Saturday, December 9, 2017

McCarthyism

I enjoy studying American history of the post-World War II period, and just remembered that earlier this week we passed the anniversary of a milestone for that period: On December 2, 1954, the United States Senate voted 65 to 22 to condemn McCarthy for "conduct that tends to bring the Senate into dishonor and disrepute", signaling the erosion of the crushing anti-communist excesses of the previous years. McCarthyism has been applied indiscriminately and almost invariably incorrectly to any number of perceived political and social excesses, but it is worth recalling it for what it was. 

First, to criticize McCarthyism is not to diminish the real threats. We must understand that at the time there was a real, broadly recognized threat to the U.S.  Through documents from Soviet archives and Soviet messages, we know that the Soviet Union engaged in substantial espionage activities in the United States during the 1940's, that the Communist Party in the U.S. was being funded by the Soviet Union, and that it was used as a base for recruiting spies. We should not have McCarthyism diminish the reality of the subversive elements of the time.

The threat was real, but the reaction to that threat was a frenzy, often described as a witch hunt, that was particularly focused on those in the entertainment industry and government. A simple accusation was sufficient for people to be attacked, lose their job and even their career, with no further prospects for employment at more than a menial level. President Truman remarked that, "A man is ruined everywhere and forever. No responsible employer would be likely to take a chance in giving him a job." Those who were accused had no recourse because the process took place through extra-judicial channels; no response could hold sway. Pleading the Fifth Amendment during the proceedings was taken as an indication of guilt.

What is more, although there were instances of serious attempts at subversion, there also were many who were attacked for activities from decades earlier that, though perhaps outside the social and political norm, had been benign. These were pulled up and judged with the now more stringent standard. It was as if a law had been enacted, and those who did not follow that law in the past were found guilty.

Yet at the time, these excessive and unlawful efforts which cast aside any notion of due process were supported by many thoughtful people. For example, William F. Buckley Jr., a prominent conservative intellectual, wrote that McCarthyism “is a movement around which men of good will and stern morality can close ranks." Certainly there were those who were opposed, but popular opinion – and no doubt the concern that those who opposed the juggernaut would be painted with the same brush – kept them silenced.

The political climate of McCarthyism declined through the 1950’s as public opinion shifted, and a number of court rulings pushed back against the processes that supported it. Most notable is one in 1956 that pushed back on using the invocation of the Fifth Amendment to infer guilt. The Court wrote that “we must condemn the practice of imputing a sinister meaning to the exercise of a person's constitutional right under the Fifth Amendment”, and in 1957, when the Court condemned cases where “Guilt or innocence may turn on what Marx or Engels or someone else wrote or advocated as much as a hundred years or more ago.”   



Monday, December 4, 2017

Assisted Dying for the Rest of Us

The baby boomers have changed our society as their demographic wave has washed over one institution and norm after another. Split sessions for public schools, a new level of competition for elite colleges, the free love generation and the rise of student protest, the housing bubble, the creation of the Millennials, (a.k.a. the echo boomers). They have the numbers and the political will to do things, and they have time and again pushed against the norm. To use the phrase of one baby boomer, they think different.

The final change will occur with the crashing of that wave: The availability of assisted dying for all. Assisted dying is already becoming the norm for those with terminal illnesses. Australia is the most recent to join the ranks of Sweden, the Netherlands, Belgium, Canada, Columbia, and Luxembourg, as well as California, Colorado, Washington, D.C., and Oregon in the U.S. (I use the term assisted dying broadly, to also involve giving the subject a lethal drug, and not literally being on hand as they take it and pass away. That is what is allowed in California.)

Currently there are restrictions, like having a terminal illness, especially one that is either painful or imminent. But once the mechanics are in place and the threshold has been passed, it is only a matter of degree to have assisted dying for those who decide that their debilitating state makes them no better off than one who is terminally ill. Once we have clear diagnosis tools for Alzheimers, for example, I can imagine voluntary assisted dying protocols along the lines of a more successful and less surreptitious Alice Howland in the film Still Alice.

The way is being paved to make this more acceptable. For example, consider the context provided by a recent full section in the New York Times devoted to the bleak world of old age and dying in Japan. We will see more articles depicting the emptiness of old age, the drain on society and our children, arguments that we should take charge of our death just as we do our lives -- this is the sort of thing that resonates with the baby boomers, also called the "me generation" -- and even arguing, as I have, that keeping someone alive can be akin to torture. I also have argued in a past post that we could help matters along by giving payments (obviously to a designated beneficiary) if someone elects to forgo expensive treatments that would only delay death by a short period.

