Andrew Lo, the Right Kind of Finance Academic

MIT's Andrew Lo is perhaps the most market-savvy academic out there, probably because he runs a hedge fund as well as MIT's Laboratory for Financial Engineering (you can check out my previous posts on Dr. Lo). Not entirely coincidentally, he is a proponent of technical analysis (as his presentation to the MTA a couple of years ago can attest to) and an opponent of the random walk theory of market prices (he is the author of the transparently and aptly titled A Non-Random Walk Down Wall Street). All this to say that I read his interview by Mike Hogan in the latest Barron's with great anticipation and I was not disappointed.

Here are a few notable excerpts (emphasis mine):

The years 2007 through 2009 were all about liquidity or the lack of it. Just as we have in every previous meltdown, we saw an unwinding of liquid positions to cover illiquid positions in 2008 and a sudden flight to quality. Correlation is the flip side of liquidity. It is only when there is a liquidity shock that you discover how correlated supposedly uncorrelated assets really are. [...]

We financial designers often try to think like physicists. But it's human beings who invest in the stock market, and they have feelings and behaviors that change with changing circumstances. Unlike physical laws that have operated exactly the same over billions of years, economic laws depend on who happens to show up in the market on a given day and how they feel about what they see when they get there. [...]

As a consequence of population growth and better communications, the [financial-services] industry is much more complex and competitive today, which has been a boon to investors. We have more liquidity, commissions are at the lowest they have ever been, and individuals can gain access to 60 markets around the world in the click of a mouse. But given the speed with which bets can flow back and forth across borders now and assets can align with one another, it's increasingly difficult to find the diversification investors need to manage their way through market swings. [...]

Metacognition and Other Great Leaders' Tricks

I like David Brooks latest NYT column for a change (when he stays away from political sujects, where he's too transparently partisan, his columns usually make for an interesting read). His subject is leadership and how great leaders are not always the "superconfident boardroom lions" of popular lore. This type of leader actually gets in trouble more often than not. Brooks then goes on to describe the other type of leader, the "humble hound", and I thought much of the qualities and outlook he comes up with would also perfectly describe what a good trader should be. We all know the devastation the overconfident type of trader can wreak. A better mindset for a trader would be as follows:

The humble hound leader thinks less about her mental strengths than about her weaknesses. She knows her performance slips when she has to handle more than one problem at a time, so she turns off her phone and e-mail while making decisions. She knows she has a bias for caution, so she writes a memo advocating the more daring option before writing another advocating the most safe. She knows she is bad at prediction, so she follows Peter Drucker’s old advice: After each decision, she writes a memo about what she expects to happen. Nine months later, she’ll read it to discover how far off she was.

In short, she spends a lot of time on metacognition — thinking about her thinking — and then building external scaffolding devices to compensate for her weaknesses.

She believes we only progress through a series of regulated errors. Every move is a partial failure, to be corrected by the next one. Even walking involves shifting your weight off-balance and then compensating with the next step.

She knows the world is too complex and irregular to be known, so life is about navigating uncertainty. She understands she is too quick to grasp at pseudo-objective models and confident projections that give the illusion of control. She has to remember George Eliot’s image — that life is like playing chess with chessmen who each have thoughts and feelings and motives of their own. It is complex beyond reckoning.

She spends more time seeing than analyzing. Analytic skills differ modestly from person to person, but perceptual skills vary enormously. Anybody can analyze, but the valuable people can pick out the impermanent but crucial elements of a moment or effectively grasp a context. This sort of perception takes modesty; strong personalities distort the information field around them. This sort of understanding also takes patience. As the Japanese say, don’t just study a topic. Get used to it. Live in it for a while.

Losers 2.0

Pretty pathetic NYT article on modern (as opposed to ancient, i.e. late 90s) day traders. It seems journalists get off on portraying day traders as clueless, dim-witted losers and this article is no exception.

The traders' lingo is ridiculed as "teenage haiku", the point that they face daunting odds when it comes to making money day in, day out is belabored throughout. Some rather creative insults are hurled at day traders in general:

As a job, “day trader” registers in roughly the same way as “disco ball manufacturer” or “Brooklyn farmer.” You know that someone has to be making disco balls and that maybe there are still a few plots of arable land in Brooklyn.

and at the day traders featured in the article in particular (they look like "members of a mellow Southern California rock bank that split up 15 years ago").

Some of this is obviously right on the money, especially the part about algorithmic trading wreaking havoc on overly simplistic day trading strategies. As a matter of fact, the way one of the traders reacts to a "robo trader" supposedly screwing up his trade:

That was nothing but an algorithm boogie. Goddang it. Drives me crazy. My analogy is that whole sector is doing great and they find one weak animal in a herd and they’ll attack it.

cracked me up because it sounds like an updated version of what I used to hear on the trading floor every second of every trading day in the late 90s: "it's the f**king specialist!". Which goes to show there's always somebody (or something) out to eat your lunch.

