Monday, December 15, 2014

Level, Slope and Curve Factor Model - What's this all about?

John Cochrane recently blogged about my paper.  My co-blogger asked me to explain it a little more, and I realized that a lot is lost if you aren't deep into the finance jargon.  Additionally, what's the deeper significance of the whole endeavor.  Here is an attempt to explain my goal and interpretation in a broader context.

First, let me define a "factor." A factor is just meant to describe common movements across stocks. All technology stocks go up together when there is some good news about the tech industry. All energy stocks go down together on some bad energy news (maybe lower world energy demand). The goal is to stop describing a stock as "Ford" and start describing it as a combination of factors.

The factors we really care about aren't things like industries. We want to understand the "priced" risk factors. These are the factors that represent risk to investors. I can diversify my exposure to ups and downs in tech or industry or automotives by just buying lots stocks. So we don't expect any higher returns to holding tech stocks.

It turns out there are lots of things that predict stock returns. Those are characteristics of companies: small companies have higher returns than large companies, "cheap" companies have higher returns than expensive companies. Each of these are associated with factors. Small stocks go up and down together and to some degree move opposite large stocks. Cheap stocks go up and down and to some degree move opposite expensive stocks.

The literature now is postulating more and more possible risk factors. I am arguing a lot of those factors are manifestations of three main risk factors level, slope and curve. Here's what I do. I use all of these characteristics and I sort stocks into "high return" stocks and "low return" stocks. I sort into 25 portfolios. The 25th portfolio we expect to have really high returns. The 1st we expect to have really low returns. The factors describe how those portfolios move relative to each other.

Level describes that stocks go up and down together. This has been known for 50 years or more. On good economic news all stocks go up, on bad economic news all stocks go down. The most common model of risk, the CAPM, basically describes all stocks risk as how much they go up and down with the overall market.

The "slope factor" describes that high return stocks and low return stocks often move opposite of one another. (I think) It means that whatever risk high return stocks are exposed to changes over time. Sometimes investors need to be compensated a lot to hold risky high return stocks (with high expected returns), sometimes not so much.

The "curve factor" describes that sometimes high return stocks and low return stocks go up or down together, while medium return stocks don't even move. The curve factor is the hardest to interpret. It may be related to the volatility of the slope factor above, but that's kind of speculative.

So now I can describe every stock as some manifestation of level, slope and curve. Yesterday, I needed theories to describe hundreds of priced factors. Now I only need theories to describe THREE!!! That's pretty good. And since we've been explaining level for years, we really just have two. So, I don't know why high return stocks and low return stocks move opposite each other, maybe some risk factor, as in these companies will do badly in bad times, maybe these stocks are susceptible to fits of irrational exuberance. But if I can explain level, slope and curve, I can explain why some stocks have higher returns than others.

Thursday, November 20, 2014

Executive Action on Immigration

By Robert H.

Ezra Klein has an excellent and fair take on Obama's immigration reform.  I disagree with his conclusions, though.

Congress has told the President to export over 10 million people, but they've given him the resources to export less than 500,000 people a year.  So that's a problem.  Fortunately, they've also given him broad discretion to choose which sort of cases to go after.  Given all that, you have two choices for how to manage your resources if you are the President: create clear rules for whom you will and won't deport, announce those rules, and follow them.  Alternately, just wing whom you deport in a jumble of local discretion, happenstance, and random chance.

So which of these supports rule of law?  Which supports good governance?  To me it is obviously the former. Laws should be as transparent, clear, and predictable as possible.  If our officials are choosing to prosecute some deportation cases and not others -- and they are by necessity -- we should want to know what criteria they are using.  This move gets us closer to that.

So I am not worried that this clearly legal action will somehow undermine the rule of law in America.  It will do the opposite.  But isn't it violating political norms?  Maybe.  But if there is a norm in American politics that the president should deport people in a haphazard, chaotic, and unpredictable manner rather than using his legal authority to prioritize deportations, that norm is dumb.  Thank God a president is ignoring it.

Thursday, September 18, 2014

Iron Highlander Constitution

By Robert H.


Just in case Scotland goes independent, I've been flipping through its interim constitution.  I have four thoughts:


1. It's not modeled on the German constitution.  This is basically a mistake for new countries.  It's just not going to be possible, I don't think, to turn Britain's historically and culturally contingent, unwritten constitution into a concrete written document.  They should stick to the modern constitution that people have had the most success copying (ie, Germany).


2. In terms of human rights, it adopts the rights in the European Convention on Human Rights.  This is a good idea, and covers pretty much all the rights Americans think of as rights (to some degree or another) plus some economic rights and no death penalty.  BUT


3. I have no idea what Scotland's relationship with the European Court of Human Rights is supposed to be.  The constitution incorporates EU law, but the Court is rooted in the Council of Europe, not the European Union.  The constitution doesn't mention the court, and doesn't incorporate the provisions of the European Convention on Human Rights that established the court.


