Thursday, May 7, 2009

Absolutely Phenomenal

Behold: the state of American higher educational system.  I go to a top-100 undergraduate school (Northeastern University), and this is my buddy's final paper in his college career.  This was supposed to be an op-ed for his "capstone" class (a class supposed to be the culmination of your education at this university).  FYI, he got a B- in the class... I italicized my favorite parts.

Barack Obama: the great black hope

It has been a long road for the black population of America ever since the civil war. Ever since the gears of social equality and freedom started turning with the Emancipation Proclamation issued by the 16th president on the United States, Abraham Lincoln, in 1862, scores of freedoms have been fought for and won by the once repressed minority.

From voting freedoms to equality in the work place, anti-segregation laws to equal access to education, the Civil Rights movement has taken Americans of African descent from slave to CEO. And now, for the first time, to the Presidency of the United States. With the inauguration of Senator Barack Hussein Obama, a black man formally of Muslim descent, into the highest office of our country on January 20th, 2009, the question can be asked: Is the Civil Rights Movement over?

The simple answer is yes. And if it isn’t, America will surely see the end of it during Mr. Obama’s presidency. Mr. Obama did not reach this position by himself. The true credit goes to every black man in American history. The tireless, and at times fatal, effort which every black man in America put in to enduring racism long enough to see this day. The sheer courage it took for exceptional African Americans like Dr. Martin Luther King Jr. to stand up and say “I had a dream!”; or Rosa Parks to not move from her seat normally reserved for whites and say “I knew someone had to take the first step and I made up my mind not to move.” It was these people who fought for the freedoms which enabled Mr. Obama to seize the highest office in our country.

And now, at the end of the Civil Rights Movement we have one Mr. Barack Hussein Obama saying: “Yes We Can!” In Mr. Obama is the slide show of African American history, and it is a good one. If black entrepreneurs were alive today to see their handy work they would be proud of America. Obama, you were right, we can, and all of you did!

Tuesday, June 24, 2008

Adam Smith the Soothsayer

Let us suppose that the great empire of China, with all its myriads of inhabitants, was suddenly swallowed up by an earthquake, and let us consider how a man of humanity in Europe, who had no sort of connexion with that part of the world, would be affected upon receiving intelligence of this dreadful calamity. He would, I imagine, first of all, express very strongly his sorrow for the misfortune of that unhappy people, he would make many melancholy reflections upon the precariousness of human life, and the vanity of all the labours of man, which could thus be annihilated in a moment. He would too, perhaps, if he was a man of speculation, enter into many reasonings concerning the effects which this disaster might produce upon the commerce of Europe, and the trade and business of the world in general. And when all this fine philosophy was over, when all these humane sentiments had been once fairly expressed, he would pursue his business or his pleasure, take his repose or his diversion, with the same ease and tranquillity, as if no such accident had happened. The most frivolous disaster which could befal himself would occasion a more real disturbance. If he was to lose his little finger to-morrow, he would not sleep to-night; but, provided he never saw them, he will snore with the most profound security over the ruin of a hundred millions of his brethren, and the destruction of that immense multitude seems plainly an object less interesting to him, than this paltry misfortune of his own.
-Adam Smith, The Theory of Moral Sentiments

The Lie Must Go On

There's a pretty good piece on (link down below) about a guy named Blaine Lourd, a reformed stockbroker who moved from investment bank to investment bank, disillusioned with his job. His job would be to sell hot stock tips by cold calling rich people and apparently, he got sick of losing all his clients' money. Eventually, he bought into the "efficient market hypothesis", a Truth proselytized by every self-respecting academic (i.e. the idea that it's impossible to beat the market). He cynically concluded that Wall Street was a place:

"where arrogant con men get paid ridiculous sums to perform work that is of no value to their clients or society."

I have no problem with the first part of this assertion. By any reasonable account, Wall Street does seem to employ arrogant con men, and these testosterone-filled self-righteous assholes do get paid a ridiculous sum of money. However, I feel like I need to take issue with the second part of Lourd's statement.

Finance does all sorts of good things for the society as a whole. It's a bit difficult to wrap your mind around, but what our Financial system does is allocate capital and diversify risk. What does this mean? Well, imagine you're a central planner of the old USSR. Let's say that a couple new inventions come out: first, the Xerox machine and second, satellites. How many resources should the USSR put towards building each invention? It's a trick question. There's no right answer - thus, why soviet central planning was such a spectacular failure.

