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The new astrology

Since the 2008 financial crisis, colleges and universities have faced increased pressure to identify essential disciplines, and cut the rest. In 2009, Washington State University announced it would eliminate the department of theatre and dance, the department of community and rural sociology, and the German major – the same year that the University of Louisiana at Lafayette ended its philosophy major. In 2012, Emory University in Atlanta did away with the visual arts department and its journalism programme. The cutbacks aren’t restricted to the humanities: in 2011, the state of Texas announced it would eliminate nearly half of its public undergraduate physics programmes. Even when there’s no downsizing, faculty salaries have been frozen and departmental budgets have shrunk.

But despite the funding crunch, it’s a bull market for academic economists. According to a 2015 sociological study in the Journal of Economic Perspectives, the median salary of economics teachers in 2012 increased to $103,000 – nearly $30,000 more than sociologists. For the top 10 per cent of economists, that figure jumps to $160,000, higher than the next most lucrative academic discipline – engineering. These figures, stress the study’s authors, do not include other sources of income such as consulting fees for banks and hedge funds, which, as many learned from the documentary Inside Job (2010), are often substantial. (Ben Bernanke, a former academic economist and ex-chairman of the Federal Reserve, earns $200,000-$400,000 for a single appearance.)

Unlike engineers and chemists, economists cannot point to concrete objects – cell phones, plastic – to justify the high valuation of their discipline. Nor, in the case of financial economics and macroeconomics, can they point to the predictive power of their theories. Hedge funds employ cutting-edge economists who command princely fees, but routinely underperform index funds. Eight years ago, Warren Buffet made a 10-year, $1 million bet that a portfolio of hedge funds would lose to the S&P 500, and it looks like he’s going to collect. In 1998, a fund that boasted two Nobel Laureates as advisors collapsed, nearly causing a global financial crisis.

The failure of the field to predict the 2008 crisis has also been well-documented. In 2003, for example, only five years before the Great Recession, the Nobel Laureate Robert E Lucas Jr told the American Economic Association that ‘macroeconomics […] has succeeded: its central problem of depression prevention has been solved’. Short-term predictions fair little better – in April 2014, for instance, a survey of 67 economists yielded 100 per cent consensus: interest rates would rise over the next six months. Instead, they fell. A lot.

Nonetheless, surveys indicate that economists see their discipline as ‘the most scientific of the social sciences’. What is the basis of this collective faith, shared by universities, presidents and billionaires? Shouldn’t successful and powerful people be the first to spot the exaggerated worth of a discipline, and the least likely to pay for it?

More here – Aeon

Apparently Its All Over For Commodities

Commodities form an important part of my trading universe, in fact as a I par back my universe of instruments they form a more and more integral part of what I do. This pivotal role occurs for a few reasons ranging from ease of trading, price discovery and familiarity. The first trade I ever did was on a gold stock and the interest has stuck with me for decades.  You would therefore expect that I take an interest in the market so I had more than a passing interest when this article dropped into my news feed. There are a few points I want to dissect. However before doing that it has been my experience that there are two interesting phases in the life of any market. The first is when people start to tell me this time its different. Etched indelibly into my brain are the words of Irving Fisher who could be considered one of the worlds first celebrity economists who days before the 1929 crash uttered the immortal phrase stocks have reached a permanently high plateau. The second phase is that when someone tells you that a given instrument is stuffed beyond repair and will never go up again. Neither sentiment is reflective of either the cyclic nature of markets nor the psychology of traders.

Point 1 – Firms leaving the business.

This is an interesting point because it points to the number of prop firms leaving the business. However the number of retail investors exposed to commodities via ETF’s has grown dramatically so there has been a shift in the markets demographic away from wholesale to retail. The five largest commodity ETF’s managed almost $6 billion in assets.

Point 2 – Low Volatility

This point highlights one of my enormous bug bears it is the confusion between volatility and trend – the two are not the same and one doe not rely upon the other. I thought I would take a further look at this and just have a look at the distribution of volatility within the gold market. The first thing I did was simply look at the average 15 day volatility for a given number of years ranging from 15 years to the YTD and the results are shown below.

v1

Depending upon the look back period you can make a point that there has been a drop off over time in volatility . However volatility is relative concept and the current volatility in the gold market is sitting at 11.8% which is just below the average volatility for the YTD. Yet price has trended from around $1,000 to $1,350 and then back down to around $1,000. Looking at short term volatility tells us nothing about the trend. When looking at volatility I thought I might be missing something so I broke the look back period into five year blocks to get a sense of how it might have changed over time and the results are below.

v2

When volatility is broken into blocks you can see that over time volatility has increased and then tapered off a little. The so called halcyon days of two decades ago that every longs for actually had markedly lower volatility than recent times.

