Chris Rock Explains Bias Blindness

When the nominations for the 88th annual Academy Awards were announced this past January and for the second year in a row included no minority nominees for any of the major performance categories, my first thought was here we go again. But my second thought was that Chris Rock would be hosting the Oscars’ award ceremony and that there might be fireworks.

I was not disappointed. Rock quickly let it be known that he would not be boycotting the ceremony (as he quipped during his Oscar monologue, “How come there’s only unemployed people that tell you to quit something?”) but also that his opening monologue would be addressing the #OscarsSoWhite controversy in a big way.

He sure did.

Continue reading


Is Apple Too Big to Succeed?

APPLIf, as I believe, the small-cap premium is at least partly due to the inherent efficiencies of smaller companies, larger companies have inherent inefficiencies and these inefficiencies will be reflected by the markets.  All of which brings me, via circuitous route, to a discussion of Apple. Continue reading

Nobody goes there anymore — it’s too crowded

When I was a young lawyer I got to meet the great Yogi Berra in a professional context. The Hall-of-Fame catcher and former Yankee manager was a delight in every respect.  He was a very insightful and successful businessman too.

As almost everyone knows, Yogi is also extremely quotable. Yogi’s sayings – “Yogi-isms” – have become part of the cultural landscape.  They entertainingly fracture the language but do so in very interesting and sometimes enlightening ways. 

You can observe a lot by watching.

It was déjà vu all over again.   

When you come to a fork in the road….take it. 

The future ain’t what it used to be.

One of my personal favorites is nobody goes there anymore…It’s too crowded. In the trading and investing world, it’s remarkably shrewd advice.  What works today doesn’t necessarily work tomorrow, in large measure because investment success draws crowds of copycats.  That demand – which can readily become excess demand and thus make its object bid-up and too expensive – often means that what was a good trade becomes played out and no longer is a good trade.  If a trade gets too crowded, you don’t want to go there anymore.

As reported by BloombergBusinessweek, this concept was well illustrated (albeit in a different context) during the recent presidential election.  The Obama campaign was extremely successful raising money over the internet, to the tune of $690 million, particularly via the use of email to potential donors.

Lots and lots of email. 

The email appeals used by the campaign were the product of rigorous experimentation by a large team of analysts, said Amelia Showalter, the campaign’s director of digital analytics. “We did extensive A-B testing not just on the subject lines and the amount of money we would ask people for, but on the messages themselves and even the formatting,” Showalter said.  The campaign tested multiple iterations of each email – often as many as 18 variations – before deciding what to blast out to tens of millions of subscribers.  It’s a great metric – test, re-test, quantify, analyze, adjust and target.  All investors should be so disciplined.

“When we saw something that really moved the dial, we would adopt it,” said Toby Fallsgraff, the campaign’s e-mail director, who oversaw a staff of 20 writers.  Interestingly, despite their intensive and extensive experience, the staff was remarkably poor at predicting what would work and what wouldn’t.  Ugly stuff worked.  A casual sound worked.  Profanity worked.  Surprisingly, no matter how much email was sent, very few recipients opted out.  Jon Stewart hilariously lampooned this effort here (“They’ll end up spamming the living s*** out of you!”).

This adaptability is important from an investing standpoint.  We need to be agnostic as to approach and ideology and simply focus on what works and adjust as things change.  Our points of view and opinions, no matter how strongly held, should always be tentative and subject to change due to new or better evidence.  

One reason things change is that trades get crowded and played out.  You can have too much of a good thing, as the Obama campaign found out.  No email was perfect and none kept working indefinitely. “Eventually the novelty wore off, and we had to go back and retest,” Showalter said.

As Felix Salmon recently put it, “anything which works will eventually stop working, and the less intuitive it is, the more quickly it will stop working.”  In a proposition that is both intuitively appealing and academically supported, as more people enter a trade or employ a strategy, the more and the more quickly their success will deteriorate.  As Yogi himself would recognize, it ain’t over ‘til it’s over, but eventually it is over.

Hot Action Item

Five years ago my family and I were awakened early in the morning and forced to evacuate our home due to raging wildfires burning out of control near our home in Southern California and fanned by winds gusting to over 100 miles per hour (as shown right).  Unlike many of our neighbors, we had time to gather a few things before we escaped.  We left seriously doubting that we would return to find our home still standing.

