Quant

Painting By Numbers: An Ode To Quant By James Montier of Dresdner Kleinwort Watterstein

Lovely item on cases where simple statistical models out-perform the expert. Most intereting is the fact that even when the expert know the model (as James did himself), they still under-perform.

Reputation

FT.com / Columnists / Stefan Stern - Corporate crises are years in the making: "As leaders are always closely observed by their colleagues, this attention to corporate reputation has to start at the very top. You will have no one else to blame if your corporate reputation suffers. And you would not want to find yourself in the same position as the wronged Cassio in Shakespeare’s Othello, who cries to Iago (in act 2, scene 3):
“Reputation, reputation, reputation! O, I have lost my reputation! I have lost the immortal part of myself, and what remains is bestial.”"

Leave it in the ground

Iranian oil output has never reached the levels seen back in 1979. The recent "nationalisation" of oil resources looks like it will also leave a lot more of the black stuff underground.

FT.com / World / Americas - Bolivia’s energy chief quits:

"The Bolivian government was forced to call a “temporary suspension” this month to its plan to take a greater stake in the country’s gas sector, citing lack of funds and expertise. Last week, the country’s Senate passed a motion of censure against Andrés Solíz, the hydrocarbons minister, for botching the nationalisation and for alleged corruption at YPFB."

Is it a conspiracy because oil producers know about peak oil and scarcity and want to leave oil in the ground while heading off arguments about future prices?

Private equity

Getting to the heart of the private equity boom.

FT.com / Columnists / John Plender - Private equity folk could do wonders with Microsoft: "This brings us to the real joy of private equity: the so-called “dividend re-cap”, a dividend-for-debt swap. The enhanced ability to borrow would permit the newly private company to make the greatest dividend payment of all time. At a stroke it would solve the financial problems of the army of private equity investors who have been trying – hitherto unsuccessfully – to punt their way out of pension fund deficits. Here, going begging then, is a great historic opportunity for private equity to do its job of generating excess returns from illiquidity. In truth, Microsoft would be worth more off the quoted market than on it. Thanks to the joys of leverage and dividend recaps, the excess returns would come through wondrously fast."

ERP

Lex on the equity risk premium.

There has been little change since 9/11, but...

FT.com / Lex - Catastrophe and equities:

"Yet there is an opposite and gloomier conclusion. America’s 20th century experience was exceptional. In most countries, war risks include the collapse of governments and property rights, not just recession. In such circumstances the price of “risk free” assets plummets along with everything else. This outcome is hard to imagine for the US. Still, for professional doom-mongers, the rise in real yields from post-9/11 lows suggests that what was once viewed as a manageable catastrophe is now thought to herald a new era of existential threats."

US rates

People usually have the Taylor rule as


i = (i* + π*) + ά1(π – π*) + ά2(y – y*)


with i* as the neutral real rate of interest (say 2%), π* as the inflation target (say 2%) and the brackets as the deviation of inflation from target and the deviation of the rate of growth from its potential.


Then much depends upon the ά parameters. Estimates for the Greenspan Fed show ά1 at 0.54 while ά2 was 0.99. For Volcker they were about 0.5 and 1.5.



Therefore, if we take inflation at 2.8% (PCE seems to come between 2.5% and 3.5% depending on how you measure it, so this is fairly conservative) and growth as 3.0% compared to a potential of 2.5%, we have 4% neutral nominal, plus another 0.5 for inflation and something for the output gap (say another 0.75%) would be 5.25%. Of course it depends on the assumption about potential growth. Many people would say that it is more than 2.5% and it depends on what people think the growth rate is at present. It could also be argued that the central bank needs to be more assertive in pushing down on inflation when there is a new Chairman gaining credibility and when oil prices are rising sharply.


The big weakness of the Taylor rule is that it does not deal well with the current situation. What if the output gap turns negative again but inflation remains high? In theory, many argue that ά1 should be more than 1 to ensure that the real rate rises to reduce inflation expectations.

Genius again

More on Galenson. "Experimental innovation" vs "Conceptual innovation".

Wired 14.07: What Kind of Genius Are You?

What he has found is that genius – whether in art or architecture or even business – is not the sole province of 17-year-old Picassos and 22-year-old Andreessens. Instead, it comes in two very different forms, embodied by two very different types of people. “Conceptual innovators,” as Galenson calls them, make bold, dramatic leaps in their disciplines. They do their breakthrough work when they are young. Think Edvard Munch, Herman Melville, and Orson Welles. They make the rest of us feel like also-rans. Then there’s a second character type, someone who’s just as significant but trudging by comparison. Galenson calls this group “experimental innovators.” Geniuses like Auguste Rodin, Mark Twain, and Alfred Hitchcock proceed by a lifetime of trial and error and thus do their important work much later in their careers. Galenson maintains that this duality – conceptualists are from Mars, experimentalists are from Venus – is the core of the creative process. And it applies to virtually every field of intellectual endeavor, from painters and poets to economists.

1660 fx derivatives

Pepys' Diary: Wednesday 1 July 1663: "but I hope we have this morning light on an expedient that will right all, that will answer their queries, and yet save Creed the 500l. which he did propose to make of the exchange abroad of the pieces of eight which he disbursed."

