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Another day, another article demonizing CDS

November 28, 2009 in Finance

Bloomberg has a new article up about how the CDS market is starting to crumble – the sort of piece that looks like it’s been sitting on a back burner waiting for an excuse to stoke the flames of derivative fear (thanks, Dubai!).

One of the article’s chief arguments is that “credit-default swaps tied to Thomson SA, the Paris-based owner of film processor Technicolor Inc., paid some holders 30 percent less than those with contracts expiring a day later.” First, however, a technicality – CDS can only expire on four days of the year: the 20th of March, June, September and December (the so-called “roll dates”). Thus, the description of contracts that expire “a day later” is inaccurate. This brings me to a key point: one of the nice things about (most) fixed income is that the terms are… well, fixed. Traders know in advance when a contract will terminate, as well as the quantity (or at least the terms) and timing of any future cashflows. Those definitions extend to procedures in the event of default.

The credit event in Thomson’s case was one of restructuring, the procedures for which were recently updated as part of ISDA’s new “small bang” European protocol. Naturally, in a restructuring event – the debate over whether it should even constitute an event will be left for another post – it may be tough to claim that insurance should pay out. On the one hand, the fixed income product that was being insured just had its terms adjusted (no longer fixed, no longer the same!). On the other hand, the present value of the cashflows should be unchanged which in theory would make investors indifferent (obviously, that’s not the case). Without a cessation of payments, it’s hard to claim that insurance should pay the balance. Therefore, rather than have all insurance contracts pay out uniformly for all referenced bonds, which would fail to capture the odd nature of the restructuring event, traders agreed to set up “buckets” which will each pay out a value deemed fair by market action. The buckets are divided by time to maturity; in Thomson’s case, there were multiple buckets including a 2.5 year bucket, a 5 year bucket, and a 7.5 year bucket. This way, debtholders could more accurately match their insurance claim to the affected bonds.

The crux of Bloomberg’s argument seems to be that a swap maturing on the last roll date of one bucket would pay differently than one maturing on the first roll date of the next bucket (note the semantics – none of this “maturing one day later” language). But under the terms of the protocol, which market participants ratified, that seems appropriate to me. Remember, fixed income means terms are defined in advance. If Thomson had bonds that matured one day before the restructuring was announced, then those bonds would pay out par while bonds maturing the next day would presumably have crashed on the revelation that there isn’t cash to pay them in full (remember, unlike CDS, bonds can and do mature on any day of the year). That actually just happened with the Nakheel December 2009 bonds, which were trading well above par before Dubai’s surprise announcement brought them back to the 70’s overnight. In sum, the fact that some fixed income instruments are treated differently than other is not alarming – maturity and seniority are prime components of the fixed income market and naturally force bonds into differently performing buckets on a daily basis.

So if we can’t fault CDS for the fact that one contract pays out differently than another, maybe we can find something to be upset about because the 2.5 year bucket recovered 30% more than the 5 year bucket (in CDS terms, recall that recovering more means the contract pays less: if a bond recovers its full value, the insurance would pay out nothing at all). But here’s a secret: the disparity arose because of problems in the underlying cash market, not the derivatives market! Okay, it’s not really a secret. Euroweek figured it out well before the auction even took place:

Most of Thomson’s deliverable obligations are thought to be complex private placements and little is known about their documentation. It is possible that none will be deemed eligible for delivery.

CDS payouts aren’t determined by a bunch of traders standing in a room shouting – they are set by the market-clearing price on bonds (“deliverable obligations”) that are submitted by CDS holders in return for insurance payouts. It’s a straightforward system: CDS buyers purchase bonds in the market, then give them to the CDS sellers in return for their par value. The net payment is therefore par less the bonds traded price, or recovery. If there are few bonds available, or little transparency or liquidity about those bonds, then their market price will fluctuate for technical reasons rather than fundamentals. This phenomenon can occur with any traded security: short squeezes are perhaps the most familiar example. That’s exactly what happened with Thomson – so few of the short-dated deliverables were available for public trading that the market clearing price was bid up extremely high. In the next bucket, bonds were more liquid and so reflected recovery more accurately.