After nearly a week we were allowed back into our neighborhood.  Fortunately, our home survived.  We suffered smoke damage and some damage to trees, but few other problems of note.  Many of our friends and neighbors were not nearly so lucky (see below). Just within our church community, 70 families lost their homes.  We live with “fire season” every year.  But the problems and the risks have grown consistently over the 17 years we have lived in San Diego and they will continue to grow, largely on account of climate change.

According to nearly all working scientists in the field and the various organizations representing America’s best scientists, climate change is a fact. It is very likely caused by the emission of greenhouse gases from human activities and poses significant risks for a range of human and natural systems. As these emissions continue to increase, further change and greater risks will ensue.  These risks include rising temperatures, extreme weather, and the problems caused or (more typically) exacerbated by them.  A helpful summary of the science of climate change is provided by the following video.

Without belaboring what is remarkably clear, temperatures are rising significantly.

Source: NASA

And sea level is rising and rising faster.

Source: NASA

With events like Hurricane Sandy crashing onto the East Coast recently becoming more and more common, it is exceedingly difficult to ignore the increased and intensifying storms, droughts, cold snaps, heat waves, wildfires and disease that inevitably follow from climate change and which are causing devastating damage and disaster-related losses, according to organizations like the National Oceanic and Atmospheric Administration and the Intergovernmental Panel on Climate Change.  It also means more agriculture-related problems and more variability in weather patterns.

If you don’t want to believe scientists directly, then believe the highly profit-motivated insurance industry, which has become the first major business sector to acknowledge the effects of climate change and to seek to deal with that risk in a systematic fashion.  Just two weeks before Sandy slammed onto the Jersey shore, German reinsurance giant Munich Re issued a report entitled Severe Weather in North America, in which it linked the risks of severe weather events to human-caused, or anthropogenic, climate change:  “In the long-term, anthropogenic climate change is believed to be a significant loss driver. […] It particularly affects formation of heatwaves, droughts, thunderstorms and — in the long run — tropical cyclone intensity.” Allianz actively lobbies for worldwide, binding carbon emission targets and has designed various insurance products to deal with climate change risk, such as catastrophe bonds and micro-insurance. Swiss Re also has a product line that is explicitly geared toward climate-change risks.

Or perhaps you’ll be influenced by the United States Navy, which is actively preparing for an ice-free Arctic Ocean.  Indeed, a major study commissioned by the Pentagon asserts that climate change is a greater threat to national security than terrorism. Even oil companies (see here, for example) acknowledge the facts of climate change and its human causes.

There is a dedicated group of climate change “skeptics” who insist either that climate change is a myth or that its risks are overstated.  Since causation is such a difficult matter to ascertain to everyone’s satisfaction (and especially to the asserted satisfaction of those whose financial status is threatened by climate change), there will be some kind of debate about this for the foreseeable future.  But no serious climate scientist believes that sea level will rise less than a meter this century unless we get off fossil fuels with great haste.  Many forecasts are much grimmer.  At least 20 port cities will be seriously exposed to coastal flooding risks in the coming decades including Mumbai, Calcutta, Ho Chi Minh City, Shanghai, Bangkok, Tokyo, Miami, Alexandria, and New York (as Hurricane Sandy demonstrated).

But even if the science were in dispute, when an activity raises threats of harm to human health or the environment, precautionary measures should be taken even if some cause and effect relationships are not fully established. In this context the proponent of a threatening activity, rather than the public, should bear the burden of persuasion.  If they cannot do so — by establishing that climate change is not a substantive risk — then we should act as if climate change is a major risk to our lives and health. This approach is particularly appropriate, as Nassim Taleb points out, because the extent of the threat and the risks are so high.  As Taleb explains, we should readily use a headache pill if it is deemed effective at a 95 percent confidence level but assiduously avoid such a pill if it is established that it is “not lethal” at a 95 percent confidence level.

