Category Archives: markets

The Great Bubble-ation?

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Alex Pollock writes,

Inevitably following each of the great bubbles was a price shrivel. Then many commentators talked about how people “lost their wealth,” with statements like “in the housing crisis households lost $7 trillion in wealth.” But since the $7 trillion was never really there in the first place, it wasn’t really lost.

He has a chart that shows that the biggest financial bubbles of the past 60 years occurred during the period we call the Great Moderation. Thus, during a period of macroeconomic stability, we had financial instability. Hyman Minsky would not have been surprised.

Shiller, Taleb, and Me

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Here is the 30-minute version of the 2009 New Yorker video interview with Bob Shiller and Nassim Taleb. (Tyler linked to a four-minute segment a few days ago). I want to talk about the difference between Shiller’s and Taleb’s views of inefficient markets.

When I teach regression in statistics, I show what I call the Pythagorean relationship, which describes what computer programs report as the analysis of variance. You are trying to predict a variable, Y, and the predicted values along the regression line are called Y-hat. I draw a right triangle with the standard deviation of Y-hat on one side, the standard error of the regression on another side, and the standard deviation of Y on the hypotenuse. The Pythagorean Theorem then gives you the analysis of variance.

Anyway, a lesson of this is that in an efficient prediction, the variance of your prediction will be less than the variance of the variable that you predict. Mathematically, this is because one side of a right triangle is always shorter than the hypotenuse. Intuitively, if your predictions vary by more than the variable you are trying to predict, then you can do better by toning down your predictions and moving them closer to the mean of the variable.

Shiller’s insight was to apply this idea to asset prices. In some sense, the stock price is a prediction of discounted future dividends, which I will refer to as average realized dividends. In that case, if the stock market is efficient, then the variance of stock prices should be less than the variance of average realized dividends. In fact, it is easy to see that the variance of stock prices is much higher than that of average realized dividends.

What this says, and what Fama and French later confirmed, is that you can make money by betting on mean reversion in stock prices. To do so, you assume use historical average dividends as a proxy for average realized dividends going forward. If you follow a strategy of buying when prices are low relative to historical average dividends and selling when prices are high relative to historical average dividends, then it seems that you will earn an above-normal profit.

Taleb would not bet on mean reversion. Instead, he would load up on out-of-the-money options. That way, you are betting on Black Swans.

Taleb’s point of view gets back to my criticism of Shiller’s work. From Taleb’s point of view, Shiller is like the turkey, who every day notices that the farmer is feeding him and taking care of him. The turkey does not realize that Thanksgiving is coming, and this will change the farmer’s behavior. Similarly, the markets appear to be mean-reverting, but what Shiller does not know is that a Black Swan event could come along.

For example, suppose that bond market investors have a probability p of a Black Swan, meaning that the U.S. government runs out of other options and monetizes a lot of its debt, leading to hyperinflation and making long-term bonds effectively worthless. For simplicity, suppose that this Black Swan either will or will not occur on January 1, 2020. With that simple assumption, on January 1, 2020, the true value of a long-term bond will be either 100 or 0. Whichever it turns out to be, when Shiller does his analysis in 2025, he will find that the variance of the “correct” bond price is zero. Since the price of bonds between now and 2020 is a predictor of the “correct” future bond price, to be an efficient predictor its variance can be no larger than zero.

However, between now and January 1, 2020, the bond price will vary as bond market investors’ estimate of p varies. Thus, the variance of bond prices will not be zero.

I take the view that this possibility of a Black Swan (aka, the peso problem) precludes the use of realized data to construct a “variance bound.” Only in a world where you can rule out Black Swans can you be certain that Shiller has found a market anomaly.

Although I lean toward Taleb, I consider that Shiller may be right. In any case, it is worth contemplating the tension between the two.

Blog Post of the Year?

