tag:unpleasantfacts.com,2013:/posts Unpleasant Facts and Other Musings 2014-10-22T23:22:17Z Jeff Lonsdale tag:unpleasantfacts.com,2013:Post/759014 2014-10-22T21:53:02Z 2014-10-22T23:22:17Z Attempting to Align Incentives: Banking Employees Edition William Dudley, President of the New York Federal Reserve Bank, has an interesting idea on how to align the incentives of banking employees with the desires of bank regulators: Defer their bonus payments for 10 years and take regulatory fines out of the bonus pool. From his speech:

However, in contrast to the issue of trading risk, unethical and illegal behavior may take a much longer period of time—measured in many years—to surface and to be fully resolved.  For this reason, I believe that it is also important to have a component of deferred compensation that does not begin to vest for several years.  For example, the deferral period might be five years, with uniform vesting over an additional five years.  Given recent experience, a decade would seem to be a reasonable timeframe to provide sufficient time and space for any illegal actions or violations of the firm’s culture to materialize and fines and legal penalties realized.  As I will argue below, I also believe that this longer vesting portion of the deferred compensation should be debt as opposed to equity.

There is no question that banking incentives are broken. In the run up to the 2008 financial crisis employees were generating what looked like revenue in the short term, but ended up actually destroying many companies. Other companies were found to be systematically violating regulations designed to protect consumers, often because a simple cost benefit analysis can find that breaking the rules now and paying the fines later is more profitable than other approaches. Employees involved might accurately estimate that the chance of significant bonus clawbacks are generally close to zero percent. It's the shareholders who are stuck with the bill years after the bank's employees have walked away with between 40% to 50% of the revenue they generated.

What challenges will a Dudley style system encounter?

If the bonus pool is too lumped together the responsibility will be too diffuse to matter. Bear Stearns and Lehman both had significant employee stock ownership, and yet both firms went belly up in the 2008 crisis. Work will have to be done to ensure that the people causing the trouble are hit first and hardest by the problems they cause.

The deferal unilaterally changes the deal between shareholders and employees, and employees who do not want to wait for their bonus payments will leave the regulated sector. This may actually be a good thing, as FDIC insured institutions shouldn't be in the business of creating free call options for employees looking for a quick payout.

Base salaries will go up as a portion of total compensation to make up for slower payouts. Higher base salaries and smaller bonuses can cause employees to act in a more risk averse manner.

If this system isn't implemented unilaterally through all FDIC insured banks at once the employees with the most earnings potential will leave banks implementing this policy for greener pastures. Like reform to the modern college education system, reform has to come from the high status players or all at once.  

If a mandatory deferred compensation system was imposed from the top down as one of the requirements for deposit insurance or for institutions with access to the Federal Reserve discount window or for primary dealers then it has the potential to help more than harm. Shareholders win because they are more protected from the bad behavior of their employees. Citizens who are better protected against renegade employees and less likely to fund bank bailouts win, while certain employees who have been enjoying a "heads I win, tails you lose" dynamic are inconvenienced.

One caveat: Top down regulations on compensation are generally undesirable. Right now it is arguably too difficult to comply with all of the regulations that banks are supposed to follow - it's crazy that Citi needs 30,000 people working in compliance. This part of the system is also broken. And a congress plus a regulatory body trying to implement Dudley's reforms in some form may end up doing much more harm than good. But the financial industry, with both government subsidies and significant moral hazard, needs better ways to reign in broken incentives. Dudley's proposal gets a lot of things right.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/754884 2014-10-13T22:09:09Z 2014-10-13T22:12:09Z Note to Silicon Valley: Jean Tirole is Relevant Most Nobel Prize winning economic work is ignored by people trying to understand Silicon Valley, and for good reason. Subjects like macroeconomics and trade theory are rarely relevant for what people are doing on a day to day basis. Even the issue of efficient markets is a non-question. The venture capitalists don't believe and the people trying to automate wealth management accept it is true as a matter of faith.

But the work of Jean Tirole, who was awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2014, is far more applicable to understanding the ecosystem of the technology sector. His work spanned many areas, but it is primarily on how to understand and regulate industries with few powerful firms. The Swedish Royal Academy of Sciences released a short summary of Jean Tirole's work here and their in-depth look is here - or just read Tyler Cowen's summary.

But why is this relevant for understanding the technology ecosystem? As Peter Thiel makes clear in Zero to One, one of the goals of a startup is to create an area where they are a monopoly. Google has an effective monopoly in online search. Facebook is the internet's most complete personal directory and the world's largest photo sharing company, LinkedIn owns everyone's online rolodex. Airbnb, Uber and many other successful new companies are successful because they essentially own their respective domains. Understanding the dynamics of market power is essential to understanding the most successful technology companies.

Once a firm is first to market, the question of what extent they should go to in order to deter competitors is a complicated question. In 1984, Jean Tirole and Drew Fudenberg plublished a paper on whether firms in various scenarios should over invest to protect their monopolies or if they should accept that they are going to face competition and stay lean and agile. The paper also highlights scenarios where the large initial investment to claim market share reduces a company's incentive to innovate, leaving them ripe for disruption after they have enjoyed the benefits of monopoly profits for a decade or two.

Another interesting question often faced today is that there is a company with a monopoly over one area, but how can they take that advantage to profit in other sectors? Tirole wrote many papers on vertical integration and monopoly power, and he did a literature survey of the field with Patrick Rey. Even if the goal of the literature is to figure out when to regulate these monopolies, companies can also use these strategies to find ways to expand their profit and market share. A mild version of this tactic is utilized by Microsoft when they release subpar versions of Microsoft Office to Mac so that power Excel users will be pushed to remain on the Windows platform.

Many startups are looking to build platform companies, where one company owns a two sided market and sells to both consumers and producers. Others may just want to better understand the incentives of the stores they are using to get their product to consumers. Jean was one of the first people to understand that maybe newspapers should be giving away their paper for free if that means they can charge businesses more for ads. This type of competition by the newspapers can drive their competitors out of business, but this seemingly monopolistic practice is benign - in many scenarios platform companies make is so everybody (except the platform competitors) wins. Here is a paper on Platform Competition that Tirole wrote with Jean-Charles Rochet - or better yet, a literature survey published three years later.  Alex Tabarrok and Vox have short posts addressing some of his work on platform markets.

This is only scratching the surface of his work, but it shows that many of the ideas driving value creation in Silicon Valley today have been analyzed in academia to a significant degree. These are complicated problems and sometimes returning to look at what the theory says can keep practitioners from making avoidable mistakes.  

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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/753968 2014-10-11T05:56:27Z 2014-10-11T05:56:27Z Snapshots of our world: Assorted Links
1. Tim Harford uses the analogy of picking the fastest grocery store checkout line to explain the efficient market hypothesis. Ironically, the advent of self service aisles has created an option that lets customers get out of the grocery store

2. The internet of murder things.

3. Welcome to the US, where everyone is guilty of something

4. And some things (literally things, not people) are guilty until proven innocent. (HT: MR)

5. Consumers in the US are spending more money on luxuries. All of them, not just the one percent.

6. A chart that highlights one of the impacts of the expansion of democracy to the masses. Presidents have to speak more simply in modern times. 
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/752218 2014-10-07T20:27:52Z 2014-10-07T20:27:52Z DFW: No such thing as atheism I recently came across a collection of audio recordings by David Foster Wallace. Some of the short stories from Brief Interviews with Hideous Men are far more disturbing when I am forced to listen to every word and cannot just skim quickly past some of the more gruesome scenes. 

