The Big Short and Rating Agencies

Michael Lewis' The Big Short is, in my opinion, by far the best book written up until now about the origins of the financial crisis. There are so many nuggets in this book, I have highlighted almost half of it. It is a fantastic tale of incompetence and/or dishonesty and one of the big unanswered questions in the end remains: who was incompetent and who was dishonest? It's a question the multiple lawsuits in the pipeline will only provide a partial answer to.

As the Senate recently approved new rules for credit-rating agencies, it's interesting to note that the rating agencies come out really bad in the book. They were badly gamed by the investment banks:

The pretense that these loans were not all essentially the same, doomed to default en masse the moment house prices stopped rising, had justified the decisions by Moody's and S&P to bestow triple-A ratings on roughly 80 percent of every CDO. (And made the entire CDO business possible.)

Not only that but, since rating CDOs brought in the bulk of their revenues (paid by the very investment banks who designed the CDOs), the credit-rating agencies had every incentive to do exactly as they were told and not dig any deeper than necessary. This is the damning email an S&P managing director sent one of his analysts, who apparently wanted to know a little more about the toxic waste in a CDO he was rating:

Any request for loan-level tapes is TOTALLY UNREASONABLE!! Most originators don't have it and can't provide it. Nevertheless we MUST produce a credit estimate.... It is your responsibility to provide those credit estimates and your responsibility to devise some method to do so.

Markets Are Right Only When They Agree With My Thesis

As much as I admire Paul Krugman and agree with most of his writings, I must say his latest New York Times column smacks of bad faith. Why am I saying that? This is what he writes:

Both nations [the U.S. and Greece] have lately been running large budget deficits, roughly comparable as a percentage of G.D.P. Markets, however, treat them very differently: The interest rate on Greek government bonds is more than twice the rate on U.S. bonds, because investors see a high risk that Greece will eventually default on its debt, while seeing virtually no risk that America will do the same.

Everything in this paragraph is true, that's not the issue. The problem is that, in most of his writings, Paul Krugman berates markets when they don't agree with his opinions. I remember quite a few columns in which he wrote words to the effect that "markets don't seem to agree with my way of thinking but we all know markets are stupid and anyway I don't care about markets and neither should you". But in this case, since markets seem to be giving the U.S. a pass lately (who knows for how long), mostly because American finances are a paragon of virtue compared to European finances, and that squares with his opinions, all of a sudden he has newfound respect for them. Better late than never I guess.

Or maybe this is just another example of someone talking his book, which is as close to a universal law as any Wall Street old saw.

Remember Inflation?

Mohamed El-Erian, the other genius at PIMCO, has this intriguing thought in the latest Barron's:

Most investors today haven't experienced inflation, and have very little inflation protection in their portfolios. The biggest risk is stagflation and most portfolios have very little protection. The challenge is to use 2010 to build up inflation protection for the medium term.

He sees inflation as inevitable in the medium term for two reasons. One is that governments running large deficits (as is the U.S.) will always be tempted to inflate and even if they don't, investors will expect them to, so that inflationary expectations will go up. The other is that unemployment will stay high for the foreseeable future and the Fed will be hesitant to be too hawkish lest they hurt the economy and worsen the employment situation.

Rising inflation expectations combined with a less than totally committed Fed will most likely result in some serious inflation at some point down the road. As Mr. El-Erian suggests, adding some TIPS to one's portfolio this year would qualify as a prudent move.

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?