Monday, July 25, 2022

How to Beat the Pros at Common Stock Investing

It is not hard to outperform the average professional investor, if you define "average" as the combined group of mutual fund managers, hedge fund managers, and sell-side brokers operating discretionary accounts. Because this recipe is short and easy to do, this will be a short article.

What is the Average Return?

There are so many professional investors that the average gross performance of managed investments is the market average return. As a large group the professionals cannot help but be average overall. 

Unfortunately for customers, the net return on their investments is reduced from the average, on average over all managers, by the average fees charged by the professional investment managers. These can range from 0.05% for index funds to 1.0% for smaller and specialized mutual funds, to 2% or more for specialized hedge funds. Even for famous mutual fund companies that are well-known to 401(k) participants the fees charged by their actively managed funds may be 0.3% to 0.9%, annually.

What is the average market return? Using the figures produced by SBBI, large cap stocks return about 10% annually, small caps 12% annually. Most professionals that are known are running larger amounts of money, and generally must trade in at least some large cap stocks, so returns (still on average, remember) will be a blend of 10% and 12%, and with some cash always held aside for redemptions or moving between investments, the average return will tend toward 10% or even slightly below

Your Strategy

As an independent investor, your strategy to beat those returns involves these steps:

  1. Invest in a small cap index fund with a low fee (perhaps 0.05% to 0.15%)
  2. Stay fully invested

Your long range rate of return will then be just under 12%, which will beat the average pro's return of just under 10%. You may have intermediate results that are more volatile, but over longer periods the volatility will work in your favor if you add money periodically, as you will be dollar cost averaging.

You may be wondering whether it is possible to improve on the average by market timing. The answer is a strong "not really." Academic papers showed over 30 years ago that at most 2% of investment performance depends on timing, so on average the pros could at most move their 10% large cap returns to 10.2%. The advantage remains with the small caps, and with the low fees of index funds. 

QED

Wednesday, July 20, 2022

An Outlook for Inflation

The professional economists, including experts, the Fed, university professors, and Paul Krugman, appear to have gotten the call on inflation wrong. Krugman at least admits culpability:

In this thread he reviews the results of inflation expectation surveys and finds that expectations are moderate or moderating, a sign that current rampant inflation will quickly subside over the next few years. Though human sentiment is of value, this data is not sufficient for predicting the future course of inflation, which will depend on other macro factors.

Three Causes Not Addressed

It takes more than "entrenchment" of expectations to generate inflation. The causes of current inflation include:

  1. increases in energy costs, especially prices of crude oil and gasoline;
  2. increases in the money supply. M1 and M2;
  3. surges in demand for goods and services combined with constraints on production or supply of raw materials.

As I pointed out last week, refiners foresee weak to moderate medium-to-long term demand for gasoline, and therefore do not plan to build new refineries or increase production. U.S. oil production is potentially constrained by the availability of leases on federal lands. International oil production is constrained by warfare in Ukraine and sanctions on Russia. Russia also discovered a war bonus: Sanctions have increased its income from selling oil. Even if the West were to seek to end the war soon or lift sanctions, it's not clear that Russia would increase its output. OPEC and Russia have an incentive to hold down production to raise market prices, and with the U.S. and Europe willing to throttle their own production in the name of climate change, the policy tools may not be in the toolbox to force oil supply to meet demand. 

Since energy is an input to many other costs of production, high prices of oil and gasoline will then have a cascading and continuing influence on pricing of other goods and services.

The second cause, money supply, might not be a cause of future inflation, but the existing increased level will act against possible deflationary influences, as too many dollars will continue to chase goods.

The third case has been drive in part by the so-called Great Resignation, in which people incentivized by government payments or other aspects of COVID-19 decided to retire or stay home rather than work. That doesn't seem to have changed; turnover is still high, and early retirements in many sectors are still unusually high. 

Longer term, constraints on labor supply then depend on net immigration and birth rates. Total fertility rate (TFR) in the U.S. is now below 2.0, where 2.1 is considered the minimum for replacement of a constant population level. Worldwide, TFR is well below 2.0 in nearly every developed country. Europe, China, North America, and Australia have shrinking populations when immigration is excluded. 

The ratio of retirees to workers has been decreasing for decades, and is a big problem for the solvency of Social Security. Even if SS were not a problem, one has to think about what happens to the economy when a third of the population is retired (or trying to be) and the other two-third holds jobs. Clearly the market-clearing prices for labor will rise and be under increasing pressure as time passes. Already we see many, many markets in the U.S. where the "natural" lowest wages payable for entry level work are well above the national minimum wage.

