finance: prices and fluctuations
The stock market has been doing something, and if you care you can go read about that elsewhere, but it has led to some discussion of why prices of financial assets bob around at times, and even the relatively informed discussion seems a bit narrow-minded. My own research, such as it is, is based on value that assets gain from liquidity or other effects related to heterogeneous agents, but this post is going to eschew even that, working simply from the basic Lucas asset pricing model that everyone knows and loves:
Price = total expected discounted dividendsRobert Shiller somewhat famously (in certain circles) observed several decades ago that dividends are much less volatile than price, and concluded that markets are irrational. (This summary is only slightly unfair to him, and, to be clear, I agree with him that markets aren't perfectly rational, but that's quite a leap from the evidence he provided.) When I first saw that, my thought was, "it's not the dividends that are fluctuating; it's the expectations". It turns out that many — I perhaps overly associate this with John Cochrane, and have been convinced myself now to join their camp — believe that fluctuations in price are driven by that term in between: discounted.
From this last point of view, then, a drop in the stock market is a reflection primarily of investors demanding a higher return than they were demanding before. One of the reasons for demanding higher returns is higher perceived risk, which can get recursive for agents with short time horizons: if that risk isn't a risk that dividends will be weaker than expected in the distant future, but a risk that other people will be demanding higher returns when you're looking to cash out your position, then it's hard not to imagine that there are likely to be multiple equilibria. Another reason for demanding a higher return, though, is that it is expected that new investment options will become more attractive in the near future; this especially might mean that the Federal Reserve is expected to raise interest rates, such that short-term bond investments will be more attractive than they have been in the last seven years.
I will note that long-term bonds tend to go up (their demanded yield down) on days when stocks go down and vice versa — expected risk-free returns in general can't be driving day-to-day moves in both bond markets and stock markets, so your very short term fluctuations, insofar as they're "rational", must involve some changes in expectations, risk premia, etc. In general the arguments for market efficiency work better the longer the time-frame, and daily movements are going to be driven almost entirely by entities that respond to market fluctuations on a daily basis. If you're wondering why the stock market has been expensive, compared to its recent earnings and historical price to earnings ratios, you can't ignore the yields available in the bond market, and if you think bond prices are going to come down in the next couple of years, you should probably be expecting stock prices to at least stop their climb.
economic statistics in the news
Last year on another blog I briefly recorded why labor compensation series oranges seem to lag productivity series apples, and this sort of statistic has been picked up on by one of the major presidential candidates, and so is worth noting again. I've seen a couple of other statistics (one related to that one) that are construed to mean something they probably don't, and would like to briefly note them here.
The one that's related to the wages/productivity statistic is "labor share of income", which classically was strikingly regular at 2/3; the official NIPA figure has, over the past several years in particular, come down from about 62.5% to about 58.5%. This figure is the ratio between labor expenses, as measured by NIPA, and GDP. Suppose a company produces a textile item that it sells for $4; it pays $1 for the raw input (cloth, etc.), $1 per item for machinery (which wears down and occasionally has to be refurbished or replaced), $1 per item for labor expenses, and the owner receives $1 per item in profit. This shows up as $3 of GDP—the cost of machinery is not (I think this would surprise many educated people) deducted, and on an economy-wide scale is basically double-counted—and $1 of income to labor, where a better measure might record $2 on the GDP side of the ledger and $1 to labor income. If the company is small enough, though, that the owner does all of the work—hiring no employees—and is unincorporated, then this counts as $3 to GDP and nothing to labor income—"proprietor's income" is a different category that, in order to get to 58.5%, must be excluded. It can be hard to tell which portion of "proprietor's income" should be counted as income to labor and which as income to capital (which is why it's given its own category in the first place); if you employ the crude solution of excluding proprietor's income and capital depreciation from GDP, it turns out that the ratio of labor income to Net Domestic Product Excluding Proprietor's Income has continued to bounce around between 67% and 69% for a long time. From an economist's standpoint, it is interesting that self-employment has increased, and that the capital used in production has shifted toward things like software that depreciate more quickly, but it should be noted that the changes in the NIPA labor-income to GDP ratio do not really reflect a change in the amount of actual economic income from production that is going to workers.