I should also point out that volatility in the crude oil market regularly spikes to beyond 60% so i am not sure where this missing volatility has ended up. Again it is probably the perennial confusion between trend and volatility.

Point 3 – Correlation

This point always interests me because people very rarely make it clear whether they are talking about price correlation or returns correlation. Most people when they talk about correlation talk about price without meaning to. The correct measure in such situations is the correlation between the returns across asset classes. True diversification is generated when you generate uncorrelated returns. Te first chart below looks at the daily performance correlation for gold, S&P 500 and crude oil.

p1

There is what appears to be an emerging positive correlation between gold and the S&P 500 and this surprised me a bit and I was suspicious that it was an artefact in the data so I generated a new series of data that looked back to the beginning of the century because my suspicion was that what I was seeing was actually the stagnation in gold and the rise of the US market post the GFC.

p2

Looking at the data over much longer term gives a clearer picture of what is actually happening. As US markets collapsed gold recovered and as US markets recovered gold suffered so to my eye the emerging correlation is somewhat of an artefact in the data. Much is implied in the article about how good commodities trading was in the past but it needs to be remembered that gold took 31 years to surpass its 1980 highs. That’s a long time between drinks if you are a long only trader as many commodities firms were. Commodities are the magic swing through mutli hundred dollar range tools that people think they are.

Point 4 – Leverage

An irrelevant point if you know what you are doing. Leverage has been a function of commodities markets from day one and is the staple of FX markets and they dont seem to have any problem coping.

Point 5- Liquidity –

I am not certain what the point is here since volume in the majority of commodity markets has increased dramatically over the past decade.

Point 6- Regulation

This is an old catch cry – if you dont know what you are doing blame the regulator. In some ways this is the same as football coaches who blame the umpire for their team being rubbish.

Point 7 – Its downright difficult

There is a particular sentence here I want to highlight –

For one, their idiosyncratic characteristics can make price forecasting practically impossible.

Price forecasting for all instruments is impossible. For those who need a quick refresher on how stupid this sort of thing is I give you Jon Boormans wonderful, regularly update guru predictions chart.

Predictions-2

Any attempt to predict price in any instrument is an exercise in delusional stupidity of the highest order.

The upshot of all of this is that the majority of things written about markets that have any sort of predictive narrative about the trajectory of a given market or markets is largely irrelevant and that includes this piece. The simple fact of all markets is that they are cyclical in both tone and the level of investor involvement. If I can defer momentarily to a local example. If you were to look at a comparison between housing and equities as an investment choice you would say that equities are dead. Yet funds continue to invest in them and prices continue to go up and down and some prices go up a lot.  The same is true for commodities and I doubt it will ever stop being true.

 

 

So What Does This Mean?

In my junk folder I have for the past upteen decades been getting random charts by a group called Chart of the Day. Surprisingly, I dont get them everyday – so the implication that you get a chart everyday that is interesting is perhaps a little bit of an oversell. This morning I go the following piece of wisdom –

c2

This chart as the title suggests looks at the S&P 500 PE ratio back to the turn of the century. Putting aside the obvious gaping methodological flaws such as the S&P500 was only started in 1957 I do always find these sorts of things interesting. Markets and their history should be a topic of investigation for every trader, simply because there is nothing new. Bubbles and crashes have been a feature of markets since they began and the driving force behind such things has always been the capriciousness of market participants. Curious as to what our own market looked like I dug up some data from the folks at Market Index and plotted the local PE ratio against the All Ords to see what I could see.