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John Cochrane’s post on Nobel Laureate Robert Shiller is certainly a contender. It’s long, and you should read the whole thing. Of many possible excerpts, I choose:

No matter where you look, stock, bonds, foreign exchange, and real estate, high prices mean low subsequent returns, and low prices (relative to “fundamentals” like earnings, dividends, rents, etc) mean high subsequent returns.

These are the facts, which are not in debate. And they are a stunning reversal of how people thought the world worked in the 1970s. Constant discount rate models are flat out wrong…

To Fama, it is a business cycle related risk premium. He (with Ken French again) notices that low prices and high expected returns come in bad macroeconomic times and vice-versa. December 2008 was a recent time of low price/dividend ratios. Is it not plausible that the average investor, like our endowments, said, “sure, I know stocks are cheap, and the long-run return is a bit higher now than it was. But they are about to foreclose on the house, reposess the car, take away the dog, and I might lose my job. I can’t take any more risk right now.” Conversely, in the boom, when people “reach for yield”, is it not plausible that people say “yeah, stocks aren’t paying a lot more than bonds. But what else can I do with the money? My business is going well. I can take the risk now.”

To Shiller, no. The variation in risk premiums is too big, according to him, to be explained by variation in risk premiums across the business cycle. He sees irrational optimism and pessimism in investor’s heads. Shiller’s followers somehow think the government is more rational than investors and can and should stabilize these bubbles. Noblesse oblige.

By the way, Cochrane’s post on Lars Hansen is also top notch.

The 2014 Nobel Laureates Fama, Hansen, and Shiller

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What they have in common is the “second moment.” In statistics, the first moment of a distribution is the mean, a measure of central tendency. The second moment is the variance, or spread. Politically, their views have a high second moment. If they are asked policy questions during interviews, the differences should be wide.

Shiller is known for looking at “variance bounds” for asset prices. Previously, economists had tested the efficient market hypothesis by looking at mean returns on stocks or bonds. Shiller suggested comparing the variance of stock prices with the variance of discounted dividends. Thus, the second moment. He found that the variance of stock prices was much higher than that of discounted dividends, and this led him to view stock markets as inefficient. This in turn made him a major figure in behavioral finance.

Fama was the original advocate for efficient markets. However, he was an empiricist. He verified an important implication of Shiller’s work: if stock prices vary too much, stock returns should exhibit long-run “mean reversion.” Basically, when the ratio of stock prices to a smoothed path of dividends is high, you should sell. Conversely, when the ratio is low, you should buy. Mean reversion also says something about the properties of the second moment.

Finally, Hansen is the developer of the “generalized method-of-moments” estimator. This is a technique that is most useful if you have a theory that has implications for more than one moment of the distribution. For example, Shiller’s work shows that the efficient markets hypothesis has implications for both the first and second moment (mean and variance) of stock market returns.

Although Tyler and Alex are posting about this Nobel, I think that John Cochrane is likely to offer the best coverage. As of now, Cochrane has written two posts about Fama.

In one post, Cochrane writes,

“efficient markets” became the organizing principle for 30 years of empirical work in financial economics. That empirical work taught us much about the world, and in turn affected the world deeply.

In another post, Cochrane quotes himself

empirical finance is no longer really devoted to “debating efficient markets,” any more than modern biology debates evolution. We have moved on to other things. I think of most current research as exploring the amazing variety and subtle economics of risk premiums – focusing on the “joint hypothesis” rather than the “informational efficiency” part of Gene’s 1970 essay.

Cochrane’s point that efficient market theory is to finance what evolution is to ecology is worth pondering. I do not think that all economists would agree. Would Shiller?

Some personal notes about Shiller, who I encountered a few times early in my career.

1. His variance-bounds idea was simultaneously discovered by Stephen LeRoy and Dick Porter of the Fed. The reference for their work is 1981, “The Present-value Relation: Tests Based on Implied Variance Bound,”’ Econometrica, Vol. 49, May, pp. 555-574. Some of the initial follow-up work on the topic cited LeRoy and Porter along with Shiller, but over time their contribution has been largely forgotten.