Another ratio I've seen is the debt to GDP ratio of, in particular, Greece; it has increased from about 130% to about 170% since the first default a few years ago. This has been suggested to indicate that even the creditors would be better off if they had allowed less austerity on the part of Greece. The only way to make even logical sense of that is to suppose that maintaining a constant debt to GDP ratio would have been a reasonable counterfactual; it does not seem plausible to me that any amount of "stimulus" would have led Greek GDP, measured in any moderately consistent (credible or not) way, to be 17/13 times what it actually is. Even if you trust the official GDP figure as much as you do its American counterpart, it's not clear that even that late starting point for the GDP figure was "sustainable", and of course the problems with Greek official statistics are well-known. What I want to call more attention to, though, is that numerator, and the form of default that is most popular among sovereign debtors, especially those trying to pretend that they aren't really defaulting, which is called "terming out"; the nominal size of the debt (in whatever its unit of account) is held fixed, but the payment dates are pushed into the future, with no interest accruing for the extra time the debt is owed. This is, of course, nonsense; the change of terms associated with the first default was widely viewed as effectively being about a 30% haircut to bond holders, who mostly sold at those reduced prices to European governmental institutions. The way debt is accounted, though, this 30% actual haircut made no change to the official amount of Greek debt outstanding; the numerator in that debt-to-GDP figure did not change from an accounting standpoint (because it was specifically engineered not to change from an accounting standpoint), but it did drop from a true economic standpoint.
Puerto Rico seems to have about a 90% ratio; I'd be interested in seeing ratios computed for both Greece and Puerto Rico in terms of cashflows discounted by a risk-free interest rate, viz. what would the present value of their bonds be if we were sure they wouldn't default? If you're trying to figure out whether a debtor could possibly avoid default, that seems like a useful measuring stick, and it has the virtue of changing when you change the real economics of the bonds. (It would surely raise all of the debt-to-GDP figures, but in particular for Greece would raise the 130% by a larger factor than the 170%.)
stock buybacks and corporate investment
So some Senators think corporate stock buy-backs constitute market manipulation, which is weird, so there's a lot one could potentially address there, but once again I find a particular bit of minutia interesting and fixate on
A growing body of research suggests that the vast amounts U.S. corporations have spent to repurchase their own stock is a chief cause of the stagnation of American wages and investment, and could be a potential source of long-term national decline.Levine's response is that if you return the money to shareholders, they're probably not just letting it sit there, and that they might be better at identifying investment opportunities than the corporations earning the money, especially if those opportunities are in industries other than where corporations are especially profitable, but also especially for those corporations that are inclined to return money to the shareholders. I've heavily interpreted and added to Levine's argument, but that last bit leads into my response, which is that the causality that she's implying is not intuitive.
Now perhaps the research to which she's referring does make that causal case; one can imagine that if some external force induced companies to return cash to investors, that would naturally reduce the amount of money they have available to invest in their own operations. The usual story, though, is that a lot of companies are returning cash to shareholders because they can't find useful internal investments; it seems worth noting that the usual biases and conflicts of interest of management are to be too quick to invest in unpromising projects instead of disgorging cash, so it would lend them credibility if they're buying out shareholders instead. The Senator's story would suggest that the buybacks leave too little cash for responsible investment, while the conventional story indicates that the buybacks are being caused by companies' having a lot of cash, so I will note that corporate cash holdings are notoriously high right now; there are unrelated reasons why one would expect cash to be higher (and debt to be lower) in equilibrium than a few years ago, but this data point at least seems much more consistent with a story of "we have a huge amount of cash and nothing useful to do with it internally, so we'll give some of it to shareholders and sit on a less huge amount of cash" than "we don't have enough cash to spend more on R&D, because we gave too much back to investors."
stock market valuations
I feel like, perhaps especially after that last post, I should say something about "Is the stock market overvalued?", which seems to be a popular question. As usual, insofar as the question is well-formed, the answer is "I don't know", but that's not a fun answer, so, without making too long a post, my answer instead is "The bond market is overvalued." I (obviously?) don't really know that, either, but if you're comparing stock prices to some sort of flow (dividends, earnings, etc.), the appropriate ratio is surely something that changes with time in a way that should correlate with interest rates, and the estimates I've seen lately of "the equity risk premium" are all higher than historical norms — which is to say (very crudely) that stocks are undervalued relative to bonds relative to their historical relationship. In perhaps more basic terms, if you're looking to sell stocks because you think they're overvalued — not, insofar as it can be made distinct, because you think they're especially risky — then your alternative is basically cash.
