Sunday, February 11, 2018

My Amazon Review of Andrew Lo's "Adaptive Markets: Financial Evolution at the Speed of Thought"

Biological Finance

I am a sucker for kids from middle-class Queens who become great successes. (I am one, without the success part.) Andrew Lo, a M.I.T. finance professor and hedge fund manager is one of the more notable ones. Aside from being a finance super-star, Andrew Lo is a great story teller. I wish I could take his class. However at times he tells too much and as result his 504 page book in the print edition is too long.

Lo’s thesis, building on the work of Kahneman, Tversky, Thaler and Haidt argues rather convincingly that the home economicus model that modern day financial economics relies on is a special case and shouldn’t be generalized for all markets in all seasons. Thus the physics math that finance uses, while it creates reasonably good heuristics, is not complete. Simply put the efficient market hypothesis works most of the time, but not all of time.  

Lo is an expert on modern finance and he presents a well-documented history as to how it came into being starting with an obscure mathematics dissertation written in French by Louis Bachelier which ultimately became the foundation for options pricing models. He makes one mistake here by noting that Paul Samuelson received his Ph.D. in 1947. It was 1941 while his Ph.D. was formally published in 1947.

Be that as it may Lo brings to the table of modern finance neuroscience, evolutionary biology and behavioral economics. When doing this much of the rigor of physics math goes away but it makes his adaptive markets far more relevant to the real world. After all, despite the rise of the machines, markets are made by human beings who have a multitude of motives many of which are not “rational” and many of which are unconscious. Instead of thinking about the day-to-day chaos that appears on the stock exchanges, think of traders fighting for survival on the African Savannah. This would certainly put the concept of seeking alpha in a different light.

Professor Lo also comes up with a neat idea for mass funding of cancer research through the creation of a $30 billion biotech fund that is following the science rather than the near term dictates of the venture capital market place.

In sum, Andrew Lo has written an important book and it should be part of the curriculum in all serious finance departments.

Tuesday, January 30, 2018

My Amazon Review of Robert Harris' "Munich: A Novel"

Two Flies on the Diplomatic Wall

Author Robert Harris has given us a well-researched fast paced novel on the 1938 Munich Conference where Britain and France surrendered the Sudetenland portion of Czechoslovakia to Nazi Germany to avoid a war that was surely coming. His two protagonists Hugh Legat, a junior secretary at 10 Downing Street, and Paul von Hartmann, an official in the German Foreign Office, act as flies on the wall as Hitler and Chamberlain meet at the Regina Palast Hotel in Munich to settle the crisis. Legat and von Hartmann are linked by their past connections at Oxford.

The book opens with Hitler’s September 27th ultimatum to Czechoslovakia to surrender the Sudetenland or face an invasion. It is here where Legat and von Hartmann watch as events transpire and we hear conversations of the very real historical figures on both sides. We see Chamberlain scrambling to get Mussolini to act as a mediator which quickly brings about the conference. Both Legat and von Hartman end up at the conference as interpreters through the manipulation of the intelligence services of both countries. In von Hartmann’s case, he is a member of the Oster conspiracy to bring Hitler down. It failed in 1938 and failed spectacularly in 1944. Von Hartmann is bringing to Munich the minutes of a 1937 meeting which Hitler announced his plans for a general European war to his senior military and foreign policy officials. Von Hartmann naively believes that if Chamberlain had that information he wouldn’t yield to Hitler forcing a war that the German military would rebel against Hitler.

Through the very anti-Nazi Legat Harris paints a sympathetic picture of Chamberlain trying to avoid the second Great War in 20 years. He has Chamberlain understanding that Britain was both militarily and psychologically unprepared for war and his appeasement policy was buying time to strengthen the country. However he avoids bringing up the facts that it was the Baldwin-Chamberlain policies that put Britain in the position of weakness.

Along the way we get a sense of what life was like in 10 Downing Street, the precariousness of air travel and the general yearning for peace in both Britain and Germany. Chamberlain was hailed as a hero in both countries, much to the chagrin of Hitler. I found the book to be a great read and it was hard to put down.  

Saturday, January 27, 2018

Eerie Parallels: January 2018 - January 1987

                             "History doesn't repeat itself but it often rhymes"
                                               Attributed to Mark Twain

The amazing run of stock prices since the start of the year has me thinking about a similar rise in January 1987. Thus far this month the S&P 500 is up 7.5%, not as extreme as 13.2% gain recorded in 1987, but nevertheless quite a move. We all remember what happened after that as stocks continued to a gain of 39% by August, but to give it all back and then some by October. From peak to trough the S&P 500 declined by 33%. However by year end the index ended up for the year by a nominal 2%.

The parallels to 1987 look striking when we look at the economic back drop then and compare it to today. Because history rhymes I will also note a few striking differences.


