book reviews
Extending the Canon: New Titles
The Heretics of Finance | Restoring Financial Stability |
More Mortgage Meltdown
Going to Extremes | Trading Options at Expiration | A Failure of Capitalism
Poorly Made in China | The Myth of the Rational Market
The Heretics of Finance: Conversations with Leading Practitioners of Technical Analysis
by Andrew W. Lo and Jasmina Hasanhodzic. Bloomberg Press. 2009. 288 pages. $29.95.
Fundamental analysis and technical analysis have developed independently over the past several decades, for the most part. The Heretics of Finance, coauthored by Andrew Lo and Jasmina Hasanhodzic, enables fundamental analysts and portfolio managers to better understand the evolving profession of technical analysis.
Typically, a book like this would be chockfull of graphics depicting support and resistance levels for the markets, but Lo and Hasanhodzic have opted for a different approach. Thirteen technical gurus are interviewed (a Fibonacci selection by coincidence?), to wit: Ralph J. Acampora, Laszlo Birinyi Jr., Walter Deemer, Paul F. Desmond, Gail M. Dudack, Robert J. Farrell, Ian McAvity, John J. Murphy, Robert R. Prechter Jr., Linda Bradford Raschke, Alan R. Shaw, Anthony W. Tabell, and Stan Weinstein. In the book’s opening, all thirteen masters relate the origins of their interest in technical analysis, confess their most instructive mistakes, elaborate on the analytic styles they’ve made their own, explain the separation of signal detection from random noise, and run through their typical workdays. Subsequent chapters are crafted as a roundtable discussion of key aspects of technical analysis—the development of the profession, inescapable emotional challenges, and favorite patterns and indicators.
The divergence of opinions on salient questions is particularly intriguing. For instance, when asked if technical analysis is more effective on its own or in combination with fundamental analysis, Birinyi acknowledges he’s been successful in combining both disciplines, while Desmond prefers to operate “entirely on technical” factors. Dudack, on the other hand, suggests that although “technical analysis excels at tops and bottoms,” fundamental analysis “works best in the middle of an economic cycle.” Farrell, who endorses a combined approach, cautions against using “one as an excuse for the other or as an excuse for the failure of what you’re trying to achieve.” Readers may be swayed by some arguments more than others, but there’s an impressive sense of the dedication and passion these leading practitioners bring to the field.
Of particular value is the treatment of the evolution of technical analysis in the computer age. Stan Weinstein observes that even though the impact of the rapid evolution of information technology is obvious, “charts are still valid for the simple reason that what we’re measuring is supply and demand, which is never going to change … Fear and greed are always the same.”
Lo and Hasanhodzic give a convincing picture of the breadth of technical analysis, with its wide range of market tools and its myriad applications of techniques. Perhaps the public’s misunderstanding of the discipline stems in part from time-constrained media broadcasts that distill complex probabilistic investment themes into deterministic sound bites. Technical analysts earn their recognition through public awareness of the prominent correct or incorrect calls they make, over time, on the market’s direction, and The Heretics of Finance is a valuable reminder of the extent to which technical analysis is really a science of probabilities. Prechter, for example, emphasizes this, noting that the study of history provides a “basis for probabilistic expectations.”
Of particular value is the authors’ treatment of the evolution of technical analysis in the computer age. Technicians now have instant access to thousands of charts that were once drawn painstakingly by hand. But veteran trader Raschke observes that although “computers have definitely speeded things up,” the “window of opportunity is not as big as it used to be.” Birinyi, for his part, cautions that “we don’t realize the potential weakness of data when we’re getting it off of a machine.” And Weinstein observes that even though the impact of the rapid evolution of information technology is obvious, “charts are still valid for the simple reason that what we’re measuring is supply and demand, which is never going to change … Fear and greed are always the same.” Recent history unequivocally underscored Weinstein’s point, when General Electric shares experienced a rare but classic “major reversal” pattern on March 4, 2009, as a downtrend abruptly ended with the exchange of an astounding 752.7 million shares. Interestingly, the S&P 500 index turned higher two days later, on March 6.