Euroweek described it nicely (again, well before the auction even took place):

…it is very likely that there will be a shortage of deliverable obligations and a scramble to get hold of what is available. The consequent short squeeze will drive up prices and the recovery rate much higher than it would otherwise be — good news for protection sellers but bad news for the buyers. For example, the most likely and liquid deliverable obligation, according to Citigroup analysts, is the June 2012 revolver, which would fall in the 2-1/2 to five year maturity bucket. It has been pushed from a 40% price to 70% in recent days.

But the real difficulties lie in the 0 to 2-1/2 year bucket. Thomson, a French media firm, was a regular member of the main iTraxx Europe Index from series 1 to series 7 and was thus much referenced in index CDOs. There are a lot of single name hedges against the name with maturities between now and 2012, putting particular pressure on the 0 to 2-1/2 year bucket.

I’m still waiting for the article titled “CDS auction goes smoothly despite problems in bond market.”

To Bloomberg’s credit, there is a deserved debate over restructuring events and CDS more generally outside the Bang protocols (and even within them). Moreover, the Thomson example – though I disagree with the author’s specific points – is a good one for demonstrating how settling CDS remains a mystifying and seemingly arbitrary process. There is no doubt that further clarity is needed, for the benefit of all market participants. The rest of the article deals with the lack of transparency into what qualifies as a credit event and murkiness following that declaration. I have to point out that though the arguments there have merit, their very existence demonstrates that CDS by nature doesn’t force companies into default or anything along those lines – otherwise these arguments would be settled by a simple imperative to bankrupt the firm.

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More derivative witch hunts

November 17, 2009 in Finance

Going through the FT’s original post on exchange traded currency notes, I saw a couple of sentences that really bothered me. One thing we do not need right now are witch hunt statements without basis (a point especially compounded by the fact that the FT completely misunderstood how these products worked, even as they wrote a piece describing them):

First:

In quick conclusion, the ETCs appear to be another fine example of how exchange-traded products are mutating from their transparent replication-based beginnings into ever more complex instruments.

Granted, an ETC isn’t going to be as easy to understand as SPY. But that doesn’t mean it’s “out to get” investors. Remember when Seeking Alpha tried to help people lose money even faster with FAZ and FAS? Now those were truly frightening derivatives – leveraged, options and/or swaps based plays with complex end of day delta-balancing schemes. These ETC’s are nothing compared to that. In fact, they’re no more terrifyingly complex – and much less manipulable – than the commodity ETFs Alphaville covers so frequently. Yes, they’re the first currency ETFs (sorry, FT insists that it’s wrong to confuse these for ETFs, even though they don’t say why). Get over it.

Second:

The type of financial whizz-kidery that brought us CDOs, meanwhile, appears to be thriving well in ETFs.

I don’t even know where to start with this one. Maybe the author wrote this because the word “collateral” appears frequently in the prospectus. I wonder if it’s the same financial whizz-kidery that brought us secured loans and mortgages, too? What is this sentence doing here, besides making people associate these products with those that ruined the financial system? We’re talking about total return indices on the deepest, most liquid market in the world – not distressed CDO tranches.

Third (regarding Morgan Stanley, the derivative counterparty):

Morgan uses the proceeds it receives to hedge its total-return-swap exposure — but essentially can do whatever it pleases with the money.

What does this really mean? Morgan Stanley might be fooling investors, opting to take their cash elsewhere rather than hedging their exposures? Well in that case, Morgan Stanley is taking on currency risk equal and opposite to those investors; so it’s not exactly a free trade. One of two things must be true:

MS doesn’t want currency exposure. In this case, they have two options: they use the ETC proceeds to hedge their currency risk OR they “steal” the ETC proceeds and use cash from elsewhere to hedge the exposure. The economic outcome is identical.
MS wants currency exposure. Again, two options: they use the ETC proceeds to hedge their currency risk, after which they put on the desired currency exposure OR they “steal” the ETC proceeds and pray that the ETC investors in aggregate have taken the exact opposite viewpoint from the one MS wants to take. Since option two is extraordinarily unreasonable and volatile, there’s really only one option here: hedge the currency risk with the ETC proceeds.