The escape valve for labor costs since 1995 or before has been offshoring, especially to China for manufactured goods and India for IT services. As China's economy booms, wages have been increasing there too. They will not be "cheap" relative to American wages forever. When they catch up, wage inflation in China will then affect goods inflation in the U.S.

Forecast

Officially, there is no Vorpal Trade forecast on inflation. Best I can do is ramble on about what I might believe and why, and then you can take it from there to decide what will happen.

Structurally, the world is presently set up to avoid inflation as long as work can move across national borders. There are limits to the rate of this process, so there will always be pockets of inflation, such as in China, when countries run out of under-employed populations. The amount of liquidity in the US is ridiculous; with so much cash and high absolute levels of wealth even among the poor and middle class long-term low interest rates will still dominate in the long term future.

Against that backdrop is the usual rent-seeking behavior of elites, much of it both unconscious and arising from entitlement feelings. Colleges, medical care, and glamour city real estate will continue to be highly controlled for the benefit of the elite, and will experience severe long term inflation in the future. This is a trend that could go too far. If there were a perception that lack of college was cool, or dying nobly without medical care was cool, or some other crazy systemic shock, then denying medical cost inflation could turn into a macro phenomenon. But the odds are low because these scenarios are just plain weird.

As for the headline numbers, CPI and PPI, they will likely subside once the initial post-COVID YOLO and FOMO impetuses have run their course. In Spring 2022 people finally felt released from the confines of their houses and had enormous spring fever and urges to travel and be outside, which required large amounts of gasoline. People are fond of blaming Biden for high oil prices. He mostly didn't cause it directly, except that restrictive health policies exacerbated the pent up demand for outdoor travel experiences, so in that sense both the CDC and Putin caused our 2022 gas prices

The labor shortage is real, as people decided to take the CDC seriously that they might die any minute, so why bother working? It just takes a few percentage points and some poor policy that exacerbates the trend to cause a serious imbalance. Old people are retiring, and since women no longer have children, the old workers are not being replaced by younger ones. Expect labor shortages and wage inflation to continue at rates that are beyond the cost inflation of inputs like fuel and mining outputs.

The other factor that seems remote to U.S. persons but is very unfortunately real to citizens of countries like Sri Lanka is that food prices have exploded and will not retreat because ESG policies will heavily constrain food production. This is a partly world-wide WEF agenda movement that will constrain food production in a way that we haven't seen before. I see very little chance of the ESG and pro-WEF folks backing down. The starvation caused by food restrictions is, unfortunately, part of the plan, and since the first world elite will deny that this pain exists, it will continue.

We cannot foresee the political fallout. As for inflation economics, the net result will be strange: computers, games, television, communications, gadgets, and clothes will show little to no inflation, while medical care, transportation, and food will continue to see moderate inflation, possibly lasting a decade or more.

House price inflation is likely already dead, at least for a while. To me housing looks like it has finished a "bang-bang slam" against the constraints and topped out. It is strange to see this happen to housing again, as before say 1996 we didn't used to see so much boom and bust in real estate. Boom or mini-boom, yes, but bust? Not very often. When I say "bang-bang" I'm thinking of the tendency of some commodity markets to slam back and forth between over bought (high price) and over sold (low price) conditions, not spending much time in middle prices and back and forth steady state markets. Hence, I would not be surprised to see housing park itself at current prices for two to five years before the next major move.

Update: Additional News and Sources

AMZN: Janet H. Cho and Liz Moyer at Barron's say in CEO Pay and Corporate Profits Rose in 2021. Workers Wages Didn't Keep Up.: 

The average starting pay for Amazon workers is more than $18 an hour, the spokesperson told MarketWatch.

$18 per hour is about $36,000 annually, assuming full time work at 40 hours per week and two weeks unpaid time off, or $37,440 paid time off. The spokesperson did not elaborate on how many salaried and information technology workers are included in the average. 

According to Indeed, Amazon packers, warehouse workers, drivers, and store shoppers make between $15 and $16 per hour ($30,000 to $32,000 annually).

Small business: According to guest writer Nancy Rommelman reporting at Common Sense, small business owners are being hit in multiple ways by inflation: by increased costs for the goods they buy, by customers who blame them for the high prices, and by reduced store traffic as customers shy away from travel (contradicting VT's "ferment" thesis) and buying things because the high prices no longer fit their budget. Says the owner of Taiwan Pork Chop House in NYC:

“We’ll never return to the way we were living before,” Wang says. “There’s so much instability, with the government but also with individuals and lifestyles and concepts and even our ideas of what life and work and eating out should be. You never know.”  