The Heretics of Finance is a captivating read that’s likely to inspire many to continue their explorations of this controversial field. Some may wish to take advantage of the fact that Acampora still approaches his course on technical analysis at the New York Institute of Finance with unbridled enthusiasm. Others may admit that they’re long overdue to read Raschke’s Street Smarts: High-Probability Short-Term Trading Strategies (with Laurence A. Connors, M. Gordon Publishing Group 1996). And—given the lingering turmoil in global capital markets—further investigation of Prechter’s evolving socionomic theories would make a timely sequel to Lo and Hasanhodzic’s work here.
Robert K. Becker, CFA, is a consultant for Catamount Management Group. He explores and develops methods of combining fundamental and technical analysis.
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Restoring Financial Stability: How to Repair a Failed System
edited by Viral V. Acharya and Matthew Richardson. Wiley. 2009. 416 pages. $49.95.
When it comes to the causes of the current financial crisis, Restoring Financial Stability (also known as the “NYU Stern Report”) takes a multifaceted perspective. The book features 18 papers, written by 33 New York University and NYU Stern faculty members. Taken together, the papers give a system-wide context for the meltdown and offer insights into the role played by market participants—banks, the shadow banking system, rating agencies, regulators, and government. Each paper also suggests reforms intended to minimize the possibility of similar future crises.
Central to the case for reform is the emergence over the past 25 years of LCFIs (large, complex financial institutions), which by virtue of their size and interconnectedness give rise to systemic risk. The issue is compounded by the mispricing of the government’s express or implied guarantees to such institutions. Mispriced guarantees to institutions deemed “too big to fail” effectively create incentives for risk taking or for engaging in regulatory arbitrage through, for example, the use of off-balance-sheet vehicles to reduce associated capital requirements and increase leverage. The contributors also make the case that this type of mispricing in and of itself encourages financial companies to grow to systemic size and complexity in order to compete. They contend that regulation is a key quid pro quo for providing systemic guarantees, and suggest extending appropriate reporting and disclosure requirements to the shadow banking system, possibly including hedge funds. They also point out that, given the global nature of many LCFIs, effective regulation must include mechanisms for international coordination.
Strong emphasis is placed on flaws in incentive compensation, including the lack of incentives to assess risk in the “originate to distribute” securitization model. The suggested solutions include, for example, requirements that originating banks keep representative loans on their balance sheets, and spreading payments over time based on a given securitization transaction’s credit experience. In “Rethinking Compensation in Financial Firms,” the authors indicate that the widespread use of return on equity as a key performance metric for senior executives likely provides incentives to increase leverage. They propose the use of return on assets as a more balanced metric.
Mispriced guarantees to institutions deemed “too big to fail” effectively create incentives for risk taking or for engaging in regulatory arbitrage. This type of mispricing in and of itself encourages financial companies to grow to systemic size and complexity in order to compete.
In “The Rating Agencies: Is Regulation the Answer?,” the authors point out the potential conflicts of interest associated with the “issuer pays” model, and highlight model specification issues inherent to rating complex securities for which the claims effectively constitute compound put options such as CDOs (collateralized debt obligations) of residential mortgage-backed securities, or CDOs of CDOs. Interestingly, given margin call provisions’ current reliance on ratings, the paper comes out as generally in favor of “rating through the cycle,” even though the authors feel this gives rise to ratings which may change too slowly under certain conditions. Ideas for reform include the potential for regulatory administration of ratings mandates (to prevent issuers from shopping for ratings), or eliminating the concept of a nationally recognized statistical rating organization. The latter would place the onus on regulated financial institutions to use their own methods—justified to a regulator—to assess the quality of fixed income securities. Such methods could include the use of outside ratings as inputs.
