On Trading, Investing, Data Science, Machine Learning, FinTech and life as a Quant.
Investment Management with Python and Machine Learning Specialization: The uniqueness of this series is that it is taught by both professors with academic background but also practitioner who is actually running an asset management firm. I find their Python Lab session especially helpful.
Want to share some takeaways I had after reading Jefferies’ Feb 7 2019 report on convertible bonds (Sean Darby, ‘Global Asset Allocation: An Equity Investor’s Guide to Convertible Bonds’).
The bottom line: CBs offer equity ‘optionality’ with low volatility alongside reduced drawdown. CBs’ asymmetric structure combines the best of equties and bonds, making them a perfect diversification tool as Central Banks normalize policy.
In a village, there lives 100 people. Among them, there are 95 people with blue eye, and 5 of them are with red eye. Everyone can see the eye color of the rest 99 people, but they don’t know their own eye color and they are not allowed to ask people about it or check it themselves in a mirror.
There is a strange ancient law that anyone who knows their own eye color must suicide the next day in the central park of the village. As a result, no one in the village likes to discuss about the eye color in their daily conversations.
One day, a tourist visited the village. Due to their hospitality, they held a celebration dinner for the visitor. During the dinner, the visitor gave a toast that he really enjoyed the trip and he is glad to find out that there are people with the same eye color as him- red. He didn’t mention who is red eye, but suddenly people are all in silence. The visitor realized that he has toughed on something he should not have brought up, so he left shortly after with guilt.
Question: If all the 100 people living in the village are rational people and sufficiently intelligent, what will happen?
Answer: 5 days later, all the 5 people with red eyes suicided in the central park.
The original question is from Terry Tao’s blog[1]. This question can be solved using exhaustive sampling or mathematical induction.
Exhaustive method
Mathematical induction:
So here seems to be have a paradox: what new information did the visitor bring by announcing that there are people with red eye in the village? Isn’t that something people already know?
Yes, there are new information. Before the visitor makes the announcement, ‘there are people with red eye’ is a mutual knowledge. However, after the announcement, it becomes ‘common knowledge’.
[1] https://terrytao.wordpress.com/2008/02/05/the-blue-eyed-islanders-puzzle/
Where are we on the current debt cycle?
There are multiple stages of the cycle
The period we are in is very similar to when we are in 1930’s. there are only two periods of debt crisis in the contrary when the interest rate hits zero. In both times, the central bank must print money and go to a different type of monetary policy (quantitative easing) and to buy financial assets. This drives up asset and start recovery, but it drives interest rates down to zero or near zero, and that buying (in this case 15 trillion of financial assets).
It’s also caused populism, more populism. Because that process creates wealth gap. The top 10% is about to the bottom 90% combined.
We are in the later part of the cycle where QE has been used most of its energy, asset prices are up, interest rates are low, and we are beginning a tightening of monetary policy (not too much capacity to squeeze out of the economy). Very much like the begin of 1937. And we have a political situation that we have more of a conflict between the rich and the poor, which brings up populism/nationalism around the world.
The current reflection: where we are and the concerns
We are in the 7th inning of a 9 inning game. We are in the later part of the cycle, the part of the cycle in which monetary policy is tightening, and as interest rates rise, if they rise faster than is discounted in the curve, asset prices will fall. And some point we are going to have a down turn because that’s why we have recessions.
The concern is what that down turn would be. It not likely to be immediate. Maybe in 2 years.
Geo-politically, antagonism between Established power and immerging power, rising china and united states. It starts as economic rivalry and become antagonism.
What to do to avoid what happened in 1930s-40s?
To make sure that capitalism works for most people. Look at the bottom 60% as metric. Is it Improving the wealth gap (the increase in asset value is not accruing to 6—80% of the population)? Opportunity gap? Should be considered an imperative.
We are in a privileged position to have a reserve currency. One determination of how debt can be managed is whether debt is denominated in their own currency.
We will have a squeeze to not only debt, but to pensions and health care obligations.
President should declare it as a national emergency. Bring together a commission of people, a bipartisan commission to be dealing with it, in public private partnership. For example, education (22% of high school students in Connecticut is disengaged or disconnected); Support micro-finance.
Does it mean an increase in tax? Probably, but more important is increase in productivity.
Do you have concern over the current way president Trump is dealing with debt? Not too much concern for private debt. I am concerned in about 2-year time the amount of dollar-denominated debt we need to sell abroad, which we need for funding the deficit and to have the Fed balance sheet to go down. That will require a significant amount of selling and will have an upward pressure on interest rates.