His commencement speech "This is Water" (transcript) is one of the more striking parts of the collection. This passage is towards the end of the piece:

Because here's something else that's weird but true: in the day-to day trenches of adult life, there is actually no such thing as atheism. There is no such thing as not worshipping. Everybody worships. The only choice we get is what to worship. And the compelling reason for maybe choosing some sort of god or spiritual-type thing to worship -- be it JC or Allah, be it YHWH or the Wiccan Mother Goddess, or the Four Noble Truths, or some inviolable set of ethical principles -- is that pretty much anything else you worship will eat you alive. If you worship money and things, if they are where you tap real meaning in life, then you will never have enough, never feel you have enough. It's the truth. Worship your body and beauty and sexual allure and you will always feel ugly. And when time and age start showing, you will die a million deaths before they finally grieve you. On one level, we all know this stuff already. It's been codified as myths, proverbs, clichés, epigrams, parables; the skeleton of every great story. The whole trick is keeping the truth up front in daily consciousness.

Worship power, you will end up feeling weak and afraid, and you will need ever more power over others to numb you to your own fear. Worship your intellect, being seen as smart, you will end up feeling stupid, a fraud, always on the verge of being found out. But the insidious thing about these forms of worship is not that they're evil or sinful, it's that they're unconscious. They are default settings.

It's worth noting that a trite message can still be important, true and undervalued.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/747950 2014-09-29T00:17:57Z 2014-09-29T00:17:58Z Assorted Links 1. Bill Gross left Pimco. When some CEOs leave their companies the shareholders celebrate. In the case of Bill Gross leaving the shareholders of Pimco's parent company, Allianz, decided that the company was worth about 3.8 billion dollars less than the day before. Part of this 3.8 billion dollars is related to new information about the severity of the problems that caused Gross to leave in the first place. But because Bill Gross chose to join Janus Capital the same day, we are left with an estimate of about how much the market values the human capital of Bill Gross - slightly under $900 million dollars.

2. Clay Shirky tries to help his students stop multitasking. Apparently there are many drawbacks to multitasking and I should stop making assorted link posts. (fortunately for me these posts are generally a symptom of my multitasking and not one of its causes)

3. Regulatory capture in the financial sector: Goldman Sachs vs the Fed. We should expect these problems to persist for as long as regulators are hoping to find work for the companies they are regulating (or companies doing a significant amount of business with the regulated companies).

It's interesting to see the PR machine of Goldman go to work on damage control. First the response is "This person tried to get a job from us many times" implying that the employee was merely bitter. They also highlighted the fact that Goldman did have a conflict of interest policy and thus the whistle-blower was wrong (without any emphasis as to whether or not it was effective). Shortly thereafter, there is a massive change in Goldman's conflict of interest policy. 
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/745841 2014-09-23T23:37:16Z 2014-09-23T23:37:16Z The Best People on the Internet Are those who don't comment. So those who accidentally browse the comment section of popular websites should take solace in the fact that comments are not a reflection of the general population.

Via slate and the original paper.

While the study focuses on the behavior of trolls, it's interesting to note that people who are interested in debating issues also have more traits associated with Machiavellianism and sadism than others.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/744103 2014-09-19T20:48:52Z 2014-09-19T20:48:52Z An implication of the BABA IPO After the Alibaba IPO, the market is on average expecting that Yahoo's CEO Marissa Mayer is going to destroy $11 billion dollars in shareholder value. That's how much the operating company of Yahoo is valued at when stripped of its cash, Alibaba and Yahoo Japan holdings.  

This is actually a little harsh. There are some tax issues which would lower the $11 billion number slightly. On top of this - Alibaba is currently very hard for an arbitrager to short. Once it becomes easier to borrow Alibaba stock it is likely that the implicit negative valuation of the core Yahoo business will shrink.

Investors are guessing that a significant portion of proceeds from Yahoo's Alibaba stake are going to go towards value destroying acquisitions that boost the importance of the CEO at the expense of shareholders. When Facebook bought Instagram, they made a good decision to buy a nascent competitor who understood the mobile space. When Yahoo bought Tumblr for $1.1 billion, Mayer spent $750 million of that cost on intangible assets in an attempt to try make Yahoo relevant/cool, with the side effect that the person running Yahoo would also be more relevant*. 

Mayer can prove the doubters wrong in one of two ways. The easiest way is to find a tax advantageous way to return money and shares to the shareholders. The harder way is to make acquisitions like the market expects, but to buy companies that will actually generate earnings for the core operating company.

Mayer taking the hard approach is the most likely, but she has committed to returning at least 50% of the proceeds of the Alibaba IPO to Yahoo shareholders. Given that this payback, it is really hard to destroy as much value as the market is currently pricing in . They are probably paying too much attention to Yahoo's past acquisitions of GeoCities and Broadcast.com. 

And given how cheaply Yahoo is currently trading, this entire discussion could be moot. Yahoo itself could be bought before we have a chance to find out what Mayer would have done with its influx of money.


*It's important to note that Tumblr's value has gone up if value is measured on a basis of how many users the service has, but it has disappointed the market in that it has been harder than expected to generate revenue from these users.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/742266 2014-09-16T07:23:16Z 2014-09-16T07:23:18Z Assorted Links 1. One of the scariest things for a start up in the valley today is the prospect of a down round. Interestingly enough, Facebook had one in 2009. Their value was over $10 billion and it was in the midst of a financial crisis, but it's still interesting to note that it happened.

2. Peter Thiel did an AMA. I for one have always thought that capitalism was the private ownership of the means of production. But the insight that the best investments are outside of commodified industries almost sounds like the best businesses are those with a moat or long lasting competitive advantage. This theme has helped other investors compound significant amounts of capital for a long time.

3. Positive news on the US patent front. But there is a long way to go.

4. The concept of time optimization, engaging in activities at unusual time to get better use out of underutilized resources, is severely undervalued in most people's everyday life. This advice from Tyler Cowen about eating early in the evening before restaurants get sloppy is interesting. It's best for those who either do not need to eat with others or who have enough status to convince others to eat with them at an unconventional time.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/735810 2014-09-03T07:04:50Z 2014-09-03T19:43:05Z Revolving Door Politics Needs a Systemic Solution Eric Cantor, the former House Majority Leader who recently lost his primary, demonstrates a major hole in the current campaign finance reform agenda via his recent actions.

Long accused of being too friendly to Wall Street, Cantor is now being paid very well to work for a boutique investment bank. His contract includes a relatively common provision in which leaving to go back to work in politics is essentially encouraged:

Unvested initial RSUs and unvested incentive RSUs will be forfeited if Group LP terminates Mr. Cantor for cause or if Mr. Cantor terminates his employment other than (i) for good reason or (ii) after the second anniversary of the grant date, to take a full-time elected or appointed position in federal government, state government, or a national political party.

So not only are they monetizing his connections now, but they are paying him millions of dollars and assuming that he will go back into politics after two years. This is a very common practice. Rahm Emanuel also decided to monetize his political connections after his time with the Clinton White House. Then in late 2008 he was part of an incoming Obama team, part of whose job was to determine whether or not the bail out of the financial system should retain the status quo in which too big to fail banks could make the equivalent of "Heads I win, tails you lose" bets. It's hard to imagine that a group of people who know that multimillion dollar jobs are easily available from the companies whose fates are in their hands will be able to remain unbiased. 

More egregiously, Raj Date worked as deputy director of the Consumer Financial Protection Bureau where he helped create regulations that drove banks out of an area of the mortgage business and then started a financial company to take advantage of the hole in the market he helped create. Less ambitious regulators might not create business opportunities for themselves quite so directly, but the incentives and opportunities for them to do this are there.

Ideas like the PAC to end all PACs would reform the financing of elections, letting congressmen study legislation more closely if they didn't have to spend as much time fundraising. But this does nothing about where their big pay days come from after leaving office. Even under a revised system, any officials and elected representatives can still choose to spend a significant portion of their time thinking about how they can help the very same people they are soliciting political donations from today. The practice doesn't have to be obvious, they don't even need to get jobs directly from the influentials they help. If the officials/politicians are owed favors they can call in favors while working for their new employer and everything will look above board.