Fourth:

Bank of New York Mellon has the responsibility of monitoring the eligibility of the collateral, but to all extents and purposes, from what we can make out, Morgan Stanley determines the valuation on a daily mark-to-market basis.

Another piece of conspiracy-bait. Fortunately, FT lays out what that collateral can consist of: “AA-rated G20 government bond, AAA-rated shares of government or treasury money market funds, AAA-rated supranational bonds, unsubordinated bonds issued by Ginnie Mae and any equity listed on ’specified indices’ anywhere in the world” (and I’m going to hazard that adding “anywhere in the world” is yet more bait, since the “specified indices” are major ones in developed economies). Let’s call it like it is: Morgan Stanley is not going to be able to make up their own arbitrary marks, thereby cheating the investor out of their collateral backing, on these deep and liquid securities. In any case, they are disincentivized to do so (as FT reveals in the next paragraph) by a set of over-collateralization rules.

Fifth:

As for the investor — remembering the products were launched as a response to investor demand for “secure, transparent and liquid currency package”– it means a potential upside scenario of receiving all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then) and downside scenarios that include credit-exposure to Morgan Stanley, covered by a claim on potentially illiquid securities, as valued by Morgan Stanley. Compulsory redemptions at inopportune moments due to a myriad of different triggers. And in the event of counterparty default, a position third-in-line for repayment.

Right off, the carry trade claim is simply wrong. Moreover, these are total return indices, so there ARE all the benefits of interest and dividends – they are just reinvested rather than distributed. The downside scenario is correct that this gives some credit exposure to MS, but the “potentially illiquid” line goes a little too far. I know that the prospectus says that these securities might not have a deep secondary market, because it has to, but in default they are extraordinarily liquid – they represent claims on FX derivatives! There’s no uncertainty about what they are worth in default.

Sixth:

ETF Securities’ ETCs are based on Morgan Stanley’s MSFX Total-Return Currency Indices. The way they achieve that performance, however, is not by replicating the components of those indices, but by taking out a total return swap with a counterparty that assures the performance of that index.

In ETF Securities’ case that counterparty happens to be Morgan Stanley (and only Morgan Stanley for the time being).

Again, misplaced suspicion. Here’s a scenario: to get exposure to the S&P 500 I can either 1) use cash to buy all 500 stocks and actively manage their exposure every day, making sure to reinvest dividends or 2) enter a total return swap which tracks the level of the actual S&P 500, plus dividends, perfectly. (There’s a third option, which is to buy SPY – effectively paying someone to do option one on my behalf.) Which one has a lesser chance of error? (Hint: it’s the swap.) Yes, a TRS is a derivative – but it’s not evil by that virtue. It’s exactly the same as a vanilla interest rate swap, the most liquid derivative in the world, only it reference the level of the S&P 500 instead of Libor. So let’s not get all suspicious of these crazy methods for replicating payoffs.

I’m not going to pretend that these ETCs are vanilla securities. They carry risks – perhaps large ones – and will likely experience liquidity difficulties until (and if) their market attracts traders, just like any security. No, I haven’t read the prospectus, and my comments are based purely on the FT post; moreover, my concern regards the FT’s attitude rather than the securities themselves. I can’t endorse any sort of derivative witch hunt of this sort – its unfounded, based if anything in popular fears that themselves were borne out of ignorance (on the part of both retail investors and institutions). It may be in journalistic vogue, but it’s hardly appropriate here.

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Things you should know before you invest

November 2, 2009 in Finance

The WSJ’s top story this morning was one titled “The Cruel Math of Big Losses” – an article written as if it were an eye-opening expose into a little-known piece of financial wisdom rather than a blatantly obvious restatement of basic math: when you lose X%, it takes a gain of more than X% to get back to even.

Nonetheless, I’ve seen the mistake time and time again – and it is exactly what leads people to chase levered ETFs despite their downward bias. It is especially amusing that many of the comments on the article fall in two camps: either the article is a waste of time because percentages don’t matter, only dollar amounts, or it’s a waste of time because its a boilerplate nascent recovery article.

