tag:blogger.com,1999:blog-582368152716771238.post7427594146348526049..comments2021-03-07T22:37:54.534-06:00Comments on The Grumpy Economist: Stock GyrationsJohn H. Cochranehttp://www.blogger.com/profile/04842601651429471525noreply@blogger.comBlogger62125tag:blogger.com,1999:blog-582368152716771238.post-17591897865054322762018-03-28T13:24:12.871-05:002018-03-28T13:24:12.871-05:00Thanks for the remarks. They encourage me to look ...Thanks for the remarks. They encourage me to look deeper into Campbell-Shiller (1988) and their model, as well as examining the CRSP data in the appendix to this article.Old Eagle Eyehttps://www.blogger.com/profile/05270080708077871311noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-10127419551052878522018-03-22T22:06:58.318-05:002018-03-22T22:06:58.318-05:00Actually the content of the real version here is f...Actually the content of the real version here is free of assumptions. The dynamic gordon growth formula as developed by campbell and shiller and used in the underlying academic articles has only one assumption, the definition of the rate of return R_t+1 = (P_t+1 + D+t+1)P_t, plus the transversality condition that D/P does not grow or shrink without bound. I used static Gordon growth here just to make the point more simple for a blog. John H. Cochranehttps://www.blogger.com/profile/04842601651429471525noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-50233220552049684312018-03-22T13:29:35.978-05:002018-03-22T13:29:35.978-05:00I'm aware of who John Cochrane, PhD, is and wh...I'm aware of who John Cochrane, PhD, is and what his research covers - macroeconomics. His line of argument in this essay rests on the assumption that the Gordon Growth Model ("GGM") of equity prices holds true. The assumptions on which the model is based are restrictive and do not hold in general. Furthermore, the "GGM" assumptions do not hold for the stock market as a whole. Pound the table all you want, a round peg will not fit a square hole. Should we defer to Cochrane simply because he holds a certain position in Academia and is widely published, though he errs from time to time, as we all do? That is not the basis upon which knowledge is advanced.Old Eagle Eyehttps://www.blogger.com/profile/05270080708077871311noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-70331346256126213322018-03-21T20:16:30.804-05:002018-03-21T20:16:30.804-05:00My God... If you had any idea who John Cochrane is...My God... If you had any idea who John Cochrane is you wouldn't have posted this awkward message. It is almost funny how you're trying to lecture someone that is a leading academic expert in asset pricing. He is trying to keep the point simple for the blog, and yet, in its simplicity he is also right. Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-59252115829180152952018-03-02T07:35:13.821-06:002018-03-02T07:35:13.821-06:00Incredible post - I wish I had discovered your blo...Incredible post - I wish I had discovered your blog earlier. However, I think the elephant in the room (which I am surprised only one other commenter brought up) is: what is the appropriate level of "gamma"? Are you inferring it based on asset price reactions to changes in expected growth, or is there a way to calculate it ex-ante? <br /><br />Secondly, there is now talk of tariffs that could potentially hurt growth. If you believe gamma > 1, then lower growth expectations should lead to higher stock prices, but that does not appear to be the case (of course, single day price action, etc.)Pravithttps://www.blogger.com/profile/16090163668879331389noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-20248276279614240052018-02-23T09:01:08.851-06:002018-02-23T09:01:08.851-06:00Sorry to be lazy and ADD'ed, but a TL;DR would...Sorry to be lazy and ADD'ed, but a TL;DR would help! Bulleted summary at the top? Conclusion? I'm working my through bit by bit, but throw a guy a bone!Hey-nonny Boshhttps://www.blogger.com/profile/06193004584864416488noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-23050217732076760462018-02-18T08:34:42.238-06:002018-02-18T08:34:42.238-06:00Please find a link to a graph that I could not inc...Please find a link to a graph that I could not includ ein the post:<br /><br />A large part of the GDP increase may be described as financially engineered, which is especially important if it turns out that the economy cannot face higher interest rates due to a high debt base and hence debt servicing costs. To be precise, the disproportionate increase in rental income, resulting from lower mortgage servicing costs is an extremely illustrative example:<br /><br />https://www.dropbox.com/s/kszue3cplcgy0kb/fredgraph.png?dl=0<br />Anonymoushttps://www.blogger.com/profile/14693711877883591791noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-28777108510100288142018-02-18T02:50:41.977-06:002018-02-18T02:50:41.977-06:00continued...
