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Showing posts from 2009

Out With The Old Year, and In WIth The New

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Well, it's the last finally the day of the year. So, here's wishing you all a safe, happy, and prosperous New Year.

It's been a pretty eventful one in the Unknown Household - we had one son pass away from cancer, and had another one join the family. So, I can pretty much guarantee that 2010 will be less eventful for us than 2009 (at least I hope so).

We finished out the old year yesterday by taking the Unknown Daughter up to Boston to see the Science Museum's Harry Potter Exhibit. Total Cost:
Three Tickets - $93Parking - $9Various Junk from the Museum Store - $35Overcooked and dried food from the Museum Food Court - $20Hearing the Unknown Daughter say (wide-eyed) "This is Fantastic" - Priceless
Luckily, our two nieces were home from college., They drove down the night before to baby-sit Wonder Boy for the day, so we got to go without munchkin in tow. But Boston traffic still sucked - it took us 45 minuted to go about 3 miles on Rte 93 (and this was not eve…

As The Semester Winds Down

Since Unknown University starts (and ends) their fall semester a bit late, I'm just putting the finishing touches on my grades - two classes down and one (the smallest, luckily) to go.

It's been a tough semester - three preps (for the non academics among you, a prep is a unique class - so three preps means I taught three different classes), and one was a brand new one (Fixed Income) for me. I took it because the senior faculty who regularly teaches it took a sabbatical, and it's required of all our students. The new prep took far more time than I'd thought, so I didn't get as much research done as I'd hoped.

The winter break will be dedicated first to getting two papers completed and submitted to journals. I let things slide a bit these last few years due to the Unknown Son's illness, so I'm glad to be finally working on things that have the potential to go to decent journals - these two will likely be sent to Financial Management and Journal of Ban…

Lots of This White Stuff

I love living in the NorthEast - it's where I grew up, and there's just something about real winter that feels right. But I can do without 3-foot snowdifts in my driveway. Luckily I have neighbors with plows and snowblowers.

The Unknown Daughter was at a friend's house for a birthday party/sleepover. No school for her tomorrow, so we get to see if we can get the neighborhoods to build a huge snowman.

Good stuff.

Do Deficits Matter?

In a previous post I described the theoretical implausibility as well as the empirical rarity of governments inflating away their debt. I concluded that a deficit-driven buyer’s strike was unlikely, by itself, to pop the bond bubble.

Does this mean that “deficits don’t matter”? Oh no, quite the contrary. Deficits do matter, but it’s important to understand the mechanism. Deficits don’t operate via a buyer’s strike unless you go into hyperinflation. Instead the channel is monetary policy.

The Treasury issues bonds. The Fed buys them. As far as I’m concerned, that’s just an internal transfer. The external effect is not bond supply; the bonds never hit the street. Instead, the external effect is government expenditure. Essentially the Treasury is spending dollars that have been newly printed by the Fed.

In the short run this policy will boost private sector consumption and employment, as indeed it is designed to do. But in the long run it will lead to inflation; seigniorage alw…

Information Traders Must Be Compensated

I'm still in the thick of exams week (one to give today, one Friday, and one Saturday), and they're not all written yet. But this piece from Burton Malkiel in FT.com was worth highlighting. The best part was the last paragraph:
As de facto market makers, high-frequency traders can exploit pricing anomalies and pick up pennies at the expense of other traders. Such activities are not sinister. The paradox of the efficient market hypothesis is that the people whose trades help make the market efficient must be compensated for their efforts. As former SEC Chairman Arthur Levitt has written: “We should not set a speed limit to slow everyone down to the pace set by those unwilling or unable to compete.” High-frequency trading networks let large and small investors enjoy a more efficient and less costly trading environment.
Read the whole thing here.

HT: Abnormal Returns

R.I.P. Paul Samuelson

Paul Samuelson (the first American Nobel Laureate in Economics, and arguably the most influential economist of the 20th century) died today at home at age 94. He was largely responsible for the transformation of economics from a largely descriptive and discursive discipline to a highly mathematical and rigorous one.

He was responsible for turning MIT into a world-class economics center - over the years, he played a role in bringing in Solow, Engle, Klein, Krugman, Modigliani, Merton, and Stiglitz.

In addition, he wrote perhaps the single most popular and widely used economics text in history - "Economics", published in 1948. I read it in my undergraduate years in the late 1970s, and it was still selling 50,000 copies a year in the late 1980s.

A giant has passed.