To the first point, percentages are all that matter. Yes, if you lose $50 you need to make back $50. But what if you started with $100? What if you started with $1,000 – or $51? The risk (both future and encountered) on those three portfolios is very different and must be considered as such. It remains beyond me why we insist on reporting stock changes in terms of dollars or points. Is it relevant to me that the S&P is up 12.8 and the Dow is up 124.2? Of course not! – but saying that both of them are up 1.26% is actually useful information. At least with individual stocks you could do some mental arithmetic, taking the numbers of shares you hold times the dollar change – but that doesn’t work with the indices. Let’s beware this “dollar price” fallacy: if you don’t have a spreadsheet (and even if you do!) dollar prices should not be your primary concern.

To the second point, a wise investor would keep in mind that this math works both ways (neither of them helpful): gains can quickly evaporate when the market drops a relatively smaller amount.

This article serves a useful purpose: it reminds us of the basic temperament of the market. It forces us to confront the difficult nature of the investing exercise. But it should never come as a surprise.

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Because no one knows commodities like we do

September 22, 2009 in Finance, Internet

Why did a post up titled “How To Play Natural Gas With Small Cap Stocks” pop up in Silicon Alley Insider’s RSS feed? A little investigating (elementary, my dear Watson) shows that it’s actually from The Money Game – another blog under the Business Insider umbrella. The blogs themselves and current RSS feeds show no cross-posting; the only evidence remains in my Google Reader (which notoriously caches every post).

So what’s the deal – does SAI feel a need to comment on every hey-you-gotta-get-in-on-this bubble out there? Isn’t one enough?

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CDS Markets, briefly (or not so briefly)

July 15, 2009 in Finance

In response to Daniel Indiviglio’s call for “someone who understands the derivatives market,” I posted the following comment on the Atlantic Business blog – and I reprint it here not just because it turned out a surprisingly complete thought, but because I’m a glutton for blogging laziness:

The CDS market works similarly to any other market: traders announce prices (privately or otherwise) at which they are willing to trade, and if two traders’ levels agree, a trade may be executed. These levels may be informed by quantitative models, gut feelings, even sheer necessity – but the mechanism by which trades are conducted is quite straightforward: two CDS traders agree to a trade, at which time their respective firms enter a legally binding contract to exchange the necessary cashflows. That part takes place off the desk, however.

There are two predominant forces in the CDS markets – again, as with most markets – the “buy side” and the “sell side”. The buy side refers to those traders looking to place directional bets; they look to trade securities as advantageous prices, hold them for some time, and then sell them at a profit. The sell side, by contrast, is not interested in taking risk; it merely wants to service the buy side and be compensated for doing so. To accomplish this, sell side traders seek to simultaneously buy and sell the same security, capturing the difference in price for themselves and taking no exposure to the security in the process. The market dynamics arise out of this tension – buy side traders looking for “good” prices, and sell side traders seeking to capture a “bid ask” spread. Increasingly, however, sell side traders are starting to resemble the buy side as banks take on proprietary risk (evidenced most recently by Goldman Sachs).

It would appear that most of the regulatory concern with the CDS market is not about *how* contracts are traded, but rather the management of those contracts themselves. The CDS market is an “over the counter” (OTC) market, meaning transactions are executed between two consenting parties rather than via an anonymous exchange. In any OTC market, there is an advantage in being “the counter” – or the sell side. This is because the sell side 1) has an information asymmetry in that they see much more of the market than any individual buy side trader and 2) can adjust their price – even away from the “fundamentally correct” price – to take advantage of the supply or demand they perceive in the wider market. Thus, one of the first regulatory aims is increased price transparency.

A second concern is how each trader’s firm treats the contract after it has been traded. AIG was not required to post collateral on their sold CDS, and consequently was ruined when they discovered they had sold more contracts than they had collateral to back them. Lehman’s bankruptcy locked away funds owed to other firms, because they did not only have exposure to the firm they traded CDS *on*; they had exposure to the firm they traded *with* as well. The regulatory solution to the issue of counterparty risk is to create a CDS clearinghouse, which will standardize all collateral disputes and decrease counterparty risk throughout the market.