Very odd.  Different European countries give the court different effects: in Russia, the court's rulings are binding law.  In Switzerland, they are more very strong suggestions.  In Scotland, they are going to be I have no idea what, if the court even has jurisdiction.


4. No eternity clause (unless I missed it).  This means that, like America, ultimately the will of the people is truly sovereign, and a supermajority can amend the constitution even to remove fundamental human rights.


Caveat -- this is based on a quick skimming and a weak knowledge of European law. 

Thursday, July 24, 2014

Japan Breakeven Data Update

Just for my reference, I pulled off some of the Japanese Breakeven rate info off Bloomberg.  As always, this data may have some problems.  These contracts are not very liquidly traded and have risk premiums embedded in them.

1 year, 4.38%:



5 year, 2.33%:

10 year, 1.21%:

Jason Smith sends me to this Scott Sumner quote in a comment on the previous post:

4.  Japan will be hit by an adverse supply shock next year (higher sales tax rates) which will boost inflation–making it look like they will hit their 2% target.  Don’t be fooled.  When the effects wear off Japanese inflation will slip back below 2%. Because of Japan’s fiscal situation, it has no good options.  The sales tax increase will hurt the economy, but is needed.  I used to think they should delay it, but now I think they should bite the bullet and do it.

Maybe.  Certainly the VAT is affecting the CPI and through it the break even rates.  Will inflation backslide below 2%?

The 2 year break even is 3.317%.  That implies a second year rate of 2.26%.  Using the five year, we get a final four year rates of 1.82%.  Using the ten year and five years together, we can see that the market predicts the last five years to have inflation very close to 0, about .5%.

So the market is looking forward to several years of rising prices.  That's quite a different prediction that many gave when Abeonomics started.  Will the BOJ hit it's of 2% over five years?  It looks like they are expected to be around that range.  Certainly with some help from the VAT, but even in the last four years prices are expected to rise.

On a long horizon, will they revert back to zero?  Maybe.  Maybe as soon as everyone comes around, everything will start heading backwards.  I would caution that the longer we go out in time, the worse the expectations theory probably is.  Risk premiums may be more important to model on longer horizons.  Ignoring them for several years compounds the error.  

Wednesday, July 23, 2014

Japan Update: We've Waited, Let's See


A few months ago, Stephen Williamson posted this unfortunate picture.


It turned out that the large drop in inflation that he thought was evidence in favor of his views on monetary policy was actually the result of an accidental misuse of Japan data (as I pointed out in this post and in the comments on his blog).  He corrected the mistake and adopted a wait and see attitude, "Thus, the Bank of Japan seems to have had some difficulty in producing inflation - but this time may be different. Given that the Bank seems intent on holding the short-term nominal interest rate at zero (essentially), I don't see it, but I'm curious to see how the data unfolds."

Well, we've waited a bit and can see a little more.  Let's update the graph:



Wow!  It's almost directly opposite of the original.  Japan yoy inflation is up close to 4%.  What liquidity trap?

It's interesting to note that way back in April of 2013, we noticed that markets were predicting a rapid rise in the second year of Abeonomics.  The market predicted .35% for year one (until April 2014) and then 2.3% the following year.  Well, the market estimate was obviously low.  Inflation actually averaged about 0.89%, but we may be seeing that the dynamics of back loaded inflation is substantially correct.  Now will the BOJ be able to hit their target?  What is their target?

In response to a comment, here are the index values: (Data)



Learn This Simple Trick To Know How To Legally Kill Dudes

By Robert H.

This is a weird contradiction I have noticed:

1. Among military and International Humanitarian Law lawyers, there is pretty widespread agreement about the standard for how to judge whether civilian casualties are excessive.  Where there are disagreements, it is over application.  But,

2. Among laymen, there not only isn't agreement about the standard by which to judge civilian casualties, almost no one adopts the standard universally agreed to by lawyers and policy makers.

So, elaboration: Under international law and most national laws, if you want to attack a military target but think you are going to hurt civilians or damage their property in the process, the main test is the Principle of Proportionality.  If the damage that will likely be done to civilians is clearly not proportional to the military advantage you will gain from the attack, it's illegal.  There is a lot to fight over within that definition -- how do we define military advantage, what's proportional, do we judge attacks on a granular or broad level (ie, do we ask "was the air offensive proportional" or "was each air strike proportional") -- but everyone from the IDF lawyers approving gaza air strikes to peacenick UN officials denouncing those same air strikes agree on the basic framework.