The results of the presidential election and the impact of Hurricane Sandy suggest that there might finally be some traction toward dealing with climate change.  After a campaign devoid of its consideration, climate change was finally brought up by New York City Mayor Michael Bloomberg in his surprising last-minute endorsement of President Obama in the wake of Sandy. The President himself returned the issue to public light by speaking of it in his acceptance speech on election night:

“We want our children to live in an America that isn’t burdened by debt, that isn’t weakened by inequality, that isn’t threatened by the destructive power of a warming planet.”

Yet, to this point, little has been done.  Neither New York City nor New Jersey, which took the brunt of Hurricane Sandy’s force, have made climate change response a serious priority, perhaps because doing so would create further tax burdens on a population already economically stretched.  More cynically, while storm mitigation is largely a state and local expense, disaster clean-up garners major federal dollars.  Irrespective of the reasons, much needs to be done and almost nothing has been done.

But is there an investment play here?

The reality of climate change doesn’t mean that there’s a trade to be made. Jeremy Grantham (see here) addresses the issue directly: Global warming will be the most important investment issue for the foreseeable future. But how to make money around this issue in the next few years is not yet clear to me.”  I hesitate to disagree with Grantham because of the great respect I have for him, but disagree I do.

With the possible exception of the inverting demographic pyramid, I expect climate change to be the dominant investment challenge and opportunity of our time. But I don’t expect it to play out quickly. For most traders, an actionable item is one that can and should be undertaken right now and is expected to pay off essentially right away (not that there’s anything wrong with that).  But no matter how often I point out that lunch tomorrow is not a long-range plan, I don’t seem to get heard all that often on this point.  Yet I will not be deterred.  Today I offer an action item that will almost surely pay off in the longer term for those with the necessary patience based upon any reasonable interpretation of the available data.  The climate is changing and those changes will have to be dealt with sooner or later.

The denialists do not trouble me in the least.  As Bruce Chadwick puts it, “if your investment horizon is long enough and your position sizing is appropriate, you simply don’t argue with idiocy, you bet against it.”

Investment opportunities in this area fall into two general categories.  Climate mitigation focuses on reducing greenhouse gas emissions while climate change adaptation refers to actions taken to address the risks and opportunities associated with the physical effects of climate change such as changes to temperature, rainfall and ecosystems.

I remain unconvinced about the investment opportunities available with respect to mitigation. Since entrenched energy interests have a strong economic incentive to delay governmental initiatives towards climate mitigation, since climate denialists are likely to oppose such initiatives, and since it remains decidedly unclear which approaches will succeed (even assuming the “correct” approach(es) currently exist), Grantham’s uncertainty is well placed in this regard.  From an investment perspective, we can avoid arguing about the causes of climate change — which are fraught with political peril despite science that is clear — and simply put our money to work in companies that deal with the consequences of climate change while avoiding those entities and regions with the most to lose.

Thus the better investment opportunities exist in climate change adaptation.  Adaptation efforts include improved infrastructure design (Sandy clearly demonstrated the fragility of our energy infrastructure), more sustainable management of water and other natural resources, modified agricultural practices, and improved emergency responses to storms, floods, fires and heat waves.  Infrastructural improvements include sea-walls, dykes, tidal barriers, and detached breakwaters. But since these improvements may have unintended and damaging side effects, for example by displacing erosion and sedimentation, we might also consider “softer” accommodation options that involve restoring dunes or creating or restoring coastal wetlands, or continuing with indigenous approaches such as afforestation.

Other accommodation options include warning systems for extreme weather events as well as longer-term measures such as improving drainage systems by increasing pump capacity or using wider pipes. Of particular interest ought to be food technologies that are resistant to heat, drought and flooding.  Water needs provide opportunities in adaptation strategies for water conservation, storm water control and capture, resilience to water quality degradation, preparation for extreme weather events and diversification of water supply options.

Harsher and more wide-spread droughts will lead to a strain on communities and farmers that need fresh water. At the same time, rising sea levels will affect coastal regions, potentially leading to an increase of salt in ground water. So-called desalination technology has been a non-starter to this point; venture capitalists may want to re-think that. Other water recycling approaches are also promising. Further opportunities exist with respect to innovations in dealing with infectious diseases and pest control, weather forecasting technologies and more efficient irrigation systems.