CAG: ConAgra's FY22Q4 shows that even though customers didn't cut back as much as expected in response to increased prices, overall results were not adequate, and the market sold off CAG. Says Morgan Stanley:

CAG’s Q4 organic sales were relatively in-line with expectations (+6.8% vs. consensus +7.1%) reflecting stronger than expected price/mix +13.2% and softer volumes -6.4% as demand elasticity has remained below historical levels. 

Monday, July 18, 2022

Progressive Write Down Dings PGR Shares

In the recently completed June quarter PGR wrote down a substantial portion of the goodwill from its acquisition of ARX Holding Corp., the parent holding company of American Strategic Insurance (ASI) in St. Petersburg. The amount, $224.8 in the month of June, is marked with an annotation in the June report as "Reflects partial write down of goodwill associated with the ARX Holding Corp. acquisition."

Likely the problem is that ASI "gunned" its property insurance business, writing business with one expectation of coverage that does not reflect what customers were led to believe. Hence although paid claims matched expectations of the ASI group, PGR is losing business as customers drop off the platform. In some cases, PGR may be losing multiple lines of business associated with ASI, including auto insurance, to other carriers.

Some of these issues were likely known in May 2021 or earlier. PGR was weak prior to the June 2022 earnings release, indicating that news of the writedown may have become known outside PGR.

Long term, PGR will eventually recover, as the ethics that came with the ASI acquisition do not appear to have infected the rest of PGR. Look for some more turbulence over the rest of 2022 and perhaps 2023 as PGR figures out what to do with its property insurance business.

Updates posted 2:35 p.m. EDT:

Review of a sell side report indicates that ASI impairment is not fully showing up in analysis.

Morgan Stanley analyst Michael Phillips maintains Progressive (NYSE:PGR) with a Equal-Weight and raises the price target from $115 to $121. (Benzinga)

MKM Partners Maintains Buy Rating, raises its price target from $125.00 to $135.00.

Reinsurancene says PGR "has seen a significant dent in its H1 2022 results due to investments losses and the writedown of ARX Holdings impacting the property segment." PGR holds common stocks in its investment portfolio.  Progressive said: 

“Based on our analysis, we concluded that the fair value of our Property segment is less than the current carrying value, primarily driven by reduced forecasted profitability given the magnitude of recent weather events, as well as other factors impacting our plans to restore our Property business to target profitability in a timely fashion.

“There is no indication of impairment on the remaining $227.9 million of goodwill, which is primarily attributable to our Personal Lines Agency business and related to the ARX acquisition.” 

(As noted above, ARX held the ASI business.)

References, added 7/19/22:

https://stpetecatalyst.com/progressive-is-about-to-complete-its-1-4-billion-deal-for-homegrown-insurer-asi/

https://www.americanstrategic.com/about-asi/our-companies-and-affiliations

"Progressive Insurance Acquiring Homeowners Group ASI for $875M; December 16, 2014" https://www.insurancejournal.com/news/national/2014/12/16/350221.htm

  • $875M to bring ownership from 5% to 67% (+62%, implied valuation of $1,411M as of 2014)
  • This article has 21 comments primarily from agents and similar close parties.

Friday, July 15, 2022

A Critical Cathie Wood Macro Error

In April 2021, Cathie Wood laid out a macroeconomic case that stocks were too low relative to GDP, based on the observation that in the late 1800s there was a much higher ratio.

In her third reply on this thread, she says

The technologically-enabled innovation evolving today dwarfs that of the late 1800s/early 1900s: genomic sequencing, robotics, energy storage, artificial intelligence, and blockchain technology. Moreover, Bitcoin could be today’s “gold standard”, increasing purchasing power!

The problem with this analysis, as I see it, is that the late 1800s saw the introduction and refinement of technologies that generated enormous amounts of leverage over physical economic results. Prior to this phase of the Industrial Revolution, human manual labor was limiting economic growth. The ratio of stock market value to GDP then reflected this new and incredibly optimistic (but rational!) result.

In contrast, the post-silicon stock market results in enormous gains in mental economic growth. This is a completely different animal, in which physical comforts (food, shelter, clothing, transportation) continue at a more or less constant or only gradually improving level, while ideas, manipulation of ideas, and computer-enhanced communication experience much greater gains. Part of the current problem with the economy is that the post-silicon world is validly better only for or primarily for information workers, not physical object workers. 

As an example, consider the costs of getting a barrel of oil out of the ground, in terms of barrels of oil. There is no gain unless the ratio is more than one-to-one. In the early 1900s this ratio might have been 50-to-one from the numbers I have seen. More recently, U.S. oil fields might be more like a five-to-one ratio, with Alberta tar sands being quoted by some sources at three-to-one. Clearly, as this ratio declines less physical gain is available for increasing the basic human standard of living.