As it turns out, financial markets can solve the allocation problem almost by magic. James Surowiecki coined the term, "the wisdom of crowds". Don't believe me? Here's a fun science fair experiment for you: get a jar of pennies and have people guess how many pennies are in the jar. Measure the average of all the guesses, and take note of the guesses that were closest to the real number of pennies. Most of the time, the average guess will be much closer to the actual number than that of any of the individuals. Pretty wild, huh?

So yes, this process is of allocating capital is of plenty of value to society; without these markets, capitalism wouldn't function. The capital from initial public offerings goes to companies that use the money to hire more employees, build factories, expand, etc. The money raised selling municipal bonds pays for our hospitals and bridges. And what's more? Through our financial system almost exactly the right proportion of capital goes to each company!

Another amazingly important function of Wall Street is to diversify risk. What does this mean? Well, over the years, banks have been smart enough to slice up both corporate ownership and big loans into bite sized "securities" - stocks and bonds respectively. Back in the 19th century, if you wanted to own Heinz you would have to be incredibly wealthy and buy up part of a partnership. Nowadays, anyone can own a little piece of Heinz, and a little piece of Google, and a bit of Comcast, maybe some Exxon Mobil...

"But Chris! All of that is well and good, but you're talking about primary markets! What about the money that I put in a mutual fund, a hedge fund, or the hot tip that Blaine Lourd gave me over the phone?" The key here is to separate what's good for the client vs what's good for society. Yeah, it's true: if you, as an individual, are putting a chunk of your equity into a mutual fund or actively trading it yourself, you're a fool. Everyone in finance knows this. If they say otherwise they're either: a. an idiot, b. lying to themselves, or c. lying to you. 99.99% of individual investors should call up Vanguard and buy up a handful of low cost index funds and forget about them until they're 65.

But suddenly we get to a dilemma - what if everyone did just put all of their money in index funds instead of foolishly trying to beat the market? Well, our financial system would cease to function. This is another concept that's difficult to wrap your mind around, but it's important. Every single financial market depends on one thing and one thing alone - liquidity. What is liquidity? Well, going back to the Finance 101 definition, how liquid an asset is how easily you can "covert it into cash" (i.e. sell it). You can sell a stock much faster and easier than you can sell, say, a car. Why? Because there's a big, centralized market for stocks in New York that has a whole lot of prospective buyers; the market is very, very active. So in literally minutes, even seconds, you could sell your stock. But why is the market so active? Because there's a whole class of people that think that they can beat the market by picking stocks, timing trades, etc (even if they can't). The primary market that we were glowingly talking about earlier (the IPOs of stocks and bonds and such) depends on this lively, liquid aftermarket.

So now we've reached a contradiction. What is best for the individual is not what is best for the group. The very concept that people can systematically beat the market is very wrong, but deeply ingrained into our society. I remember watching a TV show called "Wall Street Warriors" on CNBC. This show was fascinating for a Finance dweeb like me. It chronicled the success stories of all sorts of young "day-traders", who would attempt to beat the market through silly things like chart patterns and volume signals. What fascinated me wasn't the young traders themselves, who were using downright stupid and reckless strategies and are probably broke by the day I'm writing this, but the characterization and idolization of these people as Geniuses. Indeed, going to school in Boston and even moreso in Hong Kong, I'm bombarded by these self-righteous, self-proclaimed geniuses that tell stories about all money they've made day-trading. "I bought Google at $200!", they'll bombastically proclaim. But then I dig a little deeper, asking what strategies they use or inquiring about a written chronicle of their trading history, and it turns out it's all bullshit. Maybe they did buy Google at $200, but then again, maybe they also bought Bear Stearns at $130. Maybe they never owned Google at all. It makes me laugh, but deep down I know that this person will go onto make an excellent broker.

So what's the point? The idea that smart people can beat the market is a compelling narrative. Active money management is a lie, but it is a Useful Lie. And the Lie Must Go On. And the Lie Will Go On, because humans are designed to believe it. If your neighbor gets rich, it's not a satisfying conclusion to say, "well, he got lucky using risky strategies based on the random fluctuations of a complex system". It never will be. "He got rich because he's smart - and daring. And if he could do it, goddammit, I can too!"

If you view trading within a microcosm, it is a silly game. But the silly game must continue, because our economy depends on it.

The Evolution of an Investor
Michael Lewis

The Head of the China Banking Regulatory Commission is full of it

Western governments must strengthen their oversight of financial markets and improve cross-border regulatory co-operation if they are to avoid future global financial crises, a senior Chinese banking regulator told the Financial Times on Tuesday.

"I feel the western consensus on the relation between the market and the government should be reviewed," said Liao Min, director-general and acting head of the general office of the China Banking Regulatory Commission....

