Bubbles: Knowing You’re In One Is Not Even Half The Battle

Select excerpts from Aaron Brown and Richard Dewey’s paper:

Toil and Trouble, Don’t Get Burned Shorting Bubbles (SSRN)

It was not a mystery that there was a bubble in subprime from 2005-2008. That did not mean shorting it was an easy trade. With the benefit of hindsight, we can learn about the risks of shorting frothy assets that may even be a bubble.


From the abstract:

Bubbles are among the most puzzling and controversial phenomena of financial markets. Although rare, their cumulative impact on both investor returns and the broader economy can be great. One particular question that has motivated research is why shrewd short sellers don’t prevent excessive price increases. The “limits to arbitrage” idea argues that correcting inefficient market prices is neither easy, cheap nor riskless. The “rational bubble” literature identifies situations in which being long the bubble is a better trade than being short, even if investors know for certain the bubble will pop.

We examine the “short subprime” trade from 2005 to 2008 to evaluate these and other explanations. We argue that the short subprime trades had more risk than is commonly appreciated. We discuss how the opaque and illiquid nature of subprime mortgages deterred some investors from purchasing CDS contracts and note that other investors assessed the risk of counterparty failure, government intervention and unknown time horizon to be sufficient enough not to purchase CDS contracts.

Talking to investors who saw the bubble and passed on shorting it, instead opting for alternative strategies:

We interviewed and analyzed the internal research of several investors who evaluated the short subprime mortgage trade and decided not to purchase CDS contracts and present some of their reasoning below.
    • The Basis Trade: Magnetar Capital in Chicago.

      Magnetar did not cooperate with the media, so their story has not been widely told. Magnetar reportedly employed a strategy whereby they purchased the riskiest equity tranche in many CDOs which often offered double-digit returns. They used this positive carry to pay for protection on the AAA tranches that most investors assumed were safe. Magnetar appreciated that the correlation between the safest AAA tranche and the lowest quality equity tranche would be close to one in a crisis due to the way these securities were constructed.

    • Picking-up-the pieces trade: Soros and Tepper

      Soros

      Perhaps the safest way to profit from the subprime mortgage meltdown was the time-honored method of picking up the pieces at the bottom. George Soros and his Chief Investment Officer Keith Anderson smelled opportunity and hired two ex-Salomon Brothersmortgage experts, Mason Haupt and Howie Rubin.

      Tepper

      David Tepper purchased shares of Citi and Bank of America near the bottom, helping his Appaloosa fund return 120% in 2009 on $12 billion in capital.

    • Convex-listed hedges correlated with a downturn: Talpins and Dalio

      Ray Dalio at Bridgewater and Jeff Talpins at Element Capital are rumored to have purchased futures or options on government bonds that would rise in value if the Fed aggressively cut interest rates. Many on Wall Street believe that Element purchased Eurodollar options in 2007 that helped his firm generate returns of 26.4% in 2007 and 34.9% in 20083. Talpins has posted annualized returns north of 20%, without a single losing year in the decade that followed. And simply being long volatility in equity markets, fixed income or currency markets paid off nicely for many traders. The key to these trades is that they removed some of the unattractive aspects of the subprime trade, by using more liquid instruments, waiting for the crisis to materialize or constructing more nuanced expressions.

The collection of people that did these trades: George Soros, David Tepper and the team at PIMCO are investors with long-term track records. They made their money quietly, in sensible trades over several years, and were also able to put large amounts of capital to work.

The sobering difficulty of the short subprime trade:

Betting against subprime mortgages worked, but it was somewhat of a Goldilocks trade: it required default rates to get high enough to generate profits on your insurance, but low enough that the banking system survived to pay you and that the government didn’t help out borrowers at your expense.

Current backdrop:

As we write this analysis in the first quarter of 2021, financial market pundits are calling bubbles in everything from cryptocurrencies and TSLA to SPACs, high-end real estate and, most recently, stocks hyped on Reddit.

My takeaways:

    • Shorting subprime looked like a hero trade but the path was painful and uncertain. You needed to weather the negative carry and margin calls on bilateral trades with banks for years. And you needed to bet against on institutions that were not bailed out.
    • Taking a bubble on straight ahead looks like foolish risk reward, especially if the bubble is “rational”1 and has no clear correcting catalyst.
    • Need to think about the risks and incentives of the system. For example, if you believe bonds are currently overpriced and shorting them, even with their low-yield and therefore relatively small negative carry, you cannot ignore the possibility that the rules can be tampered with in the name of the system. Just as banks were bailed out, it’s not impossible to imagine a yield curve control policy (YCC) similar to post-WWII would cap any upside on a short Treasury trade.
    • The paper describes what you are up against eloquently:

      The reality is that structuring good trades is often every bit as difficult as forecasting. This is particularly true if a trade is contingent on a crisis materializing, when pricing is less reliable, liquidity dries up and contractual obligations are sometimes not honored. In these instances, trade construction is everything. Even if an asset price bubble can be confidently identified ex-ante (no easy task), making money from the bubble is perhaps equally challenging….

      This separates opinion havers from risk-takers. Getting the right odds on the right contingent payoff in the state of the world that matched that payoff. And then actually being able to collect. Having an opinion on markets is like have a business idea but no ability to execute.


Graham Duncan’s “What’s Going On Here, With This Human?”

Excerpts from Graham Duncan’s “What’s Going On Here, With This Human?” (Link)

Interviewing is really a narrow application of a broader art. Duncan begins:

The philosopher Kwame Appiah writes that “in life, the challenge is not so much to figure out how best to play the game; the challenge is to figure out what game you’re playing.”

When I try to figure out what game I’m playing, I see that for the last 25 years I have been playing a game of strategy applied to people, a game where over and over I try to answer the question “what’s going on here, with this human?”  In this essay, I make recommendations about candidate selection based on thousands of assessments I have made and my somewhat obsessive interest in the topic.

My goal in this essay is to help others make better decisions on a potential hire, business partner, or even life partner as quickly and as accurately as possible.  It’s made up of suggested action steps and some of the ruminations that underlie them. At the end I include my own assessment of different personality assessments and some of my go-to interview and reference questions.

These notes are select excerpts from the essay that I want to keep as a reference. My favorite line from the entire essay:

One of the greatest gifts we have for each other, for our children and spouses, for our teammates, is the positive feedback loop we can put someone into purely by believing in them, by seeing their genius and their dysfunction clearly and then helping them construct conditions for the former to flourish.

That emphasis is mine. I consider this to be one of the cheapest forms of human capital and this essay is ultimately about allocating that capital.


From the introduction

My summary: When we interview someone for a job we are looking for signs that they will do the job well. But when our goal is to “see someone clearly”, our focus shifts to finding the best role for them.

Excerpt

It can be useful, when interviewing someone, to take Rumelt’s cue and ask explicitly: what’s going on here with this person in front of me?  The more I’ve done it, the more I realize that what most people think of as the hard parts of hiring—asking just the right question that catches the candidate off guard, defining the role correctly, assessing the person’s skills—are less important than a more basic task: how do you see someone, including yourself, clearly?

Seeing people clearly—or at least more clearly—matters not just when finding the “best” hire, but in identifying the best role for them. Even looking at those of us who are lucky enough to have a high degree of choice about what we do with our work, I’ll bet that as few as 20% of us are in the seat that best optimizes our talents and skills at any given time—the seat that makes us feel at home in the world. That’s not good for the 80%, and it’s not good for their teams either.