Conclusion
Following almost a decade...continued...<br /><br />Conclusion<br />Following almost a decade of unconventional monetary policies by the major central banks, we may be entering a regime where macro risk are paramount in the determination of aggregate equity market valuation in major international equity markets. I have made a preliminary case that in such a regime, the equity valuation model can be reduced to 2 factors: total financial assets and the allocation preference (bonds versus equity). This ratio has remarkably tended to mean revert to an even greater extent than P/E ratios. <br />Anonymoushttps://www.blogger.com/profile/14693711877883591791noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-2160023714887535122018-02-18T02:50:16.553-06:002018-02-18T02:50:16.553-06:00continued...
When equity valuation is viewed thro...continued...<br /><br />When equity valuation is viewed through the lens of these 2 macro factors, one can quickly make the following useful observations:<br /><br />1. The Ratio of Market Value of Corporate Equities to Total USD denominated Financial Assets has not moved much between now and the last equity market high before the 2008 crash.<br /><br />2. The total USD denominated Financial Assets have grown substantially faster than GDP between 2006 and 2017.<br /><br />3. Purely from the demand / supply perspective, the total supply of outstanding listed shares on NYSE has remained relatively flat during this period. Even if one were to assume a constant allocation between equity and debt, the math would dictate a proportionally higher share price. The market value of total debt has, of course, increased due to new issuance as well as capital appreciation due to much lower interest rates despite the (minimal) write-offs.<br /><br />Further, the following anomalies stand out:<br /><br />A large part of the GDP increase may be described as financially engineered, which is especially important if it turns out that the economy cannot face higher interest rates due to a high debt base and hence debt servicing costs. To be precise, the disproportionate increase in rental income, resulting from lower mortgage servicing costs is an extremely illustrative example:<br /><br /> <br /><br /><br />Based on other factors such as these, I have approximated an Adjusted GDP figure to be $2T lower. This takes out the fed induced low interest rate effects on GDP.<br /><br /><br />Assuming that one of the 2 factors namely the allocation preference (bonds versus equity) is mean reverting and varies within a narrow band, the task to ascertain the aggregate value of US equity market distills down to the other remaining factor: total value of USD denominated financial assets. The following important question arises:<br /><br />Is the current growth in USD financial assets sustainable?<br />If US cannot run a budget surplus after approx. 9 years into an economic expansion, does it mean that US government debt is on a perpetual growth path? Historically, the total credit in the US economy (i.e. Total Financial Assets) has never shrunk without severe economic downturns. Within the classic Keynesian model, the US government has used its credit at times when the creditworthiness of the private borrowers has been impaired. Two scenarios may be envisioned:<br />Scenario 1: The credit worthy borrowers (government and private) of the reserve currency (USD) have infinite capacity to borrow at low interest rates (independent of activity i.e. GDP)<br />The equity valuation model can then certainly be reduced to 2 factors: total financial assets and the allocation preference (bonds versus equity). The ratio of Market Value of Corporate Equities to Total USD denominated Financial Assets has mean reverted remarkably well in the medium term well across regimes. <br /> <br />Scenario 2: US treasury funding rates rise, i.e. Fed loses control of long term nominal interest rates<br />The following trifecta of factors that can cause this:<br />- Treasury’s continued need to fund record deficits<br />- Shrinking US trade deficit, driven by export oriented policies, i.e. less money in the hands of foreign central banks the traditional buyers of US Treasuries other than the Fed.<br />- Fed has flipped to the supply side of govt. bonds<br />In such a scenario, while a DDM approach will have fairly limited predictive power due to the difficulty in forecasting risk premiums. The aggregate MV of Equities will ultimately be determined by the amount of write-off in the bond markets which is where, arguably, the real bubble resides. <br />Anonymoushttps://www.blogger.com/profile/14693711877883591791noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-9502210923274613812018-02-18T02:48:58.681-06:002018-02-18T02:48:58.681-06:00Prof. Cochrane,
I have the following questions:
Q... <br />Prof. Cochrane,<br />I have the following questions:<br />Question 1 <br />How are the ideas presented in this blog post different from what we already know through a basic application of the “Fed Mode” that compares the stock market's earnings yield (E/P) to the yield on long-term government bonds?<br />Question 2 <br />Is the Dividend Discount Model a suitable tool to value the aggregate equity market? Would a simple and common measure like P/E be more suitable since it has tended to mean revert in the long term?<br />To be clear, DDM is certainly suitable for single names. Also DDM can never be disproved since Projected Cash Flows and the discount rate are both unobservable at the time of estimation and price is the only truth. <br />Why applying DDM in the current context feels like trying to fit a square peg in a round hole.<br />DDM relies on the following for valuation: Projected Cash Flows, Risk Free Rate, Equity Risk Premium and Growth. <br />3 out of the above 4 factors are assumptions and the 4th one has been controlled through central bank intervention recently. The control exercised by central banks is evident in the historic magnitude of central bank balance sheet growth and in the outsized growth in total USD denominated financial assets relative to GDP(discussed later). In my view, the price control exercised by the major central banks has effectively changed the numeraire for financial asset. From the perspective of financial assets, the effect of central bank actions is akin to a National Bank declaring a “currency split”, i.e. declaring that all holder of the currency will receive a 2 units (or a multiple) of the currency for every unit of the same currency. If consider such as scenario, in a closed system, all assets, prices and wages would theoretically double and the announcement would have no economic impact what so ever.<br />The difference is that the dollar system is not a closed system and the change of numeraire has had an uneven effect on wages, prices and financial asset, favoring financial assets disproportionately. This may be attributable to many factors including:<br />- The reserve currency status of the dollar that allows US importers to pay their bills to foreign suppliers in the USD.<br />- The inability of the labor markets in US and Europe to negotiate a proportional wage.<br />- The reluctance and inability of the major exporters to the US such as China to transmit the benefits to their factors of production enabled through structural and political factors (such as oligopolies of SOEs).<br />In the above outlined context one could argue that deriving a risk premium out of prevailing prices which are observable (given a certain assumption for growth and cash flows) is equivalent to deriving prices from assuming a risk premium that is unobservable. <br /><br />A two factor model independent of discount rate assumptions<br />In the current context where the price of money, a key macro variable that is an input to DDM and the only one that is observable, is controlled, the equity valuation model can be reduced to 2 factors: total financial assets and the allocation preference (bonds versus equity). This ratio has remarkably tended to mean revert to an even greater extent than P/E ratios. The following table is illustrative:<br /><br /> Financial Assets Corporate Equities Ratio (CE/FA) GDP Adjusted GDP<br />2017 220345 38588 17.51% 19000 17000<br />2006 132001 20909 15.84% 14000 14000<br />Growth 166.93% 184.55% 135.71% 121.43%<br />Anonymoushttps://www.blogger.com/profile/14693711877883591791noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-87672003031167379102018-02-17T10:20:31.708-06:002018-02-17T10:20:31.708-06:00> I start from the CRSP return with and without...> I start from the CRSP return with and without dividends and infer the dividend yield. ''Dividends" here includes not only cash dividends but all cash payments to shareholders. So, if your small company gets bought by Google, and the shareholders get cash, that is a "dividend" payout.<br /><br />Is it? I'm not a CRSP user but looking at the definitions of "Returns" and "Returns Without Dividends" available at http://www.crsp.com/products/documentation/data-definitions-r I understand that "dividends" doesn't even include extra-ordinary dividends.<br /><br />If the stock price is $100, a $1 dividend is distributed and then the company is acquired by Google at $200 per share I would expect the "returns" to be 101% and the "returns without dividends" to be 100%.<br />Baldrickhttps://www.blogger.com/profile/14343651673411970797noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-63220382184253783152018-02-17T10:08:59.408-06:002018-02-17T10:08:59.408-06:00Maybe it can be explained, at least in part, by th...Maybe it can be explained, at least in part, by the choice of the NYSE as representative for the stock market.