Finally, people are afraid that CDS are mathematically complex, difficult to price products – and to an extent they can be. Nonetheless, this fear arises with many derivatives, because they do not trade on an open market and do not represent “pure” parts of the capital structure (as if companies only issued simple stock and bonds in the first place). A response would be that having a mathematical grounding should actually increase people’s faith in receiving an honest price, for in the absence of a highly liquid market, how else can you determine whether a price is fair? Thinly traded stocks may jump tens of percents each day, because there is no price discovery mechanism – and without a grounding in transparent math, who can say what the proper level is? Unfortunately, many attempts to explain CDS veer into complex math simply because they can, not because they need to. CDOs, while more complex, have a similar problem (though I recently tried my hand here).

I believe that these three items: OTC, counterparties, and scary math have greatly contributed to the demonization of CDS contracts. As Petrobull stated, the incestuous nature of many trading desks and sometimes-difficult trading vocabulary only add to the confusion. Moreover, we have seen the concrete and disastrous toll that derivatives can have in AIG and Lehman, among others, cementing (or necessitating the invention of) the error of these market’s ways in our collective psychology.

Indiviglio was last seen on TGR here.

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Irrational markets: V-shaped edition

June 8, 2009 in Economics, Finance

The market shot up late this afternoon because Paul Krugman stated:

“I would not be surprised if the official end of the U.S. recession ends up being, in retrospect, dated sometime this summer,” he said in a lecture today at the London School of Economics. “Things seem to be getting worse more slowly. There’s some reason to think that we’re stabilizing.”

In an exceptional display of reverse-causality, Krugman clarified today’s remarks with ones he made last Friday:

Nobel Prize-winning economist Paul Krugman said the world’s economy is showing “not a hint” of a “V-shaped” recovery marked by a swift decline and revival.

The economy is “stabilizing, not recovering,” Krugman, an economics professor at Princeton University in New Jersey, said today at a conference in Dublin. “Things are getting worse more slowly.”

“We have made the transition from sheer panic to chronic anxiety,” Krugman said, adding he’s has a “hard time” seeing what might drive a “full” economic recovery.

Indeed, anyone following Krugman for the last year is certainly aware that he doesn’t see the end of the recession as anything more than a semantic difference. An L-shaped recovery is hardly a “recovery” at all. But don’t tell the day-traders.

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A Non-Random Walk Down Wall Street

June 6, 2009 in Finance

I couldn’t have been happier than to see this article in the NYT about efforts to refute the efficient markets hypothesis.

My title of course is shared with Andrew Lo’s excellent collection of anti-EMH statistical demonstrations, as well as a play on Malkiel’s classic investing guide.

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A casualty of chance

April 20, 2009 in Finance, Risk

I discovered this Atlantic article (“Why I Fired My Broker“) on MB’s blog. I came to enjoy it in the end, but while I was reading it I was struck by how representative it is of contemporary financial journalism. This is the new cookie cutter article: naive reporter is encouraged by rich capitalists to invest, loses everything, gets insightful quotes from capitalists on what he did wrong. Along the way, he – and we, his audience – learn a bit about the markets.

We start out by meeting our journalist, Jeffrey Goldberg, who promptly informs us “I took a random walk down Wall Street and got hit by a bus.” Good start. He follows it with the obligatory quote from a “financial advisor” (Richard Bernstein, Chief Investment Strategist of Merrill Lynch), urging him to adopt a buy and hold strategy so to give his “strategy time to reach gestation.” To which Goldberg wryly observes

But my investment strategy gestated for 15 years. And then it died.

This was, for me, a red flag that maybe Goldberg wasn’t going to be as insightful as I hoped. If he’s had a portfolio for 15 years, then this is his portfolio’s second death, the first coming seven years ago. But the disclaimers come marching – worst recession in history, going to get worse, everything is bad – so we’ll give him the benefit of the doubt.

And it’s a good thing we do, because his interview with Robert Soros is worth the price of admission and then some:

I went to see [Soros] at his office, where he spent two hours performing an autopsy on my assumptions.

“You think a brokerage should be a place you go to pay commissions for fair and unbiased advice, right?” he asked.