Thomas F. Cooley and Andrew Caplin take the US government to task for avoiding a fundamental problem: the likelihood that homeowner mortgage defaults will lead to deadweight social costs and higher losses for the financial system. Their solution is a debt-for-equity swap, in which a homeowner’s principal balance is reduced in return for a share in the appreciation of the home’s value. In a separate paper, Cooley and Thomas Philippon question whether the government has adequately formulated its eventual exit from bank recapitalization programs and guarantees. If not, maintaining high liquidity indefinitely could give rise to the next crisis.
Despite an arguable bias toward regulation, Restoring Financial Stability ably tackles complex issues and covers a wide spectrum of the current debate, including the multiplicity of regulators, the need for international regulatory coordination, transparency, fair value accounting, compensation reform, and the extent to which monetary policy should address systemic asset bubbles. Several of the ideas in the book, a draft of which was distributed to lawmakers and administration officials in December 2008, are in fact incorporated in the US Treasury’s June 2009 proposals for financial reform.
Costas Chrysostomou, CFA, is a corporate finance analyst with Moody’s Investors Service.
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More Mortgage Meltdown: Six Ways to Profit in These Bad Times
by Whitney Tilson and Glenn Tongue. Wiley. 2009. 306 pages. $27.95.
Whitney Tilson and Glenn Tongue join a long line of value investors, stemming from Benjamin Graham, who both practice and teach the art of value investing. More Mortgage Meltdown is the latest addition to Tilson’s body of pedagogical work: he’s also the cofounder of the semiannual Value Investing Congress and of the newsletters Value Investor Insight and SuperInvestor Insight.
Why do value investors make it so easy to learn their secrets? Shouldn’t they hoard information if they want to preserve their abnormal profits? Warren Buffett spoke to that point in “The Superinvestors of Graham-and-Doddsville,” his famous speech of 1984. “The secret has been out for 50 years,” said Buffet, “… yet I have seen no trend toward value investing … There seems to be some perverse human characteristic that likes to make easy things difficult.”
Twenty-five years later, Tilson and Tongue put some more flesh on the bones of Buffett’s explanation. The reason that everyone isn’t a value investor, given the soundness of the approach, they say, is that value investors “must be able to estimate the value of a business, which requires a great deal of skill and experience to do with reasonable accuracy.” They also explain investors’ relative resistance to a value approach by referencing some of the research that has emerged in the field of behavioral finance since Buffett’s time.
Human beings can never eliminate emotion from the investing process. We succumb, en masse, to greed and panic, sparking, for example, the 1987 crash, the 1990s technology bubble, and the recent housing bubble. When asset prices diverge from a calm, reasoned estimate of their intrinsic value, value investors—a contrarian minority—swoop in.
Value investors also take advantage of the fact that several thousand companies are too small or have too little trading volume to attract much research or accrue much of a following. This is where many value investors work, especially those investors with a small asset base, because few institutional managers can invest here, and small, individual investors often have insufficient experience to do so. Exposing their secrets, then, doesn’t pose much of a risk to value investors’ abnormal profits—even today, at the 75th anniversary of Graham and David Dodd’s Security Analysis.
Reading through Tilson and Tongue’s dissection of their four long and two short positions creates an intuitive understanding of what it is a true value investor actually does. It’s reminiscent of Graham’s publications and Buffett’s annual letters.
More Mortgage Meltdown could have appeared as two separate volumes. The first part is a meticulous account of the housing and mortgage phenomena that led to the credit crunch. It’s a reference work on the recent madness, and it makes a convincing case that the worst in mortgage defaults and losses is yet to come. Here, the authors set up some of the pins they’ll knock down in their detailed discussion, in the second section, of six positions they initiated.
Many investors will prefer this second part. Reading through Tilson and Tongue’s dissection of their four long and two short positions creates an intuitive understanding of what it is a true value investor actually does. It’s reminiscent of Graham’s publications, Buffett’s annual letters, and, more recently, work by David Einhorn. Each position is analyzed several ways from several angles, with frequent “sanity checks” deployed to avoid behavioral traps.
Value investing is not for the lazy. Although even naïve value investing strategies have proven to be successful relative to the market, the real glory—large abnormal returns—goes to those who are able to get into the guts of a business.