The poet David Whyte describes the unfolding of life and career as a “conversation with reality”:

Whatever a human being desires for themselves will not come about exactly as they first imagined it or first laid it out in their minds…what always happens is the meeting between what you desire from your world and what the world desires of you. It’s this frontier where you overhear yourself and you overhear the world.And that frontier is the only place where things are real…in which you just try to keep an integrity and groundedness while keeping your eyes and your voice dedicated toward the horizon that you’re going to, or the horizon in another person you’re meeting.

Whyte captures how hiring can be an art form. When you see people clearly, you see the transcript of their conversation with reality up until that moment of your meeting, and you glimpse the horizon that stretches out ahead of them. And then sometimes you can help them overhear themselves and overhear what the world wants from them, whether or not that includes working in the role that you had initially imagined for them.

Part I: Seeing your Reflection in the Window

My summary: The role of being an interviewer can affect your judgment in ways in which you are not aware.

Excerpt

If I picture my thirty-year-old self doing an interview, I see him as the friend looking through the window: not seeing the way his mind was constantly making snap judgments about the candidate, creating stories with the slightest bit of material, “I like this,” “I don’t like that.” He would project his reality onto the reality of the other person, missing that, for instance, often even very senior people are not their usual selves in a formal interview setting, that there’s a power dynamic that he should not take lightly. He would not yet be aware that while his sensitivity to being hustled is a gift, it also creates a blind spot that causes him to mistakenly pass on a particularly good sales person or someone who is earlier in their career and still relies on jargon or cliché.

Part II: Seeing the Elephants in the Room

My summary: There are meta-techniques for overcoming your own blindspots

Excerpt

So let’s reframe the interview process: there are two elephants in the room, yours and that of the person you’re trying to see. The bad news is that you’re mostly blind to both elephants. The good news is that there are a lot of other riders who’ve traveled alongside the other rider and elephant. If you take your perspective on the rider and your glimpses of his or her elephant, and add everyone else’s experience of the rider and their elephant, and then control a bit for your own elephant and the references’ own elephants, you can get a good sense of how the candidate’s rider-elephant combination behaves.

Diving into techniques:

  • During interviews, I try to create a stillness that helps separate signal from noise, elephants from riders.

    During interviews, I try to create a stillness that helps separate signal from noise, elephants from riders. The easiest way to create conditions of stillness is to talk very little. It also helps to have the candidate you’re trying to see clearly ask you questions. Questions have very high signal value compared to most anything else you can get from a candidate. This is harder to do in practice than you might think—you need to make the candidate feel safe enough to ask their true questions, and you need to answer concisely or you’ll run out of time (which is particularly hard if the person asks good questions). I write down each question and sometimes respond with “I’ll answer, but first I’m curious, why did you ask that?” I’m looking for the felt sense of a “hungry mind” based on the way their questions flow. That’s very hard to fake.

    I like asking up-front, “So what criteria would you use if you were the one hiring someone for this role?” I love this question because of how unexpected the answers are. Some are tactical when you expect abstraction. Some improve your own criteria. Some use jargon that may indicate they are playing someone else’s game versus authoring their own. All are quite revealing.

  • I now consider in-person references with someone who knows the candidate well 5x more valuable than an interview. They can be 10x more valuable when you are already in a high-trust relationship with the reference-giver, and the reference-giver is in a position to see the candidate clearly, with no agendas and few blind spots of their own.

    • Given the importance of references, the highest purpose of your own interview with a candidate might be to improve your ability to conduct reference interviews, where you hold your own view as just one in a collection of views. This requires an ability to hold multiple perspectives at once. This is difficult to do because your own impressions from the interview are so vivid and multi-sensory, and everyone else’s views are mainly conveyed through language. In my experience, holding your own perspective alongside those of references should feel slightly uncomfortable and disorienting, or you’re doing it wrong. You should find the candidate confusing at times. If you first see their dysfunction, you should know you have yet to find their genius, and vice versa.
    • I try to conduct references with an eye to quirky forms of excellence. When I’m on the receiving end of reference calls, I notice that the caller is often subtly framing the exercise with a mildly suspicious “gotcha” vibe (“so why did George leave after only two years?”). I don’t find that particularly effective; it tends to make me shut down as a reference giver. Instead, when I’m calling someone, I try to imagine myself as head of people operations for the entire hedge fund or private equity ecosystem, that I’m agnostic as to where they should sit and just trying to help them get to the best spot.  That mindset seems to allow me to size up people more generously and accurately, and to accommodate more quirkiness…I also try to stick to the default assumption that “everyone is an A player at something.” It’s a more effective and more dynamic way to approach an interview—a live, fascinating puzzle to discover what the elephant and the rider do well—rather than going in with the purpose of determining whether someone is an A player in a binary, Manichean way. I prefer to imagine that I’m trying to find the candidate the best possible job for them; it may be the job I had in mind, or something else altogether.
    • As your sample size of references goes up, you can begin to calibrate on the credibility of the reference giver (what’s their sample size? What are their biases?) as well as to tune into what a “table-pounding” reference sounds like. Fourteen years later I still remember a reference I did for our CFO hire: the woman who had worked with him had a tone of “why are you wasting your time talking to me and not spending your time trying to convince him to join you?”

    • The hardest part is understanding the dog that doesn’t bark. If you don’t hear that table-pounding from someone who knows the reference well, is it contextual in some way (the person is tired, you caught them right after a tough conversation, they are jealous, etc.) or is there signal there? It’s one element of the process that requires the 10,000 hours of practice to get calibrated.

 

Part III: Seeing the Water

My summary: After making best efforts to illuminate your own blindspots, you also need to consider the context from which the candidate you are evaluating emerges.

Excerpt

I now believe that there is no such thing as an A player in the abstract, across all time, in whatever ecosystem they end up in.

Considering the candidates’ context:

  • When you’re taking someone from one ecosystem to another, changing their context, you have to try to see the water in both.

    • It’s disruptive and risky to take someone out of the setting in which they’re thriving, since there are a lot of subtle things going on in the original that may not be immediately obvious. How much of their success depends on the water in the first ecosystem?  Was there someone there who believed in them that set a positive feedback loop in motion that may not persist across systems? Try to understand as much as possible about “what’s going on here” in the candidate’s prior ecosystem. For instance in the investment management context, often a portfolio manager will run a large idea by their boss and subtle reactions (a raised eyebrow, a long pause) will cause them to actually size the position smaller.  That constant tension is constructive, and if you take the portfolio manager out of that container they will not perform in the same way in the absence of the tension. This particularly applies to people who leave to start their own companies—in part because they may have a hard time recreating the culture and context that allowed them to thrive when they worked in a structure designed by someone else.

    • It’s even possible that strengths in one context become weaknesses in another. Take someone who is super motivated and who loves to win, but because of this competitiveness doesn’t give as much as they get from peers. In one ecosystem they develop a reputation as a talented “taker” that people are wary of, while in another they are celebrated without reservation.

    • It’s even possible that strengths in one context become weaknesses in another. Take someone who is super motivated and who loves to win, but because of this competitiveness doesn’t give as much as they get from peers. In one ecosystem they develop a reputation as a talented “taker” that people are wary of, while in another they are celebrated without reservation.