Other physical industries have improvement rates that are far less than the miraculous growth rates of information technology. Although we see technological progress in autos, chemicals, space transportation, ocean shipping, construction and other physical industries, they constantly work against the continually increasing cost of petroleum fuels and certainly experience much lower technical growth rates than IT.

It is entirely possible for the mental revolution of computation improvements to feel good, but be illusory. In fact, we have had more or less flat economic gains for most of the U.S. population since 1973 (when did the Intel 8080 debut? when did the 1970s oil crisis hit? when did worker wage gains cease climbing?) while the elite, 1%, college-educated, and knowledge workers have done quite well, but perhaps at the expense of physical workers. Leverage over physical workers could be, and was, enhanced through free-trade agreements that off-shored factory and much manual labor to countries with lower labor costs.

In short, Cathie Wood's ratios are meaningful, but she has not interpreted them correctly. Instead, they highlight the problem with reaching the limits of the physical Industrial Revolution, especially when the elite "conspire" to capture an outsized portion of the economic profits. 


Hence You Must Invest in Equities

An understated theme here in Vorpal Trade is that everyone, not just the elite but especially the physical workers of the U.S., need to continually underspend their earnings, save, build capital, and invest that capital into equity of U.S. and international corporations. The economic model of the 1970s and after is that all persons, even those earning minimum wage, need to build up a capital base that pays dividends forever after the initial savings. A "factory worker" in their 40s and 50s then winds up with two revenue streams, one from manual work, but a large and increasingly important stream from dividends and capital gains. This second stream does not depend on the actions of management, and can in fact be used in conjunction with other equity owners to influence company operations, if necessary. I will have more to say about this process in future posts.

If manual labor ceases to achieve gains because the underlying technology is not advancing rapidly enough to generate gains of physical goods, then the goal of a manual laborer must be to gain capital to own the means of production. If corporations then collect rent on intellectual capital, then a manual worker owning stock of the corporation is in turn collecting rent on intellectual capital

The alternatives to ownership are messy. Redistribution through taxation and welfare programs tends to reduce agency and cause psychological damage to those who are "helped", slows the economy, and causes increased incentives for corruption among the elite. We already see all of these effects. Some people see this result, claim that capitalism has failed, and call for socialism or other centrally-planned solutions, which are more of the same types of redistribution, but with worse results, messier side effects, and even greater corruption. Even worse, the price of redistribution schemes may turn out to be entrenching an elite class that, through personal connections and rights of family and birth, comes to feel that they are entitled to the reins of the economy.

I am not intentionally mixing normative and objective; what you personally choose to do should not be governed or directed by national policy or the tides of public opinion. Just the opposite. The point is that the solution for each individual does not depend on government action, and that individual actions are nonetheless not only the path to a personal glorious future of success, but then incidentally are the salvation of the country.

That doesn't mean that the U.S. cannot do better by reducing corruption among the elite. It should, and must. For some examples, see The Captured Economy: How the Powerful Enrich Themselves, Slow Down Growth, and Increase Inequality. The legal and medical professions are rife with rent capture, as are occupational licensing, college tuition, and real estate zoning laws. Some of this is subtle, but still evil. Little Grandma in her 5,000 sf house on 16 acres in Mountain View, CA rails against further real estate development, and donates heavily to her local town councilmen; who is willing to write a newspaper article calling her evil? And yet she is corrupt, as the legal machinations that elevate the price of her real estate and keep low-earning local workers destitute are nevertheless manipulations of the system design to enrich her at the expense of others

In the meantime, put away 10% or more of what you earn, take advantage of low stock prices, and build up a dividend stream that Grandma Tyrant can't have any effect on. 

Monday, July 11, 2022

The State of Refining

A few words about refining. This is not an area where I claim much expertise, beyond a materials science college course that covered hydrocarbon chemistry many years ago and pumping my own gas. World oil prices are distorted by the Ukraine war. In turn, gasoline prices are also distorted. You can see it in this chart:

Gasoline prices are behaving as though they are constrained by supply. Since gasoline is apparently an exportable product, U.S. domestic prices are affected by world market prices. So if you bid $3.00 a gallon for Exxon gas, but Brazil bids $4.00, guess who Exxon will sell the gasoline to? This appears to be well-documented (see WSJ article) but never referenced by politicians. Washington D.C. could regain control over prices by passing legislation prohibiting exports of fuel from the U.S. If they have decided not to do that, it may be because they know that it would be bad policy.