It's difficult to quantify the potential positive impact of campaign finance reform compared to closing the revolving door between business and government, but on a relative basis solutions for the revolving door problem deserves much more attention.

Right now the revolving door is only brought up during partisan high profile nominations (when the partisans will bring up anything that makes a nominee look bad) or when those appointed officials are perceived to be misbehaving (like with Tom Wheeler and the FCC's and net neutrality rules).  And so the US still lacks broad systemic rules to stop those who create or enforce legislation and regulation from immediately getting high profile jobs in the private sector where they can monetize their owed favors and connections. Unless the officials are making decisions directly related to government contracts it doesn't matter where they work. And activists don't seem to be putting actionable solutions on the table - outing the people involved in revolving door politics or trying to block a few nominations seems to be as far as most groups will go.

Partially this is because there is less incentive for people in power on either side of the aisle to bring further attention to a practice that helps themselves or at least helps their friends and colleagues. Finance reform has a natural constuency among legislators - those who aren't as good at raising money and those who dislike the process of raising money can support it or at least be lukewarm about the idea. On top of this, those on the left don't favor revolving door storylines that paint government officials in a negative light when the problem of attracting good people to government work and getting voters to back additional progressive policies is a higher priority. 

And the op-ed writers pushing for campaign finance reform have an extra selfish incentive to do so - if generic rich people have a harder time making their voice heard then the ones in control of the media, such as the writers who have a column every Sunday, will have more impact.  They don't have the same incentive to talk about system wide solutions to revolving door politics. Pushing for policies that would hurt the economic wellbeing of legislators and officials could cause them to lose the access that makes their job significantly easier. 

Like campaign finance reform, the solution to the revolving door issue can get messy and complicated once implementation is considered.  France imposes a three year waiting period between working for the government and working in the private sector. This seems biased towards keeping poor people out of politics, but some version of this rule with exceptions carved out for unrelated jobs such as medical practice or teaching would be an improvement on the status quo. Singapore's solution of paying officials very well, just not quite as well as their private sector counterparts, works well in the context of their political system. Mandatory transparency from former officials in their business dealings after leaving office would also improve the situation.

When it comes to getting money out of politics, it's time to admit that the revolving door is a significant problem that requires a systemic solution.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/729079 2014-08-18T21:41:38Z 2014-08-18T21:41:38Z Unassociated Links 1. The Flynn effect has yet to have a significant impact in Liberia.

Exhibit A: The looting of an Ebola quarantine center and the stealing of, among other things, bloody sheets.

Incidentally, the next time we see an article on how average white political science major can't possible do much good over there - remember how irrational and uneducated members of these developing countries can be.

2. Brad DeLong on long run market returns and the cyclically adjusted PE. There are a lot of reasons to be skeptical of the Shiller's CAPE as it applies to predicting future long run equity market returns - it's a relatively unhelpful metric that gets far too much airtime.

3. An example of how not to run a police officer camera program - the SDPD refuses to release camera footage when it matters.

"San Diego police effectively lock any relevant videos in a vault and throw away the public's key. The footage their officers record will never show up on YouTube and go viral. Nor will it help fill in the gaps when a major crime leaves lots of unanswered questions. Crime victims or their families may never get to see and hear what the devices recorded."

It's not just a question of getting police to wear cameras, the policy also has to promote transparency.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/727494 2014-08-14T20:26:47Z 2014-08-16T00:14:43Z Some Thoughts on Ferguson and Police Transparency We don't know what happened when Michael Brown was killed, but the way the Ferguson police department is acting makes them hard to trust. Washingtonpost reporters have been arrested in two cities this year: Tehran, Iran and Ferguson, MO.  It is likely that the non-police witness's version of the story is true. an unarmed black teen was killed with his hands up by a white police officer. The way the Ferguson police department is refusing to even name the officer is reminiscent of the way police departments around the country often respond to investigations - by protecting their own. And the records indicate that Ferguson police are racially biased - the percent of whites found with contraband that are arrested is just 15% compared to the almost 50% for blacks (Presumably not all of these arrests are related to the contraband found, but it's a way to control for how police treat members of the groups who have committed some type of crime).

Rand Paul's op ed on the excessive militarization of police is dead on. It's interesting that he is walking the fine line and taking what can be construed as an anti-law and order stance because he is one of the front runners for the GOP nomination. 

It's probably because he is aiming to win the nomination that he didn't go farther: Active duty police officers need to be automatically recording everything they do. With recordings, incidents such as those happening in Ferguson can be quickly resolved one way or another. When tested in Rialto, California, recording reduced both complaints filed against police officers and the incidents where use of force was required. There will still be cases where police officers use excessive force in murky situations but by and large transparancy via recorded police and citizen interactions should protect the innocent parties, see more guilty parties punished and cause better behavior all around.

The main obstacle for making officers record everything is the political reaction to how such policies impact the status of police officers. The word of a police officer is generally trusted more than the word of a suspect. Telling officers "We are going to make you record every interaction" sounds less like "We are protecting you from false allegations" and more like "Officers, we know you often risk you life as you protect citizens but we don't quite trust you." The way many police officers currently respond to citizens legally filming on duty police is telling - many officers would prefer to remain in control of situations without anyone looking over their shoulder. And the options on the table aren't just "Recording or no recording" - there is also the option of letting police officers record when it protects the officer and not record when it might incriminate themselves. 

Even if recording was always on there is still the issue of structuring the system so the police are unable to delete incriminating evidence. There is also the problem of whether or not pervassive recording might have unintended negative side effects when recording technology is combined with facial recognition and prosecutorial discretion. 

Despite its potential flaws, the upside of preventing police misconduct (murder/manslaughter, for instance) and the potential riots that follow are likely bigger than the downsides. The idea that interactions between police and citizens needs to be recorded as a matter of course needs to be a bigger part of the discussion after these types of events.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/726576 2014-08-13T01:19:22Z 2014-08-13T01:19:22Z Assorted Links 1. Advice to Hillary for 2016 from an anti-interventionist: Please just lie to us? Apologies for the pseudo partisan snark, but if anti-war candidates from Woodrow Wilson to Barack Obama can't seem to keep our country out of war it seems odd to think that pressuring a known element to modify their rhetoric will have any real impact.

2. College admissions and sports - 20% of admissions at Ivy's and small liberal arts colleges are recruited atheletes. And it isn't just the big sports, Harvard has 39 intercollegiate teams. Are esoteric sports that are rare outside of wealthy school districts the easiest ways for colleges to discriminate in favor of wealthy and/or legacy admissions?  This is probably why preferential admission for college athletics lacks many of the critics that are directed at affirmative action. While the plight of the college football players who aren't ready for college might get some notice, the rich, relatively athletic but otherwise average student who gets into their Ivy of choice because of lacrosse or crew isn't given a second thought.

3. This defense of large US braodband companies by the Mercatus Institute is interesting because it challenges the current zeitgeist, but it misses the point on quite a few marks. First, they add in media taxes that EU citizens are paying anyway for owning television and radio and use this to erroneously suggest that this makes US broadband costs equivalent to rates of other developed countries. More generally, arguing for an institutional structure that encourages and rewards investment is correct, but most of these companies are also holding local monopolies which need to be addressed.

4.  Sometimes, low investor confidence is an opportunity that needs to be taken advantage of rather than a problem that needs to be solved. Kinder Morgan's gigantic M&A transaction shows how connected businessmen can capitalize on control of their companies when faced with doubters. The Kinder Morgan Energy Partners LP was trading at a discount to peers after it looked like the bulk of its future gains would go to the general partner and not the limited partners of the MLP.  This made the economics of the general partner KMI buying out the LPs favorable to everyone relative to the status quo. 
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/724981 2014-08-09T00:00:09Z 2014-08-09T00:00:09Z Correlation and Causation and Inequality In a takedown of the recent S&P study on inequality and growth (HT: MR), John Cochrane gives us the following quip that I wanted to share/save:

Well, that's what forecasting is about. "The weather forecaster causes rain" is a model that forecasts well. Until you try to kidnap the forecaster and make a sunny day.