Because the facts (and the science) are inexorable, society is going to have to adapt to higher temperatures and a rising sea level.  Obviously, it’s much cheaper to deal with climate change before a crisis hits than after a city has been flooded. But there is no reason to believe or expect that we will have the public policy sense to do so.  Moreover, green-energy technologies are still too speculative for the type of call I’m making here. The obvious investment priority is in adaptation technologies that will prepare and help us to deal with effects of climate change.

It is a highly speculative play.  It is a very long-term play.  But it is the right play.  Our atmosphere is getting warmer and that has inevitable consequences.  It is the most important hot action item of our time.

Running Out of Money

My latest column for Research magazine, Running Out of Money, is available here.  Here’s a taste:

Nearly half of all Americans die essentially broke and entirely dependent upon Social Security payments and the kindness of others for support. Not only are they unable to withstand financial upheavals such as medical needs which are not covered by entitlement programs, but because Social Security payments are generally relatively low—they were never designed to be one’s sole source of retirement income—these seniors live out their lives every single day in serious financial peril.

Worth Reading

I commend some recent articles to your attention.

Demography as Destiny

Josh Brown had an interesting post yesterday based upon a report from Tobias Levkovich of Citi (Bloomberg story here) focusing on the anticipated boom in 35- to 39-year-olds — those in their key “savings years.” This age group is said to be poised to increase for the next 17 years. Saving and investing by these echo boomers “would generate a new set of equity fund inflows,” Levkovich claims. Levkovich expects the S&P 500 to rise to 1,615 in 2013, about 50 points higher than the index’s October 2007 record and about 12 percent above current levels. Besides demographics, he argues that expansion in U.S. manufacturing, energy, mobile technology and housing and efforts to curb federal budget deficits will combine to drive stocks higher.  He also sees valuations as attractive.

Obviously, Levkovich is generally paid to be bullish, so his forecast needs to be considered in that light.  But still, I hope he’s right.  However, I’m not sold on the growing strength of the economy, anything other than ongoing governmental dysfunction (see here and here, for example) or attractive valuations — even though I could easily be wrong.  I’m also skeptical of his view of the demographics.

The ongoing demography as destiny argument is a fascinating one. A useful paper called Demography and the Long-Run Predictability of the Stock Market back in 2002 argued that P/E ratios are correlated to the ratio of middle-aged people to young adults (the “MY ratio”). When MY rises, the market P/E will tend to rise and when it falls, P/Es tend to fall.  This study claimed that we should see a continued fall in P/E ratios from then (2002) through and until a long-term bottom in stock prices forming about 2018.  So by that measure, Levkovich is about five years early.  It may be hard to imagine a Wall Street analyst being too bullish too soon, but there you go.

On the other hand, a report on Boomer retirement and demand for stocks by researchers from the Federal Reserve Bank of San Francisco got a fair amount of play about a year ago and came to a different conclusion. The full report is available here. They see a strong relationship between the age distribution of the U.S. population and stock market performance too. But they see the aging of the baby boom generation as the key demographic. As Boomers reach retirement age, they are seen as likely to shift from buying stocks to selling their equity holdings to finance retirement. They report that their statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades. 

A helpful discussion of the methodological differences between the papers cited above by Cam Hui is available here.  Hui’s analysis also carefully notes that the differences between the respective findings are not all that great.  The San Francisco Fed researchers concluded that stock prices will bottom in 2021, instead of 2018 as implied by the other paper cited above.   That’s not much more than a rounding error for this types of analysis.

On the other hand (although, like Tevye in Fiddler on the Roof, there is no other hand), a Congressional Budget Office background paper published in 2009 comes to a different conclusion from that offered by the San Francisco Fed researchers.   The CBO paper argues that Boomers won’t sell assets very rapidly to finance retirement on account of several factors.

  1. Boomers will be careful — they are concerned that they might live longer than expected or might face higher than anticipated medical costs.
  2. Boomers desire to transfer assets to the next generation, which should also blunt asset sales.
  3. Since the wealthiest one percent of Americans own about one-third of the nation’s financial assets and, for the most part, the very wealthy don’t sell assets to finance retirement, this asset concentration will help to keep demand steady.
  4. Many Boomers may work longer than they otherwise would have due to losses of retirement assets due to the 2008-09 financial crisis (but the empirical evidence on this point is inconclusive and the impact might be small).