Refining is constrained because, although the U.S. is generally well-supplied with refineries, the number of existing working refineries is shrinking and has been for a long time. The industry, taking cues from actual declines in demand (driven by auto manufacturer fleet MPG requirements and increasing numbers of EVs on the road) and extremely popular left-leaning climate change rhetoric, has taken the message ("DON'T BUILD REFINERIES") seriously. 

Of course, the screaming on Twitter by know-nothings echoes the politically-motivated outrage and moral grandstanding by Biden. It's a temper tantrum, deserving of the same respect one would give a two year old's demands for candy. I find it much easier to believe the American Fuel & Petrochemical Manufacturers, especially when they cite a Motley Fool posting that cites Chevron's Mike Wirth saying that "he doesn't believe there will ever be another new oil refinery built in the U.S." 

Chevron like all of the other oil majors, is making money this year. But overall the oil business has had a tough past six years. Chevron made losses or near-zero earnings in 2015, 2016, 2017, 2019, and 2020.

It's very difficult to have sympathy for the critics of the oil industry. Sure, all customers want your best product for free, but, by definition, no industry can survive when it is directed to commit suicide. The lack of mature understanding and lack of cooperative spirit makes it clear that those criticizing the oil industry are not capable of providing supervision for a complex modern economy.

Oil supplies in the U.S. are tight, but not tight enough to be the bottleneck. Clearly it is refining, as you can see in these tweets outlining the long term business prospects and current utilization, which is so near 100% the industry is probably setting records:


A Barron's analysis found that profits of gas stations are actually down this year.

U.S. Government figures match what the industry is saying. The U.S. Energy Industry Administration data shows refineries over time if you want to check.

Once you understand the refinery situation, it's clear why tapping the Strategic Petroleum Reserve could and would result in sending oil to China. Refineries already have 100% of their supply lined up. Adding to crude supply then just sends it to the next hungry market, part of which will be overseas. Strategically, it might make a small amount of sense to capitalize on high oil prices by selling some of the SPR oil. After all, we got that SPR oil cheap when Trump decided to add to SPR reserves against a rainy day. The rainy day is here. The U.S. Government is making a profit from the oil shortage. What's wrong with that?

Links in this article:

https://www.wsj.com/articles/high-u-s-fuel-exports-are-contributing-to-5-a-gallon-gas-11655371801

https://www.fool.com/investing/2022/06/05/chevrons-ceo-says-no-more-us-oil-refineries-what-s/

https://www.afpm.org/newsroom/blog/refining-capacity-101-what-understand-demanding-restarts

https://www.eia.gov/dnav/pet/pet_pnp_cap1_dcu_nus_a.htm

Sunday, July 10, 2022

Is it time to stop hyping the idea that AI has been hyped?

It has become fashionable to capitalize on the mistakes of individuals, who as humans are quick to anthropomorphize things, who encounter text-based (e.g. GPT-3) AI systems and conclude that they might be sentient. Come on people! Isn't it time to stop hyping the idea that AI has been hyped?

Here we have yet another story, yet another piece in social media, this one in LinkedIn, about the need to stop hyping AI.


Ever since the dawn of the Industrial Revolution in the 1700s, coming shortly after the full flower of The Enlightenment, we have experienced significant, continual profound changes in technology and society. This has led to both people anticipating more change, and to people failing to fully understand and keep up with changes that have already occurred. This includes the mundane, such as user interface changes to browsers and operating systems that wipe out personal productivity gained from daily practice, to profound societal challenges, such as erosion of community cohesion as religious institutions have declined in popularity and not been replaced with equivalent neighborhood-building systems.

With artificial intelligence, even the basic curve fitting model of deep learning that is in widespread practice is both taken for granted and yet not fully understood. When it comes to AGI, it is not the case that most people believe that it exists. Those who believe in dualism basically find the idea of AGI impossible. Then there are AI researchers who, having failed many ways in the past to create AI beyond curve-fitting or Eliza-era symbol manipulation, think that it is impossible for anyone else to create it either. Hubris never so clearly indicated that a contrary event was just around the corner.

The deeply learned cynics have certainly been keen to smash AI anticipation based on Terminator movie -like fears or suspicions. Social media, as always, is prone to promote outrage and the barely believable. Yet is there a sense that people are committing, en masse, to the firm belief that AGI exists right now? I don't see it. The existence of a single blog post, tweet, or Facebook message doesn't prove that there is mass hyping of AGI.