Discussion of Personality Tests

The Big 5 or OCEAN personality test

My summary: I have noticed this is a favorite of the tech world. Marc Andreesen addresses the focus on ‘concientiousness’ in his interview on education (my notes here). Founder Slava Akhmechet says the Big 5 personality traits “are kind of like Myers Briggs, except real.”

Excerpt

There are thousands of studies using the Big Five. Within psychology, it’s the equivalent of gravity, and at this point, nearly everyone in academia finds it a useful mental model for personality. Sam Barondes’ book Making Sense of People is a great introduction to the Big Five. I tracked down Sam and asked him about the book’s raison d’être. He told me that he wrote it because he knew the Big Five was solid as science but had noticed that, in his own hiring in the medical department at UCSF as well as among the fancy tech CEOs he counseled, no one was actually using it in practice.

ghSMART 

My summary: A high-signal form of interviewing described in Geoff Smart’s book Who and his father Brad Smart’s book Topgrading. 

Excerpt

“Resourcefulness” is the meta competency:  

Resourcefulness is the single most important competency, so here’s my advice: look for evidence of Resourcefulness 100% of the time as you evaluate candidates. Imagine that you have special magical glasses that register through the lens whether the candidate is, at this moment, revealing Resourcefulness and maybe then it flashes green, or lack of Resourcefulness and maybe then it flashes red. I’m making the point that Resourcefulness is not a competency you first think of after the interview while you’re reviewing your notes. You must constantly ask yourself, “Does that example, what I’m seeing, what I’m feeling, what I’m hearing, show Resourcefulness, or lack of it?” 

I sometimes imagine I’ve dropped the candidate I’m interviewing on a desert island and I come back five years later. Some people I’d worry about, some people I wouldn’t. The Y Combinator application question “what’s a system or game you’ve hacked in the last year?” is a good arrow in the quiver when exploring the resourcefulness dimension.

Guide to References

  • Preparing for reference calls

    Before calling references, Duncan and his team review these points:

    • There are two kinds of information: public information and private information. Our personal assessments of our peers and former employees are firmly in the bucket of private information. That’s both what makes references valuable, and what makes them hard to get.
    • Your mission is to collect as many private assessments on your candidate as possible.
    • Remind yourself that your base case is that you will not proceed with the candidate despite the fact you’re at the stage of doing references. You want to create a default mindset that listening to the references is going to actively make you change your mind to make the hire. “Let the references speak” is our mantra.
    • For each candidate there is often one reference that is the motherlode, the Yoda reference—the unbiased, calibrated, no bullshit, clear-eyed reference, someone with “acerbic good taste” who has experienced your candidate with limited ego baggage of their own and is willing to transfer that private information to you. Sometimes you get them on the first call, sometimes it’s on the 20th call. Have you found that reference giver yet? If not and the context permits, do not proceed with the hire, allow yourself to hold the uncertainty.
    • Assess whether the reference giver is calibrated—what’s their sample size and do they actually know what excellence in this role is? (Assume 80% of people are not calibrated on the Michael Jordan of this thing.)
    • Assess whether you find the reference givers themselves credible. Identify any biases. Would you hire the reference givers or want to work for them? If not, make sure you weight the content of the reference slightly lower.
    • Try to mess with the expected “script” of a reference conversation, where the reference giver reads a LinkedIn testimonial and you read from a check-list of questions. Skim the questions below in advance in order to have them in mind, but try not to read from the list because it creates a different dynamic, more interrogation and less creative exploration and appreciation of someone’s idiosyncrasies.
    • The dog that doesn’t bark is the hardest thing to assess and requires calibration / a big sample size —what could they say on the positive side but are not saying?
    • Do references in person if you can, Zoom is second best, phone is third best.
    • Start with an opener that makes it safe to convey private information: “Thanks for taking the time. I’m trying to find the right seat for Jane and I’m investing the time in speaking to people who know her. Everything you say will be off the record, and I don’t plan on conveying any of it back to Jane.”

  • Reference questions

    • How would you describe Jane to someone who doesn’t know her?
    • What’s your sample size of people in the role in which you knew Jane?
    • Who was the best person at this role that you’ve ever seen?
    • If we call that person a “100”, the gold standard, where’s Jane right now on a 1-100?
    • Does she remind you of anyone else you know?
    • If Jane’s number comes up on your caller ID, what does your brain anticipate she’s going to be calling about? What’s the feeling?
    • Three attributes I like to keep in mind are someone’s hunger, their humility, and how smart they are about people. If you were to force rank those for Jane from what she exhibits the most to least, how would you rank them?
    • What motivates Jane at this stage of her life?
    • If you were coaching Jane, how would you help her take her game up?
    • If you were going to hire someone to complement Jane doing the same activity (NOT a different role), what would they be good at to offset Jane’s strengths and weaknesses?
    • How strong is your endorsement of Jane on a 1-10? (If they answer 7, say actually sorry 7s are not allowed, 6 or 8? If the answer is an 8, “What is in that two points?”)

Guide to Interviews

  • Preparing for interviews

    • Remember that your mission is primarily to get to know the person well enough to do effective reference checks
    • Can you glimpse the person’s elephant as distinct from the rider, who is speaking to you?
    • Can you establish enough safety to allow the frame of “how can I help you find the best job for you in the world?” instead of “are you an A player, are you a fit for this role?”
    • Interrupt often to establish a fast cadence and avoid monologues

  • Interview Questions

    • What criteria would you use to hire someone to do this job if you were in my seat?
    • How would your spouse or sibling describe you with ten adjectives?
    • I think we’re aligned in wanting this to be a good fit, you don’t want us to counsel you out in six months and neither do we. Let’s take the perspective of ourselves in six months and it didn’t work. What’s your best guess of what was going on that made it not work?
    • What are the names of your last five managers, and how would they each rate your overall performance on a 1-100?
    • What are you most torn about right now in your professional life?
    • How did you prepare for this interview?
    • How do you feel this interview is going?

The Why And How Of Taking “Discoverable Notes”

I have been an active note-taker for years and a fan of how meta Tiago Forte gets about the process of taking notes. Tiago’s Building A Second Brain course is very popular in productivity circles. While I have never take it, I recently came across his essay Progressive Summarization: A Practical Technique for Designing Discoverable Notes. (Link)

It’s an outstanding framework for understanding the whys and hows of taking notes. I, by accident, have arrived at a very similar system so it was interesting to see someone explain it thoroughly as only Tiago can.

This is a summary of what resonated with me.


The Why Of Taking Notes


The Right Info At The Wrong Time

What you read is good and useful and very important, you’re just reading it at the wrong time.

The challenge is knowing which knowledge is worth acquiring. And then building a system to forward bits of it through time, to the future situation or problem or challenge where it is most applicable, and most needed.

Bridging The Acquisition And Use Of Knowledge

It’s too mentally expensive, if not impossible, to internalize all or most of the information we consume. A good system is intended to bridge the time between when you discovered the information to when you use it.

At that future point, when you’re applying that knowledge directly to a real-world challenge…By the time you’re done solving a real problem with it, book knowledge has become experiential knowledge [which you carry forever].

The How Of Taking Notes


Defining The “Second Brain”

An external, integrated digital repository for the things you learn and the resources from which they come. It is a storage and retrieval system, packaging bits of knowledge into discrete packets that can be forwarded to various points in time to be reviewed, utilized, or deleted.

Designing The “Second Brain”

Goal: You are trying to triage information in an organized way. You read something you know is interesting and you want to be able to reference later.