The majority of China's financial sector is still owned by the state, and the government retains tight control over many aspects of the industry, including senior personnel decisions at the country's largest banks, insurers and brokerages.

Thanks to China's lack of integration with global financial markets as well as the cautious regulatory approach of the CBRC, Chinese banks have emerged relatively unscathed from the global credit crisis, which so far has caused nearly $380bn of losses at western financial institutions.

Just because you've "protected" your banks from investing in foreign assets doesn't make your financial system less backward. The big danger for Chinese banks is a crash in China, which would put at center stage the dusty artifact that is the Chinese financial system. Need I remind you of the Asian financial crisis, which while barely affecting China macroeconomically, caused a whole string of Chinese banks to collapse? What will happen to Chinese banks when the real crisis comes (and it will come)? Nomura and other Japanese banks had this same sort of dismissive attitude toward western banks in the 1980s, but then when the tide finally went out we all discovered that all the Japanese banks were swimming naked.

Want to know something cool about the "Western" financial system? Even though big investment banks have had their share of woes, commercial banks have been largely unscathed. The same cannot be said about Chinese commercial banks. As recently as 2003, Chinese commercial banks have gone bankrupt for routinely giving out bad loans. How fucking ignorant are you? Do you really think the Chinese financial system is of good health? When the People's Bank of China can't even keep domestic inflation in control without having to raise reserve requirements, because the money market for domestic treasuries is, to put it lightly, broken?

Having China lecture us about our financial system would be akin to Saudi Arabia lecturing us on the freedom of religion. It's really, truly, rich. Because idiots like Liao Min obviously have no clue how deeply dysfunctional the Chinese banking system is, I won't be able to help but show my schadenfreude when the house of tofu finally comes crumbling down.

The Chinese financial system is a relic. It is the number one risk facing China's long term growth. Time and time again, we've seen the importance of having healthy and flexible banking systems - the great depression was largely due to the collapse of the faulty banking sector, and the lingering lack of growth in Japan is most likely due to their continuing refusal to bring their financial system into the 21st century. It may not be this decade, but if China doesn't take the initiative to reform their brain dead banks now, the country will stagnate. And it won't be pretty.

Monday, April 2, 2007

Delusions of Growth

Stephen Coleman predicts that Apple stock will hit $200 per share by the end of the year:
The Apple Stores, the iPods, the MacTel computers, the iTunes Music Store, the OS X operating system, Apple TV and the iPhone all deliver the great user experience those of us in the Apple world covet and demand. We know that excellence is on the way. We buy without pause. That is why Apple Inc. is going to deliver outstanding results this year and why the stock will hit $200 per share.
Don't get me wrong: Apple Inc is an outstanding company. They make great products. But $200 per share? I just don't understand how these fund managers can so blatently ignore basic mathematics. Some facts:
  • Right now, Apple is trading at 34x earnings.
  • Apple's earnings are $2.76 per share.
  • Apple's stock is currently around $93.5
  • In order to be trading at around the same P/E ratio, Apple's earnings would need to jump to $5.88 per share.
  • This would imply a growth rate of 113%.
  • Apple has never recorded a growth rate this large.

Let's all face it, the iPod was a slam dunk - one that has very little probability of being repeated. Everyone was scared away from making mp3 players at the time due to the murky legality of digital music. Apple took a risk, made a great product, and capitalized. But what of their current generation of new products? Will they dominate the market similar to the iPod? I think even Steve Job's mom would have a hard time imagining that the stars will align for Apple once again. I mean sure, the iPhone is a cool product, but much like the computer market, the cell phone market is saturated with competitors that have competent, much less expensive products. The Apple TV seems like it has all sorts of potential, but it too is bombarded with competition (TiVo, Microsoft, Sony, etc) and doesn't figure to be a real growth driver for a while now.

Google is another stock that growth investors foam at the mouth over, and yet if it were valued similarly to Apple the stock would be worth $946.

And all of this isn't even mentioning macroeconomic trends, such as the fact that we're nearing the back end of the business cycle. Or the swaths of liquidity flowing into global equity that is destined to be corrected.

Apple has gone from $50 to $95 in less than a year. That's insane. Shorting Apple at this point is the kind of trade that value investors dream about. Here you have a situation where the market leaning heavily bullish toward a stock when the numbers just plain don't add up.

Thursday, February 22, 2007

The flimflam man works for Goldman Sachs

Mutual Funds are the greatest con of the 20th century.

