the auditors for some interesting perspectives until I get around to finishing, eventually) but below I’ve presented an easily-understandable translation of the SEC’s responses to their own FAQ’s:

Q: Can management's internal assumptions (e.g., expected cash flows) be used to measure fair value when relevant market evidence does not exist?

A: Yes, no, maybe, sometimes.  It depends.  Really, we're just clarifying the already vague language of FAS 157 (etc) with even more vague, open-ended language.  Thats just how we roll (, dawg).

Q: How should the use of "market" quotes (e.g., broker quotes or information from a pricing service) be considered when assessing the mix of information available to measure fair value?

A: Yes, but only if it represents an actual transaction price and/or a binding offer.  Unfortunately, since auditors and internal valuation groups have been using pricing services as the de facto source for the past few years as if it was level I-type information (when in fact the price may come from the service’s models or other data), this doesn’t much help now. Add to the fact that per Deloitte's own survey on Fair Value Pricing (2008),

"Over 46 percent of survey participants stated they have at least two full time resources focused on fair valuation as compared to 29 percent last year."

Uh, so 54% use 2 (or fewer) sources?  How encouraging...

Q: Are transactions that are determined to be disorderly representative of fair value? When is a distressed (disorderly) sale indicative of fair value?

A: Last line of their explanation pretty much sums it up:

“Determining whether a particular transaction is forced or disorderly requires judgment.”

Oh, thanks for clarifying.  Read the press release (or the original FAS 157 guidelines), FAsb's means of defining terms here is a serious clusterf*ck of the most circuitously ambiguous kind.  Worse than interest expense (#ERROR) in a merger model, I shit you not.

Q: Can transactions in an inactive market affect fair value measurements?

A: Again, last line sums it up:

” The determination of whether a market is active or not requires judgment.” 

No shit, sherlock.

Q: What factors should be considered in determining whether an investment is other-than-temporarily impaired?

A: Uh, I’ll take D – all of the above?; Again, lots of ambiguity and words in “” marks like “Rules of thumb” and “reasonable judgement”.

Summary: More ambiguous bullsh*t from some of the same schmucks whose bright idea(s) played no small part in getting us into this mess in the first place.  Who knows, they’ve got a “meeting” coming up shortly, maybe (hopefully) they’re just saving the big reveal (step 1: remove head from ass…) for Friday?

Oh Sh*t

Because at midnight on a Sunday night, this is what we do with our lives...(stalk the "Paulson")

I'm paraphrasing here, but the point is, well, we have no idea what the f*ck is going on.  Apparently theres a massive "bailout" package that just got approved by Congress, and We hear that there's some d-bags in the "Senate" that oh-I dunno, just might pull their heads out of their asses and f*cking approve it. Lets not get into the fact that no-one involved has any idea wtf is going on, but hey, thats what Glenfiddich is for, right?

Per the WSJ, uh, um, (go to cash ASAP).

Happy Monday, Happy whatever, and, uh, lets just sing some freaking Kumbaya

What the eff is this, Marquee?

I agree with Bess at Dealbreaker. Membership to the Do Not Short list should require at least an Hermes tie.

The following companies recently felt they'd join the Market Manipulation Party, hosted by David Jaffee.

(Note David Einhorn's white whale, Allied Capital even made the list.)

Oh Gee, Wonder What This Means...

Per the Federal Reserve's website Morgan Stanley and Goldman Sachs have been temporarily granted approval to become Bank Holding Companies.

To provide increased liquidity support to these firms as they transition to managing their funding within a bank holding company structure, the Federal Reserve Board authorized the Federal Reserve Bank of New York to extend credit to the U.S. broker-dealer subsidiaries of Goldman Sachs and Morgan Stanley against all types of collateral that may be pledged at the Federal Reserve's primary credit facility for depository institutions or at the existing Primary Dealer Credit Facility (PDCF); the Federal Reserve has also made these collateral arrangements available to the broker-dealer subsidiary of Merrill Lynch. In addition, the Board also authorized the Federal Reserve Bank of New York to extend credit to the London-based broker-dealer subsidiaries of Goldman Sachs, Morgan Stanley, and Merrill Lynch against collateral that would be eligible to be pledged at the PDCF.

Ladies and Gentlemen, children of all ages, lets get ready to rumble....its going to be an interesting week...

 

Um, Hello?

Over the course of the past few days (weeks, whatever) we've increasingly heard claim after claim that "The Shorts" are attacking (ahhh!!), that there has been no attendent material adverse decline in the fundamentals to explain the sudden and substantial decline in asset prices.  Just today, both John Mack and Lloyd Blankfein both put in calls to SEC Chairman Chris Cox whining for some sort of artificial protection from the invading shorts.  Of course as dealbreaker pointed out, the irony here is mind boggling, but beyond that, there's a certain question - or set thereof - that has yet to be not only answered, but asked in the first place.

But I'll get to that in a minute after a little tangent.

As if it weren't bad enough that all this goes down the week of my birthday, but its the same week that I was looking forward to spending some quality time training for a charity 10-k road race this weekend.  Rewind about 3 hours, I'm on the treadmill watching CNBC, and lo and behold they dared to put a Public Pension manager on air to get his opinion on the current short selling issue du jour.  FIrst, money managers, especially Pension managers are notoriously righteous and annoying, even moreso when they happen to be from the self-righteously annoying mecca that is California (and even moreso when they are painfully out of shape, but I digress...) Second, virtually all money managers have an uncanny ability to unabashedly pump up their own positions, often by spouting off some mix of unadulterated nonsense and vaguely truthful financial theory.  The very best ones - like Bill Gross - are so passive aggressive, so insanely pathological that to watch them speak is nothing short of inspiring.