Saturday, November 18, 2017

The Tesla Roadster Will Turn the Bugatti into a Wrist Watch

In three years Tesla will be rolling out the fastest production car in the world. And not a "production car" as in, we made ten or so of these so it can be called one. No, a production car that rolls off of an assembly line — though I hope the rate of production is controlled with DeBeers-like style — and that still outperforms any car you can buy at any price.

The Tesla Roadster that was unveiled this weekend and is slated for delivery in 2020 is not only better, it is in a different league in terms of its performance specs when compared to any car at any price. Including, for example, the 1500 hp Bugatti Chiron, which starts at $2,998,000.  The Roadster does zero to sixty in under two seconds (no other car is even built with the idea it can beat two seconds), a quarter mile in under nine seconds (no other car is even close to nine seconds). Top speed of over 250 mph. (It might be ten or twenty mph shy of the record here, we will have to see. Musk has said once it gets into production, the performance might exceed what we are seeing with the prototype. For now we just know it is "over 250 mph".) Plus, it seems to be user-friendly. Obviously it is quiet. And it seats four, at least if two of the four are small.

And, its best-in-the-world performance in terms of speed and acceleration will not even be the headline item when it gets its test-drive reviews. I predict that the Tesla Roadster will take corners unlike any car built today. First of all, it has a lower center of gravity because of its batteries. Second, it can have the distribution of that weight precisely tuned because the batteries can be placed most anywhere on the underbelly. And third, with a separate motor for each of the rear tires, the Tesla can have a computer assist that keeps the car from skidding out as you take a corner. Anyone who has tried to make a Tesla S skid on wet or icy roads already knows this. Imagine what happens when you are speeding around a turn and the computer can differentially send more torque to one tire versus the other.

And, this is only the beginning. As Musk has pointed out, by the time the car is in production there will doubtlessly be further improvements. And even then, it is only Version 1.0. The bigger point is that an electric car is a better technology than the gas-powered car. Over time the gas-powered car will have to yield.

Already, two days after the announcement, I have been reading the reaction from the aficionado of  high-end sports cars, supercars, and, as the Bugatti and its kin are called, hypercars. The basic argument is: "There is more to a sports car than how fast it goes. It is the workmanship. The feel of the car shifting gears. The sound of the engine growling.  The melding of man and machine." It is the laudable appreciation of these finer points that is behind the market for mechanical timepieces. They cannot be as accurate, but they embody the workmanship of great craftsmen; the feel of winding the spring; the sound of the mechanism ticking; the melding of man and machine (I guess).

So it will be for the exquisitely crafted cars of today, from the Ferrari to the Bugatti. If we take performance as the objective, the best car in the world will no longer be one that is one or two or three million dollars. It will, at least for a time, be the two hundred thousand dollar Tesla. And after that, it will be another electric car. Like fine timepieces, the supercars of today will be admired and owned not for superlative performance, but for an appreciation of their workmanship and their mechanical intricacy.

Tuesday, November 14, 2017

Pension Actuaries: The Joke is On Us

...An Actuary is someone who wanted to be an accountant but didn't have the personality for it....An introverted actuary stares at his own feet, and extroverted one stares at the other person's feet....What is the difference between God and an actuary?  God doesn't think he is an actuary...."Look at the white horses over there." Actuary: "They're white on this side, anyway."

Unfortunately, when it comes to the mess our pensions are in, actuaries are no joke. Pension funds labor under actuarial assumption for expected returns that are mainly pulled out of thin air without any regard for financial economics. Does anyone really think pensions will be able to grow at seven percent or more per annum? When they are constrained by their various constituents to hold 50% to 60% in bonds and cash? (See Figure 3 of this OECD publication.)

Those unrealistic assumptions lead to unsupportable levels of contributions, and thus pensions are underfunded as a matter of course. You know the assumption are wrong when virtually every pension is on the negative side of the ledger.  But the actuaries do not seem to have been trained in the concept of making course corrections. Nor do they educate themselves in financial economics to better evaluate the mess they are creating.