It sounds like the plot of a very fun movie.

With regards to the S&P report on inequality, worries about inequality impacting aggregate demand shouldn't be too worrisome. Aggregate demand is a cyclical issue that can be managed by monetary policy when needed. 

However, the hypothesis that relatively bad education outcomes are driving both low growth and higher inequality than in the past is more worrisome. The modern education system is ill suited to the needs of many people and those at the bottom of the ladder are increasingly forced to compete on a global basis when they enter the workforce (Or rather, they are forced into local service jobs because of potential global competition). Combined with assortive mating, the children of those with poor education may continue to have poor education and low productivity themselves - thus lowering future economic growth.

It should be pointed out that inequality is not the causal drver of growth in this analysis, education and globalization are the main driving factors. And while this is related to inequality, worrying about the education gap is different from worrying about whether or not the growing wealth of the 1% will impact future economic growth.

Here is a thesis of how inequality of the 1% and growth might be related (particuarly in more corrupt developing countries): High levels of inequality are sometimes a symptom of excessive rent seeking. This rent seeking is damaging to long term economic growth. In these cases redistribution may not improve growth outcomes unless the rent seeking behavior is itself taxed. Since the most successful rent seekers are generally people with significant political influence, it's very unlikely that they'd lose the battle. But it could still be one worth having. 
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/720419 2014-07-29T21:15:59Z 2014-07-29T21:15:59Z Piketty and Expected Return One of my favorite blogs came out of hibernation to comment on Piketty (Warning, it's pretty overtly political), and it reminded me that I still haven't contributed.

A lot of ink has been spilled the question of whether or not the return on capital after will be above the growth rate for significant periods of time.  The merits of the arguments generally fall on the side of r > g in perpetuity being nonsense. Either labor prices have to eventually rise (on a global basis they are doing just that) or the return on capital needs to fall.

How can the return on capital fall? Two ways come to mind.

1. Earnings stop growing. This can happen when effective taxes go up more than prices rise to compensate for the increase. This would also occur if unit labor costs started increasing more quickly than the prices of goods sold and profit margins fall. Already, the sales growth of the S&P 500 has been below the economic growth rate of the economy for the past few years - and this is noteable because the S&P also has exposure to faster growing emerging market economies. 

2. The expected return of assets fall. 

#2 has been interesting - because it is what has been happening over the past few years and yet analysts have if anything gotten more worried about wealth inequality. That's because in order for the expected future returns to capital to fall, prices today need to go up. A company with an earnings to enterprise value of 10% has a much higher expected future return than a very similar company with the ratio at 2.5%. But if the company is earning one million dollars a year in cash, it would have to move from a $10 million dollar valuation to a $40 million dollar valuation in order to reduce the expected return on capital. 

Analysts looking at the 16.0% total return to the S&P 500 in 2012 and 32.4% returns in 2013 will plug those numbers into models which uses past returns to predict future returns for various asset classes. After the recent bull market, they might assume that the future return on capital will be even higher than it was in the past. But over this time period, the price to earnings ratio rose from 14.87 to 18.15. In other words, the average earnings yield of all of the companies fell from 6.7% to 5.5%. Instead of concluding that the expected rate of return on capital is higher, analysts should be assuming that future returns will be lower.

The same principles apply to other asset classes, but in many cases interest rates are already below the nominal growth rate of the economy. Equities are one of the few places where the earnings yield is above the growth rate. So if we find ourselves watching the stock market go up over the next few years, it actually means Piketty is more likely to be empircally wrong than right in his r > g prediction on a forward looking basis..
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/715287 2014-07-17T19:38:40Z 2014-07-17T19:45:32Z Market Commentary from the Fed

In 1996, Alan Greenspan didn’t mean to say the markets were suffering from irrational exuberance, he just implied it when discussing whether or not central bankers should worry about the stability of asset prices:

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

Source: Bloomberg

After mentioning how concerned the Federal Reserve must be with asset price stability, Greenspan presided over one of the largest asset bubbles in modern history over the next three years.  Almost 18 years later when the S&P 500 is again making new highs, Janet Yellen has waded into the market commentary space with the Federal Reserve’s recent Monetary Policy Report. The valuation of a smaller class of equities is questioned:

Some broad equity price indexes have increased to all-time highs in nominal terms since the end of 2013. However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities. Nevertheless, valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year. Moreover, implied volatility for the overall S&P 500 index, as calculated from option prices, has declined in recent months to low levels last recorded in the mid-1990s and mid-2000s, reflecting improved market sentiment and, perhaps, the influence of “reach for yield” behavior by some investors.

(Emphasis added)

On a price to book basis, it does look like valuations are stretched in biotech companies.

Source: Bloomberg

The value of biotech companies, and social media companies for that matter, come from intangibles that aren’t measured in book value and are yet to be captured in earnings.  What the high valuation tells us is that investors think the expected value of these companies is higher relative to its tangible book value than it has been in the past. That may be because the drugs the new companies are working are particularly promising, or because investors have decided to value the lottery-like payout of biotech stocks at higher prices. But either way, investors can’t be said to be “reaching for yield” in these sectors because it’s exactly the wrong place to look for yield – yield only comes after sales and earnings exist.

The beta of the Nasdaq Biotech index to the market is 1.2, which implies that biotech stock valuations are being moved by factors other than whether or not their drug trials are going well. Part of the explanation may be that in a high liquidity environment the market will value lottery tickets more highly.  A higher proportion of companies with no earnings have been going IPO since the 1999 tech bubble.  And the companies with no earnings will on average have bigger IPO day pops than companies with earnings. It’s almost as if there is something about real earnings that makes investors look more skeptically at a company.

Source: Initial Public Offerings: Updated Statistics, Jay R. Ritter

The Federal Reserve report also mentions low interest rates, and compares them to the mid 90’s and mid 2000’s. Data for implied volatility doesn’t go back much farther than the 90’s, but we can look at the historic volatility as a proxy.

Source: Bloomberg, Author's Calculations

The other time periods that volatility was low were good economic times, the early 50’s and mid 60’s. So while regulators might be worried about the formation of eventual imbalances, it’s much more likely for low volatility time periods to lead to future periods of low volatility and high growth. The next Minsky moment in the US economy is a long way off.

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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/712021 2014-07-08T22:53:34Z 2014-07-08T23:22:50Z Unassorted Links 1. Keith Rabois has been raising money for a company that is likely to eventually be a REIT that will be easily funded thanks to its Silicon Valley halo.

2. Some of the odder parts of Transformers explained. (HT: Vasu) One of the interesting side effects of the rise of the Chinese consumer is cameos by pop stars and famous atheletes in blockbuster movies that are totally unknown to US consumers.

3. A Harvard professor demonstrates that social scientists suffer from significant cognitive biases when their status is called into question by others who fail to replicate experiments meant to prove subtle effects such as various priming scenarios. (HT: MR) The belief that most sociological theories tested in the lab are as true and unrefutable as the existence of black swans leads to silly attempts to defend them from criticism. One point that is worth thinking about is how to fully align the incentives of those who replicate studies with truth seeking behavior - if studies are only replicated when there is an axe to grind then there will be false negatives. But the proper answer to this problem should involve raising the status of those who replicate published studies rather than denigrating them. Pre-registering experimental methods (as the author suggests) - and publishing the results regardless of the outcome - would also help.