Indicator                                     January 1987                     January 2018

S&P 500                                       +13.2%                               +7.5%*
Extended Bull Market                Started 8/82                     Started 3/09
Computer Trading                      Portfolio Insurance         Algo Trading
Economy                                    Strengthening                      Strengthening
Profit Growth                             Accelerating                         Accelerating
Dollar                                         Weakening                           Weakening
Oil Prices                                    Up from lows.                     Up from lows
Inflation Rate                             Increasing                            Increasing
Fed                                             Tightening                           Tightening
10-Year Treasury Yields            Bottoming, about to rise    Rising       
Pro-Growth Tax Reform            1986 Tax Act                     2017 Tax Act
Trade Tensions                           Japan/Germany        China/NAFTA
White House Scandal                Iran/Contra        Russian Interference


Europe                                        Uniting                                   Dividing
Big Power Rivalry                      Declining                               Increasing
Shiller CAPE                               14X                                        35X

*-As of January 26.

To me the parallels to 1987 are too striking to ignore. So if 2018 stock market rhymes anywhere near its 1987 history we should see a continued advance in stock prices through the summer with the S&P 500 rising well above 3000 and then a severe decline thereafter with stocks ending the year with a modest gain. Fasten your seat belts; it's going to be a wild ride.

Friday, January 26, 2018

Why is the Economy so Strong?

Forget about the below consensus 2.6% increase in real GDP for the fourth quarter. Looking under the hood we find that final sales to private domestic purchases, which takes out the effects of trade, inventories and government, increased at a very strong 4.6% annual rate. Growth was propelled by a 3.8% increase in consumer spending and an 11.4% increase in equipment spending.This follows two quarters of 3% real growth. Simply put the economy is hot and the bond market looked through the headline number and declined. Moreover inflation as measured by the deflator for personal consumption expenditures increased at 2.8% well above the Fed's target and services inflation ran at a very hot 3.1%.

What accounts for this strength after years of so-so 2%  growth? In my opinion it represents a combination of the lagged effects of the extraordinarily easy monetary policies of the past decade, a rebound in the global economy, the deregulation policies of the Trump Administration and the prospect of major tax cuts that were enacted at the end of the quarter. It is not only the deregulation policies, but also businesses no longer live in fear that new regulations will not come from out of the blue as was the case under the Obama Administration. Thus of a sudden capital spending is exploding witnessed by the very strong gain in equipment spending.

Further we appear to be in a self reinforcing cycle of rising stock prices working to push up both consumer and business spending. Nevertheless the party won't go on for too long as the economy is running out of labor in an environment of low productivity growth and that will further increase inflation and lead to more Fed tightening that the market now expects.

Monday, January 22, 2018

My Amazon Review of Tim Harford's "Fifty Inventions that Shaped the Modern World"

The Making of the Modern Economy

Financial Times columnist Tim Harford has written a very enjoyable book about the inventions the brought about today’s globalized economy. At the outset he pays tribute to science historian James Burke who brought us “Connections” the late 1970s BBC series on the history of science.

As the title notes Harford discusses the origins and the implications of 50 inventions. I note ten of them below to give you a sample:
·        Barbed Wire – Established the practically of legal boundaries in the American West.
·        The Pill – Enabled female sexual autonomy that opened the way for women to enter the professions in the 1970s.
·        The Dynamo – The broad transmission of electrical energy.
·        The Shipping Container – Without which global commerce would be a shadow of its current self.
·        The Elevator – Perhaps the foremost mass transit invention that enables dense cities.
·        Double- Entry Bookkeeping – The way measure and control
      the efficacy of enterprise.
·        The Limited Liability Company – Enables risk taking on a grand scale.
·        The Compiler – Enables computers to be programmed in English (well sort of).
·        Property Registry – Converts land into tradeable capital.

There are, of course 40 more and Harford tells the story of all of them in a very breezy style. The chapters are short and that makes the book easy to put down and pick up with ease.

To sum up I highly recommend Harford’s book for lay readers, history buffs and economists alike interested in getting a better understanding how our world came to be.

Saturday, January 13, 2018

My Amazon Review of Douglas A. Irwin's "Clashing over Commerce: A History of U.S. Trade Policy"

Trading Places

Dartmouth economist Douglas Irwin has written a very long (832 pages in the print edition) and sometime tedious history of U.S. trade policy, but in many respects it is a tour de force. In a way he is writing American history through the lens of trade. His history starts with the economic impact of the French and Indian War’s (The Seven Years War globally) on Britain’s fiscal and colonial policy. The Boston Tea Party was the result. After independence and the chaos caused by the failed Articles of Confederation one of whose attributes were tariffs among the states a new constitution was written that centralized trade policy within the national government. In fact the second law enacted by the first Congress was a tariff. It was needed to fund the government. Thus Trade policy is as old as the Republic.