Challenge: You need to file it quickly, make it discoverable, and emphasize why it’s important so “future you” can make sense of the notes efficiently.

Tiago says:

A note-first approach to knowledge management means we have to think about design. You are, in a very real sense, designing a product for a demanding customer — Future You. Future You doesn’t necessarily trust that everything Past You put into your notes is valuable. Future You is impatient and skeptical, demanding proof upfront that the time they spend reviewing notes will be worthwhile.

Balancing Tradeoffs

  • Discoverable: Digestible notes. So needs to be compressed
  • Understandable: Context including sources, examples, details

Getting the balance between compression and context right is not a trivial matter. When the time comes for Future You to decide whether or not to review this note, seconds count.

When you fail, you successfully sent a packet of information forward through time, but not in a state where it could survive the journey… You have to summarize the note without knowing what it will be used for.

The Progressive Summarization System

  • Layer 0 is the original, full-length source text.
  • Layer 1 is the content that I initially bring into my note-taking program. I just capture anything that feels insightful, interesting, or useful.
  • Layer 2 is the first round of true summarization, in which I bold only the best parts of the passages I’ve imported. Keywords, phrases, sentences
  • Layer 3, I switch to highlighting, so I can make out the smaller number of highlighted passages among all the bolded ones. This time, I’m looking for the “best of the best”
  • Layer 4, I’m still summarizing, but going beyond highlighting the words of others, to recording my own…restating the key points in my own words
  • Layer 5 (as needed): Remix. for a tiny minority of sources, the ones that are so powerful and exciting I want them to become part of how I think and work immediately, I remix them. After pulling them apart and dissecting them from every angle in layers 1–4, I add my own personality and creativity and turn them into something else.

My Own Accidental Version of Progressive Summarization

  • Layer 0 is usually just the link without the text which is risky since the link can break. (With Slatestarcodex site being taken down I’m experiencing this firsthand)
  • Layer 1 same as Tiago
  • Layers 2 and 3 are combined. Mix of bold and italics.
  • Layer 4 is paraphrasing often drawing connections to other ideas. While time-consuming because it requires thinking I am rewarded by an easier retrieval stage. More selective about what notes I do this with.
  • Layer 5 usually means pasting the note in other notebooks when the content has multiple contexts

Li Lu on China-US Relations

Excerpts from part 2 of Li Lu’s series Discussion of Modernization:

A Look at the Future of Sino-US Relations

Link to paper

The paper traces the parallel histories of the land and nation known as the United States in the West and China in the East. An especially interesting thread was how Lu charts the shift from land to market economies. The backdrop and ensuing developments in the 20th century set the current stage and inform possible futures.


On America’s “Soft” Power

As the creator of the American Order, the United States has always retained the rights to make rules for the market, admit membership to access the market, and impose and lift sanctions on states that violate the rules. At the same time, it has borne most of the costs – military and economic – of safeguarding this global market. Rights and obligations together form the core of this American Order.

The United States has also established and promoted her set of ideological values, which we now know as her soft power. In Agrarian Civilization, imperial China established a political system structured around Legalism, and a belief system rooted in the values of Confucius and Mencius. This system of beliefs was intended to achieve the willing submission of its people through subtle cultural and spiritual influence. Similarly, the American ideology promotes freedom, democracy, human rights, constitutional government, the rule of law, free markets, free competition, free trade, and the sanctity of private property. These universal values are so powerful that they have been adopted by almost everyone in the world. It is the very combination of hard and soft power that has brought the United States such tremendous success.

On America’s “Hard” Power

America’s hard powers also include its global network of military bases, the sheer size of its economy, its huge domestic market, its open investment climate, its competitive tech sector, and its world-class universities. So, whenever a global financial crisis strikes, investors around the world will flock to the safe havens of the US Dollar and American assets. This remains true even after what happened in the 2008 crisis.

Whenever the US becomes less confident, it dispenses with the niceties of soft power, and unabashedly resorts to hard power. Those on the receiving end of American hard power are likely to conclude that while the US implements democracy at home, internationally it resorts to hegemony. As the creator of the American Order, its prerogatives include market access, market denial, and selective sanctions and penalties. These special privileges are constituent elements of American hard power.

 

Trump’s Lack of Subtlety In Wielding Power

The election of Trump has revealed the true nature of American hard power in the context of the American Order.

With China rising rapidly, areas of incompatibility between China and the US have become increasingly pronounced. In the global arena, China has presented a challenge to American dominance, and conflicts have arisen. On the economic stage, a China-led system of international institutions has been established and often without the participation of the United States. China has also pursued the militarization of the South China Sea. The US economy accounts for 25% of the global GDP, but it bears the lion’s share of military costs associated with the maintenance of the global market. From the American perspective, China’s share of global GDP is 15%, but her share of the cost is de minimis, making her a free rider. And to make matters worse, as bilateral frictions mount, the cost of maintaining the American Order has only gone up. To the US, China is becoming more and more like Russia.

One of US economic hard powers is the US Dollar as the default currency of global trade, finance, and settlement…This is why American sanctions are so effective, as evidenced by the developments following Trump’s announcement of America’s unilateral withdrawal from the Iran nuclear deal. ZTE and Huawei, two Chinese companies, have also fallen victim to American sanctions”.

4 Schools of Thought on China Policy

  1. Engagement
  2. Practical
  3. Hawkish
  4. Populist

The four schools have always had divergent views. But in recent years, in light of all the developments in China, there has been a gradual convergence. Whatever the case may be, the reality of Sino-US relations is that today the American perception of China is approaching its perception of Russia.

 

American Order Focuses on Economic Power

The American Order is mainly preoccupied with the rules of access to and exit from the global market. It doesn’t wield much power over other nations’ political choices. The UN Charter states “the Organization is based on the principle of sovereign equality of all its Members”. So in fact, under the American Order, different political systems may develop, provided that they do not directly challenge America’s superpower status. The rapid growth of China’s share of global GDP (from less than 2% to 15%) is proof of this. Indeed, there is plenty of room for sustained growth.

 


Outstanding follows for China coverage: 

Michael Pettis

Dan Wang 

 

Mauboussin on Making Better Comparisons

Michael Mauboussin Guide to Making Better Comparisons (Link)


Comparing via analogies (steps and common mistakes)

  1. Select the source for analogy
    • Common pitfall at this stage: Undersampling due to availability bias
  2. Map the source to target to make inferences usually looking for similarities
    • A common pitfall at this stage: mistaking correlation for causality
      • Consider the first attempts at flight were people putting feathers on their arms, not studying lift
      • Confusing a star performer with talent in a volatile field
  3. Adjust for differences between source and target
    • Tversky showed we place more emphasis on similarity than differences
    • The framing problem: We are influenced by which differences and similarities we are prodded to focus on (ie framing)
  4. Learn by the success or failure of the analogy
    • Pitfalls in heuristics and intuition
      • Intuition works great in chess since it is a form of pattern recognition, but works poorly in investing where outcomes are non-linear
      • Recency bias influences sample
      • Choice-supportive or confirmation bias taps into our need to be consistent; we create stories after the fact to validate our decisions
      • Hyperbolic discount rates prevail when we study inter-temporal decision making
        • Stress is good response for crisis because it focuses on immediate needs; chronic stress causes decisions to be short-sighted
    • Using poor reference points in comparison
      • 2 companies in different industries can be more similar than their peers within their own industry; this shows how we can conflate attributes with what is actually driving value
      • Not recognizing that widely varied values can be justifiable. For example, 2 companies with the same earnings growth can trade at justifiably different valuations if underlying returns on invested capital are very different
      • Anchoring bias
      • When I went to Capital Camp, Mauboussin discussed T Theory. The top row of a category have more in common with each other than the average in the category. This articulates how I think about investors! Warren Buffet, Annie Duke, and Sam Hinkie have more in common with each other than other people in the same category.