4.Tim Harford points out that low volatility is pretty consistent with good economic times. Before low volatility leads to high volatility and disruption, it leads to more low volatility growth.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/709745 2014-07-02T00:40:36Z 2014-07-02T00:40:36Z Assorted Links 1. Politics is not about policy - it's about who deserves higher status. Exhibt #5,271: The reaction to the Hobby Lobby SCOTUS ruling. (The SCOTUS is not to be confused with SCOTUSblog).

2. Facebook's psychological study caused a minor scandal, even if it didn't necessarily do what it claimed to do. On the one hand, this can be seen as worrisome that Facebook modified newsfeeds of some users and might have made them feel slightly worse. But on the other hand - it's seen as unethical to reproduce so many of the landmark experiments of our time and it is interesting that private companies have the potential to fund and run smaller experiments in potentially less regulated environments.

3. The value provided by HFT. Barclays wanted to pretend to pretend that they didn't have any "predatory" HFT firms in their system but without those firms they wouldn't have the liquidity to run their own dark pool.

4. Unfortunately for those growing up in poverty, peer group effects are very important. This link is quite relevant for anyone wondering whether or not they should utilize San Francisco's public school system.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/708040 2014-06-26T21:25:49Z 2014-06-26T21:25:49Z Momentum is still significant Campbell R. Harvey, Liu and Zhu present an analysis where they find that academic papers on cross sectional stock market factors are apparently about as untrustworthy as a large portion of medical literature. (HT: MR) Published papers in medical literature and on stock market factors suffer from data mining and publication bias issues where only positive results are analyzed and published. Not finding something is rarely seen as an accomplishment in the academic world. So after thousands of analysis are run, the paper that finds something that is only 1% likely to be a misinterpretation of random noise if you only did the study once - is likely to be exactly that - random noise. 

However, it's interesting that even with this bias there are still some very significant results to be found in cross sectional analysis of stocks. The stand out stock market cross sectional factors are value and momentum, which work well enough that even if they have been found by an explicit data mining processes the returns are good enough to suggest that they aren't just random noise.

The explanation behind value working is simple. Stocks trading at the largest premium to their book values are overvalued by overconfident market participants on average while stocks trading at lower book values are a bargain more often than not. The value approach is well known, with Warren Buffett being the prime example of a successful investor who utlizes the value approach.

Momentum is more interesting because it is less popular among the public. Adherents to momentum have often been denigrated as rash speculators, in contrast to the more stable and patient value investors. Momentum is the idea that prior price movements are preditive of relative future returns. This seems to be a violation of the weakest form of the efficient market hypothesis. Adherants to the EMH call momentum (and value for that matter) a "risk factor" - implying that stocks with higher momentum have a higher risk than low momentum stocks which keeps their theories from completely falling apart. 

But the actual mechanism behind momentum is more subtle- a fast growing company doesn't become a sensation overnight. It takes time for a company to overtake and replace its rivals even if the new company is better in almost every way. Along the way, small pieces of information will come out regarding the increasing success of the company and the well performing stock will be bought by more managers. The extra risk is that a market shock could induce aggressive managers to all sell their holdings at once or worse, change the environment that was making the company so succesful in the first place.

Momentum, value and small stocks are three of the classic cross sectional explanatory factors, with data on their performance available for download at Ken French's database - so the lack of significance of the small stock outperformance as determined by Harvey et al is notable. I've touched before on how public stock market size premium is likely to be lower than it has been in the past due to high valuations in the pre-IPO environment, but this suggests that looking to small stocks as a significant explanatory factor of performance might have always been a mistake. 

Size shouldn't be ignored - many people have found that value works much better among smaller stocks. 

The table above from Cliff Asness's white paper shows that momentum works slightly better among small cap stocks, though this result may occur more because small cap stocks are more volatile in general and not because momentum works any worse in the large cap world after adjusting for volatility.

Momentum works in multiple asset classes, and should be of interest to those who are pre-IPO investors. Everyone knows to invest in fast growing companies and to avoid companies who have had to take down rounds. An explicitly systematic momentum approach in pre-IPO companies is likely to generate significant alpha - particuarly in our current investment environment.

So when the value perspective of the 17 billion dollar pre-money Uber valuation can make the deal look ridiculous*, the investor who respects the momentum factor should be paying closer attention. After all, it seems far more likely that the dynamics of investors demand will have the company trading at a 30 billion dollar valuation before it trades at an 11 billion dollar valuation.


*The analysis underweights the increasing utilization of taxi-cab like services that the presence of Uber encourages, but apart from that it appears to be about as close to accurate as a valuation expert can be with the available information.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/702411 2014-06-10T22:21:14Z 2014-06-10T22:21:48Z Addendums In which I cover many prior topics in one post instead of making many follow up posts.

1. When will prosecutors go after Silicon Valley?  Looking at Gallup's 2013 industry poll we can see that tech is still more popular than the oil and gas industry ever was, and is currently viewed far more favorably than banking.
So despite the emergence of the trend of demonizing some people in Silicon Valley (See the TV show of the same name) - and recent lawsuits preventing wage fixing - Silicon Valley big shots still makes a less tempting target than industries like banking for a prosecutor that wants to attention and approval of the public. (The comparison to lawyers and the federal government approval rates are there purely for contrast - they aren't potential targets)

2. Following up on 10,000 hours of non-deliberate practice. The Economist looked at how much time is wasted passively watching a video. Gaming seems to be a closer substitute to work, given how both require problem solving. And the amount of time spent on gaming is growing - with 43 million people playing games for 22 hours a week in the US alone, gaming is one of the largest time sinks of intellectual power in human history.

3. High Frequency Trading - One additional worry is that trading firms pay for customer flow because they profit, but this seems much more about locking in their ability to arbitrage this flow without competing with other HFT firms rather than taking extra advantage of the retail investor.

4. Another example of 60's Conglomerate math. When Facebook bought Whatsapp, some analysts justified it on the basis of how the purchase was cheap for Facebook on a per user basis. Just like analysts in the 60's thought that when a growing company bought a stagnant company the stagnant company's earnings should be valued like a growth company, analysts are assuming that each user acquired brings a similar value to the Facebook shareholder as a current Facebook user.

Facebook's purchase might make sense strategically and might make even more sense if they violate their pledge to not serve ads to Whatsapp customers a few years down the line. But investors should constantly remind themselves that the earnings/revenue/users of one company is likely to be significantly different from that of another company. Any company using its high valuation to make significant acquisitions should be analyzed carefully so the effects of the acquisition aren't mistaken for intrinsic growth. 


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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/697845 2014-05-29T22:07:35Z 2014-05-29T22:07:36Z Unassorted Links
1. A lot of private equity shops can get away with charging more fees than they agreed to because their limited partners (more specifically, those who invest on behalf of the limited partners) seem to have an attitude of "Don't blame me, I invested in a famous name!" On top of this, the people making capital allocation decisions for pension funds are often onto their next job before the results of their fund investments are known. Maybe the next CIO of Calpers can do something smart in this area.

2. Conferences like Bilderberg are unlikely to involve any real conspiracy, but like any off the record meeting between government officials and business leaders there is "access." The meetings give those on the business side a chance to try and figure out and potentially influence future policy moves. Unfortunately, it is hard to tell which politicians will play along in return for favors and which politicians merely want opportunity to hear the perspectives of those present on an ex-ante basis. 

3. The number of freshman deciding that they want to be computer science majors is way up. The students who stick out their major for four years will probably be mildly disappointed by what the startup landscape looks like four years from now.  Some combination of a higher supply of programmers, more institutionalized processes and less extreme early stage valuations is likely to make their careers less exciting than their peers graduating today. But overall it's still a smart choice. Even if their jobs aren't directly related to coding, the general ability to be comfortable thinking algorithmically will be as important as thinking quantitatively.

4. One of the more sane perspectives on school shootings in general. More generally, it's sad how many different interest groups try to get media exposure for their favorite pet issue in the wake of high profile tragedies. 