Big Brother meets Ben Bernanke

[We interrupt our regular schedule of abstract pontification to bring you this quick note on price action]

All summer long, asset markets boomed while the US economy (in my opinion) more or less stunk. Why? Because of central bank policy.

Then on Friday we had a strong payrolls number (just 11k jobs lost, much better than expected).

I think this makes the Fed on the margin more likely to hike interest rates.

Sure enough, asset markets have been going down since the number came out.

It's almost Orwellian: war is peace, good news is bad news, strong numbers are weak numbers.

But that's what happens when you let asset prices be determined (supported) by central banks instead of by economic fundamentals.

Anyway, I'll go out on a limb and say that last week was the high for 2009 and we'll sell off into 2010.

This move will be reinforced by year-end risk reduction. Also, for what it’s worth, most technical indicators look really exhausted.

I have sold [EM] stocks aggressively over…

Backing off on Blogging For A While

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I need to focus on research for the next couple of months, so blogging will likely be much less frequent for a while. I'm not closing down, but I am scaling back - probably only a post a week or so. In the meanwhile, here's a picture of the Billboard for Anders Bookstore, which is just at the edge of the Auburn campus. Smart marketing.



For any students reading - good luck with finals - if you're at Auburn, consider a longer rental term. For all the faculty - good luck writing (and grading) them and wrapping up the semester.

Buyers' Strikes and the Debt Treadmill

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Here’s what I wrote last week:
Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.
Sure enough, and with dreary predictability, commentators from left and right have divided along partisan lines in their analysis of the deficits. Here’s conservative historian Niall Ferguson:
There is no end in sight to the borrowing binge. Unless entitlements are cut or taxes are raised, there will never be another balanced budget. By 2039, when I shuffle off this mortal coil, the federal debt held by the public will have reached 91 percent of GDP, according to the CBO’s extended baseline projec…

The Next Bubble: Are We There Yet?

My previous twoposts make it clear that all the conditions are in place for a bond bubble: strong fundamentals, technical momentum, and a mechanism for positive feedback. But these conditions are merely necessary; they are not in themselves sufficient to generate or identify a bubble.

Nonetheless there are certain indicators that suggest we may be entering bubble territory.

Let’s start by looking at the fundamentals again. One sign that a market has transitioned from boom to bubble is when the fundamentals change from bullish to bearish, but prices keep rising. I believe that this is true for the bond market. Let’s consider each of the factors I identified in my earlier post, in order:

1. Monetary policy seems to have regressed in recent years. In particular, central banks are no longer strict inflation-targeters; they have become asset-price-targeters instead1. Central banks are also less independent than before2. Finally, central banks have explicitly moved from trying to head…

Happy Thanksgiving

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This is a bit belated - I started it, and then didn't finish before all family got here for the festivities. But better late than never, eh?

Here's hoping you all had a Happy Thanksgiving. It's a good exercise to occasionally thing about the things we're thankful for, so here's a few of the things I'm particularly thankful for:
My Family - I somehow managed to marry well above my station (the Unknown Wife is far better a person than I deserve, with the exception of her poor taste in spouses), I have a nine year-old daughter who still thinks her dad is pretty cool (I figure I still have another year on that score), and a very good-natured 8 month old baby boy (yeah, I'm too old for this stuff, but it's still pretty cool). My Job - I love being a professor (well, at least most of the time). I spend my workday with smart people, I get to learn interesting things about topics of my choice (they call it research), and teaching is pretty fun. And they pay…

The Next Bubble: Positive Feedback

There are three types of positive feedback in the market: irrational feedback, rational feedback, and reflexive feedback. To distinguish between these, let me quote a previous post at length:
In a bubble, the dominant mechanism is positive feedback; the key to understanding bubbles is understanding this positive feedback. How, then, does positive feedback arise?

The most obvious explanation is the conventional one: positive feedback is a consequence of irrationality in the market. And there’s certainly an element of truth in this explanation. Greed, self-delusion, unjustified extrapolation, caring more about relative returns than absolute profits (a.k.a. “keeping up with the Joneses”), conformism (a.k.a. “if everybody else is doing it why can’t we?”), confusing the improbable with the impossible (“house prices will never go down nation-wide”) and other persistent behavioral flaws lead inevitably to bubbles. This has been true throughout the history of speculation.

But one doesn’t have t…

The Next Bubble: Fundamentals and Technicals

In my opinion there are three necessary conditions that have to be in place for a bubble to inflate: fundamentals, technicals, and feedback. Let’s look at each of these in turn.