So how to get better?

Instead of relying on analogies drawn from memory we can use “similarity-based” forecasting.

  • Inputs
    1. A wide sample for the reference class rather than 1 or 2 examples from memory
      • Additional refinement by weighting the results of the most similar samples more heavily
        • Ways to quantify the similarity
          • “nearest neighbor” algorithm (requires identifying relevant axes for the dimensions)
          • “connectionist” technique for weighting features by similarities and differences
    2. A statistical “base rate” drawn from the outcomes of varied reference classes

Matt Levine on shareholder value

Matt Levine discusses:

  • Traditional and progressive views of the role of corporations
  • How a narrow desire to raise shareholder value keeps frauds from capitalizing on investors who appeal to higher causes.
  • Compartmentalizing your job from your personhood as a necessary convenience

https://www.bloomberg.com/view/articles/2018-09-27/shareholder-value-could-be-worse



Primacy of Corporate profits

Friedman, along with Michael Jensen and William Meckling, is probably the person most associated with the theory that—as his famous article put it—“The Social Responsibility of Business Is to Increase its Profits.” In this theory, managers of a corporation have a singular duty to the shareholders to maximize their economic return as far as possible (while complying with the law), and if managers pursue any other objective—treating workers well or being good environmental stewards or standing up for what they believe in—at the expense of shareholder value, then they are misbehaving. Of course, there is plenty of room to argue that pursuing those other objectives actually enhances shareholder value. And there is much to be said for Friedman’s view—which is also after all Adam Smith’s view—that by focusing on economic profits, a company will maximize the amount of social good that it does, simply because the normal way to maximize profits is to figure out what people want and then sell it to them.

Including More Stakeholders

It is popular, these days, to criticize that view. The corporation is a political construct, embedded in a society; it has many stakeholders whose interests it needs to consider, not just shareholders. You see this criticism everywhere, from attacks on stock buybacks to Elizabeth Warren’s call for “accountable capitalism.” In its more extreme form, you can see shareholder-profit-maximizing corporations compared to science-fiction robot villains, or to psychopaths: If you value only profit and nothing else, then there is something inhuman about you.

Compartmentalizing

That probably overstates matters. If you come to work and focus on maximizing the profits of your company, that probably doesn’t mean that you’re a psychopath. It probably just means that you have a job. You compartmentalize things a bit; your work does not contain the entirety of your personhood; it’s a thing that you do because you need to make a living. In this sense, a company whose philosophy is “we will sell products that people want for more than it costs us to make them so that we can make a profit and increase our share price” is rather psychologically healthy. That is a good goal to work on during business hours Monday through Friday, and then leave. It is a modest, reasonable, businesslike goal. Obviously there are large contested margins, and you shouldn’t do psychopathic things to pursue that goal, and some people do and that’s bad, but for the most part “shareholder value” is the sort of mission that inspires people more or less the right amount. If you go around murdering people to maximize shareholder value then, yes, you are a psychopath, but most people aren’t.

The Difficulty of Accounting for Intentions

But there are other goals. Those goals are bigger, and you can wrap your whole personhood up in them, and you can believe that those goals are so important that they can justify anything. If Facebook’s goal is to maximize revenue by selling targeted ads to clothing companies, and you find out that it has features that enable genocide, then you shut down those features because the ads just aren’t worth it. If Facebook is about the “noble mission” of “connecting people,” then the tradeoffs are murkier. If “Facebook is truly the only company that’s singularly about people,” then … what even … how do you measure how about-people it is being? If you’re the singular company whose focus is people, then whatever you do is sort of necessarily good; your end is so vague and noble that it can justify any means. And for all that Facebook’s meddling with Instagram and WhatsApp seems to be driven by straightforward ad-revenue-maximization considerations, it’s worth saying that Facebook isn’t really answerable to shareholders and that its explicit ideology rejects shareholder value as a goal. “Facebook was not originally created to be a company,” Mark Zuckerberg wrote when it went public. “It was built to accomplish a social mission.” Okay!

Grand Visions Can Be Weaponzied, But Shareholder Value? Not So Much.

I am late to it, but I just finished reading John Carreyrou’s “Bad Blood,” the story of the fraud at Theranos Inc. and his work to uncover it. Theranos—in Carreyrou’s view, and the view of federal prosecutors—issued tens of thousandsof blood-test results to real patients using technology that it knew didn’t work, endangering those patients’ lives. There are a lot of passages in the book about Theranos founder Elizabeth Holmes inspiring and cajoling her employees to work harder, to get with the mission, to override their moral objections to faking the technology and push ahead. None of those passages mention shareholder value or profit maximization. They mention Holmes’s vision of revolutionizing health care to save lives and treat cancer patients. If you want to inspire people to do terrible things, it is very useful to sell them on a grand vision, a higher purpose, a noble mission. Shareholder value is nobody’s idea of an inspiring mission. That’s what’s good about it!”

How much to wager when you have edge? (Hint: median not mean outcomes!)

Link: Rational Decision-Making under Uncertainty: Observed Betting Patterns on a Biased Coin


  • Optimal bet size as a fraction of bankroll is 2p-1 where p is the probability of winning1. You will recognize this as the edge per trial reported as a percent. So a 60% coin has 20% edge.
  • The formula is a solution to a proportional betting system which implicitly assumes the gambler has log utility of wealth

Imagine tossing a 60% coin 100x and starting with a $25 bankroll

Arithmetic Mean Land

The mean of one flip is 20% positive expectancy.

Optimal bet size is 20% of bankroll since you have .20 expectancy per toss

Increase in wealth per toss betting a Kelly fraction: 20% of bankroll x .20 expectancy = 4%

Expected (mean) value of game after 100 flips betting 20% of your wealth each time

$25 * (1+.04) ^ 100 = $1,262

Median Land

The median of one flip betting a Kelly fraction is (1.2^.60 * .8^.40 – 1) or 2%

Median value of game after 100 flips betting 20% of your wealth each time

25 * (1.2^60) * (.8^40) = $187.25!

Things to note

  • The median outcome by definition is the increase in utility since Kelly betting implicitly assumes the gambler has log utility
  • After 100 flips, the median outcome is only about 1/10 of the mean outcome! The median outcome gives an idea of how much to discount the mean payoff. If your utility function is not a log function (ie does quadrupling your wealth make you twice as happy) then a different Kelly fraction should be used

Refactored “When the Culture War Comes for the Kids”

This is a 10:1 compression and refactoring of George Packer’s When the Culture War Comes for the Kids


There is a deep sense of inequality prevailing in America. 

The parents on the fortunate ledge 0f this chasm gaze down, vertigo stuns them. Far below they see a dim world of processed food, obesity, divorce, addiction, online-education scams, stagnant wages, outsourcing, rising morbidity rates—and they pledge to do whatever they can to keep their children from falling…By kindergarten, the children of elite professionals are already a full two years ahead of middle-class children, and the achievement gap is almost unbridgeable.

The need for equality and the role of merit.