Becoming accustomed to new things involves so many different waves, all overlapping. First there is creation of the thing. It's not always a binary, "it was impossible, now it's practice" event. When the Wright brothers flew their airplane at Kitty Hawk, it was a short flight at low altitude with barely any payload. It took much more experimentation, engineering, and practice to get to the primitive airplanes that fought in World War 1. The same is true of AI. First we have curve fitting, then really good curve fitting, then profound curve fitting. Perhaps then we get some ambiguous results. If the first AGI has an IQ of 40, would you call it intelligent? No, you would call it stupid! It's sentience will be highly questionable. And yet there may never be a moment when you can say, "before this all was not sentient, and after this artificial sentience exists".

The second wave is getting the news out. The researcher does the experiment. The knowledge produced may have to be replicated, shared with other researchers, discussed, written up, then published. This takes months or even years. 

The third wave is belief among many. When the news comes out, did you read about it? Did you get the right message? After all, journalists are abysmal at getting the facts straight in fields they don't experience or understand fully. As it is discussed, some believe it, others discount the news story.

The fourth wave is belief within yourself. You've heard the news, but do you believe for yourself what was conveyed. You have to not just hear it, but have a mental model of it that works. It may take some time to get enough information that you can form an accurate belief.

The fifth wave is understanding the implications of your beliefs. It is one thing to understand a phenomenon. But what does that mean for your profession? For your home life? For your religion, your beliefs, your politics? Does it change your values, how you approach the goals of your life? Does it pose a danger to any of the aforementioned?

The current state of AI and AGI is subject to all of those waves. So articles about "hype" are troughs of such waves. They could be an indication of proper sober reflection. The "experts" still put AGI out five to 15 years or more. That some laypeople are confused to think that it is happening now is well within the adoption wave system. 

Saturday, July 9, 2022

Contrarian Trading Physics

In the previous article, I may have left some with the impression that the "road to heaven" maxim as a contrarian principle was a mental trick, mere psychology. I apologize for the unfortunate emphasis. Contrarianism is built into physics. You can start with Newton's third law of motion:

To every action there is always opposed an equal reaction; or, the mutual actions of two bodies upon each other are always equal, and directed to contrary parts.

At the very least this implies that to make a change that you want to occur you must experience a force opposite to that you intend to apply. 

We can move forward to the trite and obvious, but frequently disobeyed maxims of trading securities:

Buy low, sell high.

You pay a high price for a cheery consensus.

Make a stand, lose a grand. Have a hunch, make a bunch.

To use the first law you usually have to buy when everyone is fearful, and sell when you feel like everything is going your way. The second is similar; if everyone agrees that you are buying the right investment, then it is probably too expensive. This is not just mind games. This is physics of group thought.

The third gets a little deeper into the psychology (self-contrarianism) of trading: When you try to make something happen, it often goes awry. When you are just inferring, often from scanty evidence, that something might happen, you are often right. 

This leads to some principles of trading that I sometimes use:

  1. When you've done some research and found a good investment, buy a little at the start. If you buy too much, it will decline. Buying only a little either insures that it does go up, or that you will get a second chance to buy more at a lower price and to re-evaluate your logic.
  2. If you have an informed hunch, buy fast and at the market. It's no use trying to capture a 5 cent spread with a limit order and missing a $2 gain over a week's time. If you find yourself hesitating, stop and don't do it.
  3. When the market makes you nervous, but you like your stocks, switch it off, stop checking, and do something else entirely. This especially applies when I have what I call "market maker-stoppers", stocks that I will probably hold effectively forever anyway. I gain and they lose the bid-ask spread on the dozens of trades I never make.

Between 2020 and 2022 principle #3 probably made me more money than any other action. The market is full of noise. Once you have a position, just stick with it. 

This brings me to the most contrarian point of this blog: Though it is titled Vorpal Trade, very little of my commentary will really be aimed at short-term trading. Vorpal Investment just doesn't have the same ring. Which would people be more likely to remember? Which one captures your attention?

Now that I've slipped into the psychological aspects of trading again, it's time to cite biological examples. 

Muscles grow stronger when they are used. They grow weaker if they are not. Species undergo faster evolution in heterogeneous environments. A species which enjoys a uniformly benign environment is therefore less robust against changes to its environment. In any heterogeneous environment, the best ways for an animal to make a living are to move into ecological niches that no other animal is exploiting. In any species, members of the species are in conflict with those that prey on them, but possibly even more in conflict with other members of their own species when it comes to reproduction. Among plants, the tallest one gets the sunlight, but those plants which can specialize as vines and parasitize the tall plans by growing as vines will get the sunlight without investing in costly woody parts.

The structure of the financial system contains many, many contrarian elements. Government guarantees lead to systemic weaknesses. Mandates to service particular markets induce over-consumption leading to societal dead-weight losses and add systemic risk. Taxes reduce market sizes, distort markets, reduce and overall economic vitality. Subsidies lead to overuse, excessive prices and speculation, and destabilize markets. Good-meaning policies lead to more policies which lead to (undetected or "I don't want to see that") bad policies which undermine the financial system. 