Capture

On the chart above I dropped a series of vertical lines – the three black ones denote a time when valuations according to the markets PE ratio could be considered extreme, the red one is the GFC. Pundits who look at valuation models work on the notion that markets or their component equities have a fair valuation and deviations from this point indicate that something is either overvalued or undervalued. Decisions are then made upon this interpretations. The first black line is easy to identify – its the 1987 crash.  The second one took me a little while to remember until I remembered the tail end of the 1991/2 recession combined with the banks nearly sending themselves under after property bit the dust.  The third black line is the tech wreck, The question when looking at any methodology is what value does it add to your decision making.  This is an important question since our decision making is bounded by the time we have to make the decision, the amount of information we have and our cognitive ability. None of these components can be infinite so our decision making is always somewhat half arsed. However, we need to add to this the notion of decision fatigue. It is estimated that during an average day we make anywhere between 20,000 and 25, 000 conscious and unconscious decisions and each of these decisions extracts a toll. Decision making is not a free ride, everything has a cost. Therefore efficiency of decision making is of paramount importance. If you have to force a decision then you are merely adding to your own mental loading without achieving anything.

As to whether the chart above tells me anything I dont already now about market extremes is doubtful As to whether it adds anything to my overall view of the world and approach to trading I am certain it doesn’t. But your mileage may vary.

Remember, Money Doesn’t Have to Be the Root of All Evil

It may cost more than $100 million, but many social problems could be alleviated with the creative infusion of cash. Compensating organ donors could increase the supply of organs and save thousands of lives annually. Paying opium farmers in Afghanistan and Latin America to grow something else could bring an even larger dividend in averted addictions and wars. And why not neutralize opposition to reducing carbon emissions by reimbursing coal miners, or the entire fossil fuel industry, for their losses?

More here – The New York Times

Property Versus Shares

I was mucking around on the Valuer Generals site the other day searching for historical bits and pieces relating to my property when I noticed that the VG kept historical records on their estimation of the median house price in Melbourne. One of the things I have always found difficult in real estate is not the paperwork, the land rats, tenants, maintenance or the incredibly primitive way that houses are actually sold but rather the paucity of data that surrounds their instrument. Reliable and consistent data seems to be very hard to find and this was an issue I found when I was looking the the VG estimations – I couldn’t get them to tie in with other bits and pieces I found. However, only the VG site had any depth of historical information. Imagine trying to deal in a stock that had half a dozen conflicting prices from different sources, none of which you could actually deal in because prices are largely made up and then trying to find out what the price was five years ago only to get another half a dozen differing prices. It seems as if the real estate market is deliberately set up to be obscure and in some ways reminds me of an embryonic options market where those involved either didn’t understand their market very well or were being deliberately opaque.

Out of curiosity I downloaded the VG’s median house price data just to have a look at the trajectory. Because I am frequently bored I like to look at the history and structure of various markets – too few people are actually students of the markets they operate in. As such they miss out on a large number of free lessons that can short cut their process. No one makes original mistakes in their investing, everyone has made the same mistakes before you and the lessons from these mistakes can often be found in the data. Whilst mucking around with the data I remembered that the ASX often produces a comparison between the returns that are generated by various investment categories. I have always thought that these comparisons had a flaw in that they relied upon simple average returns, looking at averages is fraught with danger because they can be extremely misleading. Which is why managed funds constantly quote them.

As an extreme example consider the following investment scenario. I discover a magic fund with brilliant marketing material and on day one of year one I invest $100,000. In the first year the fund makes a return of 100% and I think I am a genius. In the second year the fund loses 50% and naturally I think the fund manager is an idiot but I am consoled by the fact that the year before I made 100%. When I present this scenario to people I ask them what the average rate of return is for those two years and most people answer correctly – it is 25% (100%-50%/2). I then ask how much have I made on my original $100,000 and I generally get an answer in the ball park of $100,000 x 25%pa. These guesses range from $125,000 to $150,000 as people try and do a compound interest calculation in their head. The truth is I have made zero – in the first year I doubled my money and in the second year I halved my money thereby returning me to my starting point. Yet my average return is 25%. This is why when looking at returns we have to be careful about using a long term average to generate an idea of how much we would have made. It is better to look at each individual piece of return data and assign a dollar value to it. This way you can build some form of equity curves which gives you a lot more information as to the trajectory of the value of your investment.