The claim of democracy doesn’t negate meritocracy, but they’re in tension. One values equality and openness, the other achievement and security. Neither can answer every need. To lose sight of either makes life poorer. The essential task is to bring meritocracy and democracy into a relation where they can coexist and even flourish.

In 2014 the front line of social advocacy hardened

This new mood was progressive but not hopeful…At the heart of the new progressivism was indignation, sometimes rage, about ongoing injustice against groups of Americans who had always been relegated to the outskirts of power and dignity…Over time the new mood took on the substance and hard edges of a radically egalitarian ideology…its biggest influence came in realms more inchoate than policy: the private spaces where we think and imagine and talk and write, and the public spaces where institutions shape the contours of our culture and guard its perimeter…You could almost believe they spoke for a majority—but you would be wrong…The new progressivism was a limited, mainly elite phenomenon.

“For better or worse, it’s all identity now.”

The battleground of the new progressivism is identity…progressive politics meant thinking in groups. In politics, identity is an appeal to authority—the moral authority of the oppressed: I am what I am, which explains my view and makes it the truth. The politics of identity starts out with the universal principles of equality, dignity, and freedom, but in practice it becomes an end in itself—often a dead end, a trap from which there’s no easy escape and maybe no desire for escape. Instead of equality, it sets up a new hierarchy that inverts the old, discredited one—a new moral caste system that ranks people by the oppression of their group identity. It makes race, which is a dubious and sinister social construct, an essence that defines individuals regardless of agency or circumstance—as when Representative Ayanna Pressley said, “We don’t need any more brown faces that don’t want to be a brown voice; we don’t need black faces that don’t want to be a black voice.”

De Blasio’s schools chancellor, Richard Carranza, has answered critics of the diversity initiative by calling them out for racism…Carranza has mandated anti-bias training…One training slide was titled “White Supremacy Culture.” It included “Perfectionism,” “Individualism,” “Objectivity,” and “Worship of the Written Word” among the white-supremacist values that need to be disrupted.

Witchhunt?

At times the new progressivism, for all its up-to-the-minuteness, carries a whiff of the 17th century, with heresy hunts and denunciations of sin and displays of self-mortification. The atmosphere of mental constriction in progressive milieus, the self-censorship and fear of public shaming, the intolerance of dissent—these are qualities of an illiberal politics.

[In Jared Dillian’s Daily Dirtnap, he recounts “I’m not sure if you heard about the spectacle at the Des Moines Register, but here goes. Guy goes to a football game and holds up a sign asking for beer money over Venmo. He gets some money. He gets more money. Then more money. He has $1 million! He donates it to a children’s hospital. Reporter at the Des Moines Register digs up old racist tweets from him when he was 16. The guy who saved the children. Outrage mob forms, digs up old racist and homophobic tweets on the reporter. Pandemonium ensues. Thousands of people canceling subscriptions from the newspaper. Newspaper editors stonewalling. Now death threats. This is where we are. Every day is worse than the last. Tomorrow will be worse than today. Yesterday was worse than the day before. This will continue for the next 20-30 years.”]

[Dave Chappelle, in his Netflix special Sticks and Stones, calls out the prevailing ‘cancel culture’: “If you do anything wrong in your life and I find out about it, I’m gonna try to take everything away from you!”]

It struck me that this would punish kids whom the movement was supposed to protect…

In the name of equality, disadvantaged kids were likelier to falter and disappear behind a mist of togetherness and self-deception. Banishing tests seemed like a way to let everyone off the hook. This was the price of dismissing meritocracy.

The middle-school scramble subjected 10- and 11-year-olds to the dictates of meritocracy and democracy at the same time: a furiously competitive contest and a heavy-handed ideology. The two systems don’t coexist so much as drive children simultaneously toward opposite extremes, realms that are equally inhospitable to the delicate, complex organism of a child’s mind.. Wokeness prettifies the success race, making contestants feel better about the heartless world into which they’re pushing their children. Constantly checking your privilege is one way of not having to give it up.

Our goal shouldn’t be to tell children what to think. The point is to teach them how to think so they can grow up to find their own answers.

There is no answer to this

I can imagine the retort—the rebuke to everything I’ve written here: Your privilege has spared them. There’s no answer to that—which is why it’s a potent weapon—except to say that identity alone should neither uphold nor invalidate an idea

“The legacy of racism, together with a false meritocracy in America today that keeps children trapped where they are, is the root cause of the inequalities in the city’s schools. But calling out racism and getting rid of objective standards won’t create real equality or close the achievement gap, and might have the perverse effect of making it worse by driving out families of all races who cling to an idea of education based on real merit. If integration is a necessary condition for equality, it isn’t sufficient. Equality is too important to be left to an ideology that rejects universal values.

 

 

Tradeoffs in tax policy

Excerpts from Howard Mark’s memo: It’s All Very Taxing

The concept of “paying a fair share” is nebulous at best. It’s very contentious because everyone has a horse in the race. Mark’s memo is my favorite reference for the complexities and competing goals when designing tax policy.

Mark’s published the memo in November 2011 so the specifics are outdated but this doesn’t negate the reasoning. In fact, the changes actually highlight how our tax code evolves to punish or incentivize certain behavior.


Intro

We have a progressive system of taxation, meaning that higher earners don’t merely pay more in terms of dollars; they generally pay a higher percentage of their incomes in taxes. Most people agree that this is fair. But is it? Why should success be penalized through greater taxation? And if the tax rate for those who earn more should be higher, how much higher?

Under the U.S. system, people in higher income brackets pay tax at higher rates. In large part, the question of fairness primarily surrounds whether the higher rates are high enough. Talk about “the eye of the beholder.” There’s evidence on both sides of this debate: The top 1% of U.S. taxpayers pay 38% of all individual federal taxes.

A breakdown of the numbers

The top 10% pay 70% of all taxes, the top 25% pay 86%, and the top 50% pay 97%. The bottom 50% of all taxpayers paying only 3% of the total.

About half of Americans pay no federal income tax, and almost 25% pay no federal taxes at all. The average federal income tax rate for the top 1% of Americans is 23% (and for the top half it’s 14%), while the average rate for the bottom half is 3%.

They pay at lower rates than they used to and it seems progressivity has declined. . . . the effective federal tax rate, including payroll taxes, for the wealthiest 0.01 percent of earners fell to 31.5 percent in 2005, from 42.9 percent in 1979 [for a decline of 26.6%], according to data from the Congressional Budget Office. Over the same time, effective rates for taxpayers in the center of the range fell to 14.2 percent, a decrease of just 4 percentage points [or 22.0%]. (The New York Times, September 21, 2011). Total revenues from income taxes have declined in the U.S. – they “are at a historic low. of 15.3 percent of the gross domestic product, compared with a postwar average of 18.5. percent” (Financial Times, September 25) – and they’ve declined more for top earners. than for the rest. This is because of both specific rate cuts that have been enacted and the fact that the rates applied to dividends and capital gains – which clearly flow more to people in the upper-income brackets – have declined relative to the rates on salaries and wages.

  • On average, higher earners absolutely do pay a higher percentage than those who earn less.
  • But the decision as to whether the differential is just right, too little or too great is highly subjective and certainly a valid topic for debate.

A non-exhaustive list of trade-offs to consider

  • Are some forms of income more desirable to society and thus deserving of taxation at lower rates?

