The NY Times had another article about math wizards and their trading efforts on Wall St. It is such a comforting idea that genius can overcome randomness. All you need is brains and you’ll find anomalies galore that will give Madoff style returns forever.
Alas, there’s a catch. If the law of large numbers leads to an anomaly – a 2 or 3 standard deviation from the norm then they drool and put the trade on, believing that at some point normalcy will return. If it deviates further then they just add to the trade.
The question then becomes: At what point do they decide that this time is truly different and exit the position? This is the same question you should be asking the portfolio manager you have hired for your stock portfolio. The answer is usually either:
- We can hold the position to expiry or maturity if we have to .. or
- The trade is so juicy that we have put it on in huge size so we can’t exit on weakness ; the market isn’t that liquid.
A quant suffers from the same mentality as a fundamental small cap. stock manager – the more a position goes against them the more they like it.
In all cases there must be stop loss levels attached to every trade and a mechanism must exist so they don’t immediately re-enter the position. Usually this means the positions can’t get too big which is why hiring a manager with huge assets can be a huge mistake.
If you look at the AIG, Citibank, Merrill Lynch problems ,they all can be explained by this simple problem. They had no stops, they were too big in every trade and they had no mechanism to keep them from always seeing value as the assets’ prices fell .
Ivan Boesky once argued it was, since it channeled resources into profitable enterprises and rewarded aggression. Gordon Gekko extended the argument to say that only shareholders had the best interests of a company in mind – not bureaucratic board members.
The economic system changed in the 80’s toward rewarding management for stock performance but in a perverted way. It swung toward options as a means of allocation, not shares. If a manager (or trader) earns options then he has no downside. He is implicitly driven to bet big. Real shareholders will suffer all the losses and he (they) will be long gone.
The biggest problem with the philosophy is that even in our world of free market capitalism there are two industries that are sacrosanct: banks and accounting. The fiduciary role of the former requires us to restrict any kind of greed from infecting their corporate culture. The second’s accuracy and honesty are the basis upon which we believe and measure every other company’s financial performance. If they are compromised by bad incentives then our entire system is left in the dark, without the accurate information we depend on to allocate resources.
That is why God gave us regulation.
Alan G. has written an article defending his easy money policy. He contends that the
flat yield curve was testimony to a capital surplus that flooded into risky
assets and lowered risk premiums to bubble levels. His efforts to reduce
liquidity by raising short rates were defeated by these conditions.
The problem is that he created this ocean of liquidity by lowering rates to
negative (“real”) levels in 2002. The only way to correct this problem was to
raise rates by a lot – a lot more that he eventually did.
He did exactly the same thing in the late 90’s. As the stock market rocketed
into a crazy bubble state, he raised rates gently with an eye on CPI. He has
always been happy to allow asset prices to rise inexorably because his defining
moment was the stock market crash of 1987 which occurred 2 weeks after he became
The massive move to outsourcing has kept goods inflation at very benign
levels for 20 years so he could always be the good guy when it came to propping
up asset markets. His tightening moves were almost symbolic and always quickly
reversed. The stock market eventually came to count on The Greenspan
If CPI is kept low by structural changes then excessive liquidity needs an
outlet. That outlet is usually asset prices. The Fed never changed policy to
address asset bubbles – I guess he never thought it was his job.
Now he wants us to believe that there was nothing he could have done about
The NY Times had an article discussing the (correct) philosophy that banks should be regulated and managed like utilities while investment banks can be casinos. A bank utility would have severely limited leverage ), and asset quality restrictions. They would also be restricted from having long dated contracts with casinos like CDS’s and Interest rate swaps.
In this case, if a casino (say Bear Stearns) goes bust then we could let it go, since it may affect other casinos but not the fiduciaries of the nations savings. The debate we’re having is whether we can or should save all these corrupt, mismanaged, overleveraged companies. Because of all the interlocking connections to our retail bank deposit system, the government has to save almost everyone.
The NY Times article doesn’t seem to understand that the “utilities” had vastly more leverage than they should or ever used to have (by law prior to 1999). He mentions Northern Rock – which had 42X leverage! It follows that if they had less leverage then the off balance sheet derivative books of the casinos would have been much smaller since a lot of their counterparty exposure was to those banks.
