Former Fed Chairman Paul Volcker on 'The Volcker Rule'
Read the opinion piece Volcker references in the above video.
February 02, 2010
January 30, 2010
Did Government's Q4 GDP Growth Estimate Overstate Reality?
By Ravi Nagarajan
While reviewing the Bureau of Economic Analysis (BEA) “advance estimate” of Q4 2009 GDP, it seems instructive to revisit the Q3 2009 “advance estimate” which was discussed here exactly three months ago. A quick review suggests that there is little point in treating preliminary reports too seriously due to significant inaccuracies which often result in subsequent revisions. While investors and politicians always fixate on the advance number, few outside the economics profession seem to pay much attention to subsequent revisions.
Q3 2009: 3.5% Estimate vs. 2.2% Reality
The advance GDP estimate for Q3 was 3.5% while the current estimate is 2.2%. This is obviously a very significant change. The BEA does not pretend that advance estimates are accurate. In each quarterly GDP release, the BEA publishes a table showing “vintage comparisons” between the advance estimates and subsequent revisions. From the advance estimate to the final figures, the average revision in Real GDP, without regard to sign, was 1.3% for estimates made between 1983 and 2006. This happens to be the difference between the advance estimate and latest revision for the Q3 GDP data.
Q4 Advance Estimate: 5.7% Growth
Since we know that subsequent revisions are likely, the advance estimate should be treated with some skepticism. Nevertheless, a quick review is still interesting. In addition to the data in the main release, the BEA has an interactive tool that can be used to generate tables such as the report shown below which breaks down the contributions to the percentage change in real GDP (click on the image for a larger view of the data):
From the table, one can quickly see that inventories accounted for the bulk of the growth in GDP for the quarter with a 3.39 percent contribution. Private business decreased inventories by $33.5 billion in the fourth quarter compared to a decrease of $139.2 billion in the third quarter. Real GDP measures production, not final sales, so changes in inventories can often have a major influence on reported GDP numbers. In this case, the decrease in the rate of inventory liquidation accounts for a major boost to GDP.
The report shows signs of weakness in other areas including anemic growth in personal consumption. Notably, final sales of domestic product (GDP less changes in private inventories) only increased 2.2 percent in the fourth quarter. Although this is a slight improvement over the 1.5 percent increase in final sales in the third quarter, growth is still quite slow. It appears that GDP growth in the first quarter may depend on whether companies decide to begin building inventories rather than only reducing the rate of inventory liquidation.
Pay More Attention to Revisions
While it is understandable for markets to react to the advance estimate, it is less obvious why revisions to the initial estimate attract little attention in comparison. To the extent that investors consider macro factors at all, which is itself a debatable practice, more attention should be given to the second and final revisions to GDP and less to the advance estimate which is only an “educated guess” based on incomplete data.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Davos: Global Economic Outlook
"The International Monetary Fund is forecasting positive growth in 2010; yet, it warns the pace of growth will be too sluggish to prevent further increases in unemployment across the global economy. What is the outlook for the global economy in 2010?"
Speakers: Josef Ackermann, Montek S. Ahluwalia, Dominique Strauss-Kahn, Lawrence H. Summers, Zhu Min, Martin Wolf, Yoshito Sengoku
January 26, 2010
The New Yorker on Richard Thaler
By Greenbackd
The New Yorker has John Cassidy’s interview with Richard Thaler, Chicago School economist and co-author (along with Werner F.M. DeBondt) of Further Evidence on Investor Overreaction and Stock Market Seasonality, a paper I like to cite in relation to low P/B quintiles and earnings mean reversion. Thaler is also the “Thaler” in Fuller & Thaler Asset Management, which James Montier identifies in his 2006 research report Painting By Numbers: An Ode To Quant as being a “fairly normal” quantitative fund (as opposed to being “rocket scientist uber-geeks”) with an “admirable track [record] in terms of outperformance.” I diverge from Thaler on a number of issues, but on these two I think he’s right:
On the remnants of efficient markets hypothesis:
Well, I always stress that there are two components to the theory. One, the market price is always right. Two, there is no free lunch: you can’t beat the market without taking on more risk. The no-free-lunch component is still sturdy, and it was in no way shaken by recent events: in fact, it may have been strengthened. Some people thought that they could make a lot of money without taking more risk, and actually they couldn’t. So either you can’t beat the market, or beating the market is very difficult—everybody agrees with that. My own view is that you can [beat the market] but it is difficult.
The question of whether asset prices get things right is where there is a lot of dispute. Gene [Fama] doesn’t like to talk about that much, but it’s crucial from a policy point of view. We had two enormous bubbles in the last decade, with massive consequences for the allocation of resources.
On stock market bubbles:
[Cassidy] When I spoke to Fama, he said he didn’t know what a bubble is—he doesn’t even like the term.
[Thaler] I think we know what a bubble is. It’s not that we can predict bubbles—if we could we would be rich. But we can certainly have a bubble warning system. You can look at things like price-to-earnings ratios, and price-to-rent ratios. These were telling stories, and the story they seemed to be telling was true.