Nor is value investing for the faint of heart. Many value investors buy too early, only to see prices drop more; or exit too soon, before prices overshoot to the upside. To find the courage to stick with their strategies, they must rely heavily on a sound analysis of intrinsic value. That way, they can scoop up the lion’s share of returns, leaving the remaining returns (and the risk) to others.
Remarkably, shortly before the book’s publication, one of the authors’ short positions actually turned into a long position when the stock’s price plummeted, going from overvalued to undervalued in a few weeks. In that instance, and throughout, Tilson and Tongue demonstrate what all value investors know: Price is what you pay, but value is what you get.
Ray Galkowski, CFA, is a portfolio manager at Princeton Absolute Returns, LLC, the value-focused private partnership he founded.
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Going to Extremes: How Like Minds Unite and Divide
by Cass R. Sunstein. Oxford University Press. 2009. 208 pages. $21.95.
Cass Sunstein writes, “The economic crisis that began in 2008 was a product, in significant part, of a form of group polarization, in which skeptics about the real estate bubble, armed with statistical evidence, did not receive a fair hearing or were in a sense silenced.” This raises a couple of immediate questions. For example, how do group dynamics influence individual and group (that is, market) decisions? What can astute investors or financial decision makers learn from Sunstein that will improve the way they process information and arrive at conclusions?
Going to Extremes is an excellent study of the conditions that drive events like the financial crisis, and it gives rise to at least two direct applications for the investment industry. The first of these pertains to the impact of politics on economic decisions. Think GM, Chrysler, Bank of America, and Citibank. Those who understand political methodologies and agendas will form a more accurate assessment of which political environment could be most (or least) conducive to certain investment decisions. The second application of Sunstein’s theories to the financial sector involves risk. Regulators and business organizations that perceive the impact of group composition on the degree of risk taking present in the decision-making process will be able to optimize the design of their teams.
Sunstein lays out a number of key concepts, exploring the implications of each, and suggesting countering actions for cases in which those implications are potentially adverse. He deals, for instance, with group polarization. This concept arises from studies of the effects of opinionated discussion on people inclined to take risks. After group discussions, the studies found, such individuals became significantly more disposed to risky decisions. He also investigates rhetorical advantage, a concept applied to jury awards and the idea of altruism. Studies of juries suggest that punitive awards are likely to be larger after group discussions take place. Regardless of the circumstances of a case, the fact that it’s easier to justify a large award than defend a small one gives rise to an artificial advantage for higher awards. In another scenario, groups that discussed how much money they should “share” with others were more generous than the individual members would have been outside the group environment. In this instance, it appears that the generosity is motivated by the desire to be perceived as altruistic by others in the group.
Sunstein believes in the “wisdom of crowds.” He devotes a number of pages to explaining why that concept has substantial statistical validity, particularly when there is significant diversity in the composition of the crowd. Those in charge of putting together investment teams would be well advised to include thinkers who can offer downside views to be vetted during the group’s decision-making process.
Sunstein also explores three techniques for countering situations that have the potential to encourage groups to adopt more extreme positions. First, there’s traditionalism, which proposes that reasonable citizens aware of their limitations will effectively delegate a good deal of authority to their traditions, and will defer to the status quo. Traditionalism may apply unevenly across demographics—the “me generation,” for example, might be relatively unaffected by this countermeasure. Second is consequentialism, which suggests that group decisions may be influenced by a deliberative review of the specific results of a particular decision—costs, scenarios, and so on. Consequentialism more or less boils down to the idea that a solid reality check can mitigate overly extreme degrees of risk or identify possible negative outcomes. Finally, there are checks and balances. This technique makes reference to the benefits of “deliberative democracy” and attempts to combine a process of reflection and discussion with a focus on accountability. This countermeasure can be applied not only to systems of government, but to the establishment of prudent practices in financial decision making as well.
In addition to these formal countering techniques, Sunstein also believes in the “wisdom of crowds.” He devotes a number of pages to explaining why that concept has substantial statistical validity, particularly when there is significant diversity in the composition of the crowd. Those in charge of putting together investment teams would be well advised to include thinkers who can offer downside views to be vetted during the group’s decision-making process.