I'll leave these statements here without proof, because this is not intended to be a political article. If you want to see some of the logic, here are a couple of places to start:

Lindsey, B., & Teles, S. M. (2017). The captured economy: How the powerful enrich themselves, slow down growth, and increase inequality. Oxford University Press.

Sowell, T. (2011). The housing boom and bust. Basic Books.

(this is part two of a series on contrarianism)

Thursday, July 7, 2022

Is Human Level Artificial General Intelligence Possible?

In a highly regarded (4.6 stars out of 5 on Amazon) book, The Myth of Artificial Intelligence, Erik Larson makes the case the AGI is much more difficult and farther out than some of the hype might make people think. 


The Amazon capsule description make it clear Larson's position is that such hype is wrong:

Ever since Alan Turing, AI enthusiasts have equated artificial intelligence with human intelligence. This is a profound mistake. 

To the degree that his message is aimed at hype, he is probably correct. The problem is that not all predictions of AGI are hype or hyperbole, and those describing potential AGI outcomes are not necessarily enthusiasts.

One could make the case that Larson's book is a good reference for those seeking to capitalize on the expertise and work of past researchers like Larson in order to learn all the methods that have failed so far, or at least which don't look promising and are in other researchers' blind spots.

Though I haven't read the book, the main challenge to its thesis I see is that Larson is not addressing all of the AGI "construction cases", one of which is design through evolution. 

Today I bumped into this exchange, in which Ed Hagen cites a research paper on design through artificial evolution:

The paper is available here. If the link doesn't work, use Google Scholar and search for "Explorations in Design Space: Unconventional electronics design through artificial evolution".

Just in case the Twitter message is deleted, I'm reproduced the snapshot of the abstract that Hagen cited here:

The primary point is this: Evolution can generate unusual designs that appear to be well outside the thought patterns of experienced designers. If AGI is possible, it is quite likely that it would be built using a design that Larson is unlikely to try or think would work.

In the Twitter thread Hagen goes on to cite another paper (actually, a 1993 Scientific American article) about the ability of the barn owl to locate prey in total darkness using differences in acoustic arrival times. It is a mechanism that at first seemed impossible using the "neuron toolkit" available, but once known to be possible, led to speculation about the design, which then was found to be present in barn owls. 


All of this fits neatly into Arthur Clarke's first law:

When a distinguished but elderly scientist states that something is possible, he is almost certainly right. When he states that something is impossible, he is very probably wrong.

Generating AGI via evolutionary methods is likely to violate the sensibilities of some who would like to be careful about how we bring AGI in existence. Growing it randomly in a soup of randomly changing evolutionary individual instances is not going to satisfy the AI equivalent of "biohazard" rules. But if all known and upstanding labs that follow the law adhere to such standards, then it will be only those labs operating outside industry safety standards who have a chance of growing such an AGI. Hence, standards too rigidly applied will then cause AGI to be grown somewhere darker and less controlled.

Detecting emergent AGI will then be even more difficult because we've been told it is not possible, or not possible at the present time, and the first discovery will not occur in a "name" lab. By the time the "impossible" is detected and confirmed, much more time will have passed than we would have liked.

[edited 7/8/22 to change book link, rephrase a sentence, and clarify the "hype" comments]

Friday, July 1, 2022

Small Cap Index Funds, Series I, Hedging Gas Costs

The half ended 6/30/22 is reportedly the worst first half of a year in many decades, depending on the index you are looking at. The extended stock market has been hit much harder than the large cap and especially Dow 30 stocks. If you are looking to trade against the trend and pick up a reversion-to-the-mean wave, look at buying into the hard hit extended market, Russell 2000, and small caps generally. Strangely, the downdraft has not hit the S&P SmallCap 600 the same way. It was off its 52-week high high of 1466.02 on 11/8/21 by about 23% as of mid-day Thursday 6/30/22 (1132.34 when I looked), somewhat less than NASDAQ. Why not buy into the NASDAQ index? Because the peak NASDAQ includes participation by tech names that were genuinely overextended in 2021, including TSLA, NFLX, NVDA, and FB. This also means that while it might seem "safe" to be in large caps that have not been dragged down as far (PEP is a good example), they are more likely to underperform the general market in the next 24 months. The market is willing to accept lower prospective returns because of the premium on safety right now.

In the long run, you want to have a higher allocation to small cap stocks anyway, so if you are currently underweighted in small caps, this might be the time to shift some assets there. SBBI still applies, especially after a substantial correction from market highs. 