And I love this line in relation to the impact of the recent crisis on behavioral economics:
I think it is seen as a watershed, but we have had a lot of watersheds. October 1987 was a watershed. The Internet stock bubble was a watershed. Now we have had another one. What is the old line—that science progresses funeral by funeral? Nobody changes their mind.
Science progresses funeral by funeral. Nobody changes their mind. It seems to me it’s not the only discipline that proceeds by funeral.
January 11, 2010
Empirical Finance Newsletter on Capacity Constraints, Profit Margins and Stock Returns (plus Stock Screen Results)
Our partners Wesley R. Gray of the University of Chicago and Andrew E. Kern of the University of Missouri present:
January 2010 — Empirical Finance Newsletter on Capacity Constraints, Profit Margins and Stock Returns, a paper by Bjorn N. Jorgensen, Jing Li and Gil Sadka
Abstract: This paper studies the effects of capacity utilization on accounting profit margins and stock returns. Since accounting profit margins represent the average profit per unit and not the economists' concept of unit contribution margin, the marginal/variable profit per unit, a firm with idle capacity can increase its profit margins by increasing sales (output). However, if the firm is operating at full capacity, an increase in output must be preceded by an increase in capacity (and fixed costs) resulting in lower profit margins. Our empirical findings suggest that firms' profit margins increase in sales when there is idle capacity, but decreases in sales when the firm approaches full capacity. We show that firms experiencing high growth in sales, operating in industries with high capacity utilization, experience abnormally low stock returns in the following period.
Conclusions: This paper addresses a basic economic phenomenon that is very difficult to describe with present accounting standards. Thus, it reiterates that if investors are too reliant on asreported earnings, they may not accurately assess the economic reality of the firm.
The Positive Socioeconomic Impact of Mobile Telephony in Emerging Economies
Adam Weinrich forwards this insightful special report on telecoms in emerging markets by The Economist. Adam sums it up well: "I think it is underappreciated how much mobile telephony has done for 1) the economic growth of low income countries over the last 10 years, 2) the social liberties of people living in poor countries."December 17, 2009
Debating the Economic Theories of Keynes and Hayek
By Ravi Nagarajan
As we discussed in September, much of the response to the global economic crisis of the past two years was based, at least in part, on the economic theories of John Maynard Keynes. Broad based government intervention in the economy has been defended as essential to avoid a complete systemic collapse. However, as the economy emerges from this period of crisis, the views of F. A. Hayek have been cited by many who wish to see government intervention promptly reversed.
F. A. Hayek’s classic book, The Road to Serfdom, was written in 1944 and warned readers about the tendency of unchecked government intervention to diminish individual freedoms. As we emerge from the extraordinary events of the past two years, it is a good time to revisit Hayek’s arguments particularly when considering how quickly government intervention should be reversed.
In the PBS NewsHour segment shown below, Keynes biographer Robert Skidelsky discusses the legacy of Keynes and Hayek with George Mason University Professor Russ Roberts and NewsHour correspondent Paul Solman.
The question of whether Keynes or Hayek’s views are more appropriate for today’s economy is obviously open for debate. However, I hope that everyone can agree that economists should probably not rap…
The author of this post, Ravi Nagarajan, is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
December 16, 2009
Are U.S. Stocks a Buy or Sell? Get the Expert View on Tobin's Q
In the new issue of the quarterly report Equities and Tobin's Q, former James Tobin research associate and Manual of Ideas editor John Mihaljevic provides an update on Tobin's Q using recently released data by the Federal Reserve. Mihaljevic puts Q in historical context in order to draw conclusions for the U.S. equity market outlook. For the first time, Mihaljevic also compares Tobin's Q to Shiller's ten-year P/E since 1900, finding a striking correlation between the two time series.
The following is an excerpt from the executive summary of the 47-page report:
- Tobin’s Q increased from 0.73 at the end of the second quarter to 0.88 at the end of the third quarter, based on data provided by the Federal Reserve in a flow of funds release on December 10th. The sequential increase in Q of 21%, coming on the heels of a 20% increase from Q1 to Q2, was driven by an 18% increase in the numerator (market value) and a 2% decline in the denominator (replacement cost). Year-to-date, replacement cost is up 1%.
- We estimate that Q has increased another 6% since September 30th, to 0.93 as of the market close on December 15th, based on Q3 figures contained in the Fed’s Z.1 release, adjusted to reflect the 6% return of the S&P 500 Index since the end of Q3. As our current estimate of Q is based partly on data expected to be updated in the next Z.1 release on March 11th, we base the market outlook in this report both on the Q3 estimate of Q as well as on our admittedly rough estimate of the Q ratio as of December 15th.