This separation and redefinition would not stop excessive speculation, bear markets and bad lending decisions, but the scale would be greatly reduced and mainly isolated to those casinos that the investment banks have become.
The "Asian" model of economic development is to subsidize exports, prevent imports and maximize your foreign exchange earnings. I call it modern mercantilism. If a country runs up a huge export surplus then those earnings have to be recirculated to balance their account so the country then buys a debtor country's debt or equities or even their sub-prime loans. If you depended on the US consumer to buy all your exports then you just hit a wall. The biggest exporters of capital are now in big trouble. And they are…
and the winners will be…
A lot of analysts, authors, and regulators are trying to assign blame for all our economic woes. They look at all the corruption in the mortgage business and the leverage on Wall St. But it really all comes down to one thing – price. The free price of debt made it irresistible to everyone. Who do we blame for that .. one man :
And there was a second (virtual) freebie. The price of new imports from China (Asia in general). When goods are produced by workers who earn $3 a month, flat screen TV's suddenly get awfully cheap from the perspective of a first world earner. It especially helps if those 3rd world countries manage to block their own purchases of anything we sell. Who do we blame for this? One man :
Bill Clinton ..
-who sprinkled MFN status on every country in the world in 1994 like it was pixie dust.
A TV news host is supposed to ask a question and if it is not answered he is expected to ask it again and again until it is answered. That is his only job.
I never want to hear his opinion or forecast or analysis of anything. He is a conduit – a medium, through which I am supposed to get "expert" opinion. When a news shows interviews another news host they are wasting my time.
In fact I think every time any expert is interviewed a list of his historical predictions should be put up on a split screen (with the help of say factcheck). If he has no record or is always wrong he should not be allowed on camera until he gets something big right.
Yesterday, markets collapsed as China failed to deliver on it's temporary idea of initiating a second stimulus plan. Why does anyone think that a stimulus plan by China would help any economy other than China's?
Can China switch from being a mercantilist economy – totally dependent on exports, to one that consumes what it makes and maybe a even a little of what other countries make?
The front page of the NY Times shows Mahmoud Karzai (Hamid's brother) planning a new apartment complex in Kabul. He has been busy getting sweetheart deals in banking, cement, real estate, coal mines, and car dealerships. He proclaims: “I’m in love with the idea that Afghanistan can become a Singapore, a Hong Kong.”
Has he been watching what's going on over there lately? It's easy to show him. All he has to do is turn to page A8 which explains the economic crisis going on there. The statistic of the day:
"Singapore, where the population is just 4.6 million compared with
Taiwan’s 23 million, is particularly vulnerable to a decline in trade.
It typically imports unfinished products, does some processing of the
goods and then exports them, so the total dollar value of its exports
and imports is far larger than its gross domestic product — about three
and a half times as much, in fact."
That is staggering …the world is full of drug addicts addicted to US consumption.
Chinese Trade Surplus Will Never Die (?)
So you say – we have entered a global recession, maybe even a
depression; surely the Chinese trade surplus will wither as western
import demand shrivels up. The first report is in. We have a new
record! In October the surplus reached $35.2 bn.. In fact export
growth did weaken from a rate of 21.5% year over year to 19.1% but
incredibly, import growth collapsed from a rate of 21.3% to 12.4%.
Specifically the trade surplus with the US rose 13.3% year over year. It is easy to
argue that Chinese goods that feed through say Walmart into the US can
not be replaced by US production and in fact are necessities that will
be bought even if the economy tanks. I find neither one of these
arguments to be very compelling but the swing factor here is NOT our
imports which are down a little and acting as they should. I would
expect to see further declines here as the economy falls further. The
real story is (US) exports.
The published growth rate of the Chinese
economy has declined from 10.1% to 9%. How does such a small decline
in the rate of GDP growth drive such a massive instant drop in
imports. There are precious few explanations of this in the press
beyond the countless anecdotes about their economic malaise. Could
their economy be so addicted to exports that any decline in exports
triggers a collapse in domestic demand? If that’s true then the GDP
figures are being produced in a Chinese Disneyland.