A discussion about investment vs wage income

    • Long-term capital gains are taxed at reduced rates because of a judgment that long-term investment in things like securities, companies and real estate is beneficial for the economy and should be encouraged. Right now, the top tax rate on long-term investment profit is less than half that on short-term gains and ordinary income.
    • What about interest? Why are dividends taxed at preferential rates and interest at ordinary rates? The explanation may lie in the fact that interest is deductible for corporations, while dividends aren’t. Interest is paid out of pretax income, while in theory dividends are paid out of after-tax income – although the existence of corporate deductions and credits means dividends may, in fact, be paid out of income that hasn’t been taxed by the U.S. Alternatively, the difference in tax treatment may be the result of a desire to encourage investment in “risky” equities rather than “safe” debt. But some companies’ dividends are no doubt safer than some other companies’ interest payments, so this distinction is questionable. If the goal is to encourage risk-bearing, is dividend versus interest the right criterion?
    • While on the subject of gains from investments, it’s interesting to note that, not long ago, dividends were included with interest under the rubric “unearned income.” And it was taxed more heavily than wages.
    • But now things have turned 180 degrees, and returns on capital are taxed at lower rates than wages. It’s worth noting that the Democrats – commonly considered the party of labor – controlled the government for much of the period 1928 to 1980, when earned income was favored. On the other hand, the Republicans – the party of those with capital to invest – have been in control more of the time since 1980, and the taxation of returns on capital has declined in relative terms. The definition of virtuous income that should be encouraged through lower taxes clearly is subjective, impermanent and subject to change with the winds of politics.
  • Should we encourage certain expenditures by making them deductible from taxable income?

The drafters called them deductions: provisions that reduce the net income on which taxes are levied. Critics call them loopholes, suggesting there’s something underhanded
about those provisions. And politicians use the laudatory-sounding term tax incentives to describe tax code provisions that reduce tax revenues in order to encourage certain
behavior. It all depends on your point of view.

Interest on mortgages

    • For as long as I can remember, interest on home mortgages has been treated as a desirable expenditure that should be encouraged. Because homeownership is considered part of the American dream, the tax code subsidizes it by reducing the after-tax cost for those who borrow to buy homes (and are able to itemize rather than take the standard deduction). While everything else may be arguable, certainly this seems fair. But is it? Are homeowners more virtuous than renters? If mortgage interest is deductible but rent isn’t, we’re requiring renters to subsidize owners. Is that appropriate?
    • On average, homeowners are from the middle and upper-income brackets. Is it fair that poorer renters provide a benefit for richer owners?
    • And is it desirable that those able to buy more expensive homes should get more of a subsidy than those consigned to cheaper ones?
    • As with the taxation of dividends, judgments on these matters change over time. Until 1987, there was no limit on the amount of mortgage interest that could be deducted. If you could afford to own ten homes with multiple million-dollar mortgages on each one, taxpayers would collectively share the cost by reducing your income taxes due. Today interest is deductible on only a maximum of $1.1 million of debt, and only on first and second mortgages, and only on a primary residence and a second home. So the tax treatment of owners of many homes and more expensive homes has become less generous. But it’s still better than that of renters. Is that proper?

Charitable deductions

    • As I travel the world visiting with clients, I see that two things about the U.S. are quite uncommon: (a) Americans give a lot of money to charity and (b) donations to charity are deductible in calculating taxable income. Everyone tells me the latter is the main reason for the former. In particular, these things are part of the explanation for the existence of the
      many private, non-state-supported colleges and universities in the U.S.
    • Part of this is true because legislators decided at some point to subsidize non-profits by encouraging contributions through the tax code. That’s certainly understandable. And yet, changes were made in recent years to limit upper-bracket taxpayers’ use of deductions in order to ensure that they pay some minimum tax rate. What about the unevenness of the subsidy?
      • The cost of giving $1 to charity is reduced by the amount of taxes it saves the donor, which is equal to $1 times the person’s tax rate. So today, speaking simplistically, it costs a top-bracket taxpayer 65 cents to give a dollar to charity, while it costs a bottom-bracket taxpayer 85 cents. Is that fair? Should the bigger earner receive a greater reward for a dollar of philanthropy than someone who can afford it less easily?
      • And should those who aren’t inclined to give to charity be required to subsidize those who are?

State and local deductions (SALT)

    • Deductibility on the federal tax return somewhat evens out the burden and ensures that (a) the states get first crack at taxing income and (b) the federal government can only tax
      what’s left, in line with federalist principles.
    • This raises a number of questions. Is the deductibility of state and local taxes fair? As with other deductions, the key question is “fair to whom?” Some people pay more state
      and local taxes than others, meaning they get greater deductions than others. As a result, while a person with a given income who lives in a high-tax state pays higher total taxes,
      he or she pays less federal tax than someone in a low-tax state. Is that fair?
    • Should the federal government subsidize spending on the part of high-tax states? That is, should residents in low-tax states bear part of the expenses of high-tax states?
    • While the source of an exemption rather than a deduction, what about interest on “municipal bonds” issued by states, counties, cities and local agencies. This is exempt from federal taxation, under the legal doctrine that the federal government mustn’t tax the operations of the states. But here again, we’re talking about a federal benefit (in the form of a lower cost of capital) for the biggest-spending local governments and their citizens, and a tax break for people who lend to them.

Property and sales taxes

    • Property taxes deductible without limitation. Thus the owner of a mansion – or ten mansions – receives more of a tax benefit than a low-income earner. And it’s another subsidy for homeowners versus renters. Is this right, or should it be changed?
    • Sales tax used to be deductible, too (meaning the buyer of a Rolls Royce got assistance from the federal government). Now it’s not. More fair?

The biggest exclusions of all: employer-provided health care and the deferral of taxation of contributions to pension plans

    • In both cases, those receiving these employer-paid benefits enjoy a substantial benefit not shared by those not fortunate enough to participate. For instance, is it fair that many better-paid workers get thousands of dollars a year in untaxed health-care benefits, while other workers enjoy no such subsidy?
  • Just think of how complicated the argument is on “fair” ways to raise taxesThere’s an argument that for the deficit solution to be equitable, all citizens should contribute to it. Though some government spending benefits all citizens alike, such as national defense, national parks and the administration of justice, much spending disproportionately benefits lower earners, in the form of public education and transportation (which are supported by the federal government), unemployment insurance, food stamps, Medicare and Medicaid, etc. Thus the effect of the coming spending cuts will fall more heavily on the poor. Some argue that since they receive less in benefits and are therefore less likely to experience their loss, the wealthy should share the burden of reducing the deficit through increased tax payments.
  • Keeping taxes low in general
    • Reduce wastefulness
    • Laffer curve
    • Encourage growth

Notes on OSAM’s Factors from Scratch

http://osam.com/Commentary/factors-from-scratch

How does the ‘value’ factor generate excess return?