5. Occupational licensing - keeping both prices and unemployment high!

6. Looking at this extreme inequality, we are reminded that politics isn't about policy. It is about who deserves high status.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/695100 2014-05-22T23:36:28Z 2014-06-02T17:54:50Z The 60's Conglomerate Boom and Today's Growth Companies The Conglomerate Boom of the 60's, like all bubbles, sounds ridiculous in hindsight. From 1965 through 1969, the market was obsessed with rising earnings and investors didn't seem to care if the earnings came from new business or from buying other business. As long as earnings growth was up the company would keep its high valuation multiple.

The basic formula was that a fast growing company valued favorably by the market would use their stock to purchase low growth companies - and the earnings of the combined company would have the same multiple as the fast growing company. 

Investors didn't seem to realize that the low growth company's earnings wouldn't magically start growing just because it was bought by a company with a high multiple. The total valuation of the combined company would be higher than the prior valuation of the separate companies. The market's irrational behavior created incentives for unnecessary mergers. This lasted as long as the credit financing mergers was cheap (Conglomerates didn't have to properly account for convertible debt until 1969) and the market was willing to give high valuations to companies that produced earnings growth through the acquisition of other companies.

We might be seeing the start of similar incentives in today's private early growth stage companies. Most of the new start up companies are seen as competitors with the potential to disrupt whole industries. They are judged more on revenue than on earnings since the logic is that revenue will be more easily turned into earnings after the competition is decimated. Winning is what matters.

Whenever there are successful companies attracting capital and getting high valuations, there are less successful companies who will only succeed in mimicking the visible traits of successful companies. This creates some perverse incentives. The valuation given to successful growth companies is anywhere from five to ten times revenue - or higher. Meanwhile, the average company in the S&P 500 is trading at 1.7 times sales and the smaller companies in the Russell 2000 are trading around 1.2 times sales. Right now, it should be very tempting for a variety of early growth companies with high valuation multiples to go out and use their stock to buy companies with old economy valuations, point to total revenue growth, and hope that investors don't significantly change their valuation multiples.

Lending Club's $140 million cash and stock acquisition of Springstone Financial LLC looks like a good example of the conglomerate boom dynamic resurfacing in the current market. Lending Club is currently valued at 40 times its 2013 revenue, which appears to be significantly more than Spingstone Financial was valued. If the market mistakes the additional revenue from Springstone as indistinguishable from growth in Lending Club's core business then the acquisition will push up the market value of Lending Club's future IPO. This could happen regardless of whether or not the move into financing private education and elective medical procedures works out for the company in the long run.

For those looking to make long term investments in growth stage companies, it's important to make sure that the revenue these companies are valued against is the type of revenue that can scale and not revenue gained from the acquisition of businesses. Nostalgia for the 60's should have its limits.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/693538 2014-05-20T08:51:42Z 2014-05-20T09:43:05Z Assorted Current Events 1. The DOJ is finally putting pressure on the Chinese government hackers that have been attacking multinational corporations for the past decade.  

It seems like the main difference between the Chinese and the Russian hackers is that Russian hackers are more often working purely for ways to immediately enrich themselves via theft/fraud, while the Chinese hackers have also mounted operations to support their state-owned enterprises. 

I wonder if the calculation of real return on equity for state-owned companies in China included these services as part of their hidden subsidies. 

2. The seemingly increasing closed mindedness of the political youth is an interesting phenomena. Between these graduation speaker protests and requests for trigger warnings on class material, it's hard to tell if the college students have gotten crazier or if the rest of society has gotten used to taking crazy people more seriously. 

3. Twitch TV, online game streaming platform, is rumored to be in talks to sell themselves to Youtube. This would make sense for Twitch for numerous reasons. Most obviously, tech valuations are relatively high but have been unstable recently so it makes sense to look to sell while values are still high. (Whether or not one billion dollars is a high price for Twitch is unclear, in 1999 Broadcast.com was able to sell themselves to Yahoo for $5.7 billion)

Beyond the volatility around technology valuations, a further risk to Twitch is that a very significant portion of their viewers come from a single game - League of Legends (LoL). Many of the popular LoL streamers are paid directly by Riot, the owner of LoL. If Riot decided to make their gamers stream on a platform of their own creation then Twitch could lose a lot of eyeballs/advertising revenue. 

If Riot does this successfully, it shows that those who own the games can choose to monetize their streamers directly unless Twitch works to keep them on board. This could lead to a situation where the economics of Twitch resemble music streaming services more than Youtube channels. If viewers left to watch their games on other services, this would also show that Twitch viewers aren't necessarily as sticky as Twitch would like buyers to think*. 

*Whether or not users will stick around in the long run seems to be one of the big questions when it comes to the valuation of many current tech companies. 
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/686896 2014-05-05T21:09:43Z 2014-05-06T07:00:37Z Pay more attention to the newer guys at the Ira Sohn Conference The Ira Sohn Conference is going on today. This is a charity event where top fund managers pitch trade ideas to attendees who spend (donate) thousands of dollars for the right to attend. Looking at the performance of last year's picks gives some clues to the incentives the presenters have. 

The big names, people like Bill Ackman, David Einhorn, Jeffrey Gundlach, Kyle Bass* and Jim Chaos, can push their largest positions or trades that have been doing well recently. They can impress investors just by the media and market reaction to their views. The common stock of Fannie Mae and Freddie Mac, two companies whose stock might go to zero without extensive lobbying efforts, shot up today after Bill Ackman talked about them. And given that these managers are already well known, the marginal value of additional positive press is relatively small.

It's the smaller investors who need to make their name. The exposure from the conference gives many of these managers more media exposure than most of them have had in the past. A big win that was widely publicized ahead of time can help their funds gain a lot of exposure and make it much easier to raise assets. We know that the best ideas of fund managers are often be good ideas - so when lesser known managers are pitching their best ideas it makes sense to take a closer look.


*Apparently his fund makes money for investors, but every time his views are expressed in the news (Japan hasn't gone bankrupt yet!) it seems like following those views would lose a lot of money so I'm genuinely curious as to how that happens.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/683582 2014-04-28T23:56:39Z 2014-04-28T23:56:40Z A little bit of help My friend Ben (via his awesome tumblr) pointed me towards an article in National Geographic that highlights an empirical study on the impact of privilege and luck.

In order to study this topic, they looked at four different ways of giving out small levels of success - small amounts of funding on Kickstarter, positive ratings on Epinions, signatures on Change.org petitions, and awards to Wikipedia editors.


(van de Rijt et al, 2014.)

Those who were randomly given a random initial boost went on to do significantly better than those in the control group. Whether this is because the success attracted notice by others or more because the success made those granted positive feedback try harder isn't clear (except in the case of ratings, where additional effort would be less likely to impact a comment that is already made).  

But whichever effect dominates, the implication for what to do when you have friends embarking on projects is clear. Helping them a little bit can have a large impact on their eventual success. 

The study also found that large amounts of help were only marginally better than small amounts of help. This implies that helping four friends a little bit is probably going to have a higher return than spending four times as much effort helping just one person.  

This also explains why networking properly - helping lots of people you meet in little ways - can have a large impact in the long run.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/683456 2014-04-28T20:03:09Z 2014-05-01T13:30:58Z Assorted Links: Politics, Google, politics and antiobiotics 1. South Korean politics are strange. I could pretend that my model of scapegoats could somehow have predicted this, but the fact that a prime minister would have to resign after a (very tragic) regional accident really surprised me.

