An Ugly Surprise

I had an unpleasant surprise at the airport last week.

I walked into the TSA Pre line and handed the agent my boarding pass and ID. But rather than being greeted with the knowing wink and nod that comes with taking the VIP line, the agent dismissively pointed me in the direction of the general security line with the rest of the filthy hoi polloi.

Now, keep in mind, I travel frequently and have been TSA Pre approved for ages. So, the thought of – gasp! – taking off my shoes, removing my jacket and putting my laptop into one of the gray bins with the rest of the unwashed masses was absolute anathema to me.

How dare they!

I’m a little embarrassed by how poorly I handled this situation… and I’m probably lucky the TSA agent didn’t toss me out of the airport for the attitude I gave him. I was that guy… the one who throws an absolute fit over what was nothing more than a minor inconvenience.

And it was likely my fault. I made the reservation in a hurry, and it is likely I simply forgot to include my TSA Pre number, which is why the airline didn’t print it on my boarding pass.

I tell this story to make a point about expectations. It’s not that the general security line was that bad. It’s just that was expecting the VIP treatment in the TSA Pre line. And not getting what I expected was a letdown.

I fear that millions of Americans are due for dashed expectations as well… for something vastly more important than my travel comfort.


I wrote last week that Social Security – the bedrock of most Americans’ retirement plans – is starting to deplete its “trust fund.” Of course, there really is no trust fund. It was never more than accounting gimmickry.

The trust fund was invested in U.S. government bonds, which means that Uncle Sam was essentially borrowing from himself and calling it an asset. The larger problem is simply that Social Security is paying out more in benefits than it is taking in via tax revenues, which means the money has to be pulled from elsewhere in the budget.

In case you haven’t noticed, our government wasn’t able to balance its budget even when Social Security was running surpluses. Adding Social Security blows out the budget deficit all the worse.

The most likely “solution” is that Congress will move the goalpost by either raising the retirement age, raising taxes on benefits, or means-testing the benefits, effectively telling middle-class and wealthy Americans that they no longer qualify for the program.

None of these options are that bad.  But they are certainly going to fell that way because they are not at all what most Americans are expecting.

Let’s take this a step further and look at expectations for stock returns. Many – perhaps most – Americans are expecting stock returns to be 8% to 10% per year or better. Their retirement plans are built around those assumptions.

But what if those returns come in below expectations?

One of my favorite models for finding a “quick and dirty” estimate for stock returns over the next decade uses the cyclically-adjusted price/earnings ratio (“CAPE”). The CAPE compares current stock prices to an average of the past 10 years’ worth of earnings. Using a 10-year average smooths out the booms and busts of the business cycle and makes it easier to compare valuations over time.

Using the current CAPE value, you can estimate what stock returns will look like if valuations move back to their long-term averages.

Well, today stocks trade at a CAPE ratio of 32.5, which is more than 92% higher than the long-term average of 16.9.

Crunching the numbers, this implies that stock will actually lose 2% to 3% per year over the next decade. If you’re retirement plan depends on gains of 8% or better, that’s a big problem.



Beware the Bangladeshi Butter Bias

Bangladeshi butter.

If you’re looking for the indicator with the highest correlation to the S&P 500, it’s not GDP growth or even earnings growth. No, it’s butter production in Bangladesh.

In a paper published two decades ago, mathematician David Leinweber and portfolio manager Dave Krider found that butter production in Bangladesh had the tightest correlation to the S&P 500 of any data series they could find.

Collectively with American cheese production and the Bangladeshi sheep population, this three-variable model “explained” 99% of the S&P 500’s movements.

Now, before you roll your eyes, Leinweber and Krider published the study in jest. These are geeky quants enjoying geeky quant humor. It’s precisely the kind of thing I would have done with my grad school buddies after a few pints at the Three Tuns in London. We would have gotten a good laugh out of this wild idea and then likely gotten a drink dumped on our heads after trying to ask for a girl’s phone number.

The problem is that a lot of traders aren’t smart enough to know it’s a joke.

In an article he wrote for Forbes a few years ago, Leinweber commented that 20 years later he still gets calls to his office asking for the latest Bangladeshi butter production figures.
Amazingly, it’s not just knuckle-dragging traders that fail to get the joke. Even professional researchers fall for it — some more than others.

Leinweber recounts a 2011 paper written by Tatu Westling, a professor at the University of Helsinki, that “explores the link between economic growth and penile length.”
Yes, you read that right.

According to Westling:

The average [GDP] growth rates from 1960 to 1985 are found to be negatively correlated with penile lengths: a unit centimetre increase in its physical dimension is found to reduce GDP growth by 5% to 7% between 1960 and 1985. Quite remarkable is the finding that male organ alone can explain 20% of the between-country variation in GDP growth rates between 1960 and 1985.

Regarding the relative importance of political institutions in shaping economic development, it seems that male organ is more strongly associated with GDP growth than country’s political regime type.

So, for every additional centimeter of manhood, GDP growth falls 5% to 7%.

As with all things in life, it appears there are trade-offs. If I have to choose between the two, perhaps wealth is overrated.

The author goes on to hypothesize that well-endowed men are inherently happier and more confident and thus don’t feel the need to work as hard, thus the lower level of economic development.
Apparently, the massive skyscrapers that penetrate the New York skyline really are a form of compensation.