I'll add a couple of links here:
- Vox makes more or less the same point
- If you adjust for corporate cash holdings, market P/E ratios are much lower than the naive calculation.
- A pdf from the New York Fed indicating that the equity risk premium is high. The actual value they give is higher than most other sites, but Damodaran also suggests the ERP is on the high end of normal.
- I will acknowledge that the ratio of corporate earnings to GDP is high, and seems likely to revert to lower values as the labor market (finally) tightens.
- Added June 1: Siegel and Shiller have their usual opinions.
I spent more time on this post than I meant to.
the modern stock market
There's a paper on SSRN about the modern stock market with its high-frequency traders and dark pools and so on, and I recommend it. I'd like to offer a couple remarks on some small bits of it:
- They give an example of a high-frequency trader placing orders to sell a stock on multiple exchanges at the same time; when one of the orders executes, it cancels the other. A large trader, with less speed, attempts to lift both offers, and finds that it can't. I have trouble intuiting that I should be sympathetic to the poor buyer here; it seems to me that one very appropriate response to market fragmentation is to get very fast access, post the same order at multiple venues, and sell wherever it sells first. Certainly the HFT is running the risk that the offers will be executed at both venues before even it can respond, and I wouldn't be especially broken-hearted for it if that happened, but it seems perfectly reasonable for it to do this when it can. It's worth noting that the authors' proposed regulatory change to address controversial behavior by HFTs — not to let agents have order-book information until the official NBBO has been updated and disseminated — would not impair this behavior unless they are also delaying execution transmission (or unless that takes longer anyway to go out than inside quote information does); you couldn't cancel your order in response to somebody else's execution on the other exchange, but you could still manage your own attempts to sell a quantity wherever you can without undue risk of executing more than you intended.
- The "maker-taker" fees seem a bit fraudulent in conjunction with the NMS rules and fiduciary duty rules for brokers. If a bid sitting at a venue at 45.00 will actually result in the buyer's receiving $45.002 per share executed, and the seller's paying $45.0025, it feels wrong to me for the tape to reflect an execution at $45.00; it doesn't feel quite as fraudulent to me for the "best bid" to be disseminated as $45.00 (I'm used to the idea that commissions are in addition to the quoted price), though possibly it should. If another venue is "paying for order flow" — I'm not talking here about the Citadels "internalizing" executable orders, but the practice that elsewhere seems to be called "customer priority" — and a bid resting at $45.00 means the seller pays a net of $44.999, calling that $45.00 again feels more fraudulent, and an agent required to route an order to the "national best bid" shouldn't seem to be able to call that a tie. This little irregularity also makes me wonder whether any high-frequency shops try to make much of their net revenue from payments for liquidity provision by e.g. having an order to buy at $45 on the platform where that would net $45.002 and responding to an execution by trying immediately to hit a bid at $45 on the platform that pays for marketable orders. It might be that the fraction of a tick per share would be insufficient to compensate them for the risks, especially in light of other opportunities for profit.
- There's some level on which I regard a lot of the controversial actions of the high-frequency traders as tying the different exchanges together into more of a true national market, and I view the objections to them as a mixture of denial and regret that the pretense of a single market is being blown.
- More broadly, I'm not sure the model of "informed" vs. "uninformed" traders is never misleading. I don't know whether there's work on what the environment of the no-trade theorems looks like when agents have different stochastic discount factors, but I'd like a little bit of a deeper understanding of ex-ante gains from trade in which it is common knowledge that some agents have different information from others. The general dynamic that traders motivated by needs for liquidity and traders motivated by superior information will both want to look like the former is presumably true, but where efficiency is being evaluated in terms of providing returns to cultivating information it seems like nuance here might be important — that in an important sense the liquidity traders may not lose as much from trading with informed counterparties as is being supposed in their models, and that conversely the informed buyers will ultimately be interested in having a liquid market into which to sell as well.
I started my adult life in physics, and have now come to economics by way of finance; one of the differences between how economics is practiced and how physics is practiced is that economics frequently suppresses "units"; especially in introductory economics, supply and demand curves are frequently specified with quantity and price in some implicit units and coefficients of e.g. "5" where a physicist would say "5 $/widget2". In practical contexts, this is most pervasive in economic and financial contexts when the implicit unit is time; "year" frequently is 1. Otherwise smart people seem occasionally to forget that interest rates have an implicit time unit in them; bonds are yielding 3%per year.