Preceding every bubble there is a boom: a justified increase in prices driven by positive fundamentals. In the aftermath of a bubble, it’s easy to mock the excesses that marked the bubble’s apogee (boo.com! ninja loans!) but all too often people forget the backstory. In fact there were very good macro and micro reasons why the tech sector boomed in the early 90s, and why real estate boomed in the early 00s; it wasn’t all froth.

So, have the fundamentals been positive for bonds? I think the answer is yes, they undoubtedly have. Here are some of the factors that have led to lower and more stable interest rates over the last few decades, in no particular order:

1. Improved monetary policy – specifically, central bank independence and inflation targeting – starting with the Volcker Fed
2. The end of the cold war;…

The Next Bubble: Disclaimer and Disclosure

Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.

So, in the interests of full disclosure, and for what it’s worth: I am not a US citizen or resident, I do not pay US taxes or receive US benefits, I am not currently connected with the US financial industry (except as an external observer and generic investor), and I do not support any US political party. In short, I have no dog in this race.

All I want to do is understand what has happened, what is happening, and what will happen, insofar as (and no further than!) it helps me as a trader and investor. And my current under…

The Next Bubble: Introduction

Bubbles fascinate me. Nowhere else will you find such a variegated proving ground for the vagaries of human psychology, nor such a vivid illustration of the wondrous complexity that is the market. The various tensions on display – between individuals and institutions; between incentives and emotions; between rationality and greed; between the short term and the long run; between macro economics and micro behavior; between fundamentals and technicals – offer limitless scope to the curious observer.

If the study of markets is the study of human nature, then the study of bubbles is the study of markets in microcosm.

My fascination with bubbles will come as no surprise to regular readers of this blog, as evidenced by my choice of subject matter. In recent weeks I have written about bubbles and the rational trader; scale invariance in bubbles; feedback effects in bubbles; the link between asset price bubbles and jobless recoveries; the identification of bubbles; and the stages in the ev…

SNL Takes a Chunk Out of Obama

Looks like SNL is finally starting to put Obama in the cross-hairs:

The funniest part (a little rude, but funny nonetheless) is about 2/3 of the way through - "Will you kiss me? I believe it is the polite thing to do when someone is doing sex to me!"

Not a good sign for the President - to this point, comics have been slow to start ragging him. Looks like the honeymoon's over.

Amazing Dance Video

A friend just sent this. They call this guy (Robert Muraine) "Mr Fantastic" after the rubber-limbed comic-book hero in the Fantastic Four. Here's a clip of his entry on "So You Think You Can Dance".

I used to have what's called hyper-mobile joints (before I got old and still) - I could easily get my elbows well past each other behind my back, do full splits, get my feet behind my head, and so on.

But this is in a whole 'nother world.

Bulls and Bears: How Asset Prices Evolve

In last week’s post I mentioned three stages in the evolution of a market:
Identifying full-blown bubbles is easy. What’s not so easy is identifying the transitions that bookend a bubble. It’s not easy to know precisely when a rational, fundamentals-driven boom will morph into an irrational, sell-to-the-greater-fool frenzy. It’s not easy to know precisely when an irrational frenzy will reverse into an equally irrational stampede for the exits.These three stages – rational boom, frenzied bubble, irrational panic – are in fact just three out of a total of six stages in my own idiosyncratic (and highly unscientific) taxonomy of bull and bear markets. Here’s how it works.

The first stage in any bull market is what I like to call the bounce. A sector or asset class that has been moribund for years or even decades suddenly starts rising in price. This could be due to exogenous shocks such as regulatory or technological changes; it could be due to Schumpeterian creative destruction, wherein…

Scott Adams Must Be Eavesdropping on My Email

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This sounds like a couple of my students. For some reason, family deaths always seem to increase around exam time.

Identifying Bubbles: It's Really Not That Hard

In an opinion piece written for the Financial Times on Monday, former Fed governor (and current Columbia professor) Frederic Mishkin argues that central bankers cannot reliably identify asset-price bubbles; that certain types of bubbles – specifically, those without a credit element, which Mishkin calls ‘pure irrational exuberance bubbles’ (sic) – do not do much harm when they pop; that central bankers should not, in fact, try to pop the latter type of bubble; and that when in doubt a central banker should err on the side of benign inaction.

Implicit in all these arguments is the Greenspanist view that policy is better suited to mitigating the painful after-effects of a popped bubble, than it is to spotting and deflating the bubble in the first place. I was under the impression that this particular stance had been discredited along with the rest of Alan Greenspan’s philosophy of central banking, but evidently not. Here are the relevant quotes from Mishkin’s piece:
Because the second…

Spreadsheets, Spreadsheet, and More Spreadsheets.