Creed has miscalculated the value of Spanish currency. The value of the pices of eight varies between 5 shillings and 4 shillings and sixpence. Much more here.

Real yields

The FT looks at the rise in real yields. Strong economic growth would certainly argue for higher real yields as a response to the demand for capital. However, this does not square with the recent sell off in emerging markets and commodities.

FT.com / Markets - The Short View: Real yields still have room to grow:

"But real yields have also been rising. According to Ian Scott of Lehman Brothers, a weighted average of real yields in the US, France and the UK hit a low of 1.3 per cent in June last year and has now risen to 2.1 per cent. That still leaves real yields well below their heights during the dotcom boom when, on Scott’s calculations, they almost touched 4 per cent. "

Most likely the emerging and commodity sell off is just a deflation of a bubble.

Luck

Excellent article in the LA Times. Thanks to Paul Kedrosky for the pointer. The maths of luck in the film industry.

Meet Hollywood's Latest Genius - Los Angeles Times: "That's precisely how films behave in the marketplace. If we hear good things, we go and perhaps tell others; if we hear bad things, we stay away. It's that process—the way consumers learn from others about the expected quality of the product—that De Vany found is the key to the odd behavior of the film business today. Economists call it an 'information cascade.'"

The chaotic nature of the success of failure of a film means that the big starts and business leaders have runs of good luck and bad luck. The rest is an attempt to bring meaning to this statistical noise.

Clearly this could be taken further - dare I say it - even as far as the World Cup.

Profits and investment

Tim Worstall: The Rolling Stock Leasing Companies


"Perhaps it would be better to have lengthened the trains. Question: are there any more carriages around to add to the trains? I spotted yesterday (not sure where) a point that no, in fact there are not any more trains. All the rolling stock in the country is currently in full use. Which means that someone has to go out and buy some more: those leasing companies. Who are, it seems, not allowed to make profits on the stock that they do buy."

but...

"The Department of Transport, run by the Brownite Douglas Alexander, has called on the Office of Rail Regulation to investigate the three rolling stock companies for making excessive profits with a view to referring the matter to the Competition Commission. These are the businesses that own and lease the country's trains used by the various regional operating companies. The banks that own them are livid and they have good reason. The leases are commercial agreements between private companies. But they have also, at every stage since privatisation, been subject to government scrutiny. They're as much the Government's leases as anybody's. The three rolling stock companies make a combined profit of up to £165m, having sunk £6bn into new trains since 1998".

Corruption

From Truck and Barter.

Does corruption oil the social wheels? This experiment suggests that it does not.
Truck and Barter: The benefits of corruption are not worth the costs:

"“We follow 822 applicants through the process of obtaining a driver’s license in New Delhi, India. To understand how the bureaucracy responds to individual and social needs, participants were randomly assigned to one of three groups: bonus, lesson, and comparison groups. Participants in the bonus group were offered a financial reward if they could obtain their license fast; participants in the lesson group were offered free driving lessons. To gauge driving skills, we performed a surprise driving test after participants had obtained their licenses. Several interesting facts regarding corruption emerge. First, the bureaucracy responds to individual needs. Those who want their license faster (e.g. the bonus group), get it 40% faster and at a 20% higher rate. Second, the bureaucracy is insensitive to social needs. The bonus group does not learn to drive safely in order to obtain their license: in fact, 69% of them were rated as “failures” on the independent driving test. Those in the lesson group, despite superior driving skills, are only slightly more likely to obtain a license than the comparison group and far less likely (by 29 percentage points) than the bonus group. Detailed surveys allow us to document the mechanisms of corruption. We find that bureaucrats arbitrarily fail drivers at a high rate during the driving exam, irrespective of their ability to drive. To overcome this, individuals pay informal “agents” to bribe the bureaucrat and avoid taking the exam altogether. An audit study of agents further highlights the insensitivity of agents’ pricing to driving skills. Together, these results suggest that bureaucrats raise red tape to extract bribes and that this corruption undermines the very purpose of regulation"

EMU and trade

Trade and EMU:
The Economist looks at the benefits of a single currency and voices some scepticism over the trade gains.

"A new study* by Richard Baldwin, a trade economist at the Graduate Institute of International Studies in Geneva, scythes through these and earlier, even higher, estimates. He works out that the boost to trade within the euro area from the single currency is much smaller: between 5% and 15%, with a best estimate of 9%. Furthermore, the gain does not build up over time but has already occurred. And the three European Union countries that stayed out—Britain, Sweden and Denmark—have gained almost as much as founder members, since the single currency has raised their exports to the euro zone by 7%."

Amongst Baldwin's arguments is thidentificationon of previous studies that find a collapse in imports and exports when a monetary union dissolves. This, he argues, is as much thresultlt of the creation of new tariffs and barriers or war and civil disobedience than a single currency.