Why am I going into this? Over the weekend I attended an event honoring a former colleague of mine from my days at Morgan Stanley, Jeremy Gold.  He is an actuary who has spent his career trying to move the pension actuaries toward a firmer foundation in financial economics -- to have them at least avail themselves of what financial economists can provide. In the mid-1980's, Jeremy and I worked together in the Fixed Income Research Group at Morgan Stanley. He and I went on various trips to push fixed income products, and to market the fledging new strategy of portfolio insurance (flying out once to have dinner with the head of the Port Authority of Los Angeles, who we discovered, part way through the first course, had -- surprise -- thought we were selling port insurance). We co-authored a paper in 1988, In Search of the Liability Asset, that is still on various reading lists, maybe not for actuaries, but at least for those in finance.

Jeremy left Morgan Stanley in the late 1980's to get a Ph.D. from Wharton, and spent the next twenty years as a thorn in the side of the actuarial profession, pushing them to add financial and economic structure to their methods. One of the best and most widely read of his works for this is the paper Reinventing Pension Actuarial Science.

At the base of it, finance is not actuarial science.  It is not predicated on repeatable, or even known, probabilities. There is no appeal to the law of large numbers for the systematic risks of the financial system.The future does not look like the past. There are no mortality tables for asset returns.

...What do actuaries and Packer fans have in common? They both think that history will repeat itself...

So if you want to be the arbiter for over 20 trillion of U.S. pension assets, a good start is to do it based upon a foundation in finance.


Monday, November 13, 2017

More on ETFs -- A Little Craziness in High Yield Bond ETFs

I wrote a post a month or so ago on the risks from ETFs, in particular how ETFs on less liquid markets -- with high yield bonds being my poster child -- could cause problems for the market generally.  Basically that there is a fundamental flaw when people think an instrument based on a illiquid market is capable of intraday liquidity. And that if the ETFs in such a market have a severe problem, ETFs generally might be considered tainted by a range of retail investors, leading to an outflow from even the more liquid ETFs.

Here is an article that points toward the potential for problems with high yield bond ETFs:
Investors Playing ETF Rout Pushed Junk Bonds to Brink of Chaos. 

Excerpt:

Trading in exchange-traded funds got a little crazy last week when it became clear that junk bonds were in for more pain. But the market was fortunate the consequences weren’t more severe, strategists warn. Though spared the worst, investors came close to creating a scenario where ETF activity drove prices....a snowball effect where a dislocation develops between the fund price and the value of its underlying assets.

Saturday, November 4, 2017

Our Low Risk (Low Volatility) World

In case you haven't noticed -- and I haven't -- we apparently are in a world of exceptionally low risk. To see this you need look no further than the volatility of the major markets. The volatility of the U.S. equity market, for one, is at its lowest level in a generation. So, no worries here, right?

I wrote a blog post in 2011 titled The Volatility Paradox which explained that when volatility is low, risk is actually rising because people are more emboldened to take on higher leverage and to move to riskier assets. If volatility is half of what it used to be, why not lever twice as much? Thus the immediate question is what happens if there is a sudden surge in volatility from our current, low level. What is the dynamic through which a volatility shock might propagate across the financial system?

A conventional stress test will assess positions that have explicit volatility exposure, such as positions in options, in the VIX and other volatility-based instruments. There is plenty of dry powder here; over the course of 2017, as the U.S. equity market volatility as measured by the VIX index dropped to one of its lowest points in history, we have seen a growing concentration in short volatility exposure by leveraged ETFs, mutual funds, and hedge funds.

But a stress test that does the simple mathematical calculation of direct portfolio exposure to volatility will underestimate the effect of a rise in volatility, because there are dynamics triggered by other strategies that do not have explicit volatility exposure but that have a link to the volatility of assets and to the assets themselves. A rise in volatility will trigger actions for these strategies, leading to selling of the underlying assets, and this in turn will lead volatility to rise even more, creating a positive feedback between the volatility of the market and the assets in the market.

