Very interesting research from Nassim Taleb
and the referenced research paper
and the referenced research paper
Tuesday, May 14, 2013
And Hussman Said It Best
As a follow up to my post about the lunacy in the Fed's equity risk premium/the market is undervalued analysis, John Hussman of Hussman Funds says it best in his weekly column...
The
total capitalization of the U.S. stock market is presently about $17
trillion (about $16.2 trillion as non-financials). The Federal Reserve
is purchasing $85 billion of Treasury and mortgage-backed bonds each
month. This creates a pool of bank reserves that have to be held by someone at
each point in time, until those reserves are retired. This
zero-interest cash is a hot potato that certainly creates speculative
demand. But it is thesuperstitious aspect
of the belief in QE – as if it has some inexplicable power to remove
downside risk – that deserves just as much credit for the recent
advance. It is the superstition that QE mysteriously removes economic risk, and the psychological discomfort of
low interest rates far beyond its true effect on investment value, that
has encouraged investors to abandon their demand for a risk premium to
adequately compensate them for the risk they are taking.
How
can we know that? Simple. We can demonstrate that QE is not exerting
the bulk of its effects through cash flows or the effect of lower
interest rates on earnings or present discounted value. This leaves the
suppression ofrisk premiums as the remaining and primary effect of QE. In other words, QE has not increased the value of equities. It has only increased the price, but that increase in price has no significant fundamental underpinning.
To
see this, first consider cash flows. Imagine that instead of attempting
to boost stock prices indirectly through quantitative easing, the Fed
took the candy-land approach of literally handing the $85 billion directly to
stockholders to reward them for owning stocks. How much would that
direct cash distribution benefit a stock market with a $17 trillion
market capitalization? Do the arithmetic. Only 0.5% a month. Yet
investors have chased prices at a far more rapid pace as a result of
quantitative easing. Remember, of course, that the Fed is not in fact
distributing cash to shareholders.
What
about the benefit of lower interest rates? Domestic nonfinancial
corporate debt is presently $8.6 trillion. Even a 4% reduction in
interest rates (400 basis points) comes to $344 billion a year. Assume
that benefit accrues strictly to publicly traded companies, and extend
that benefit over 5 years. It’s still only worth 10% of market
capitalization. As a side note, lower interest rates also suppress
income from corporate investments, particularly with large amounts of
cash on corporate balance sheets. And though it has become a fad to
subtract out cash from market capitalization, it is a profoundly
incorrect fad. If it was correct, a company with a billion dollars of
market cap could issue a billion dollars of debt, hold the proceeds in
cash, and the stock could be considered "free."
What
about higher GDP leading to greater profits and supporting stocks that
way? Take the current ratio of corporate profits/GDP of 11% at face
value (even though that share is 70% above the historical norm), and
let’s even assume that all of these profits go to corporations with
publicly traded stocks. How much would GDP have to rise, sustained over 5
years, to justify even a 10% increase in market capitalization? The
required amount of additional GDP is 1.7 trillion / 0.11, or $15.5
trillion, or about $3.1 trillion a year sustained over 5 years. The
present size of the U.S. economy is about $16 trillion. So yes, if QE
could boost the size of the U.S. economy by about 20% and sustain it
over 5 years, and the additional earnings could be delivered entirely to
stock market investors in cash, it would justify a 10% increase in
market capitalization.
Here’s
one for geeks: What about the effect of a lower capitalization rate on
discounted future cash flows? Simple. Take a given initial cash
distribution and assume 6% annual growth, which is about the long-term
peak-to-peak growth rate of earnings and nominal GDP over the economic
cycle. Discount those cash flows annually into the indefinite future.
Now drop the discount rate by about 4% (400 basis points) for 5 years.
Even 10 years. Try 15. How much does the present discounted value
increase? Not much – about 5-15% depending on your initial discount rate
and how long you sustain the change.
We’ve
certainly seen people correlate the monetary base with the S&P 500
since 2009, ignoring that two rising lines will always have a
correlation of over 90%, and inferring targets for the S&P based on
assumptions about base money. But this is little more than extrapolation
based on statistical misuse. It may very well be that the promise of
more QE will produce a reflexive pursuit of stocks in the same
direction, but investors should at least be aware that this pursuit has
no fundamental basis, and rests purely on the willingness of investors
to abandon any need to be compensated for risk.
What
concerns me most here is the lack of effort that investors are taking
to analyze and quantify the mechanism by which quantitative easing
should work, beyond a vague superstition that “it just does.” The notes I
receive suggesting that somehow QE makes all historical economic
relationships, profit margin dynamics, and financial relationships
irrelevant remind me of some remarks that appeared in Business Week:
“During
every preceding period of stock speculation and subsequent collapse
there has been the same widespread idea that in some miraculous way,
endlessly elaborated but never actually defined, the fundamental
conditions and requirements of progress and prosperity have been
changed, that old economic principles have been abrogated, that all
economic problems have been solved, that industry has suddenly become
more efficient than it ever was before … that business profits are
destined to grow faster and without limit, and that the expansion of
credit can have no end.”
Those remarks unfortunately waited to appear until November 1929.
In short, there is no transmission mechanism by which QE has any large and beneficial effect on the value of equities. There has certainly been an effect on price – but this effect is driven by the
willingness of investors to abandon their demand for a risk premium
that will actually compensate them for the risk they are taking.