As far as the application of Sunstein’s work to the financial services sector goes, the research studies summarized in the “Findings of Group Polarization” appendix provide excellent resources for investigating the effect group dynamics can have on risk management. While Going to Extremes won’t be found in bookstores’ finance and investing sections, it’s a valuable survey of research pertinent to managers in various areas of finance, and it suggests a range of practical, utilizable approaches to improving decision-making processes.
A. Mark Harbour, CFP, CFA, CIMA, is a financial advisor in Los Angeles.
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Trading Options at Expiration: Strategies and Models for Winning the Endgame
by Jeff Augen. 2009. FT Press. 176 pages. $34.99.
In Trading Options at Expiration, Jeff Augen tackles a topic that bedevils many traders and investors. The author draws on his extensive experience with options trading and computer code, algorithm writing, and database management to skillfully blend general trading rules with logistical advice for building the infrastructure necessary to analyze minute-by-minute price data.
Augen identifies “windows of opportunity” that appear in the few days leading up to expiration, allowing the investor to realize high risk-adjusted returns. He believes these opportunities exist because “traditional approaches to calculating the value of an option contract fail, and prices become distorted.” As most traders exit their positions with expiration approaching, the informed options trader can profit handsomely.
Extending the analytical framework of his previous book, The Volatility Edge in Options Trading (FT Press 2008), Augen gives an overview of how to build a database to house the data necessary to analyze options’ and underlying contracts’ minute-by-minute price histories. He delves into logistics about the kinds of stocks to trade (heavily traded stocks that have high open-interest options contracts) and the amount of capital that could be deployed in this kind of strategy ($10,000 to $10 million). The book is filled with specific formulas for data analysis, including an appendix describing the use of Excel’s Visual Basic for Applications program to count the number of strike crosses using the underlying’s price history.
But Augen errs in failing to fully explain all aspects of the data analysis he performs. Although he provides many specific pieces of his methodology, readers must do additional work on their own to fully detail their investment strategies (probably because Augen presumably continues to use this expiration trading tactic in his own investing).
Any options trader is well advised to review this volume’s argument that the three dynamics of stock-option expiration enable the trader to achieve high risk-adjusted returns. Augen offers no short cut or magic formula, but his guidelines are clear and detailed. He builds a unique framework for analyzing stocks’ behavior during the onset of expiration.
In addition to offering specific logistical guidance, the author follows three broad principles, illustrated by specific examples, when he lays out his trading strategy: accelerated time decay, implied volatility collapse, and the tendency of the underlying stock to migrate to a strike as expiration nears.
The time decay of an option’s value is shown to increase in importance with the advance of expiration. The 17.5 hours per day that the stock options market is closed become progressively more significant as expiration approaches for an option valuation. Overnight price changes tend to be modest in the absence of a quarterly earnings release. Increasing time decay constitutes one major dynamic the investor can exploit.
A similar phenomenon is implied volatility’s tendency to collapse on the Friday of expiration. Augen believes this “collapse has a distinctive profile that can be used to help time entry points for various types of expiration day trades. The fine structure of this profile, which differs between stocks, is apparent in minute-by-minute charts for near-the-money options.” The key here is the propensity of expiration behavior to repeat itself—that’s what presents traders with their opportunities.
The third dynamic shaping Augen’s strategy is the predilection of the underlying stock to migrate toward a strike. This phenomenon, called “pinning,” has been widely studied, but Augen goes beyond expiration near a strike, and examines the minute-by-minute stock behavior of strike crosses, noting the number of minutes that a stock trades at greater than a given distance from a strike. Analyses at this level of detail enhance a trader’s ability to exploit a stock’s habit of migrating toward and hovering near a strike.
Any options trader is well advised to review this volume’s argument that the three dynamics of stock-option expiration enable the trader to achieve high risk-adjusted returns. Augen offers no short cut or magic formula, but his guidelines are clear and detailed. He builds a unique framework for analyzing stocks’ behavior during the onset of expiration.
