my guess is that eventually the home price rise from, say, 1995 to 2007 will turn out to be 90 percent due to a permanently lower risk premium and 10 percent bubble, rather than the other way around.
That is me, writing in September of 2007.
Category Archives: markets
A Time to Buy Put Options?
I note this, from Tobias Adrian and Michael Fleming:
we present a table listing attributes of the fifteen largest bond market selloffs since 1961. The three selloffs highlighted in this post—1994, 2003, and 2013—are ranked fifth, ninth, and thirteenth, respectively, and are highlighted in blue. Beyond reporting figures behind the earlier discussion, the table shows the change in the ten-year, zero-coupon yield and in the spread between the ten-year and three-month yields between the start of each selloff and the maximum selloff date. Of note, the recent episode and 2003 are instances in which the yield spread moved almost as much as the ten-year yield itself (that is, the three-month yield rose little), explaining the importance of the term premium in those cases.
Pointer from Mark Thoma.
and this, from John Mauldin.
The Shiller P/E is now 24.4, about the same level as August 1929, higher than December 1972, higher than August 1987, but less extreme than the level of 43 that was reached in March 2000 (a level that has been followed by more than 13 years of market returns within a fraction of a percent of the return on Treasury bills – and even then only by revisiting significantly overvalued levels today). The Shiller P/E is presently moderately below the level of 27 at the October 2007 market peak. It’s worth noting that the 2000-2001 recession is already out of the Shiller calculation. Moreover, looking closely at the data, the implied profit margin embedded in today’s Shiller P/E is 6.3%, compared with a historical average of only about 5.3%. At normal profit margins, the current Shiller P/E would be 29.
John Cochrane on Valuing Government Pensions
A good response occurred to me, to those cited by Josh who want to argue that underfunding is a mere $1 trillion. OK, let’s issue the extra $1 trillion of Federal debt. Put it in with the pension assets. Now, convert the pensions entirely to defined-contribution. Give the employees and pensioners their money now, in IRA or 401(k) form. If indeed the pensions are “funded,” then the pensioners are just as well off as if they had the existing pensions. (This might even be a tricky way for states to legally cut the value of their pension promises)
I suspect the other side would not take this deal. Well, tell us how much money you think the pension promises really are worth — how much money we have to give pensioners today, to invest just as the pension plans would, to make them whole. Hmm, I think we’ll end up a lot closer to Josh’s numbers.
That is, one way to value government pensions is to ask workers how much they would be willing to take in the form of an individual retirement account to give up their pensions. Of course, if the government workers believe that their pensions are at risk, they might take a low figure. But if we take that possibility off the table, then workers are likely to demand a lot more money than the current stated value of the pension obligations.
I think others have pointed this out before, but when the subject of Social Security privatization comes up, aggressive assumptions about stock market returns seem reasonable to those on the Right and crazy to those on the Left. But their positions reverse when the subject changes to state and local pension funding. My own preference is to make conservative assumptions about stock market returns for both discussions.
Should You Buy Bonds?
Lacy Hunt and Van Hoisington write,
Presently the inflation picture is most favorable to bond yields. The year-over-year change in the core personal consumption expenditures deflator, an indicator to which the Fed pays close attention, stands at a record low for the entire five plus decades of the series
True.
Over the past year, the Treasury bond yield rose as the nominal growth in GDP slowed. The difference between the Treasury bond yield and the nominal GDP growth rate (Chart 4) is important in two respects. First, when the bond yield rises more rapidly than the GDP growth rate, monetary conditions are a restraint on economic growth. This condition occurred prior to all the recessions since the 1950s, as indicated in the chart. This condition also signaled the growth recessions in 1962 and 1966-67. Second, the nominal GDP growth rate represents the yield on the total economy
True.
But then I downloaded from the Fred database the 10-year Treasury rate and the level of nominal GDP. I took the three-year average of nominal GDP growth rate, and I subtracted it from the 10-year rate, to get a rough measure of the differential between the 10-year rate and the growth rate of nominal GDP. From 1963 to present, this differential averages -.18. A super-simplistic model is that the nominal interest rate should revert to this average differential. So, if nominal GDP growth is 6.25 percent and the average differential applies, the nominal interest rate should be 6.07 percent.
For the latest three years, ending in Q1 of this year, nominal GDP growth has averaged 3.85 percent. Using the super-simplistic model of the nominal rate, it should now be 3.67 percent. In fact, it is now 2.52 percent.
Hunt and Hoisington are betting that the nominal interest rate is going to fall, but when I look at the same GDP data they do, I think it ought to be higher than it is now.
How to Interpret Asset Market Prices?
Jeremy Stein says (in my words) “Don’t try.” His words are
fundamentals only explain a small part of the variation in the prices of assets such as equities, long-term Treasury securities, and corporate bonds. The bulk of the variation comes from what finance academics call “changes in discount rates,” which is a fancy way of saying the non-fundamental stuff that we don’t understand very well–and which can include changes in either investor sentiment or risk aversion, price movements due to forced selling by either levered investors or convexity hedgers, and a variety of other effects that fall under the broad heading of internal market dynamics.
If true (and I believe it is), this is a very important statement. It implies that events are in the saddle and ride the Fed. Not the other way around.
Pointer from “G.I.” of The Economist blog, via Mark Thoma.
Market Failure in Government
Coming soon: The Tiebout model is wrong in fact, but how can it be wrong in theory?
The Tiebout model is a model of government competition based on exit rather than voice. If you do not like your local government services, then you leave. That forces governments to get better.
I think that the market for government services fails, for a number of reasons. First, exit is difficult. I would gladly trade my Maryland government for the government in Texas or for that of a Swiss canton. But my friends are in Maryland.
Second, there is a lot of bundling. Government is like cable TV. You have to buy the whole package, not just the channels you want. In the case of cable TV, the justification for this is high fixed cost. Once you have the cable hooked up, the marginal cost of a particular channel is low, so it makes some sense to charge a bundled price.
In the case of local government, I think that the bundling is more pernicious. It is not the case that bundling K-12 schools with snow removal serves to spread a high fixed cost that covers both.
In the third part of the widely-unread Unchecked and Unbalanced, I talk about steps that could be taken to make government more competitive by making it easier to exercise the exit option.