2. An interesting article on Larry Page and Google.  Investors should take note of the following:

"Page recognized that Google’s search-advertising business, with its insane profit margins and sustained growth, was exactly the kind of cash-generating machine that his hero, Nikola Tesla, would have used to fund his wildest dreams. "

A portfolio allocation towards Google seems less about betting on them creating shareholder value in the short or medium term, and more about making sure that if this company takes over large sections of the economy then at least they are hedged. A third scenario is that Google is more like the Xerox of our day. They might be the first to invent and implement a product that becomes as common as a computer mouse (Wow, this example might be a bit dated), but they might not be the company that fully benefits from their advancements. This is a risk as long as the cost of computing keeps falling, since what only a big company can do today might be cheap enough for college students to do from their dorm rooms five years from now.

3. The US Treasury is cracking down on financial insiders trading on material nonpublic government information.  Perhaps "cracking down" is the wrong set of words, "facilitating" seems to be a better word choice.  They are warning privileged investors about additional Russian sanctions before the rest of the market finds out.

Unfortunately this is nothing new - many financial players will attend events like the World Economic Forum because policy makers will often tell market participants what they are thinking before it is more widely known - Trichet in particular told attendees at a meeting a few years before the financial crisis that the ECB's monetary policy was going to be tighter than expected because of petrodollar flows. 

And it should be mentioned that the ones who go there to learn about policy ahead of time are the less harmful ones - those who use access to help shape policy in their interest, leading to regulatory capture, are the ones that do the most damage.

4. New Delhi metallo is an enzyme that can be produced by some bacteria that turns them into antibiotic superbugs. There were 6 cases in the UK in 2008 and 143 in 2013. Scientists are only sure about one treatment working, and expect that treatment to eventually stop working. 

Antibiotic resistance is one of the more interesting (and troubling) collective action problems of our day. Our medical system currently doesn't incentivize research into novel antibiotics enough since novel antibiotics are saved as a last line of defense against resistant bacteria. Part of the solution to this problem involves X-prize type bounties that incentivize researchers and companies to discover novel forms of antibiotics the can be used against bacteria with these new defenses. This is much more important than developing a tricorder, but perhaps it is too backwards looking for those who might otherwise want to be affiliated with the project.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/682690 2014-04-27T04:06:45Z 2014-04-27T04:06:46Z Why haven't prosecutors gone after Silicon Valley yet? One of the patterns of modern day politics is that prosecutors can move on to higher political offices by taking down a big name or two. Rudy Giuliani famously took down Michael Milken by threatening him and his company with the RICO act, a law that was designed to only apply to Mafia style organized crime organizations. That victory gave him the name recognition that helped him become the mayor of NYC.

Eliot Spitzer publicly went after many people on Wall Street, which raised his profile enough to become governor or New York State. He was eventually caught with a prostitute, but his story still adds another data point to the idea that all a prosecutor needs to do to achieve higher office is win high profile cases against big names. 

It doesn't matter to the prosecutor's career if the company or person getting prosecuted is acting significantly worse than their peers. All that matters is that the prosector gets positive press for fighting a big name (That they help the press demonize) and that the prosecutor finds some way to win. 

Today, inequality is a growing political issue. Many people see technology, and Silicon Valley as its proxy, as one of the driving factors of inequality. That leads to the obvious question: Why haven't prosecutors gone after any big Silicon Valley targets? 

It isn't because they don't have anyone to go after. Carl Icahn's attack against Marc Andreessen gives an overview of plenty of grey areas where it looks like a prosecutor could make his career.  The quote, "No conflict, no interest" is frequently attributed to John Doerr.  He sits on numerous public company boards while making VC investments in companies while benefiting from internal information gained at these board meetings. While there are many ways to break federal law, breaches of fiduciary duties are generally regarded as civil actions. So regardless of whether or not a determined investigation would find wrongdoing, this might not be as fertile an area for prosecutors as the headlines make it appear.

There are still other places prosecutors can look. Despite what many people seem to think, insider trading in private companies is illegal. And there are likely to be a few big names out there involved with situations where employees, the most sympathetic of the investors allowed to own shares in private companies, are found to have been ripped off by insiders who traded with them while misrepresenting relevant information about the company.

Michael Milken was largely thought to be a target of Giuliani because of how unpopular he was among certain groups of people. His work in high yield bonds took business from banks (if it weren't for the "junk bond" market, companies would have to get much higher cost loans from banks) and facilitated leveraged buy outs which were unpopular with both existing management and with workers at the companies that might get laid off after a takeover.  Eliot Spitzer only became the Sheriff of Wall Street after the stock market crash.

This presents two ways that Silicon Valley can be dragged into the bullseye of prosectors.

1. A financial crash centered around tech stocks. If investors start losing lots of money in tech stocks, a scapegoat will be required. This is the Spitzer scenario. In this case those behind the most inflated valuations will be most at risk.

2. The continued success of Silicon Valley as entrepreneurs focus on more traditional industries. If software continues to eat the world, those incumbents who find themselves being pushed to the sidelines will fight back. They might do more than fight to protect their rents, they might use their political connections to get prosecutors to punish those who they see as responsible for their business's growing irrelevance.

Either way, those in Silicon Valley should remember to be careful in their electronic communication. I'm sure that many of them are ahead of the curve when it comes to this issue, maybe that is why all of those secret sharing applications are getting funding.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/672615 2014-04-03T23:07:17Z 2014-04-03T23:07:18Z Simple Truths about High Frequency Trading The interest in High Frequency Trading, of HFT for short, comes from how it combines finance, technology and secrecy. The press around the subject has increased dramatically as Michael Lewis has been promoting his new book on the topic, Flash Boys.  A chapter appeared in the NYTimes that is well worth the read. Discussions around the issue made CNBC's daytime market coverage look very similar to Fox News (because of the yelling and screaming, not because of any right wing agenda).  In the midst of this uproar, the high frequency trading firm Virtu has delayed their IPO.

Michael Lewis is a good author, but he likes to tell narrative stories with good guys and bad guys. And as Tyler Cowen once said, "As a simple rule of thumb, just imagine every time you’re telling a good vs. evil story, you’re basically lowering your IQ by ten points or more."  So without getting into some of the more esoteric details, what's really going on?

1. The market has always needed intermediaries, the people who help connect buyers and sellers when they don't want to buy and sell at exactly the same time. These intermediaries need to make money. Without some money being paid to liquidity providers there will be no liquidity.

2. As floor traders have been replaced by computers running algorithms, spreads have narrowed. Investors spend significantly less money getting into and out of positions compared to 10 or 15 years ago.

3. HFT firms attempt to front run large traders. Any market intermediary needs to try to get out of the way of big buyers after the shares they have offered to buy or sell have been taken because if they didn't they would go out of business very quickly. But HFT set ups allow them to pretend there is are more shares available to be bought or sold in the market than there actually is which can be quite frustrating for those trying to execute large trades.

4. Googling "backing away" shows that intermediaries have been causing issues well before they consisted of the population labelled as "high frequency traders".

5. The ones losing the most money from high frequency traders are those attempting to trade large amounts of stock on the market. These are institutions such as mutual funds, pension funds and hedge funds.

6. While the situation remains annoying to institutions, HFT volumes and profits have actually been falling over the past few years. 

Wall Street rips people off all the time, but there seems to be more of an outrage when the people making money are outsiders and the people losing money are closer to being insiders. 

HFT firms have been the best customers of many of the exchanges - they pay high fees to get their servers situated next to the exchange and provide large amounts of volume to the exchange. In an effort to increase their profits from HFT traders many of the exchanges have implemented some trading rules that benefit HFTs at the expense of other traders on the exchange. Michael Lewis's story explains how some large institutional traders have figured out how they are being taken advantage of and are turning to people such as the IEX Group (The "good guys" in his book) in order to trade without having to worry about people gaming the system. 

Exchanges are going to have to reevaluate their own systems and make them more favorable to institutions that engage in relatively simplistic trading if they want to be profitable in the long run. (Part of this also involves setting up incentives for market makers which reduce the probability of future flash crashes, but that's a much more complicated subject).