<br /><br />A rough calculation on the S&P 500 stocks shows that two thirds (by market cap) are listed on the NYSE and the (weighted) average yield is 2.2% while one third is listed on the NASDAQ Stock Market with an average yield of just 1.1%.Baldrickhttps://www.blogger.com/profile/14343651673411970797noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-69641146092410591672018-02-15T23:57:42.263-06:002018-02-15T23:57:42.263-06:00I think you are saying the real rate = gamma times...I think you are saying the real rate = gamma times growth and gamma > 1 but is gamma being > 1 an empirical observation or is there a rational explanation or both?<br /><br />As for the "good" reason for a higher real interest rate: Most of the value of a company is assumed to depend upon cash flows that occur beyond the term of the current administration that gave us some deregulation and tax cuts. It seems likely that was already priced in given that there was the expectation that in the next 100 years sometimes there would be administrations of that bent. <br /><br />As for the "bad" reason for a higher real interest rate: The tax cut passed in December so it should have been priced in. I don't know about the $300B you referred to but people expected big spending news (infrastructure) eventually so I wonder if there really was any late-January or early-February budget/debt news that could be considered to be "new news" caable of changing expectations? <br /><br />The news I think mattered: the fact that equities went up a lot in January and that inflation expectations went up also in the context of a weakening immigration outlook.zqxjhttps://www.blogger.com/profile/17381002338572024933noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-54156681277551507732018-02-14T12:49:48.478-06:002018-02-14T12:49:48.478-06:00≠
John, the model you are using is the "Gord...≠<br /><br />John, the model you are using is the "Gordon Growth Model" formulation for the price of equities. The model is named for Myron J. Gordon (U. of Toronto) who, along with E. Shapiro, presented it in a 1956 publication. The variable D in the equation is next year's dividend (i.e., in period k=1, if the current period is k=0). The variable g is the expected compound annual growth rate in the dividends, assumed constant for all k=1,...,infinity. The variable r is the discount rate, in nominal terms, because the dividend D is in nominal dollars. The discount rate, r, is assumed constant for k=1,...,infinity. These assumptions limit the application of the model. A further restriction applies: i.e., r > g. If r and g are determined by independent processes, then it is not certain that r- g >0 for all time t. One can fudge it, by stating that r is the sum of two processes, i.e., the real return and a ‘risk premia’ (without specifying either one, or both, noting that the 'risk premia' may include more that one factor, i.e., it may include the expected inflation rate). <br /><br />In your construction of the chart of P/D vs time, P=P(t), where t equals the current date. But D is a time-lagged average, exponentially-smoothed, of past dividend payments, i.e., D= D(t)= a*DD(t)+ (1-a)*D(t-1), where DD(t) is the current period dividend payment, not the future dividend payment. The Gordon Growth Model requires that D= DD(t+1), i.e., a future value. Because DD(t+1) is given as a single value, it is the expected value of DD(t+1) which is a stochastic variable, i.e., uncertain. Consequently, the inference that P/D from your charts is equal to 1/(r- g) does not follow. At best it is a loose approximation suitable for academic class room discussion, but it is not appropriate for valuation purposes. Which is to say, one cannot prove that the market index value P is determined by the quotient of D and (r- g).<br /><br />If r and g vary with time t, then the simple Gordon Growth Model no longer applies, i.e., P≠ D/(r-g). In that case, one must move to another model, e.g., CAPM, or any one of a number of asset pricing models for which the economic theory is on a sounder footing than the Gordon Growth Model.<br />Old Eagle Eyehttps://www.blogger.com/profile/05270080708077871311noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-9144287570717415192018-02-13T17:50:10.891-06:002018-02-13T17:50:10.891-06:00Professor Cochrane: This is a great article. Thank...Professor Cochrane: This is a great article. Thanks for posting. You make financial economics look easy. I wish!Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-18646011112129759642018-02-12T12:01:24.113-06:002018-02-12T12:01:24.113-06:00That seems to be an excellent question. If we are ...That seems to be an excellent question. If we are going to have a fair minded discussion about macro policy surely we should recognize that there was recovery. We should probably also recognize that the sequester, now recently abandoned, may have constrained the recovery. Absalonhttps://www.blogger.com/profile/09131268683451462949noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-23127140407003764272018-02-11T20:57:45.047-06:002018-02-11T20:57:45.047-06:00"The economy seems finally to be growing,... ..."The economy seems finally to be growing,... "<br /><br />I would love an explanation of this. Didn't the economy grow for the last 6 years of the Obama Presidency? <br /><br /> -- Jonathan Goodmanlgmhttps://www.blogger.com/profile/04798554540232650867noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-28597102490155268072018-02-11T11:40:49.262-06:002018-02-11T11:40:49.262-06:00How do you explain the Nikkei falling so much?How do you explain the Nikkei falling so much?Anonymoushttps://www.blogger.com/profile/13589236992482012002noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-9958091684422917952018-02-10T21:35:22.719-06:002018-02-10T21:35:22.719-06:00My question also.My question also.Fat Manhttps://www.blogger.com/profile/09554029467445000453noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-12689066833478850872018-02-10T13:30:27.884-06:002018-02-10T13:30:27.884-06:00The real question, Benjamin, is whether the Fed wi...The real question, Benjamin, is whether the Fed will be serious about trying to protect the New Normal. Higher rates help some things. But they don't help collateral bonds which are in widespread use in clearing houses near you. Or near the UK. :)Gary Andersonhttps://www.blogger.com/profile/15499434824034613894noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-26175019206465636412018-02-10T12:34:39.111-06:002018-02-10T12:34:39.111-06:00I think you are missing the point that the long tr...I think you are missing the point that the long trend of disinflation in the US has allowed the Fed to act as a shock absorber, reducing economic volatility and therefore decreasing the equity risk premium. In a world where inflation is above the fed's target, they could no longer perform this function and we should see lower equity valuations as a result of higher risk premia. Also I think its important to note that the g in your equation is the growth rate of dividends, not economic growth. While the two are related, the long uptrend in corporate profits as a % of GDP has likely meant g>rl which has led to higher valuations. Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-40296592938121738062018-02-10T11:24:28.286-06:002018-02-10T11:24:28.286-06:00It is an interesting article. But really, the caus...It is an interesting article. But really, the cause of Volatility was Goldma Sachs. Politics can destroy that which seems foolproof. They set out to bludgeon the New Normal when the Goldman Men came on board. That was their plan. Will it work without creating systemic risk and economic disaster? If not they will all be hung, or wish they had been hung. http://www.talkmarkets.com/content/economics--politics-education/did-goldman-sachs-have-anything-to-do-with-market-volatility?post=165425&uid=4798Gary Andersonhttps://www.blogger.com/profile/15499434824034613894noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-89371876963442518302018-02-10T10:26:15.272-06:002018-02-10T10:26:15.272-06:00No. A stock buyback is not the same as a dividend....No. A stock buyback is not the same as a dividend. Conceptually, D includes all the things it should so that price = present value of dividends continues to hold. For that, if the company is bought by Google, you need that cash payment. If the company buys back some of its own shares, you don't have to tender, so you can ignore it. The CRSP documentation online says just what they do and don't include, especially how they treat stocks that get delisted. That's important. If you just drop the stock, then you assume people sell on the last day, which requires clairvoyance. Delisting returns make many fun strategies fall apart. John H. Cochranehttps://www.blogger.com/profile/04842601651429471525noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-28570333441044851912018-02-10T02:21:31.330-06:002018-02-10T02:21:31.330-06:00Thank you for an excellent post. It's rare to ...Thank you for an excellent post. It's rare to see such complex issues explained so succinctly. My one problem with your analysis is that it does not explain the speed in which these price changes are happening. If this is about discount rates adjusting you would expect the changes to be continuous and slow, rather then erratic and fast. While this could be a shock to liquidity premium the latest TED spread report from the SL Fed was still lower then one year ago.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-70592645932527782782018-02-10T02:02:09.500-06:002018-02-10T02:02:09.500-06:00Just to doublecheck, your dividend metric D includ...Just to doublecheck, your dividend metric D includes all stock buybacks? (This is implied by your definition but not expressly stated). <br /><br />Thanks for the clarification. S Woolleynoreply@blogger.com