Kirk Howell, CFA, is vice president of product development at Sungard’s Kiodex, where he manages development of Kiodex’s commodity risk management solutions.
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A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression
by Richard A. Posner. Harvard University Press. 2009. 368 pages. $23.95.
Most call it simply “the crisis.” Richard Posner calls it a depression. When it comes to analyzing the factors behind it, he objects strongly to the addiction—common among journalists, politicians, economists, and ideologues and populists of every stripe—to finger-pointing, name-calling, and partisan sniping. At the same time, he rejects Wall Street’s claims of helpless innocence, its contention that no one could possibly have known what was coming, its grumblings of hindsight being 20–20. Posner cites economists and journalists whose foresight needed no spectacles, whose warnings covered everything from the housing bubble, to low savings rates, to deregulation, to risky new instruments. Despite some major shortcomings, A Failure of Capitalism will be of use to anyone who’s still looking for an overview of the meltdown. And those weary of populist, partisan accounts will find Posner’s no-nonsense, jargon-free engagement with tangible issues refreshing.
Posner argues that the economic collapse was not caused by greedy or incompetent financiers, by irresponsible homebuyers, or by government interference in the free market. The real villains? Financial deregulation, dating from the 1970s and consolidated during the Clinton administration; and interest rates kept too low for too long by the Greenspan and Bernanke Feds. Those two policy decisions encouraged increased leverage in financial institutions and lower personal savings rates, weakening the economy’s resilience to shock. Overleverage in the financial system allowed small losses to threaten the solvency of major institutions. Consumers’ lack of savings left them without recourse when faced with job losses or other hardships. Systemic weakness followed these developments as night follows day. The main culprit, according to Posner, was the system’s vulnerability to the bursting of the housing bubble.
Even if housing price increases are unsustainable, living in the bubble is the rational response, says Posner. He argues that “bankers and consumers alike seem on the whole to have been acting in conformity with their rational self-interest.” The depression is simply the result “of normal business activity in a laissez-faire economic regime.” The market economy failed us.
But why would managers risk bankrupting their companies by taking on too much debt? Why would consumers take out unaffordable mortgages? For Posner, these aren’t the right questions. Economic decisions are always made in an environment of risk and uncertainty, he points out, and financiers and consumers have little incentive to worry about small probability events.
In economics, the best guide to the future is usually the present. If housing prices go up today it is, as a matter of fact, reasonable to expect that they will continue to rise. There’s no judging whether the price increase represents fundamentals or is the result of a bubble until the moment when the bubble, if it exists, actually bursts. Even if the increases are unsustainable, living in the bubble is the rational response, says Posner. He argues that “bankers and consumers alike seem on the whole to have been acting in conformity with their rational self-interest.” The depression is simply the result “of normal business activity in a laissez-faire economic regime.” The market economy failed us.
Coming from Posner, a Reagan judicial appointee and a leading conservative intellectual, these are startling words. No less startling is his conclusion that “we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.” Posner has determined that it falls to the government to remember that individual investors’ rational indifference to improbable events carries with it the risk of catastrophe.
So far, his approach is surprising and interesting, though many readers will prove resistant to Posner’s reasoning, particularly his definition of rational behavior and his assertion that blame should be assigned only to such market failures as incomplete incentives, conflicts of interest, moral hazard, and search costs. And when it comes to planning the future, rather than raking over the past, the author stumbles. His chapter “The Way Forward” is among the shortest in the book—only the chapter on the future of conservatism is shorter, tellingly. To expect a comprehensive plan of regulatory reform may be asking too much, but Posner’s attempt at forward thinking is seriously disorganized.
To bolster his case, Posner quotes former Citigroup CEO Chuck Prince’s infamous statement that “when the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Prince said this in July 2007, however—long after the housing bubble had already burst and the subprime mortgage market had collapsed. Perhaps, as Posner believes, it’s rational to keep dancing as long as the music is playing. But if you’re jitterbugging on once the band has left the stage, people may begin to ask how much you’ve had to drink.