No laymen seem to, though.   Instead laymen seem to

1. Obsess over casualties -- especially deaths -- at the expense of property damage or the destruction of materiel.  A pro-war type will treat an attack that blows up a city block as presumptively reasonable and acceptable, provided the block was evacuated ahead of time, despite the fact that damage to civilian property is explicitly weighed in the proportionality analysis.  Just so, a pacifist type will often look at the civilian/combatant casualty ratio rather than taking a more holistic view of "military advantage."  This is in error: an air strike that kills a civilian but blows up a cache of long-range rockets and launchers may yield a higher military advantage than a strike that kills a civilian and a low-ranking Hamas militant while doing no other damage, even though the second strike has a much more favorable civilian/combatant casualty ratio.

2. Adopt extreme positions.  I can't count the number of times I've heard arguments that amount to "any attack that kills civilians is wrong" or "when your enemy hides among civilians, being touchy about civilian casualties just rewards and encourages that behavior, so bomb 'em all."

3. Effectively ignore the other side of the balancing test.  Most of these errors focus on the civilian side of the equation at the expense of the military side: Anti-war types wax eloquent for op-ed after op-ed about all the damage being done to civilians without even trying to articulate what military advantage is being gained.  Alternatively, pro-war types will talk about all the precautions being taken to avoid civilian casualties without going on to argue that civilian casualties are not only low, they are proportional to the military advantage gained.  All that said, you occasionally see people ignore the civilian side in favor of the military advantage side -- "we have to do this to enhance our security/protect ourselves/defeat Hamas" without adding "also it will likely result in bringing us close enough to effecting that goal to be worthwhile when weighed against the harm to civilians."

Anyways, maybe all that is boring, but it strikes me as genuinely weird.  If I ask some random laymen what genocide is or whether it's right to use chemical weapons, I bet they could come close to articulating the international consensus.  If I ask laymen whether it's right to use landmines, they would probably disagree with each other because there isn't an international consensus.  But in the weird world of collateral damage you've got all kinds of international consensus but no lay-understanding.  Weird!

Friday, June 27, 2014

Is The New York Ban On Tiger Selfies Constitutional?

By Robert H.

No. New York’s ban on Tiger Selfies is almost certainly not constitutional.

What is a Tiger Selfie?

It is a picture of yourself posing next to a live, unrestrained (though probably stoned) tiger.  Men in New York use them to attract women because we are a squalid culture  that  hoards and sleeps and feeds and knows not God.

Why is it unconstitutional?

Because it is a content based ban on speech.  The government actually has a lot of freedom to restrict when and where and even how you say things.  “No protests in the park without a permit,” for example.  It has way, way less authority to ban speech based on the *content* of the speech. "No protests against gay rights in the park without a permit." 
In this case, pictures are a kind of speech, “men posing with tigers” is the content of that speech, and banning it puts the government in hot water.

So New York Can’t Do This?

Maybe they can!  If you narrowly tailor your content-based restriction to promote a compelling government interest, the Courts will uphold a content based ban on speech.

Wait, “We Don’t Want Tigers Tortured and Idiots Mauled Over Dating Profiles” Isn’t a Compelling Government Interest?

It Probs is!  But the law may not be sufficiently narrowly tailored.  Here's why:
The Supreme Court very recently struck down a law banning depictions of animal cruelty.  Essentially, the law didn't let you have a photo or video of an animal being hurt or killed if it would be illegal for you to hurt or kill the animal that way in the same jurisdiction the video existed in.  So, for example, a video of someone crushing a marmoset was illegal in a city where it was illegal to crush marmosets.  The Court’s reasoning in striking the law down was that it was overbroad -- it effectively constrained lots of legitimate activity.  So, for example, imagine you go Marmoset hunting in a state where that is legal, film it, and take the video to a city where it is *illegal* to hunt marmosets.  Even though the activity being filmed was totally legal when and where you did it, even though it isn't the more morally objectionable depictions of animal cruelty the law was targeting, you are now guilty under the statute.

This looks analogous to that.  If Siegfried wants to take a picture with his pet tiger in a state where it is legal to have pet tigers, that activity seems perfectly legitimate to me, even if he later takes the picture to New York.  And while it's true that there probably isn't a whole heck of a lot of legitimate "men by tiger" depictions out there, the ratio of "legitimate" to "bad" "men with tiger pictures" seems A. hard to prove, and B. likely to mean you are taking out roughly as much legitimate as illegitimate speech. 


So why might it still be constitutional?


Because the law is complicated and stuff.  More specifically, there may be relevant laws I have missed and courts may find the analogy to the animal cruelty case weaker than I do and I haven't even read the law so what do I know.  This isn't a brief to the Supreme Court, here I'm just winging it.