Three Ideas

With current inflation at 8.6% or thereabouts, you may be feeling some pressure to deploy cash. Consider adding to a small cap index fund. As just stated, it is likely oversold, at least relative to the rest of the market. If you believe in value (as opposed to efficient market random walk theory), then it is discounted to where it was last year. And if you do believe in efficient market theory, there is no reason to believe that from this price, today, that it won't rise as should, so you ought to be buying small caps even if you don't believe in fundamental equity valuation as a cause for investment return.

The next thought came from my blind spot: Saving bonds. It took a Twitter post to wake me up to this, but Series I savings bonds are currently paying 9.62%. That is not a typo; Series I bonds contain a fixed interest rate component and one tied to the CPI measure of inflation. The only catch: You are limited to investing only $10,000 per year. It is worth pursuing because even if inflation subsides, this is an asset class that should be kept in your awareness anyway. For those approaching retirement, this is an excellent way to store some of the cash that you need to keep on hand against bear markets.

And that brings me to target date mutual funds. The theory is that most investors who save for retirement will eventually need to withdraw the money and live off it, but that withdrawals during bear markets would consume unfortunately large portions of the portfolio, assuming constant dollar withdrawals. The mitigation for this is keeping portions of cash and bonds in the portfolio as a buffer against bear markets, and the proportion kept in more stable assets then increases with the investor's age and presumably decreasing time horizon (until death). Target date mutual funds automate with process. It has become very popular with companies offering 401(k) and 403(b) plans, so much so that many companies have eliminated 90% of the mutual fund options they formerly offered, with target date funds making up as much as 90% of the choices available to the employee

This sad state of affairs is driven in part by theories of behavioral economics: Most people know little about investing and theoretically make poor choices (like not investing at all, and failing to pick up the free money offered to them via the company match), so the company and its hired mutual fund company instead play defense. Choice theory says that people given too many choices make none. So to help people make a choice, the company strips down the choices to just money market, bond fund, international fund, stock fund of some sort, and target date funds. Theoretically, most of the asset categories are there, but this induces employees to make a very substantial mistake.

The problem is with bonds. As I wrote in 2012, and which has remained true for over 10 years, the long bull market in bonds (circa 1980 to 2010) is over. When you start from low yields, it is difficult to make capital gains with bonds, and obviously the yield isn't going to make up for that. Mature target date funds (e.g. 2020, 2025) are loaded with bonds, and although the 2020 and 2025 target dates should involve relatively stable assets, with bond yields so low, they have suffered nearly as badly over the past 12 months as more aggressive equity mutual funds. 

Yields have risen a little. 10 year Treasuries traded up to 3.5% in the last few weeks, then rolled back. From this level, it is now theoretically possible to get cap gains from bonds, so you might make a little more money from bond funds in 2022 to 2027 than you did from 2010 to 2022. Maybe. I would still hesitate to make much use of bond funds or target date funds until inflation is lower (not until mid-2023 perhaps) or 10 year Treasuries are at 4%. For those in their 60s or retired, I would shy away from target date funds and make more explicit use of money market and equity funds, and the Series I savings bonds mentioned above.

The third idea involves hedging gasoline costs by investing in oil stocks. While gas at $4.50 to $6.00 per gallon is quite painful, you could mitigate it by investing in oil equities that are sensitive to the price of gasoline. The basic procedure: Figure out a time horizon, perhaps two to three years, and estimate how much gasoline you will need to buy over that time. Then estimate how much that will cost at prices of $4.50 per gallon vs say $3.00 per gallon. The difference is the amount that you now can attempt to capture through equity investments like OXY, CVX, XOM, PSX, SHEL, COP, BP, MPC, VLO. If gasoline continues to be expensive, you will do well in your oil investment. If gasoline drops in price, you get the benefit of reduced expenses. You will need to decide whether this is a serious hedge or just a psychological salve; as I wrote last week CVX is at a price that is too high if oil prices revert to $40 to $60 levels. Losing money on an equity investment may not sound like a good idea, just because you hate paying $80 for a full tank of gas. Of course, that is what makes it a hedge, if you want to make real money, make a prediction that is accurate and act on it beforehand. You can decide whether this is a token investment of 10 shares of XOM to make you feel better, or a serious prediction that world oil markets will be disrupted indefinitely.

The true benefit is the idea, the option to trade this as a hedge. You can obtain more control over your future net expenditures if you want that. Stock market pricing will be chaotic, and might even move the stock price in the wrong direction, but having the option to hedge may provide you with more of a feeling of control, more "thinking space" with less emotion and fewer cognitive mistakes.