Returns to art

Is art a wise investment? By Daniel Gross

"Moses and Mei have compiled 9,000 such repeat-sale pairs and add between 300 and 400 every six months, enabling them to compile an index. (The paintings in the index aren't all blockbusters. Moses estimates that the median size of recent transactions charted is about $200,000 or $300,000.) As their most recent update shows, over the last 50 years, stocks (as represented by the S&P 500) returned 10.9 percent annually, while the art index returned 10.5 percent per annum. And in the five years between 2001 and 2005, art trounced stocks. But not all art performs equally. In recent years, old masters haven't done so well, while American art before 1950 has been soaring—up 25.2 percent in the last year alone. And across categories, masterpieces (like the Klimt that Lauder just bought) tend to underperform lower-priced paintings by a substantial margin. Why? Like blue-chip stocks, well-known paintings by blue-chip artists are known quantities and offer safety and stability. As with stocks, the greatest opportunity for growth in art values comes when investors suddenly focus their attention on a hot new sector or name. "

Gross takes a good look at an index that tries to find the returns to art. It sounds as if the returns are very similar to those on equities. There is even evidence of a smaller return for the more stable and less risky "blue chip" art compared to that of the smaller firms.

However, as Tyler Cowen points out Is art a good investment?, there is a clear bias towards the winners - though this may be like survivorship bias.

European distressed debt

US banks focus on European distressed debt

"Investment banks have specifically been hiring bankers and traders who focus on distressed debt. Morgan Stanley in London has created a team of 40 bankers in the past three years, while Deutsche BankÂ’s London operation now has 130 employees, making it the biggest team in distressed debt.
Many hedge funds are anticipating that rising inflation and interest rates will soon lead to a credit crunch, when the money readily available for loans to companies at low rates will run out. Hedge funds are looking to Europe in search of higher returns because they already dominate distressed debt in America"

The revenge of the nerdd. The accountant as trader. Picking over the balance sheet, valuing the collateral and market swinging around on the basis of the latest court ruling. However, in Europe, it can only add to the talk of locusts and vultures hovering over the body of dead firms.

Offloading pension liabilities.

Companies sell unwanted pension debts to insurers
:

"Under structured buyouts, companies can select a group of current or deferred pension fund members and sell the assets and liabilities relating to their retirement savings to the insurer. For example, a medium-sized business with a few directors or executives whose generous pension promises make up a huge part of the company’s liabilities could sell those promises to the Pru."

It makes sense to me that these liabilities are managed by financial firms rather than those that make plastic cups. It sems to be bizzar structure that allow mortal firms to be in charge of the long term assets of individuals. However, it appears that, in many cases, only some of the liabilities can be removed. Many firms will not be able to afford the immediate cost of removing this problem.

China and Innovation

What is the nature of innovation? How does innovation relate to the ability to change, criticise and create?

Economist's View: Tolerance and Innovation:

"Look at Japan, which is also a conformist society. It displays great creativity in animation and other art forms, but apart from those, the only other major innovation it can claim is perhaps the Walkman. However, the number of patents it owns is one of the highest, and it has many global brands such as Sony and Toyota. If this is the model we want to emulate, we will arrive there in a relatively short period, and without needing to do much soul-searching. But in that case, we might have to forget about Silicon Valley, information technology and many other major breakthroughs. "

This links with my earlier post about Gladwell and innovation. He argues that there are two types - product (SUV) and process (JIT).

Benefits of Active Management

Pimco outline their view of the benefits of active management.

Pimco link

PIMCO has identified three specific reasons why active management strategies are likely to produce higher returns than passive strategies, with limited changes to overall portfolio risk:


Bond Market Inefficiencies: Inefficiencies in the bond market, often the result of restrictions on passive strategies, provide both structural and tactical opportunities to generate returns that should exceed those of benchmark indices.

Diverse Sources of Added Value: Active managers with extensive resources and expertise across all sectors of the market can identify many small and diverse sources of added value, which should boost returns on a consistent basis without significantly altering risk levels. This philosophy is embedded in PIMCO's approach to core active management.

Passive Management Limitations: Passive strategies often sacrifice return because of restrictions on the securities they can invest in, while a structural tilt toward higher-yielding issues can add unexpected risks that most passive managers lack the resources to evaluate"

Specifically, they talk about looking for
1) Term premiums
2) Liquidity premiums
3) Volatility premiums
4) Credit premiums

Tesco

"When Tesco opened a store three miles from Tealby in Lincolnshire last September, Peter Stooke realised that an alliance was essential to save the village store. “Almost immediately our sales went down from £800 a week to £600 a week,” he said. “We had to do something. So I contacted Tesco and said, ‘We’re having real trouble, perhaps we can work together.’"

Store giants turn good guys for village shops:

Stock exchanges

Excellent overview of stock exchanges, their actions and their future.

Economist.com | Articles by Subject | Financial exchanges: "So much for the notion that liquidity and technology will inevitably make trading a natural monopoly. NASDAQ's overwhelming market share in stocks not listed on the NYSE and American Stock Exchange disappeared a decade ago. It has never returned, despite the acquisition of its largest competitor, Instinet. Up to two-thirds of transactions in British shares and perhaps 75% of German share trades now take place off-exchange, according to Hans-Joachim Voth, an economist at Barcelona's Pompeu Fabra university. "

The pressure to merge comes as technology and market practice takes more of the secondary market and liquidity away.