For a bit of fun I decided to take the data from the VG’s site and apply the returns from the All Ordinaries Total Return Index to their initial starting capital of $75,500 and see what the comparison between the two was. In effect I built an equity curve for the median house price and an identical investment into a surrogate ETF.

hp1

I have to admit I was a little surprised at the size of the differential because when you hear talk of comparisons between the two investment vehicles the impression you get is that the returns are quite close and that with the runaway bull market in housing that property has been the place to be for long term passive investing. Plotting data like this enables you to get a sense of the trajectory of price and to me two things are immediately apparent. Equities are more volatile in terms of a passive investment and this volatility is apparent in the impact of the GFC. Property moves a little like a truck, slow and steady whereas equities tend to throw themselves around a little. However, the shocks are not as severe as I thought they would be, 1987 is a blip that doesn’t appear and the tech wreck was a mild impediment. What did do the damage was the GFC and this is the problem with a simple buy and hold methodology.

To compensate for this volatility and to give a more real world flavour to our surrogate ETF I dropped the loss from the GFC to 10% from the historical 40.38% which is reflective of what actually happened when our macro filters kicked in and dropped us out of the market. The result of this simple fix is interesting.

hp2

The dramatically different result is simply a function of controlling runaway losses and not allowing them to have a detrimental impact upon your equity. Such a technique  is not rocket science but it does seem sufficiently difficult that it eludes all professional money managers.

Despite what the data says I am doubtful that it will convince die hard property advocates of anything – people with firm opinions are immune to data and it is hard to break the emotional bond that people have with actually owning something. And that is not really the purpose of the exercise as the advantages of equity investing over property investing are many , manifest and quite easy to elucidate. But is does serve as a salutatory lesson in what the differing mechanisms of presenting returns can tell us. It also tells us in no uncertain terms as to why  the worlds second richest individual is a share investor and not a property investor.

 

 

The Final Clarke and Dawe


 

Compounding – if you live long enough to enjoy it.

I have just finished reading Edward O Thorps autobiography A Man For All Markets which is an excellent little read and a good addition to any traders library. In the book Thorp talks about he value of compounding returns. There is no doubt that success is trading or investing is based upon compounding your gains over the long term. Compounding is a wonderful tool in that what seem to be small quanta of difference can over time lead to an enormous difference in returns. For example an investment with a return of 10% compounded annually for 10 years yields $259,374 whereas the same investment compound at 11% yields $283,942. Extend the holding time to 20 years and the figures becomes $672,750 and $806,231 respectively. Time is the key to compounding and this is a point Thorp makes, he also makes the important point that most lack the patience to do this.

However, there is a sting in the tale of compounding that I have noticed that those on the sell side of the business either abuse or simply do not understand and that is one of scale. You will often see very long term charts of an index or an instrument and it shows a wonderful upward trajectory (well you wouldn’t show things that didn’t work) and the message is that you simply have to hold for whatever the requisite time is and you will eventually have a small pot of gold. The key word here is eventually because what is often overlooked is the time to achieve these mythical gains. There is no doubt at all that compounding is a very powerful tool and when combined with consistency and patience achieves remarkable things.

However there is always a but we need to be aware of. To demonstrate this I found a centuries worth of data on the All Ords and using $1 as the starting investment plotted what the return would be over the next 116 years.

$1

If you had started with $1 in 1900 and simply let the compounding returns of the index take its course you would have $487,801.23. At first glance this is quite impressive – the markets very long term rate of return sits at about 9% and if you let it do its thing for a long period of time then you get an impressive number at the end. However, there are two things to be aware of in viewing this data. Firstly, the time taken to achieve your goals, not only is the time itself a problem but the erosion of the value of your investment over time is a problem. I had a cursory look for long term inflation data but couldn’t find much dating back beyond the 1940’s but if you assumed an average inflation rate of 4% then this puts a large hole in the real end value of your investment. The second issue that is not addressed is the trajectory of the journey – the chart above is not of a capital guaranteed term deposit but of an index. The somewhat linear trajectory of the graph is deceiving since it does not take into account the extended and deep bear markets that were experienced. There were years when the market went nowhere and these events are testing for even the most hardened buy and hold advocate.

Time is both the ally and enemy of those who understand how to use compounding and it is this dualism that we need to be aware of. The practical implication of this is to leave your money in your trading account for as long as possible before taking it out and spending it. The impact of large withdrawals is quite remarkable in the damage it does to accounts but some people cannot resist spending in the short term to ensure they live in poverty in the long term

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The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.