John Merante, CFA, is a banker and economist who has advised governments in Asia and Latin America on financial crises and debt restructuring.
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Poorly Made in China: An Insider’s Account of the Tactics behind China’s Production Game
by Paul Midler. Wiley. 2009. 256 pages. $24.95.
There’s trouble in wonderland. China is increasingly the go-to spot for world global production, promising cheap fabrication, short lead times, large profit potential, and an enormous domestic target market. It’s virtually impossible not to make use of a product manufactured in China in the course of any given day. But major quality problems, such as the 2007 recall of toys containing lead paint, occur with alarming frequency. Poorly Made in China not only lifts the curtain to reveal the games behind Chinese production, it provides an acute analysis of the factors behind China’s manufacturing woes—cultural, ethical, political.
After earning his MBA from Wharton, Paul Midler moved to China and worked as an independent local partner for companies involved with manufacturing in South China. His account of that experience explores the multifaceted problems faced by manufacturers and borne by global consumers. He illustrates the stages of the business relationships between importers and Chinese manufacturers, and demonstrates how the frictions are exacerbated by cultural differences. For example, many Chinese manufacturers hold that the struggle to catch up in a harshly competitive industrial age makes any ends justify the means—a view not shared by a good number of their customers, who come from economies circumscribed by rules and standards.
Companies that build long-term relationships with Chinese manufacturers and that gain familiarity with Chinese priorities and cultural tropes still find that their partnerships continue to be fractious. But breaking up is hard to do. China makes it easy for importers to get started, with low barriers to entry into the production game, low labor costs, and rapid turnover in filling orders. All the manufacturers really require to get rolling is a sample product. That certainly helps manufacturers and agents win foreign business. So do lavish displays of samples or of whole production lines—even though many may simply be staged.
It’s virtually impossible not to make use of a product manufactured in China in the course of any given day. But major quality problems, such as the 2007 recall of toys containing lead paint, occur with alarming frequency. Poorly Made in China not only lifts the curtain to reveal the games behind Chinese production, it provides an acute analysis of the factors behind China’s manufacturing woes—cultural, ethical, political.
Midler thinks importers rush into these relationships, often impelled by lengthy cost production overruns in their home markets. They skimp on background checks for the industry as a whole and their trading partners in particular, failing to learn key information about manufacturers’ production capabilities, histories, and ownership. They never seem to learn the meaning of the phrase “too good to be true.”
Midler describes how the apparently inevitable game often begins as soon as manufacturers obtain their first orders. The resolutely short-term view of factory owners embattled by fierce competition kicks in immediately, as they focus blindly on savings, cut corners to squeeze profit, and trample on intellectual property rights. At the same time, importers begin to feel the effects in their own pockets, as their brands erode and their product quality withers. King Chemical, for example, despite an initially satisfying relationship with the importer, gradually degraded the quality of their plastic shampoo bottles, reduced the size of labels, and changed the shampoo formulation.
Importers are saddled with financial and reputational costs when low-quality products are shipped to their home countries, but they also face another peril in dealing with Chinese manufacturers: their samples are often counterfeited and sold to other markets. Despite these serious downsides, importers lack a real production alternative. What’s more, switching manufacturers can cost a bundle. Low barriers to entry turn into high barriers to exit.
Poorly Made in China will fascinate a wide audience—corporate decision makers, analysts, consumers, and students. Midler’s detailed anecdotes about actual cases are captivating, and his frustration with these cat-and-mouse games is sharply evident. But he offers few arguments as to how to actually craft successful, long-term business relationships with Chinese partners, a question he’s more than qualified to tackle. Perhaps his answer to that will require a book of its own.
Antje Seiffert-Murphy, CFA, is a trade credit and political risk senior underwriter at Atradius Trade Credit Insurance.
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The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street
by Justin Fox. HarperBusiness. 2009. 400 pages. $27.99.