Professor Westling very well might have written the paper in jest. I sincerely hope so.

But you don’t have to look far to see plenty of nearly equally ridiculous market indicators. The Super Bowl Indicator, the Hemline Indicator, head-and-shoulders patterns… I could go on all day. I’ll spare you a long explanation on overfitting, spurious correlations and data mining.

For crying out loud, I’ve spent the last half of a page making penis jokes, so getting overly technical at this point would be ridiculous.

But I can summarize it like this: If you can’t plausibly explain why a model works, then chances are good it’s a random coincidence.

There is absolutely no plausible reason why Bangladeshi butter production would predict S&P 500 returns and it’s hard to argue that average penile length determines GDP growth. (See what I did there?)

So, when looking at a model, ask yourself: Does it intuitively make sense?

As an example, I spent most of last year backtesting a stock trading model that combined several value investing metrics with momentum metrics.

The result was a portfolio strategy that delivered 43% backtested annual returns from 1999 to the present, utterly crushing the S&P 500.

Now, could this be an example of overfitting the data?

Maybe. But I don’t think so because the approach intuitively makes sense. Countless studies (most famously Fama and French’s 1993 study; click here to download it) have shown that value investing outperforms over time, and most of the famous investors throughout history, such as Warren Buffett and Benjamin Graham, were value investors.

Value investing works.

Meanwhile, various momentum and trend-following strategies have also been proven to outperform over time. So, it stands to reason that combining value and momentum would lead to solid results. I can’t guarantee that the future live results will live up to the backtest. You know the drill: Past performance is no guarantee of future results. But I’m betting it generates better returns than a Bangladeshi-butter-based market timing model.


The Lesson to Learn From Bobby Axelrod

I love the TV show Billions.

I always carve a little time from my work day on Monday afternoons to watch the episode from the night before while I’m doing paperwork at my desk.

When it airs live on Sunday nights, I’m usually worn out from a busy weekend of chasing my kids around, and I’m ready to crash.

So please, no spoilers. I haven’t seen last night’s episode yet!

In case you’re not familiar with the show, Billions tells the story of a complex cat-and-mouse game between a crooked hedge fund billionaire, Bobby Axelrod, and the equally crooked district attorney who’s out to get him, Chuck Rhodes.

It’s a brilliant show, and it’s surprisingly realistic. The writers clearly do their homework and legitimately speak the language of finance.

Perhaps I’m biased because Bobby Axelrod is played by Damian Lewis, a tall, lanky, redheaded actor who looks like he could be my older brother, but I usually root for Axelrod.

But at the end of last season, Axe found himself in a bind. He allowed Rhodes to get under his skin and ended up walking into a trap.

Spoiler Alert: Thinking he was burning Rhodes, Axelrod brutally sabotages the IPO of “Ice Juice,” a fictitious juice bar founded by Rhodes’ best friend, by planting a non-lethal toxin that makes the drinkers violently ill.

When news breaks showing Ice Juice customers vomiting on the floor, the IPO flops. Its investors are sunk.

Axelrod wiped out Rhodes’ trust fund, which was heavily invested in the IPO. But little did he realize that Rhodes had baited him in a complicated (and completely illegal) sting.

Rhodes intentionally let word get out that he was investing in the IPO, fully expecting Axelrod to try to blow it up.

It worked.

Axelrod couldn’t resist the opportunity to stick a knife in Rhodes and give it a good twist.

And the season ends with Axelrod sitting in a jail cell, with a gloating Rhodes lording over him.

Axelrod weasels out of jail this season, of course.

You can’t really have a show about the wheelings and dealings of high finance when the lead character is sitting in white-collar prison.

But his ego and lack of emotional control cost him dearly. His wife leaves him and takes their children, and his professional reputation is mud.

We can’t take much in the way of trading advice from Billions. If you tried to do half of what Axe and his cronies do in the show, you’d have federal agents in dark suits knocking on your door.

We can, however, walk away with some general principles.

This probably goes without saying, but it’s generally a bad idea to illegally manipulate a stock and force an IPO to fail.

But given that few of us have Bobby Axelrod’s money and power, that’s probably a moot point.

The bigger lesson – and one that’s applicable to us all – is this: When investing, don’t let your emotions get the best of you.

Axelrod let his hatred of Rhodes lead him to take a massive risk that nearly cost him his fortune and his freedom. But you don’t have to go to those extremes to get yourself into trouble.

How many times have you held on to a losing position because you “loved” the stock and got attached to it?

I can tell you that, over the years, I’ve done it more times than I care to remember. And nearly every time, I regretted it. My attachment to the stock cost me additional losses that I could have avoided by being more emotionally detached.

No matter how much you love a stock, it will never love you back.

A stock also couldn’t care less about your ego and whether you’ve wrapped your personal sense of worth into its performance. The stock is cold and impersonal, and that’s exactly how we need to approach investing.

But it’s not just the stocks you buy, it’s also the stocks you don’t buy.

I admit it. I hate Facebook (FB) on a primal, visceral level.

I hate the narcissistic culture it creates and that it prioritizes superficial online “friends” over the real flesh and blood variety. If I had a time machine, I would go back and kill in the company in its infancy.

Alas, I let my hatred of the company prevent me from buying the stock — to my detriment.

So, if you take one thing from Axe, make it this: Don’t let emotion get in the way.