“Yes,” I said.

“It’s not. It never has been.” He then cited another saying of Buffett’s: “‘Wall Street is a place where whatever can be sold will be sold.’ You are the consumer of their dreck. What they can sell to you, they will sell to you.”

“But they told us—”

“They lied.”

He went on: “You should be disheartened and disappointed. But don’t kid yourself. You’re a naive capitalist. They were never your advisers. Do not for a moment think that a brokerage firm is your friend.”

“So who’s my friend?”

“You don’t have one. This is the market.”

“Okay, that’s Merrill Lynch. What about the others?”

“They’re not your friends,” Soros said patiently.

“What about Chuck Schwab?”

“All brokers move products based on volume and commission,” he said.

And so we have insight #1: brokers are salesmen. Period. Cynically, if they could pick stocks better than anyone (because presumably, that is their qualification), then they would be. Now there are in fact excellent brokers out there – but do not confuse paying for their insight with paying for their execution.

Goldberg imparts a second important point via parable, when two close friends alternatively give him convincing arguments for why he should/should not buy gold. Insight #2: anytime someone gives you investment advice, he is wrong. If two people give you completely opposite pieces of advice, they are both wrong. Even when history bears out one of their opinions, it remains nonetheless wrong.

If you took bets on whether a fair coin would land heads or tails, would you attribute the winners with any special knowledge of coin dynamics? (I’m such a statistician… I can’t even write about a coin toss without specifying it’s “a fair coin”) So it is with stocks: reality will end up reflecting one opinion or the other, but that is merely a casualty of chance. One could argue that the stock market is not random, that there is real reaction to news and if you can predict the news you can predict the market. In my mind this is like saying that the coin’s path is deterministic: it is subject to the initial velocity and rotation it gets from my finger as well as friction from air molecules it passes, not to mention wind. Sure, with knowledge of the exact state of the world you can tell me what side will land face up. But you don’t have it. And as long as there are people willing to take opposing opinions in the markets, you don’t have it there either.

The eventual outcome of an asset’s price is determined by the push and pull of millions of people expressing their various opinions. The result of that outpouring of noise is that, by chance, one side will win out, because the marginal person agrees with that opinion. And to the extent that everyone suddenly acquires the same opinion, the market will jump quickly and – yes – efficicently to reflect that fact, leaving you (the naive journalist) no time to participate. Compound that with a constant flow of new information and the market participants’ fickle mindset and you have an absolutely unsolvable puzzle. So the next time someone claims to know exactly how the market will turn out, remind them that enough people must find the alternative just as obvious, or there would be no opportunity for debate. There are people who actually do know what’s going to happen. Most of them are figments of overblown marketing and bull market longs, but they’re out there. Maybe your friend with the stock tip is one of them.

Interestingly, the Wikipedia article on Brownian motion (the statistical behavior most commonly used to model asset prices) includes the following example:

Consider a large balloon of 10 meters in diameter. Imagine this large balloon in a football stadium. The balloon is so large that it lies on top of many members of the crowd. Because they are excited, these fans hit the balloon at different times and in different directions with the motions being completely random. In the end, the balloon is pushed in random directions, so it should not move on average. Consider now the force exerted at a certain time. We might have 20 supporters pushing right, and 21 other supporters pushing left, where each supporter is exerting equivalent amounts of force. In this case, the forces exerted from the left side and the right side are imbalanced in favor of the left side; the balloon will move slightly to the left. This type of imbalance exists at all times, and it causes random motion of the balloon. If we look at this situation from far above, so that we cannot see the supporters, we see the large balloon as a small object animated by erratic movement.

Substitute “stock price” for “balloon”, “buy” for “right” and “sell” for “left”, and you have quite an interesting piece of financial journalism there.

But I digress.

Goldberg then descends into the world of the survivalists and I’m going to skip that part because, while entertaining, it’s hardly relevant. He does have an interesting conversation with Seth Klarman, in which one of the fundamental truths about the American economy is revealed:

“I haven’t leveraged myself,” I said.