Yesterday, I thought I was coming down with something - I had a sore throat when I went to bed, and I woke up this morning feeling kind of blah. So, I thought I'd muddle through my classes (unfortunately, it's my long teaching day), and then come home and go to bed. By the end of the day, I felt like I'd been beaten with a stick - sore and feeling heavy-limbed all over.

But, it was the Unknown Daughter's birthday, so we had festivities first.

Then, I thought I'd put in a little work on before going to bed. Big mistake.

I started working on some spreadsheet models for my Fixed Income class at about 9 (just for an hour or so, I thought). Before I realized it, it's 3 a.m., and I've stayed up too late once again.

So far, I've made two spreadsheet models. One calculates duration and convexity for any combination of coupon, maturity, frequency, and yield, along with some graphs. The other calculates the average life of a mortgage pass-through based o…

History: It Ain't Just Bunk

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Human beings are good at interpolation, passable at extrapolation, bad at identifying inflexion points, and downright terrible at processing one-off events. It’s no coincidence that these skills are, sequentially, associated with increasing investment success: the harder it is to do something, the more money one makes for doing it.

This particular progression from easy to difficult is not merely the artifact of some deep-seated behavioral tendency or evolutionary bias. Deterministic and presumably unbiased algorithms, faced with unprecedented events, perform just as badly as humans. This is only to be expected: the very word ‘unprecedented’ implies that there is no baseline to build from or compare with, a circumstance under which most algorithmic approaches tend to flounder.

Unfortunately for all concerned, real life is full of one-off events. What we call history is, as Rudge memorably puts it, just one bloody thing after another. And that’s precisely why I’m suspicious of attemp…

The Unknown Colonoscopy

Disclaimer: the following post is not for the faint of heart (or for those who have an overly developed sense of propriety). But then again, most of my readers aren't in those categories anyway.

Since I recently turned 50, I got to have that little procedure that comes with the turf - a colonoscopy. The actual deed wasn't bad at all, but the prelude was, shall we say, less than enjoyable. Since the docs want a clear "field of play". they make you go on a clear-liquid diet for the day prior to the procedure. So, I got to teach 3 classes on a diet of Jello, black coffee, and chicken bullion - not the easiest thing to do.

More importantly, they give you what they call "prep". the best way to give you a feel for what that involves is to point you towards this this classic video (warning: may not be safe for work - so turn the audio down a bit). The "prep" is essentially laxative mixed with rocket fuel. On the bright side, I got to read a coupl…

Damodaran on the Equity Risk Premium

The Equity Risk Premium is one of the central concepts of finance theory and practice. However, when we teach it in class (usually as part of the CAPM), we tend to do a lot of hand-waving and tell students to use historical ERPs. Aswath Damodaran of New York University has an excellent piece on SSRN titled "Equity Risk Premiums: Determinants, Estimation, and Implications" that's a must-read whether you're a professor, student, or practitioner. Here's the abstract:
Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected…

Some Thoughts on Buttonwood's Trifecta

Buttonwood’s column this week is typically thought-provoking. She starts with the observation that three major asset classes – stocks, bonds and gold – have all produced double-digit returns in the last three months. She then points out that this is not usual: indeed, it has only happened thrice in the past fifty years 1. And for good reason: the three asset classes have very different exposures to risk (equities are risky, bonds and gold are canonical safe havens) and to inflation (gold is a good inflation hedge, bonds are not, and equities lie somewhere in between). She describes various fundamental explanations (divisions in investor opinion; inefficient markets; central bank intervention; increasing risk appetites). And finally, she lays out her own explanation: liquidity.
Low interest rates are driving investors out of cash and into anything that offers either the prospect of capital gain or a yield that is higher than zero. Investors used to talk about a ‘Greenspan put’ th…

Some Thoughts on the Phillips Curve

Of all the economists, journalists and assorted financial industry participants who comment on the web – and there’s certainly no shortage of them – the one whose views align most closely with my own is James Hamilton of UC San Diego and Econbrowser. I find that I rarely disagree with him, whether it’s on macroeconomics, oil, securitization, financial markets, or anything else. So I was interested to see him make the case that ‘high levels of unemployment are a factor that will put downward pressure over the next two years’.