2. When Shiller’s Journal of Political Economy paper appeared (eventually his American Economic Review paper became more famous), I sent in a criticism. I argued that his variance bound was based on actual, realized dividends (or short-term interest rates, because I think that the JPE paper was on long-term bond prices) and that in fact ex ante forecasted dividends did not have such a bound. Remember, this was about 1980, and his test was showing inefficiency of bond prices because short-term interest rates in the 1970s were far, far higher than would have been implied by long-term bond prices in the late 1960s. I thought that was a swindle.

He had the JPE reject my criticism on the grounds that all I was doing was arguing that the distribution of dividends (or short-term interest rates) is unstable, and that if you use a long enough data series, that takes care of such instability. I did not agree with his view, and I still don’t, but there was nothing I could do about it.

3. When I was at Freddie Mac, we wanted to use the Case-Shiller-Weiss repeat-sales house price index as a check against fraudulent appraisals. (The index measures house price inflation in an area by looking at the prices recorded when the same house is sold in two different years.) I contacted Shiller, who referred me to Weiss. Weiss was arrogant and unpleasant during negotiations, and we gave up and decided to create our own index using the same methodology and our loan database. Weiss was so difficult, that we actually had an easier time co-operating with Fannie on pooling our data, even though they had much more data at the time because they bought more loans than we did. Eventually, our regulator took over the process of maintaining our repeat-sales price index.

4. Here is my review of Shiller’s book on the sub-prime crisis. Here is my review of Animal Spirits, which Shiller co-wrote with George Akerlof.

Finally, note that Russ Roberts had podcasts with Fama on finance and Shiller on housing.

The Cochrane Tax

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John Cochrane proposes,

I think a simple tax is the answer – though since “tax” is a dirty word, let’s call it a “systemic externality fee” – on debt, and especially on short-term debt or any other contract where the investor has the right to demand payment, and fail the firm if not received. Every dollar of such funding will cost, say, a 10 cent fee. Payments due later generate smaller fees.

The idea is that all short-term debt contracts end up being implicitly insured by taxpayers. So from the standpoint of incentives and fairness, those contracts ought to be taxed.

Retirement and Wealth

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Timothy Taylor points to some sobering news.

those in the 1980s were more likely to be ready for retirement than those in the 1990s; those in the 1990s were more likely to be ready for retirement than those in the 2000s; and those in 2010 were least likely of all to be ready for retirement.

I know many people in close to 60 years old, currently living upper-middle class lives, with less than $200,000 in non-housing savings. I do not think they have thought ahead very far. Some questions:

1. What does this mean for their lifestyles during retirement? Less expensive meals? Less expensive vacations? Less choice about where to live?

2. What does this mean for their level of dependence on government benefits?

3. What does this mean for the prospects of reducing Social Security or Medicare benefits?

Risk Premiums and Short-term Rates

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Jeremy Stein sees a connection.

over a sample period from 1999 to 2012, a 100 basis point increase in the 2-year nominal yield on FOMC announcement day–which we take as a proxy for a change in the expected path of the federal funds rate over the following several quarters–is associated with a 42 basis point increase in the 10-year forward overnight real rate, extracted from the yield curve for Treasury inflation-protected securities (TIPS).

…These changes in term premiums then appear to reverse themselves over the following 6 to 12 months.

…Banks fit with our conception of yield-oriented
investors to the extent that they care about their reported earnings–which, given bank accounting rules for available-for-sale securities, are based on current income from securities holdings and not mark-to-market changes in value. And, indeed, we find that when the yield curve steepens, banks increase the maturity of their securities holdings.

Thanks to Tyler Cowen for the pointer.

If this is correct, then monetary policy affects long-term real rates, although having the effect reverse itself within 6 to 12 months makes me wonder. In fact, this whole thing makes me wonder….

Sentence to Ponder

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From Peter Stella.