He asked me if I had a mortgage. Yes. He then asked me if the amount of money I had invested in the stock market was greater than the amount I owed on my mortgage—could I liquidate what remained of my portfolio to pay off my mortgage? I could.

“So you are leveraged.”

America runs on Dunkin debt. It’s how we got where we are, and it’s how our government plans to get us out. But most of us don’t realize that. There is nothing inherently wrong with leverage, it is merely a tool of capitalism (albeit a sometimes dangerous one). But there is a massive problem with not understanding how it impacts one’s finances.

But the most important line in the whole article was when Goldberg protested thusly:

“But if I dump my portfolio now, I make my losses real.”

This is not the first time I’ve heard the very strange notion that losses on paper are somehow less than real. It’s not an attitude restricted to naive journalists. In fact, it is similar to the attitude which has frozen our markets – banks hoarding assets, terrified of marking them to market, as if hoisting its value on the balance sheet somehow translates to reality. The very crux of the mark to market argument is that your asset is only worth what someone will pay for it. The second your investment drops $1, you just lost $1.

I think part of this is grounded in the idea that equities will, inevitably, go up. In that world, to exit a position is to surrender the opportunity to make money when they resume their climb. The catch, of course, is that equities don’t always go up. That seems to be the underlying assumption of every naive journalist piece – how come my stocks stopped going up? Stocks are a risky asset; if they weren’t, then they wouldn’t rise much at all (see: Treasury bonds). Risky assets fall sometimes; that’s what makes them risky. There was a lot of attention lately to the finding that over a long timespan bonds had outperformed stocks. Is there anything else in the world about which people would be surprised when a less risky strategy outperformed a more risky one over time?

One of Goldberg’s early arguments revolves around the notion that you have a 46% chance of losing money by investing in stocks on any given day, but the chance decreases over time (an obvious statement). Unfortunately, probability of loss is not really the metric by which we make investment decisions. Otherwise we would all own CD’s and nothing else. Instead we balance the promise of return with the risk of loss, massaging our personal utility functions until we feel comfortable with an investment’s profile. Unfortunately, we are utterly unequipped to asses either risk or return. Goldberg finally resigns himself to ”3 or 4 percent gains a year, or 1 or 2, if necessary.” I’m left wondering if he realizes that can be had – with absolutely no risk – if he just buys Treasuries. But in naive journalist form, he remains confident in equities, feeling that now that he’s seen how bad it can get (for the second time, remember) he’ll be wiser for the lesson.

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On revisions

April 3, 2009 in Finance

A lot of headlines this morning are noting that the jobs report is “in line with expectations”, with a change of 663,000 vs the survey median of 660,000. What gets ignored is the revised number. For 13 straight months, the prior month’s number has been revised lower by a significant amount after the fact – ranging from 50,000 a year ago to more than 100,000 in recent months. The following is a chart of the reported number (white) vs the revised number (red) (click to zoom). The green line represents the survey.

How this trend gets ignored by the market is beyond me. I’m not sure if it’s systemic over-optimism built in to the reported number (read: arbitrary massaging of the data) or what, but it’s a bit ridiculous.

We generally assume that the market “prices expectations”, meaning if data is better than expected the market rallies; if not, if falls. But one thing the market fails to do is price expectations of back-dated revisions. If today’s number were announced as 150,000 more jobs lost than expected, we’d have a full scale rout on our hands. But hold off a couple months and make that announcement as part of an after-the-fact revision and the reaction is notably dampened. Indeed, in February the January number was revised down by around 60,000 and this month it was revised down almost another 100,000.

The sum of the failures to account for revisions like these, in my opinion, is an enormous sword hanging over the market. It may not take much to release it.

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Is this the bottom?

February 23, 2009 in Finance

It’s sort of like when little kids ask, “Are we there yet?” over and over and over: www.IsThisTheBottom.com

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“It is better to be roughly right than precisely wrong.”

January 31, 2009

Despicable though his character may have been, Keynes said some remarkable things, the title of this post among them. He also uttered the cliched investing mottos regarding animal spirits and beauty contests — true statements all, but widely abused by financial textbooks. My favorite, which remains somewhat unknown despite its enormous relevance, is:
The [...]

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