  • Method for decomposing the return into earnings growth and multiple expansion
    • Limit to large caps (conservative, since the factor is weakest here)
    • June 1964 – Oct 2017
    • Cheapest quintile of stocks rebalanced annually at the end of June
      • Rebalance averages about 38% turnover
      • Turnover requires technical adjustments to normalize the decomposition: “rebalancing growth” and “unrebalanced valuation change” [details in the paper]
  • Findings
    • Value stock fundamentals do deteriorate in the holding period. This is reasonably expected since these are the cheapest stocks. But the prices turn out to be overly pessimistic, as the multiple expands during the holding period more than enough to compensate for the decline in earnings.
    • The excess return becomes highly diluted after 1 year as the bulk of the market’s re-rating of the stock occurs within the first year. 1 year maximizes the “gain to time invested ratio” and also strikes a reasonable balance with the costs to rebalance
    • The market’s re-rating of the stock higher proves to be vindicated as fundamentals do stabilize. The value factor is capturing the ‘overreaction’ discount and the rebalance sells the re-rated names into the market’s stabilizing bid.
    • Value is difficult or impossible to time since it only correlates reliably with future returns at market extremes (ie dot com era).
  • ‘Value’ in recent context
    • Values has underperformed since the financial crisis although the underperformance is not unprecedented
      • Value is even cheaper today on relative basis compared to the overall market but both value and the market are about 50% more expensive than historical averages
      • Value is not currently stretched despite underperformance
      • Value may be underperfroming since cheap stock’s implied underperformance turned out to be even higher than their subsequent realized underperformance.
      • Likely that this is bad luck as opposed to the market having become better at handicapping future performance.
      • From Asness: ‘In stock selection, value is still not super cheap (i.e., super-cheap would be if the cheap stocks were way cheaper versus the expensive ones than normal).78 It would be fair to wonder why not, especially given the poor long-term value returns. Well, with any strategy, you can lose because either prices or fundamentals move against you. Unfortunately, more of this current drawdown has been about fundamentals. Value, at least using the behavioral. explanations, is a bet that prices over-extrapolate current prospects. The better companies deserve to be priced higher versus fundamentals, but even so, they’re priced too high (and vice versa). However, sometimes prices are correctly reflecting this information, and sometimes they are actually underreacting to it (meaning what looks expensive is actually an ex ante good deal). Prices may over-extrapolate on average, that’s why value works long-term, but not all of the time. Value wins more than it loses, but when price differentials underdo it (meaning, unlike most of the time, cheap companies aren’t actually cheap enough versus the expensive ones) is a time that value fails.79 Importantly, we find no signal from this analysis for timing value going forward. Value is not predictably bad or good following periods where fundamentals move against it.’

How does the ‘momentum’ factor generate excess return?

  • Momentum factor constructs equal weighted basked of top quintile of names based on prior 6 month returns
  • Findings
    • Recent returns are a better predictor of earnings growth than simple expensiveness
    • Decomposing returns we find that the resultant earnings growth exceeds the size of the multiple contraction
    • Unlike ‘value’ which leads to excess returns for many years (albeit at a declining rate after year 1, the momentum strategy is mean reverting. The excess return actually overshoots in year one and subsequent years actually show underperformance.

Combining ‘value’ and ‘momentum’

  • Value converges to fair value after initial overreaction which leaves them overly offered, momentum diverges above fair value at the tail end of the holding period as shares become overly bid.
    • This makes them complementary timing-wise over the 1 year holding period
    • They work best in opposite market environments

Digging further into factors

https://www.osam.com/Commentary/alpha-within-factors

The above describes how, in general, these factors work (distilled to their essence on average you are betting against overdone price declines in companies facing headwinds or trouble). [The strategy is innately convergent and supplies liquidity]. However, when digging into this general dynamic further, OSAM finds lots of dispersion under the hood. Since that is the case, it makes sense look for what differentiates the names which are favorably re-priced vs those which continue to underperform their price outlook.

To illustrate they show AAPL vs IBM from 2014-2018. Both stocks were in the cheapest quintile of P/E in 2014.

IBM earnings declined, AAPL’s grew and the stocks were predictably punished and rewarded respectively. They validate this is not an anomaly by looking at names historically that are priced similarly and then looking at their performance as a function of earnings growth over the next year. The names with faster-growing earnings outperform those with slower growing or declining earnings and the effects increase are amplified by the degree of growth (fastest growing, perform better than just faster growing on average etc). The paper’s appendix goes further by decomposing the stock’s returns into contributions from multiple expansion and earnings growth.

These findings unsurprisingly apply to the stock market in general — companies whose earnings grow faster, have share prices that grow faster. However, they find this dynamic to be much stronger in cheap (aka value) stocks meaning the rewards for being able to predict earnings growth are higher in the value arena.

This chart shows the ‘excess return vs historical average’ binned by rank of earnings growth. While the names with fastest growing earnings are the relative best performers, we can see how much volatility there is in the entire value factor with periods like the most recent 5 years and periods in the late 1980s being notably poor for the factor.

Zooming in:

How to capture this return with info available at the time?

“Is it possible to reliably identify the top-growing stocks in the value factor using presently-available information? The answer is surely no, especially if presently-available information is limited to price and financial statement data. The forces that determine future earnings outcomes in businesses arise out of complex, idiosyncratic chains of causality that are not fully captured in that data.”

A more reasonable and still very valuable goal is to “tilt” exposure towards the names which are more likely to be indicative of real value vs the ‘value traps’ which bring the value factor’s average down.

  1. Minimize selection bias by using a composite of measures to identify value
    • For example, P/E will be understated if a company takes a one time gain (for example if it sold a balance sheet item for much higher than its accounting value). Measures of value are vulnerable to any accounting variable which is not reflective of the ongoing business. By using a composite of measure the risk of a single accounting aberration having undue influence is mitigated.
  2. Addition by subtraction by removing the value-traps
    • Momentum: a measure of trailing total return; higher is better.
    • Growth: a measure of trailing change in earnings; higher is better.
    • Earnings Quality: a measure of accruals; lower is better.
    • Financial Strength: a measure of leverage; lower is better.

Because low scores in these indices have a disproportionately large impacts they choose to cut of say the bottom 10% as the best trade-off between the desire to avoid the worse outcomes reliably and the desire to maintain a large enough universe of names and diversification. Asymmetrical filter: Scoring poorly on those measures is a better predictor of poor performance than good scores are predictors of positive performance

  1. Create an equal weighted portfolio of the remaining top half of names: “value leaders portfolio”

Summary

The results as the portfolio becomes tilted to higher quality value names:

When the process above is used to filter value-traps and we further narrow the universe to the ‘value leaders’ we find that our equally weighted portfolio had much higher exposure to the faster-growing names than a strategy ranked according to simply cheapness (ie “Value:Top Quintile”)

This is the excess return to the traditional value factor in different historical periods:

This table shows how the tilt to the top quintile exceeded 20% in every period

This table shows the returns to strategies decomposed to multiple expansion (ie the point spread re-rating) vs earnings growth

The leaders strategy improves the generic value strategy by eliminating the names which drag on EPS growth (at the lesser expense of having less pronounced average multiple expansion)

The outperformance of the value leaders strategy is notable for three reasons:

  • First, it requires only a modest amount of intervention. The percentage of original value stocks retained in the final strategy–38%–is relatively large. Moreover, the strategy is rebalanced annually, rather than quarterly or monthly. These characteristics suggest that the strategy is able to accomplish more with less.
  • Second, it’s occurring entirely in the large cap space, a space in which factor signals are comparatively weak and, according to some, non-existent.
  • Third, it’s associated with a significant shift in allocation towards the value factor’s top growth bins, a shift that we know is efficacious, given the extreme levels of outperformance produced by stocks in those bins.”

OSAM notes that “In practice, we therefore use methods that are more focused and refined. We also take advantage of the benefits of concentration and size: factor investing is more powerful when applied in a concentrated manner and when used outside of the large cap space.”