What many are calling central bank “money creation” “helicopter money” or “rolling the printing presses” may – in combination with tighter leverage ratios – lead to a tightening of bank credit and deflationary pressures.

Pointer from John Cochrane.

Read (and re-read) the whole thing. Stella’s interesting argument is that highly-rated securities are more liquid than bank reserves. Therefore, when the Fed supplies bank reserves in exchange for highly-rated securities, it is draining liquidity from the system.

My initial reaction is that this is just too cute. It makes it sound as though investment bankers make loans, using securities as reserves. I think of investment bankers as holding inventories of securities, financed by short-term debt. The larger the inventories they have to finance, the lower their demand for securities, and the higher the interest rates on those securities. So I still think that the Fed’s purchases go in the direction of pulling down rates on securities. Of course, I count myself as a skeptic that these effects are significant.

Two Views of the Non-Taper Rally

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1. Scott Sumner:

Note that the instant reaction of stocks is a more reliable indicator of monetary policy that long term bond yields. Long term rates rose on the announcement of QE3, and rose again on taper talk. Why is the long term bond market so schizophrenic? I have no idea.

2. A press release about a new behavioral economics study:

Dr Benedetto De Martino, a researcher at Royal Holloway University of London who led the study while at the California Institute of Technology, said: “We find that in a bubble situation, people start to see the market as a strategic opponent and shift the brain processes they’re using to make financial decisions. They start trying to imagine how the other traders will behave and this leads them to modify their judgment of how valuable the asset is. They become less driven by explicit information, like actual prices, and more focused on how they imagine the market will change.

“These brain processes have evolved to help us get along better in social situations and are usually advantageous. But we’ve shown that when we use them within a complex modern system, like financial markets, they can result in unproductive behaviours that drive a cycle of boom and bust.”

The team found that when participants noticed disparity between how much they perceived an asset to be worth and the rate of transactions for that asset, they began making poor business decisions and bubbles started to form in the market.

Professor Peter Bossaerts from the University of Utah, a co-author of the study, explains: “It’s group illusion. When participants see inconsistency in the rate of transactions, they think that there are people who know better operating in the marketplace and they make a game out of it. In reality, however, there is nothing to be gained because nobody knows better.”

Colin Camerer, Robert Kirby Professor of Behavioral Economics at the California Institute of Technology, said: “There’s a mathematical measure of when the flow of traders’ orders to buy or sell changes from steady to choppy. A choppy flow is a clue that trades are bunching up around new information or pausing to see what happens next. This way of measuring has been sitting on the shelf for years. This is the first study to show that it seems to correspond to what the brain is computing.”

My own view is that the stock market is efficient in the sense that returns are nearly impossible to forecast, but it is not rational. In 1979, stocks may have been undervalued by a factor of two or more. By 2000, they may have been overvalued by that much. Given that I think that the market can be off base by 50 percent, I am reluctant to draw inferences about moves of 2 or 3 percent.

A Question

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From the comments on this post.

if it were made clear that in the event of a crisis the shareholders would be wiped out and the bondholders would take whatever loss was required, then why should anyone care what financial structure an institution chooses?

This approach could have been taken in 2008. Several economists argued that Citigroup could have been handed over to the bondholders. Why wasn’t this done? Here are some possible adverse consequences:

1. Depositors will hear “Citigroup is bankrupt” and rush to pull deposits out, even though they are safe.

2. Holders of bonds at other banks will sell those bonds in order to buy safer assets.

Of course, these concerns can always be raised about bank debt. If the government will never allow bank debtholders to take a loss, then in effect we have 100 percent government guarantees to bank debtholders. Russ Roberts has argued vociferously that this is in fact the regime we have been under, and the consequence is that banks have the incentive to maximize their debt financing.

It appears that the government cannot credibly commit to letting bank creditors bear some of the losses from an insolvency. If that is the case, then it would seem that taxpayers have an interest in forcing banks to have a capital structure with less debt and more equity.