This brings me to the term "basis point". You can go to websites (or at least comments sections of blogs) about linguistics and watch people fight about what words really mean, or which uses are inappropriate; finance specialists will have that argument about the term "basis point" perhaps more than any other term, but the permitted uses seem to be "nested", in that you won't usually encounter two people where one says A is acceptable and B isn't while the other allows for B but not A; when two people disagree about the proper use, usually one has a strictly narrower use than the other. The basic definition, though, is that a basis point is the reciprocal of 10,000 years, i.e. .01% per year.
The term "basis" is frequently used in finance to refer to a difference between two things, especially two things that are similar or related; the "basis" is then the extent to which they are different. If you buy oil futures because you need to buy jet fuel in the future and you want to hedge your risk, "basis risk" is the risk that the price of oil and the price of jet fuel don't actually move in lockstep. The term "basis point" was originally used in the context of different interest rates; an interest rate of 3.43% per year is 1bp less than an interest rate of 3.44% per year. There are some people who insist that any use of "basis point" other than in referring to differences or change in interest rates is wrong. Some people are willing to use it for anything related to interest rates, convenience yields, or other interest-rate-like objects. Any use of "basis point" that satisfies the definition I gave seems fine to me; if you want to talk about the growth rate of GDP in terms of basis points, that seems entirely cromulent to me.
The point at which I start to object is where the units are changed, which is mostly to say when people start multiplying it by "year" without telling you that. The employment-to-population ratio, for example, was .5923 in October and .5919 in November, according to the latest BLS report; there are people who would tell you that it dropped by 4 basis points. Note that, in this context, even if one were attempting to specify a rate, this is a change from one month to the next; to say that it dropped at a "rate of 50bp" is more in tune with the initial definition, and more likely to confuse people.
This morning I see in Matt Levine's linkwrap that Vanguard is looking to launch an advisory service
for a fee of 30 basis points per year instead of "an industry average of more than 1 per cent"
where I would contend "per year" should be moved from its current location to the end of the blockquote; they seek a fee of 30bp, as compared to 1 per cent per year.
I should perhaps note here that, as far as I know, I am the only person who has a problem with "basis point" meaning 1/100 of one percentage point but is fine with using it to express growth rates. If there are others, I wouldn't be surprised if they got into finance through physics, or some other field that uses a lot of dimensional analysis; it is, from my background, simply "obvious" that one system of usage is self-consistent and the other is not.
Allow me to move on from "basis point" but not from picking on Matt Levine who, as far as I've been able to tell, has adopted from FDIC regulators the practice of referring to a regulatory rule about "leveraged loans" as applying to loans to companies with debt that is "at least six times EBITDA". (I suspect Levine has no problem with this, but he doesn't seem to have originated it.) EBITDA is a flow, and debt is a stock; the ratio of debt to EBITDA again has units of time. What they all mean is "six years' worth of EBITDA"; if you have quarterly* EBITDA, multiply by 24 to get the debt limit. The national debt/GDP ratio is almost always given in years, but with the "years" unspoken; one often sees an outsized importance given to "100%", i.e. debt equal to one year's GDP, and while some of the people who see that as an important milestone may simply see that as a psychologically significant number in a broad plausibly economically relevant range, I read some commentary that seems to think it's important because, come on, all of your GDP is debt, or something — which loses even its superficial coherence if you change units.
This, ultimately, is where it matters — when it screws up people's conceptual understanding of what's going on. If you're attentive to which numbers are stock and which are flows, and you make sure to annualize anything that needs annualizing and develop an intuition around annualized numbers, various semantic conventions that seem unnecessarily confusing to me are just language, and probably is a perfectly good choice among ultimately arbitrary coding rules.* "Quarter", of course, is a unit of time equal to a quarter of a year, in the same pattern of "year=1".
Note that the FOMC has been meeting, and will be releasing a statement around 2PM EDT (I think); my fed statement comparison page should be updated shortly after that — within 40 seconds or so, if my script works properly; let's say the odds of that happening are 1 in 3. At 2:30 EDT Fed chairman Yellen will speak, and you can watch live as she then proceeds to field asinine questions from the financial press.