Dec

20

Strategies, from Jim Sogi

December 20, 2008 |

 Looking back at the year, a down year, what type of strategies worked best? A different question is also, what type of strategies that worked before would have worked this year. All this should be tested of course a la Seattle Phil's methods, but generally, from a qualitative view, it seems that timing worked better than stock picking this year. Secondly, lower leverage seems to have produced better returns. This at first blush seems obvious in a downmarket, but could produce higher profits on profitable methods. A risk return matrix could quantify the sweet point, at least in retrospect, and might be used going forward when a regime is recognized by the pilot fishes' first appearance. The February 2nd outlier turned out to be that pilot fish and the introduction of the new high volatility regime. This last Friday was a low volatility day and volatility levels seem to be dropping. With 8% daily moves in equities, 2% moves in currencies and bonds, who needs leverage?

With the Madoff imbroglio in full bloom, due diligence, apparently sorely lacking, will make a big comeback. I've commented before on the beauty of the markets ability to make large deals in standardized forms without reams of paperwork and lawyers, but the wilt is on that bloom. Now you have to keep a daily eye on the values and balance sheets of the bank, broker, contractors, car repairman, so they don't go bust while holding your stuff. Witness Refco, Lehman, Madoff, Citigroup, WaMu et. al. No wonder there is no confidence. Perhaps some of these funds and banks should have had the lawyers and accountants take a look at these multi-billion dollar investments as they would will any other deal of this size. It shows that the Emperor had no clothes, and no one noticed.

DinosaursLooking forward, the entire industry seems to be changing. The volumes are down leading to big fast moves. Many of the big Wall Street dinosaurs are dead, or dying. I think there will be opportunity from all this, like after the forest fires. Life leaps back. The ultimate slow mover, the government, will provide loads of opportunity. I started my career with the IRS. Fresh out of school I was handling huge deals, cutting my teeth. Typically a government worker is fresh out of school and will be assigned to run GM, or the entire banking system. The boss, the name, will be lunching on the private jet, but the person making the decisions will be a 23 year old kid, smart, no doubt, but still 23 years old. I, when 23, dealt with these old crafty 60 year old guys who made me feel just great, but no doubt made a great deal for their clients at the expense of the government interest.

Next year should be a good year. Just got to survive to see it!

Vinh Tu writes:

It has been an interesting year. That fact timing worked better than stock picking is consistent with the factor analysis that says that beta is by far the most important factor. That lower leverage was better than higher leverage is also very interesting. In part this was due to optimal bet sizes going down as volatility went up. On the other hand, it was also related to the highly-leveraged ecosystem being over-crowded, and the deleveraging becoming a stampede.


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2 Comments so far

  1. George Parkanyi on December 21, 2008 3:36 am

    Madoff et al … pretty far-removed from closing a deal on a hand-shake, huh?

    Depersonalizing business seems to have the same effect as depersonalizing warfare. You don’t see who you’re hurting, so emotionally, it doesn’t happen. A bomber pilot sees the equivelent of fireworks, and feels the satisfaction of scoring hits - the mother on the ground stands paralyzed in horror as she realizes her child has just been destroyed. It’s easy to foreclose on a database entry - not so easy on a homeowner with his frightened family huddled around him.

    When the consequences are not visible, the behaviour-inhibiting shields stay down. You wouldn’t dream of punching a client in the face (well OK, some clients you might), yet in most cases that would be a lot better for their overall well-being than losing half their life savings. (And they would probably agree and go with the former if they had to choose between the two.) The Madoffs of the world don’t see the pain, they just see the numbers.

    How do you protect yourself? Diversification - particularly if it’s a faceless institution (a contract won’t necessarily help you in a bankruptcy, and it may be too expensive to litigate). But even if it is someone you can normally trust, you should still diversify. They’re human, they can make mistakes, or be compromised in some fashion (e.g. health, personal problems, accident) by something out of their control. A lot of people trusted Madoff because they thought they knew him; hopefully they didn’t have ALL their money with him.

  2. William Weaver Jr. on December 25, 2008 3:17 am

    Jim,
    I completely agree with your observation regarding regime changes in volatility. A friend of mine once pointed out that when a market does in one day what it did last week in ten, one has a different market. That works in the reverse too. Since first considering this idea I have done very well by studying the effect of fractal bifurcation in equity returns.

    You stated that timing worked better than stock picking. Stock picking tends to under-perform in bear-markets because institutions are often liquidating positions in otherwise good companies, and one never knows when or where such liquidations will occur. However, market timing, especially using price-momentum oscillators, works very well as bear-markets have higher volatility. John Ehlers writes about types of market modes (cycling/trending), and suggests a few ways to determine current mode (cycling works well for oscillators whereas trending does not work well for oscillators). I have not found any of his methods to work, but I have found ways that do. The answer goes back to fractal bifurcation in volatility.

    Vinh Tu wrote that beta is the most important factor in equity analysis… Vinh. Research buddy. Stop reading papers. Start crunching numbers. IF you need ideas, read abstracts… Or watch movies… That’s my personal secret. Chocolate, talking to one’s self, and pacing help too (Peanut M&M’s).

    As for leverage, my philosophy is crude but true… Leverage is like male enhancement. If you’ve got what it takes, you don’t need it.

    Best,

    -Will Weaver

    P.S. -Ken Griffin (Citadel) was complaining after the 2/27/07 move that the markets are traded by kids. Oh well. I’m 21, such a divine year, my favorite card game and a fib number all in one! (The answer is to shorten trading hours… look at what happened to volatility when the NYSE closed every Wednesday to process orders. Thus experience is inversely proportional to reaction time given the same quality of output. Problem solved.)

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