Irwin divides his history into three eras: tariffs for revenue (1789-1860), tariffs for restriction (1861- 1933) and tariffs for reciprocity (1934-Present?). Initially export oriented (cotton and tobacco) South favored low tariffs (for revenue only) and the North supported tariffs to restrict imports as well. Given that geography Democrats were for low tariffs and Whigs/Republicans were for high tariffs. By the late 20th century the two parties traded places with Republicans favoring open trade while the Democrats became far more restrictionist. Irwin tells his story by going into the details of all of the major congressional debates on tariff questions. Sometimes this is very interesting and sometimes it gets a bit tedious, but it is history in the making.

The first real battle over trade took place in the 1820s where the political genius of Henry Clay pushed through a restrictive tariff which both protected northern industry and raised revenue to fund internal improvements. That was his American System. By 1832 led by John C. Calhoun the South rose up in protest against what he called the Tariff of Abominations and introduced the doctrine of nullification. Irwin notes that the fight over the tariff became a proxy war over slavery. Nevertheless, with the Southern Democrats largely in control tariffs were largely used for revenue only prior to the civil war.

With the Republicans coming to power in 1861 the tariff was first used to raise revenue to fund the civil war and afterwards to restrict the entry of foreign goods into the United States.  Irwin found no real evidence the high tariff policies of the Republicans promoted economic growth. This was due, in part, to the economy being wide open to immigration and technology transfers. It was also helpful that the U.S.’s leading trading partner was Britain which then had a zero tariff policy. It is unfortunate that Irwin did not note that the success of textile manufacturing in New England was due to stolen technology from Britain.

Although the Republicans were in the high tariff camp, both Presidents Garfield and McKinley in his second term were open to reciprocity. Unfortunately both were assassinated before they could implement their new ideas.

After growing unrest with the high tariff policies of the Republicans which were thought by the Democrats to promote monopoly and act as a tax on consumers, the new Wilson Administration moved swiftly to lower tariff. Irwin highlights how Wilson was very hands on in working with Congress to pass the Underwood Tariff which significantly lowered import duties. Something else was going on as well. The U.S. was becoming a major exporter of industrial goods. This was due to the discovery of huge iron deposits in the Mesabi Range of Minnesota which made the U.S. the world’s lowest cost producer of steel.

However after World War I and the Republicans returned to power tariffs were raised dramatically in 1923 with the Fordney-McCumber Tariff. That was followed by the Hawley-Smoot Tariff of 1930 which raised the already high tariffs by 15%. Irwin debunks the idea that the Hawley-Smoot Tariff caused the stock market crash and the depression. It did, however, exacerbate the global collapse of the early 1930s.

With the arrival of the Roosevelt Administration tariff policy takes a U-Turn. Secretary of State Cordell Hull established a policy of reciprocal trade, first with Latin America and then with the rest of the world. If anyone person is a hero in the book it is Cordell Hull. Under the leadership of state department official Will Clayton, the Truman Administration follows up deal by deal reciprocal trade agreements with broad multinational agreements(GATT now the WTO).

By the 1970s the parties traded places. The Republicans supporting trade in financial services and high technology products become free traders, while the labor oriented Democrats fearing the loss of union jobs become protectionists. Further the long free trade oriented South, switches sides as its textile manufacturing business come under stress. All of this came to a head with Democrat Bill Clinton supporting NAFTA against a majority of his party. NAFTA passed with Republican votes, but the fissures the battle engendered made Americans more suspicious of trade deals.

Those fears bore fruit with the leading Democratic candidates in 2016 opposing the Trans Pacific Partnership along with Donald Trump. Now with a protectionist in the White House and a protectionist Democratic Party it appears that the long era of reciprocal trade might be behind us. Irwin thinks there is too much momentum and it took the Civil War for policy to transition from revenue to restriction and it took the Great Depression to transition for restriction to reciprocity. My question is whether the Great Recession was another such trigger. I hope not.

In sum Irwin’s book is a long slog, but for those serious about how our trade policy came to be, it is well worth the effort.

Friday, January 12, 2018

E-Commerce Dominates Holiday Sales

Although brick and mortar retail had a much better than expected holiday sales season, e-commerce dominated the retail scene. Between October and December e-commerce accounted for 49% of the growth in seasonally adjusted total retail sales and 60% of the growth in its addressable market (Defined as total minus autos, gasoline and food services and bars). What this means is that more store closings are on tap as traditional retail reconfigures its store base to account for the growing competition.  Needless to say this eventuality will not be helpful for the struggling mall REITs. The data are below:

                                            In  $ Millions

Category                     October       December      Change

Total                              489,468        495,381        5,913

Less: Autos                    102,794         102,060
          Gasoline                 39,322           40,497
         Rest. & Bars            56,884           57,549

Addressable Mkt.            290,468          295,275      4,807

Non-Store Retail                52,677            55,562      2,885

Non-Store Percent of Total Change  - 49%
Percent of Addressable Change        -  60%