Sounds more like the equity risk premium is a lot lower than 5% to 6%.
Equity Risk Premiums Are Not At Highs or the Chart Analysis That Just Won't Die
This chart 'analysis" just won't appear to die. Not only did Barry Ritholtz of The Big Picture mention it last week (reiterated today), so did David Tepper of Appaloosa on CNBC this morning. The char in question....
And here is a brief explanation....
Outside of this analysis smacking me as a modified Fed Model valuation, which has been shown to be ineffective, an even more simple critique is that the FED IS HOLDING DOWN INTEREST RATES. The present period just does not have any modern historical precedence. The comparison of the current equity risk premium against the equity risk premium of the period between 1972 and the early 1980's is just bunk.
The 10-year treasury rate- which is not the best proxy of the risk-free rate but it is not the worst either- traded in a range of 7.5% to more than 15% between the mid-1970's and the early 1980's. This compares to a manipulated 10-year treasury rate of just 1.76% currently. Just do the math, the relative comparisons are not even close.
More importantly, the Fed's QE has had the affect of suppressing interest rates. I am not willing to wage any educated guess as to what degree interest rates are being held down, but the trading rage in treasuries prior to the Fed embarking on monetary easing to infinity was 2.5% to 5%. Much higher than current rates. More so, CPI inflation has been tracking in or around the 2% rate for the last few months. Adding to that a rate component for risk, growth, liquidity, etc. can bring you to an estimated risk free rate well over 2%, but probably even higher depending on your exact estimates. Whatever the estimates, the risk free rate is unlikely to be lower than 2%. Optimistically, if you adjust the risk-free for the Fed's manipulation, the actual equity risk premium is probably more like 3%. Pessimistically, there is probably no equity risk premium.
One last note on this topic, just think where this original analysis is coming from..... The Federal Reserve Bank of New York. No matter how faulty the logic, Bernanke et. al. have nearly outright stated they are targeting higher equity prices. In essence, this research from the Fed is just an attempt to sell us the benefits of the infinite money printing program.
And here is a brief explanation....
The equity risk premium is the expected future return of stocks minus the risk-free rate over some investment horizon. Because we don’t directly observe market expectations of future returns, we need a way to figure them out indirectly.
That’s where the models come in. In this post, we analyze twenty-nine of the most popular and widely used models to compute the equity risk premium over the last fifty years. They include surveys, dividend-discount models, cross-sectional regressions, and time-series regressions, which together use more than thirty different variables as predictors, ranging from price-dividend ratios to inflation. Our calculations rely on real-time information to avoid any look-ahead bias. So, to compute the equity risk premium in, say, January 1970, we only use data that was available in December 1969.while more can be found here NY Fed’s Liberty Street Economics.
Outside of this analysis smacking me as a modified Fed Model valuation, which has been shown to be ineffective, an even more simple critique is that the FED IS HOLDING DOWN INTEREST RATES. The present period just does not have any modern historical precedence. The comparison of the current equity risk premium against the equity risk premium of the period between 1972 and the early 1980's is just bunk.
The 10-year treasury rate- which is not the best proxy of the risk-free rate but it is not the worst either- traded in a range of 7.5% to more than 15% between the mid-1970's and the early 1980's. This compares to a manipulated 10-year treasury rate of just 1.76% currently. Just do the math, the relative comparisons are not even close.
More importantly, the Fed's QE has had the affect of suppressing interest rates. I am not willing to wage any educated guess as to what degree interest rates are being held down, but the trading rage in treasuries prior to the Fed embarking on monetary easing to infinity was 2.5% to 5%. Much higher than current rates. More so, CPI inflation has been tracking in or around the 2% rate for the last few months. Adding to that a rate component for risk, growth, liquidity, etc. can bring you to an estimated risk free rate well over 2%, but probably even higher depending on your exact estimates. Whatever the estimates, the risk free rate is unlikely to be lower than 2%. Optimistically, if you adjust the risk-free for the Fed's manipulation, the actual equity risk premium is probably more like 3%. Pessimistically, there is probably no equity risk premium.
One last note on this topic, just think where this original analysis is coming from..... The Federal Reserve Bank of New York. No matter how faulty the logic, Bernanke et. al. have nearly outright stated they are targeting higher equity prices. In essence, this research from the Fed is just an attempt to sell us the benefits of the infinite money printing program.
Some Investment Thoughts From Jim Rogers
This video interview of Jim Rogers via Bloomberg does not readily provide any new investment insights, per se. That said, Rogers does provide some insight into his trading strategies and how he looks to buy and sell in the markets.
Massive Solar Flare Caught By NASA Cameras
Over the weekend, the sun- which is entering the high point of its eleven-year cycle- let off a X1.7 solar flare. This type is at the high end of the flare rating scale indicating the energy released. NASA cameras jsut happened to catch a glimpse.
If we have seen one X-type solar flare, we are likely to see more as the cycle progresses. Flares pointed at Earth can produce communication and electrical equipments disruptions, but can also produce spectacular light signs via the Northern Lights. Some even as far South as the Central U.S., or at least latitudinal-relative speaking.
If we have seen one X-type solar flare, we are likely to see more as the cycle progresses. Flares pointed at Earth can produce communication and electrical equipments disruptions, but can also produce spectacular light signs via the Northern Lights. Some even as far South as the Central U.S., or at least latitudinal-relative speaking.
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