Right now, we are in a short squeeze in dollar (a debt is a short position in dollar, because it’s a promise to deliver dollars you don’t own), because there are a lot of dollar-denominated debt.
If we have lots of countries that have borrowed in dollars and have their cash flow in local currency (such as we see in Argentina, turkey and Brazil), they are in a debt squeeze. That caused the dollars to rise and that debt squeeze will be passed in two years. At the same time, if we are to sell lots of dollar-denominated debt, and that would be bearish for dollar, at that point.
What a normal investor should do?
There are two key parts of investing. First, what’s the strategic asset allocation? Second, the tactical moving around bet in alpha. For average people, don’t do market timing. Get a balanced and diversified portfolio, which Ray calls an all-weather portfolio.
How to tell where we are in the cycle?
The basic premise behind a convertible bond is to combine a bond with a call option, providing an investor the chance to participate in potential equity appreciation, while mitigating downside participation with bond-like characteristics, specifically, a periodic coupon and principal repayment at maturity.
[1] https://mainstayinvestmentsblog.com/2018/05/convertibles-shine-through-clouds-of-volatility/
[2] https://www.blackrockblog.com/2018/01/18/case-for-convertibles/
‘Be the change you wish to see’ – Gandhi.
I’m not Indian, however, as a friend of India, I hope the country to become cleaner. I’ve visited India twice, both for work and personal reasons. It’s a great country with lots of untapped potentials. However, I have to agree that: India is not clean- especially the public areas such as street, pedestrian subways and common areas of residential communities. It is not a secret that trashes, paan stains on the wall, open dumps, public urination, death traps, .etc, are commonly visible on the street of Bangalore.
I recently watched an inspirational TeD talk from TEDxBangalore called ‘Why is India so filthy?’. A citizen of India who loves the country anomalously confessed the ‘ugly truth’ of the country, and proposed his thought on how to solve it. So why is ‘India so filthy?’ If we imagine a perfect world with good governance, in which there are no corruptions, strong government revenues, etc., will the problem of ‘public filth’ being solved? No.
So is there hope? Yes, and the answer lies on the Indian people themselves. There are two theories that could well explain the underlying problem. One is called the ‘Broken Window Theory‘, which is to say that visible signs of crime encourages further crimes, including serious crimes. In other word, broken window tends to become even more broken, and unbroken window tends to stay intact. To extrapolate even further, even if someone breaks a good window, someone will fix it, but few people will try to a fix a seriously damaged window. Simply put, ugliness attracts ugliness, cleanness attracts cleanness. Another theory is called ‘The Tragedy of the Commons‘, which is an economic problem that every individual will try to reap the greatest benefits from a given common resource that is easily available to all individuals; the tragedy of the commons occurs when individuals neglect the well-being of society in the pursuit of personal gain. This is the root cause for issues like public dump.
In summary, the only way to fix a broken window is to have someone fix it first. Once someone makes the window clean, the elegance itself commands respect. Similarly, the only way to solve a public problem is to let the problem become personal. Once each small community unites together to face the problem collaboratively, it is no longer a public issue and ‘the better angel of our nature’ will motivate us to help solve the issues. Good will attracts good will. As well put by Gandhi: ‘Be the change you wish to see.’ If you take a lead, people will follow, or ignore you- but no one will and could stop you. The anomalously run ‘Ugly Indian Project’ has led to great success. Lots of volunteers, senior citizens, and even city mayors of India have worked together to solve the public problem. Now, many streets have become cleaner, and I believe India will continue to change for the better.
The same principles apply to many other aspects of life.
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Value investing, the investment act that buys cheap asset and sells expensive assets, has historically posted abnormal returns. The name of value investing is formally coined by Benjamin Graham and David Dodd through their influential publication- Security Analysis.
As one of the founders and advocators of value investing, Graham is perhaps more famously known as the teacher of the legendary investor Warren Buffett. Although value investing has been proven to be a profitable long-term investment strategy, many argue that the principle of value investing alone does not explain the outsized returns realized by Buffett. Lasse H. Pedersen from AQR made a good point on this in his post ‘The Legacy of Graham and Dodd‘. Their analysis reveals that the success of Buffett’s investment can be explained by four key principles: (1). value investing: which is the act of buying cheap and selling expensive; (2). quality investing: which is to invest in growing and profitable firms; (3) low risk investing: as average investor is leverage averse, they tend to invest in high-risk names to boost up returns, which leaves low risk names to be relatively cheap. (4). Moderate use of leverage: Buffett applies moderate leverage (1.6 to 1) in his investments to boost up returns, through his insurance, reinsurance companies, bond issues and deferred taxes.