Wharton’s Jeremy Siegel, author of Stocks for the Long Run, says (unsurprisingly) that growth in developing countries should generate enough demand to absorb a baby-boomer selloff and “keep stock prices high.”

The CBO conclusion may be the key one in this context.

Although the retirement of the baby boomers is not likely to cause a large decline in aggregate demand for assets, several economic studies suggest that the retirement and aging of baby boomers could cause a temporary decrease in asset prices. … Empirical evidence, however, has not revealed much connection between demographic trends and the changes observed in financial markets.

Demographics surely matter. Correlations are important (even if distinctly different from causation). But so do lots of other things — like (duh) the strength of the economy or lack thereof and market valuations.  The market did not tank in 2000 on account of demographics and demographics isn’t controlling the nature and extent of this secular bear market even if and as it is a noteworthy factor.  Demographic trends are interesting, useful and important for the markets.  But there is no evidence that demographics is destiny.

A New Paradigm?

Fifty years ago this month, Thomas Kuhn’s The Structure of Scientific Revolutions was published, and it remains one of the more influential books of our time.  It is also one of the most cited academic books of all time. If you haven’t read it or read it recently, you might pick up a copy of the new 50th anniversary edition

If you have ever heard or used the term “paradigm shift” then you have been influenced by Kuhn.  Before Kuhn, our views of science were dominated by ideas about how it ought to develop (the “scientific method”) together with a sense of narrative, of science marching forward inexorably and heroically. 

Where the standard account saw steady, cumulative “progress,” Kuhn saw movement and discontinuities – a set of alternating “normal” and “revolutionary” phases in which communities of specialists in particular fields are plunged into periods of difficulty and uncertainty. These revolutionary phases (e.g., the transition from Newtonian mechanics to quantum physics) correspond to great conceptual breakthroughs which are often ignored or rejected for long periods prior to ultimate acceptance and which form the foundation for succeeding phases in which the breakthrough has become the consensus. That this version of history seems no-big-deal now demonstrates how powerful his ideas have become. 

Per Popper, “normal science” is distinguished by the fact that it focuses upon refuting rather than confirming its theories. However, and consistent with more recent discoveries of our behavioral flaws and biases, “normal” scientists in reality spend most of their time trying to confirm what they already think — their paradigm.  We shouldn’t be surprised whenever confirmation bias rears its head. 

That Kuhn deemed his book a mere “sketch” (only 172 pages) is part of its charm and its power.  It is simple, straightforward and easy to understand.  It just makes sense.

A “paradigm” as an intellectual framework that makes research possible.  It’s clear (to me at least) that the finance world needs a new paradigm.  Its model-driven alleged rationality just plain doesn’t work very well.  It doesn’t fit the data and is inconsistent with experience at nearly every level.  The best of cutting-edge financial, economic and scientific research today is data- rather than theory-driven.  Being data driven is a focus of this blog (see, e.g., herehere, here and here), as the masthead proclaims. I hope that our next financial paradigm (not to mention economic and political paradigms) is predicated not upon some overarching theory, but rather upon that which can be demonstrated to work.  That’s more than enough of an intellectual framework for me.

Thomas Kuhn deserves as much.

Does “Low Risk” Outperform?

A new paper by Robert Haugen, president of research house Haugen Custom Financial Systems, and Nardin Baker, chief strategist, Global Alpha, Guggenheim Partners Asset Management, claims that low risk (really low volatility) stocks consistently delivered market-beating returns in all of the 21 developed countries they studied between 1990 and 2011 (video here). Their research showed the same was true of 12 emerging markets they looked at over a shorter period since 2001. In essence, their idea is that low volatility stocks are boring and underappreciated but outperform because money managers are looking for the big score.

The very first sentence of the paper claims that “The fact that low risk stocks have higher expected returns is a remarkable anomaly in the field of finance.” Obviously, this assertion at least seemingly contradicts a basic premise of economics — that risk and reward are inherently connected.