If you are a retail investor, the hubbub over HFT shouldn't matter that much to you. You are getting better execution than you ever did under a system managed by human market makers. HFT traders are small parasites that have outcompeted bigger parasites. Overall they've been a net benefit to the ecosystem.  

And it is worth keeping in mind that the impact of HFT firms is small compared to other financial players. The only surprising thing about revelations that many large banks have been manipulating numbers they trade in both the interest rate and foreign exchange markets is that they finally got caught. And the additional 0.1% market impact that HFT firms might cause on large trades is very small when compared to the 5.1% average commission that Real Estate brokers take in on every transaction they make.  The HFT story is smaller than it looks. 
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/668975 2014-03-28T18:24:11Z 2014-03-28T18:24:13Z Thoughts on Current Events Facebook continues shopping with its overvalued stock: 

Facebook most recently bought Oculus Rift. The key here is that the purchase of both WhatsApp and Oculus Rift only make sense if Facebook plans on eventually ignoring the wishes of the founders. WhatsApp founders don't want ads and Oculus Rift founders don't want Facebook integration. It doesn't have to happen now, but if Facebook doesn't decide to spin out those companies then in three to five years there is no way that Facebook integration and ads aren't on both of those products.  Facebook is an important stock to watch, as any long term underperformance would be a strong signal that investors are falling out of love with tech.

Corrupt US Politicians:

 Leland Yee, the Californian State Senator who was in the running to be California's next Secretary of State, is really corrupt. The surprising part about the corruption is the small scale nature of it. Campaign debt of less than $75,000 was apparently enough to get him to participate in a gun running scheme. This might have been the tip of the iceberg and he could have been making a lot more money, but if corruption occurs for such low amounts of money then this is one of the best arguments for libertarianism I've seen in a long time. Corrupt politicians do less damage when they have less power.

Putin and Crimea:

The interesting thing about Russia's takeover of Crimea is that given Crimea's history and large russian population, Russia could have taken it back without force if they wanted to. One way to interpret this situation is that when their puppet, Viktor Yanukovych, got overthrown Putin wanted to make a statement. Others say that Putin is creating an "us versus them" situation to distract from the corruption that is being revealed about the set up for the Sochi Olympics. However, given that both Russia and the rest of the world would face short term pain if the situation escalated further it is unlikely to do so in the near term.
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/668147 2014-03-27T01:09:46Z 2014-03-27T01:09:47Z Too Good to Question The Federal Reserver Bank of New York posted about their study that confirms many people's biases about moral hazard and large financial institutions. The question is "Do “Too-Big-to-Fail” Banks Take On More Risk?" and the answer is yes.  The basic idea is that higher government support leads to riskier loan portfolios, which indicates to many people that Too Big To Fail (TBTF) banks were abusing their positions by loading up on risk.

I'm sure TBTF banks have taken on more risk - I believe moral hazard exists in the financial system. But I am not sure this study should give anyone more confidence on this issue.

After controlling for many variables, the study found that on average eight months after an increase in the perceived government support as measured by Fitch's "Support Rating Floor" the bank would have more impaired loans around eight months later (and vice versa). 

This is using data from March 2007 through August 2013, so the time period covered both the financial crisis and the european sovereign debt crisis. Given that, which explanation is more likely?

1. The average bank goes out and makes riskier loans after getting government support.

2. A negative economic shock created a scenario where government indicated support rating floors are needed. Banks who more obviously needed help got it first. Because problems in banks balance sheets show up slowly, it took a while for the banks that got support to admit that more of their loans were impaired. Support goes away when it isn't needed and slowly the loans are found to be performing better.

3. Only after a bank is assured that it is getting more government support (this happens only after the support has been promised for some time) do the banks feel comfortable marking down part of their loan portfolio. 

4. Banks that take over ailing financial institutions become TBTF and get boosts in support levels. After taking over troubled institutions, they find that many of those loans end up impaired.

The analysis controlled for quarter year fixed effects among other things, so the simplistic "Oh they were just pricing in the timeline of the crisis" argument doesn't quite work.  But even so points 2, 3 and 4 seem far more likely than the first scenario. In their paper the NY Fed researchers claim that because tier 1 capital ratios didn't decrease then their interpretation of moral hazard is more likely to be correct, but this doesn't account for the capital raising that occurred during the crisis.

Thinking of it from another perspective, it's likely that the age of the impaired assets are greater than eight months - the banks didn't rush out to make or buy bad loans just because they got some more perceived support. The relationship between changes in the support floor an subsequent changes in the bank's portfolio are both related to the bank being in trouble and this isn't adequately captured by the other variables. It is far from certain that the story played out as neatly as people would like it to play out.

There is moral hazard and many banks have abused their positions a TBTF, but studies that confirm everyone's biases should be examined even more closely than usual. 
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Jeff Lonsdale
tag:unpleasantfacts.com,2013:Post/667324 2014-03-25T02:01:00Z 2014-03-29T01:41:33Z 10,000 Hours of Non-Deliberate Practice Deliberate practice is a very important.  When learning a skill, breaking down ideas into small pieces and mastering those segments can lead to competency and expertise if the process is repeated properly over a long enough period of time. 

Many people will put in the hours but will not actively engage in practice. This phenomena is everywhere, but it is most easily found in video games.  One account of players actively not learning can be found in a blog about StarCraft 2 on TeamLiquid.  In this account, the author (a player who was ranked among the top 85% percentile of all players) plays a strategy that has a counter so simple an absolutely new player could easily be coached to beat it via simple instructions. Most people he starts out playing it against do beat him, so he soon ends up playing in a league with the bottom 35% of players. Soon he starts winning about 50% of his matches with a strategy that is very simple to beat.

The mindset of the players who have been playing for a long time and are still really bad at an activity is interesting. Some of them have played for many years, and perhaps if you include their original StarCraft experience they might soon be candidates for the 10,000 hours needed to develop true expertise. And yet this is a group of people who have put in tons of time but have remained generally incompetent. It doesn't make them stupid, but they are definitely suffering from some forms of cognitive bias. Besides the relative immaturity of the players involved (both the author and his opponents), a few things stand out:

1. The losing player blames the game, claiming imbalance where none exists.
2. They declare that the player was not playing fairly. In Starcraft, "cheese" is what other games call cheap.  In both cases, the player tries to add extra rules to the game that their opponent isn't necessarily going to follow. This is a little reminiscent of investors creating structured products and claiming that they never expected housing markets to be correlated on a national level during the 2008 financial crisis.
3. They don't look up how to beat the specific strategy and apply the technique. Even more surprising is that some of the players who lost to the author had actually read his blog in which he describes quite clearly how to defeat the strategy.
4. Perhaps the most important factor is that most of the players who have been stuck at their level for a long don't conceive their actions in clear and defined plans. They act on feelings and find it hard to explain why they did what they did when thinking about the game they just played.

The importance of a plan is learned in many ways, but I was first exposed to it through chess.  Middle game rule #1 of the Thirty Rules of Chess* is probably the most broadly applicable rules of the thirty rules.

M1. Have all your moves fit into definite plans.

Rules of Planning:
a) A plan must be suggested by some feature in the position.
b) A plan must be based on sound strategic principles.
c) A plan must be flexible,
d) Concrete and,
e) Short.

Evaluating a Position:
a) Material
b) Pawn structure
c) Piece mobility
d) King safety
e) Enemy threats

Without a clear reason behind actions, in a chess game, a video game or in any activity requiring strategy, there is little room for significant improvement. Playing without a plan or a way to determine whether you are doing well or not is just as bad. 

So if you want to avoid 10,000 hours of non-deliberate practice, making sure that actions are formulated around plans with ways to determine whether or not the plan worked is a necessary start. 


*Reuben Fine's 30 rules of chess aren't really rules - they are more like suggestions that should be followed about 80% of the time by the average club level player.
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Jeff Lonsdale