At the risk of adding some more tired clichés and teenage haikus, day trading is indeed a "tough gig". It has always been and will always be a very difficult way to make a living. It can be emotionally taxing if not downright heartwrenching, and when it's easy, it's never easy for long. It is also intellectually stimulating, almost never gets boring and can be quite rewarding emotionally and financially. Only a gullible journalist out for a facile article ridiculing what is, in my admittedly biased opinion, a noble profession could pretend first to believe day trading to be an easy endeavor then pretend to discover how much harder than it looks it really is.

We Still Don't Know What Causes Depressions

That's basically the crux of Robert Shiller's recent article titled A Crisis of Understanding.

Maybe it's not so much that we don't know the cause of economic depressions as that there are so many potential culprits. Each of which could be, if not THE cause, at least the main cause but could also just be a peripheral phenomenon. The causes given for the Great Depression were:

[M]isguided government interference with markets, high income and capital gains taxes, mistaken monetary policy, pressures towards high wages, monopoly, overstocked inventories, uncertainty caused by the reorganization plan for the Supreme Court, rearmament in Europe and fear of war, government encouragement of labor disputes, a savings glut because of population shrinkage, the passing of the frontier, and easy credit before the depression.

Many of these explanations could be recycled for the Great Recession and the following could be added:

[U]nprecedented real-estate bubbles, a global savings glut, international trade imbalances, exotic financial contracts, sub-prime mortgages, unregulated over-the-counter markets, rating agencies’ errors, compromised real-estate appraisals, and complacency about counterparty risk.

Question for Brett Steenbarger

Brett Steenbarger of the always excellent TraderFeed blog is holding a webinar and is asking for suggestions as far as the topics folks might be interested in having him tackle. So by all means go here and add your question(s) to the comments section. My long-winded question is:

Brett, I would really like to know your opinion on the specialist vs. generalist divide.
Are most of the successful traders you know extremely specialized, i.e. trade only one product, one time-frame, and beyond that, one system or even one direction or one time of the day?
Or is it the case that the most successful traders can play several partitions and adapt their trading to the market conditions?

The Berkshire Annual Letter

Even though Warren Buffett has come to personify fundamental analysis and I'm more of a technical analysis kind of guy, how can one not go gaga over this kind of fundamental analysis (emphasis mine)?

Long ago, Charlie [Munger] laid out his strongest ambition: “All I want to know is where I’m going to die, so I’ll never go there.” That bit of wisdom was inspired by Jacobi, the great Prussian mathematician, who counseled “Invert, always invert” as an aid to solving difficult problems. (I can report as well that this inversion approach works on a less lofty level: Sing a country song in reverse, and you will quickly recover your car, house and wife.)

[...]

Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their

products may be. In the past, it required no brilliance for people to foresee the fabulous growth

that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But

the future then also included competitive dynamics that would decimate almost all of the

companies entering those industries. Even the survivors tended to come away bleeding.

Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean

we can judge what its profit margins and returns on capital will be as a host of competitors battle

for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to

come seems reasonably predictable. Even then, we will make plenty of mistakes.

We will never become dependent on the kindness of strangers. Too-big-to-fail is not a fallback

position at Berkshire. Instead, we will always arrange our affairs so that any requirements for cash

we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be

constantly refreshed by a gusher of earnings from our many and diverse businesses.

When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier

of liquidity and capital to the system, not a supplicant. At the very peak of the crisis, we poured

$15.5 billion into a business world that could otherwise look only to the federal government for

help. Of that, $9 billion went to bolster capital at three highly-regarded and previously-secure

American businesses that needed – without delay – our tangible vote of confidence. [...]

The $20 billion-plus of cash equivalent

assets that we customarily hold is earning a pittance at present. But we sleep well.

Argument over the Future

In this week's Barron's, Michael Santoli comes up with this gem of a sentence (emphasis mine):

The stock market is essentially an argument over the future, staged over six-and-a-half hours each weekday, among people who can't even agree what's most important to be arguing about at any given moment

thereby showing his total grasp on the behavioral aspect of the market. But then he overreaches himself with this paragraph:

The more interesting question isn't whether things in this post-crisis, heavily medicated financial system are different - plenty of things are, from government action to debt levels to consumer psychology - but whether this "differentness" is already built into the markets.

As long as I am quoting nicely-turned sentences I would be remiss if I didn't mention this one by Alan Abelson:

He was a meticulous reporter of the highest integrity, a prolific writer, an unflappable, low-key interviewer, no matter how grouchy and intimidating the subject, an astute judge of markets and possessed of an extraordinary ability to separate fact from hyperbole, truth from spin.

And no, he's not talking about himself, this is part of a eulogy to Harlan Byrne, a former colleague of his who passed away recently.

Reality Check

If you need a reality check, this is a must-read article on long-term unemployment and the ways in which this recession has been unlike any recent and not-so-recent U.S. recessions:

“The system was ill prepared for the reality of long-term unemployment,” said Maurice Emsellem, a policy director for the National Employment Law Project. “Now, you add a severe recession, and you have created a crisis of historic proportions.”

Some poverty experts say the broader social safety net is not up to cushioning the impact of the worst downturn since the Great Depression. Social services are less extensive than during the last period of double-digit unemployment, in the early 1980s