What are these strategies? Well, a good place to start are volatility targeting, risk parity, and other strategies that will rebalance their portfolios when volatility rises. Volatility targeting is a strategy that targets a level of volatility to manage risk that is typically set based on the manager’s mandate. For example, the manager might follow a strategy that will seek to keep the portfolio’s volatility near 12%. If the volatility of the market is 12%, the fund can be fully invested. However, if the volatility of the market rises to 24%, the fund will sell half of its holdings in order to stay in line with its 12% target. Risk parity allocates portfolio weights to have the same total dollar volatility in each asset class. These multi-asset class strategies often use leverage to adjust holdings of underlying assets, buying more of the lower volatility assets relative to the higher volatility ones. If the volatility of one of the asset classes rises, the fund will need to sell some of that asset class in order to maintain equal dollar volatility. In both of these cases, there is a clear mechanism going from the rise in volatility to a drop in the underlying asset.

Things won't all happen at once. The agents for these strategies differ significantly in their time horizon. Those who are directly linked to volatility, those that are in short-volatility ETFs and the like, will have an immediate P&L effect from a surge in volatility, and will need to reduce their positions immediately. The volatility targeters will only reduce positions as the rise in volatility is seen as having a non-transient component, and their adjustments will be in a weekly to monthly time scale.  And the risk parity agents will have an even longer time horizon, because they generally make asset adjustment with a monthly or quarterly time frame, and do readjustments based on a longer-term estimate of volatility.

Oh, a little more on the relationship between low volatility and risk: If you want to see really low volatility, look back at the swaps markets in the summer of 1998. But you might recall that in August of 1998 there was a rash of defaults in Russia, which was then followed by the blow up of LTCM, the (before that) famously successful quant fund whose principals a few months earlier had graced the cover of Business Week (never a good sign). In that case, low volatility didn't spell low perceptions of risk, it was an indication that no one wanted to go into those markets because things were so uncertain. I go through my first-hand experiences with this in one of the chapters of my 2007 book, A Demon of Our Own Design.

Thursday, November 2, 2017

Interview in the U.K. for the Daily Mail

I had a video interview in the U.K. on my recent book, The End of Theory, with Rachel Straus, (Big Money Questions), that just came out with the Daily Mail. You can get to it here.

Monday, October 30, 2017

The Vanishing Pavilions: The Gutting of the Government and the Loss of Oral Tradition

What will be the longest-term damage of the Trump era? A strong, principled leader will restore some semblance of decency and ethics. Foreign governments might view this period as a bad dream, or an outlier event that veered the U.S. away from a now-returning normal. The anti-scientfiic and pro-industry biases in the various departments and agencies can be rectified just as quickly as they were enacted.

There has been plenty of discussion of where the long-term damage might be on the world stage; the new path governments and businesses are taking toward China -- this might have been inevitable, and Trump has been nothing more than an accelerant; the move toward center stage of China and Germany as world leaders.

But within the U.S. the long-term damage will be more subtle. It will be the loss of the oral tradition, of institutional memory, in our government. That is, the loss of processes and interactions that are conveyed by word of mouth and by example as opposed to by written instructions.

The U.S. Treasury is a case in point. I worked there after the financial crisis, helping draft the Volcker Rule, setting up the risk management structure to get information up to the Financial Stability Oversight Council, and building an agent-based models to help assess financial instabilities. I just went back to the Treasury for the first time since the start of the year to find that is has been gutted. This is not something that is on many people's minds, but it has implications that will be felt far beyond the time that a new administration comes on the scene that wants to return the department to a more normal state.

The reason, in a nutshell, is that what the Treasury does -- and what, for that matter the State Department, a department that is in even worse shape, does -- is not in any manuals. It is set on a foundation of what might be called oral tradition. People know how things work, how to get things done, and if the keepers of the oral tradition leave, it all has to start back up from scratch.

When a new administration comes in, it is the normal course of business for all the appointees to be replaced. Generally the new appointees come from outside government, and have not had previous experience in the Treasury. They rely on the staff, which mostly stays from one administration to the next. They know the process for getting things done, for developing and administering policy.

The Treasury is not a regulator per se, but it tends to be the center of communication -- and the referee when necessary -- for the agencies that do have regulatory authority: the SEC, FDIC, CFTC, etc. There is a process that has been honed over many administrations for doing this job, for acting as the central switchboard for dealing with financial issues. What happens when the switchboard operators walk out the door, and there is no operation manual to leave behind?


Thursday, October 26, 2017

On WealthTrack for the 30th Anniversary of the 1987 Crash

I was the guest for the PBS show WealthTrack for the 30th anniversary of the 1987 stock market crash.  Here is a link to it.