His argument is straightforward: he regresses historically realized inflation against unemployment, and also against lagged inflation (the latter is to account for expectations of inflation). He finds a statistically significant negative coefficient for the period from 1948 to 2007, validating the classical Phillips Curve relationship. Since unemployment is currently very high, inflation is (ceteris paribus) likely to be contained over the next few years.

My …

I'd Eat That

I just stopped by my favorite (on campus) coffee, bagel, and sandwich shoppe - I'm spending the afternoon grading exams that are due back tomorrow (groan).

Their latest sandwich offering is a Veggie Burger with Tomato, Onion, Provolone cheese, and Bacon. That's right - a veggie burger with bacon - probably the only way I'd eat one of those. Actually, it sounds pretty good. Bacon improves just about everything.

Talking With Practitioners

Unknown University recently had a function where they brought back a number of prominent alumni to talk about various topics. At dinner after the function, I ended up at a table with an MD from a major investment bank who manages about 10Billion overall in both traditional funds and alternative investments in the market where I'm currently doing some research. It was not by chance - I offered to lead a session that he was the main speacker for, and asked to be put at his table afterward.

So, at dinner (in between him checking his Blackberry every few minutes (dan - that is distracting), I got a chance to see whether my story about what I saw in my data passed the "sniff test" from someone who works in that market on a daily basis. Luckily, it did. Having topped that bar, we started talking about what sorts of things his firm has done in terms of research on the particular topic. So, it looks like I made a connection that could result in my getting some pretty scarc…

Best Headline Ever

I'm a big fan of satire. But sometimes reality comes out with something that's far funnier and more bizarre than anything I could have come up with (even during the 70s, which were very, very interesting). Here's a newspaper headline that I just can't get out of my mind:

One gay man, two lesbians, a three-legged cat and a poisoned curry plot.

From the Mail Online. Hey - brit tabloids just do this stuff better than us.

Occam's Razor vs. Occam's Professor

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I try not to be Occam's Professor - unless it's the right thing to do.

Jobless Recoveries and Asset Market Bubbles

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Asset markets around the world have rebounded quite substantially from their lows of earlier this year. As a result, attention has increasingly become focused on the Federal Reserve’s ‘exit strategy’1. Can the Fed raise interest rates, or even credibly threaten to do so, given the bleak state of the labor market? Some central bankers think so; here’s the Philly Fed’s Charles Plosser:
As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.Others are more cautious, and would like to see a rebound in employment …

Williamson and Ostrom Win Nobel In Economics

The announcement just came in - The Nobel Prize in Economics (actually the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, to be precise) was awarded jointly to Elinor Ostrom(for her work on usage of common goods) and to Oliver Williamson(for his work on business as means of mitigating transactions costs). While I'm familiar with Williamson's work, I'm not with Ostrom's - so it looks like some reading is in order..
Click here for a list of past laureates.
In somewhat surprising related news, Obama was not awarded the prize (neither was Michael Moore or Timothy Geithner).

Obama Awarded Nobel Peace Prize

When I read this morning that Obama had been awarded the Nobel Peace Prize, I first thought it was a joke. Then, when I found out that it was real, I realized it was still a joke. Unfortunately, it was one that the prize committee played on themselves. They've definitely beclowned themselves - if I were to guess why they gave it to Obama, I'd have to say "Because he's not Bush").

I know, I know - this isn't a political blog (it's supposed to be about finance, or at least about being a finance professor). But some things cry out for comment.

Since it's Friday at 5:00, I guess it's time to call it a day. If the weather holds out, I'm trying a 100 kilometer ride tomorrow. Should be interesting - the course is not as hilly as the last ride. But, it might rain, in which case I'll stay home.

update: a reader just informed me that nominations had to be in by February 1st. So that means that Obama was nominated after eleven days in office.

Feedback in Financial Markets

In a previous post, I mentioned that bubbles were characterized by – indeed, defined by – positive feedback. This idea, and more generally, the importance of feedback in driving market dynamics, deserves a lot more ink. Here’s a first installment.

Classical economics is often concerned with analyzing various equilibrium outcomes (“comparative statics”). These outcomes are usually generated or maintained by some sort of negative feedback. The simplest example is that of security prices. Under the efficient markets hypothesis, each security has a fair price reflecting its ‘fundamental value’; furthermore, this fundamental value is known to market participants in aggregate. If the actual market price drops below this value, people step in to buy the security; if the price rises above it, people step in to sell. As a result of this negative feedback, the market price equilibriates to its natural or fundamental value.

Unfortunately markets do not always tend to equilibrium. Negative f…