While their conclusion is not original, the authors are not bashful about trumpeting their assertions. In fact, the paper could not have made its claim much more directly or triumphantly:

“As a result of the mounting body of straightforward evidence produced by us and many serious practitioners, the basic pillar of finance, that greater risk can be expected to produce a greater reward, has fallen.”

The study of  the 12 “observable” emerging markets included analysis of market returns in China, India, Brazil, South Africa, the Philippines and Poland.

But I’m not entirely sold. Here’s why.

1. The first sentence of the paper conflated expected returns with past returns.  That bonds have outperformed stocks over the past 30 years does not mean that bonds have higher expected returns going forward. 

2. Volatility and risk are hardly the same thing (see here and here, for example), so equating “low volatility” with “low risk” is a significant error.

3. If higher risk always led to higher returns, it wouldn’t be higher risk.

4. The referenced time frame is much too small to be conclusive (Antti Ilmanen, managing director of AQR Capital Management and the author of the terrific book, Expected Returns, agrees).

That said, it remains an interesting anomaly well worth exploring, particularly during secular bear markets (as these stocks should handle significant downdrafts better — see below, from Alliance Bernstein). 

However, despite the promise of a low volatility approach, I would focus more on a related category — low beta stocks (see here, hereherehere and here).

CFA Conference: The Puzzling Popularity of Active Management

The University of Chicago Booth School of Business offered this presentation examining the continuing popularity of active management. The moderator is David Barclay, COO of the Center for Research in Security Prices. The presenter is Lubos Pastor, Charles P. McQuaid Professor of Finance at the University of Chicago Booth School of Business. He is also a Research Associate at the National Bureau of Economic Research and a Research Fellow at the Centre for Economic Policy and Research. The focus of the presentation is why active management remains so popular. Note this article on this subject (more here).

My session notes follow.  As always, these are at-the-time notes.  I make no guaranty as to their accuracy or completeness.

  • Are there too many active managers?
  • Well-known stats — in 2011, 79% of large cap funds underperformed the S&P 500; the average equity fund lost 3% and the average hedge fund lost 5% v. S&P 500 being up 2%.
  • Even Peter Lynch now recommends passive investment.
  • Passive management now represents about 15% of the market.
  • Why is the active market so large given performance (the assumption is that people are stupid).
  • Pastor: It makes sense that the active market would be large even if investors are all smart.
  • Alpha becomes more elusive as more money chases it (competition to find mispricings).
  • Think of active managers as police officers and mispricings as crime.
  • With disappointing returns, investors change expectations and reduce active investment (but the reduction is cushioned by decreasing returns to scale!).
  • As passive management grows, active alpha will improve.
  • Past underperformance doesn’t imply future underperformance (just that some money should be moved active to passive).
  • Passive management should therefore only grow slowly (active should decrease slowly).
  • Without active management, there would be a lot of mispricings; thus at least some active management is optimal.
  • On an industry-wide basis, some active management makes sense; but does that apply on a personal/individual level?
  • As index funds get bigger, it will be easier for active managers to outperform.
  • Money to be made at the expense of index funds (e.g., buying ahead of an index reconstitution).
  • Burk & Green (2004): as funds get larger, it will be harder to outperform; Pastor agrees.
  • Passive management may need to grow substantially before we begin to see significant impact of the sort Pastor predicts.
  • CRSP has and will have some new index possibilities combining academic research and industry practice with objective and transparent measures (see here).
  • These indexes focus on investability.
  • Fewer U.S. securities since 2000 (down about 1/3); thus breakpoints (e.g., small to mid-cap) defined by cumulative market cap.
  • Bands around the breakpoints to decrease trading costs for passive managers.
  • Mega-Cap (top 70%; 284 stocks today)); Large (top 70%; 646 stocks today); Mid-Cap (70-85%); Small Cap (85-98%); Micro Cap (98-100%).
  • CRSP indexes and migration — considered many approaches; weighed trade-off between turnover and style-purity.
  • CRSP introduced the concept of “packeting,” which cushions movement between adjacent indexes (to reduce transaction costs).
  • Multi-dimensional approach to value and growth.
  • CRSP — Re-engineered market-cap-based indexes, emphasizing cost efficiency.