After the successive crashes of the past decade, the premise that markets can be irrational is a foregone conclusion for most. Nevertheless, there is no denying that financial theory, which assumes market rationality, has made key financial innovations possible. Justin Fox’s The Myth of the Rational Market is rich in detailed, meticulous descriptions of the evolution of financial theory, presented via a veritable Who’s Who of financial luminaries from the past century. In the course of this history, Fox provides wonderful anecdotes about characters famous, infamous, and obscure, rendering their competitive and sometimes eccentric personalities with skill.
The genesis of rational, quantitative finance begins at the turn of the last century with the observation that price changes are random and are almost distributed normally. From there, conceptualizing an investment as a bet in payoffs fluctuating around an expected return plus a random factor led to the concept of arbitrage-induced equilibrium, to equations able to capture the “right” price, and to various forms of the efficient market hypothesis. Fox points out that the rational school requires more than mathematical proofs—it needs theory to unite data with logic. Adam Smith’s invisible hand—directing markets to the right price—was aligned with most people’s ideas of a well-functioning economy and contributed to the ascension of rational finance.
Once rational theory was firmly in place, both theoretical and product-based innovation followed. The capital asset pricing model, the Black–Scholes options model, and index-based mutual funds are among the direct descendents of this theory. Fox observes the ease with which these concepts were adopted by corporate management as rational theory gained dominance—for example, options-based incentives galvanized management’s pursuit of shareholder value.
The capital asset pricing model, the Black–Scholes options model, and index-based mutual funds are direct descendents of the financial theory of market rationality. Fox observes the ease with which these concepts were adopted by corporate management as rational theory gained dominance—for example, options-based incentives galvanized management’s pursuit of shareholder value.
From the beginning, there was tension between enthusiasts who embraced the rational perspective and doubters reluctant to discount the human element and suspicious of model precision. The criticisms of the latter group have now been formally voiced by thinkers in the field of behavioral finance, who have documented many pricing anomalies that should never have existed if markets were rational. The fact that the 1987 stock market crash was so far outside the bounds of a normal distribution curve made more room for the behavioral view and spurred the rational school toward introspection. As a result, a three-factor model was developed to better explain returns. To the overall market factor, it added size and value factors in order to isolate the superior returns of small and “value” companies over long periods. But Fox dismisses this model as “clunky,” based on data mining, and resting on dubious explanations. This is a harsh assessment. Many researchers regard the three-factor model as a landmark advancement in its own right, and as the impetus for explorations into the impact of momentum, liquidity, and other return factors.
In proposing practical lessons for the investing public, Fox straddles the tenets of behavioral finance and rational markets. In a nod to rational markets, he maintains investors should begin by asking why prices do not already reflect their insights. Limits to arbitrage are real and may be the culprit behind distorted prices. He favors low-cost index funds for investors without industry insight or private information, since selecting active managers requires an understanding of the managers’ strategies, something past track records don’t reveal.
On the other hand, for individuals who have industry knowledge or are able to sniff out securities that have simply fallen out of favor, he recommends analysis of relative rather than absolute prices to identify securities that are not priced rationally and are likely to deliver superior returns. However, he does not give a sense of the ability required to dig deep into valuations in order to avoid investments in industries going down the tubes. Although his active approach to security selection is mindful of behavioral traps, he may be overestimating the public’s discipline. Indeed, in an early section of the book, he cites behavioral research that portrays active investors who typically “traded way too much, chased after stocks that had been performing well,” and tended to buy hot funds. It draws a portrait of 401(k) investors “daunted by choice,” who failed to diversify, investing heavily in their own companies’ stocks. (In an unfortunate omission, Fox doesn’t speak to the need for tax-aware strategies or to the need to frame a plan with an investment policy statement.)
Fox’s encyclopedic knowledge of the evolving debate between the rational and behavioral schools lays an immensely valuable foundation for understanding where we are today. The debate on market efficiency is destined to rage on.
Paul Tanner, CFA, is principal of Granite Hill Capital Management, LLC, in Ridgefield, Connecticut.
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