It's astonishing how many people tie up their savings and pensions into investments that continually underperforms the market. By now, it should be a well known fact: mutual funds suck. And yet, when the average Joe puts some money aside and wants it to earn some interest, they never call up State Street for information on SPDRs. They see a commercial for T. Rowe Price that proudly boasts, "for each 1-, 5-, and 10- year period, 70% of our mutual funds beat their Lipper averages", and they think, why earn the market when I can BEAT the market?

And so thousands of ego driven fund managers go out every year and do their best to do just that - beat the market. Some years are good. Some years are bad. And all in all, these fund managers - some of the brightest people in the world that spend the vast majority of their waking life working the market - over time, are almost always ineffective. Why?

A well known scam is to mass mail a large number of people a letter: mail half those people a letter that says that the market will go up in January, and the other half a letter predicting that the market will go down. If the market subsequently went up, those people that got the correct prediction for January will get another for February - again, with the prediction split evenly between the recipients. The scammer does this for a year, when he then solicits those people that got 12 correct predictions for money, saying that he could make them a fortune. He then takes whatever money any poor fool is willing to give him and runs away.
The same concept is at work in the discussion of Mutual Funds. If you look at the top performing mutual funds, it'd be common sense to assume that those funds are made up of the best and the brightest making extraordinarily sound investment decisions. And while results could vary, one would think that over the long term, these funds would continue to outperform the market.
The reality is nothing of the sort. Let's look at the ten top performing mutual funds of 1996, and see how they fared in the next ten years (click on the image to get full sized):
This graphic, in my mind, says volumes. Of the ten top performing funds, seven were liquidated out of existance in ten years.
Not enough people hear this messege. If you really want to save for retirement, or your kid's education, your money should be going into investing in low cost index funds, not in fees for some hotshot broker.

Wednesday, February 21, 2007

Global warming critics

The world's political climate is getting greener.

The last legitimate skeptics of the science are coming to see the reality of a warming world, a Republican president is challenging America to curb its use of fossil fuels, and the world economic forum in Davos was abuzz with ideas on how to confront global warming.

Yet some economists, perhaps as a sort of contrarian reflex, are questioning the wisdom of going to extreme measures to combat global warming. There is certainly an economic cost for climate change, but the question is whether that cost is greater than the cost of slowing global growth to the point where the problem can be properly addressed. In October, a UK commission, the Stern review, was able to quantify these costs and determined that, yes, the future benefits of addressing global warming far outweigh the current costs.

But the report was obviously flawed. The biggest critic was William Nordhaus, the pointed out that the discount rate (the time value of money) used by the report was next to nothing:

The Stern Review proposes using a social discount rate that is essentially zero. Combined with other assumptions, this magnifies enormously impacts in the distant future and rationalizes deep cuts in emissions, and indeed in all consumption, today.

It is true that the discount rate used by the Stern review is ludicrous. It essentially implies that the value of a dollar today is exactly the same as the value of a dollar tomorrow - which, if true, would lead one to observe a massive glut of savings and an extreme shortage of consumption (a situation not too unlike the great depression). Nordhaus thus delivers a damning critique. It seems as though he is actually right: using a discount rate that is based in reality, a cost benefit analysis determines that immediate action to confront global warming is indeed not worth the costs.

And yet, Nordhaus is still wrong.

His reasoning would be correct in a world of certainty - but we do not live in such a world. In truth, no one can precisely predict how global warming will affect our climate, our ecosystems and indeed, our global economy. You can guess, and that guess can be reasonable - but no one knows for sure. In other words, there is a high variance of outcomes. Climate change could turn out to be no big deal, or perhaps the human race will be able to successfully adapt, or maybe it will be the biggest disaster the human race has encountered in millennia. But the bottom line is that we just plain don't know.

If you're an investor, it's your job to hedge against any kind of risk, no matter how unlikely. I remember reading an amusing story of a hedge fund manager that wanted to sell an iron condor (a derivatives strategy that is profitable if the security makes little or no movement) for U.S. government bonds. To hedge this kind of position, you buy the options on the extremes of the strangle. So this manager went out and one of the options he bought was one for an interest rate of zero percent - when he did this, the bank laughed at him, "why in the world would you ever buy an option for zero percent?" The manager responded, "I don't know, with my luck the world could go to hell and someone could blow up a nuke in Manhattan and that would be the day that all my options simultaneously expire." A few days later, 19 men hijacked four planes in what was one of the deadliest days in American history.

So you just don't know. And you have to plan for every outcome, not only the most likely one. Perhaps years from now our descendants will scoff at our unnecessary alarmism toward climate change, or maybe they will shake their heads amazed that we did nothing while we were systematically destroying our world.

We only get one planet. Do we really want to play Russian roulette for an extra measly few percentage points of growth?