- We conclude that the market outlook has not changed materially from our last quarterly update. Q still sends a neutral one-year market signal and bearish signals over three, five and ten years. The medium- to longer-term outlook has dimmed as a result of the rise in the S&P 500 since the end of Q2. If the S&P 500 fell back from 1,108 to 919, the index level on June 30th, the medium- to long-term outlook would move from bearish to neutral.
- We form our neutral near-term and bearish longer-term outlook by putting recent increases in Q in historical context. Of the eleven instances when Q increased to at least 0.88, i.e., the level reached on September 30th, Q was higher one year later in five instances. Three out of eleven times, it was higher three years after the initial increase. Five years after the initial increase, Q was higher in only one of eleven instances. Ten years after the initial increase, Q was lower in all ten instances (one historical data point remains to be determined, as the initial increase occurred from 2002-03).
Read more about Tobin's Q and the U.S. equity market outlook.
Read more about Tobin's Q and the U.S. equity market outlook.
December 09, 2009
Empirical Finance Newsletter on Managerial Ownership and Equity Prices (plus Stock Screen Results)
Our partners Wesley R. Gray of the University of Chicago and Andrew E. Kern of the University of Missouri present:
December 2009 — Empirical Finance Newsletter on Managerial Ownership and Equity Prices, a paper by Feng Zhang
Abstract: This paper investigates the effects of managerial ownership on equity prices and operating performance. I find that an investment strategy that buys the highest managerial ownership decile and shorts the lowest decile would have earned an abnormal return of 6.4 percent per year from 1993-2008. Moreover, I find that firms with higher managerial ownerships are more profitable. Analysts underestimate the superior profitability of these firms, resulting in both greater forecast errors and higher earnings announcement returns for firms with higher managerial ownerships.
Conclusions: This paper provides some evidence, however weak, that an investment strategy based on levels of managerial ownership may outperform the market portfolio. The results are not strong enough to suggest that a strategy could be built on this variable alone, but are certainly strong enough to make it useful to a larger strategy. Corporate governance is notoriously difficult to quantify and measure, and thus it is tough to conclude that it directly affects stock returns. This paper however, provides some evidence that a very easily measured corporate governance variable can be linked to subsequent stock returns.
November 13, 2009
Rogoff Talks to Charlie Rose about Financial Crises (video and transcript)
Kenneth Rogoff of Harvard University and author of This Time is Different: Eight Centuries of Financial Folly speaks with Charlie Rose about the current financial crisis, putting it in historical context.
Go to CharlieRose.com to watch the interview (search for Rogoff).
Says Rogoff: "I basically favor having what we call some version of narrow banks, where our deposits go into things like Treasury
bills and things which are very, very sound instead of more speculative activities, and to separate that out in some way."
October 20, 2009
Larry Summers at The Economist’s Buttonwood Gathering
By Ravi Nagarajan
Larry Summers, Director of the White House National Economic Council, was invited to deliver a lecture at the Economist’s Buttonwood Gathering which took place last week. Mr. Summers has received high praise from Berkshire Hathaway Vice Chairman Charlie Munger who is a self-described “right-wing Republican”.
Combined with Mr. Summers’ high position in government, no further endorsements are needed for intelligent investors to pay close attention to the views expressed in the video shown below.
October 06, 2009
Tobin’s Q Now Bearish Long-Term
An article referencing the latest issue of the quarterly research publication Equities and Tobin's Q has been published by Robert Huebscher of Advisor Perspectives. Writes Huebscher, "The latest data for Tobin’s Q-Ratio, a valuation metric shown by academic studies to be highly predictive of market performance, show that investors should brace themselves for sub-par returns over the next 10 years."
September 20, 2009
Warren Buffett’s “Desert Island” Economic Indicator
In a recent CNBC interview, Warren Buffett was asked to identify one economic indicator that he would consider most relevant for evaluating overall economic conditions if he was stranded on a desert island for a month and had no other access to information. He immediately mentioned rail car loadings as a top candidate for this “desert island indicator”, and has made similar comments in the past.
Let’s assume that Mr. Buffett received the Association of American Railroads September Rail Time Indicators report and had to draw some conclusions regarding the state of the overall economy. The report actually includes a significant amount of information that is not directly related to rail shipments, so let’s just focus on a few of the indicators published in the report that pertain to railroad indicators:
- “U.S. freight railroads originated 1,116,182 carloads in August 2009, down 16.4% (218,593 carloads) from August 2008 and the 10th straight double-digit monthly carload decline. However, the percentage decline in August was the lowest since February 2009.”
- “Average weekly carloads on U.S. railroads in August 2009 (279,046) were more than 15,000 carloads higher than in July 2009 and higher than any previous month in 2009, though seasonal factors account for some of that increase…”
Looking at the report’s breakdown of rail traffic by commodity type, nearly every category still shows double digit declines from the prior year, although as the report indicates, traffic has improved significantly from the depths of the recession earlier this year. There are numerous charts in the report that show more granular details.
The rail indicators seem to show an economy that is improving but still significantly depressed compared to the period prior to the September 2008 meltdown in financial markets. Average weekly carloads still falls far short of the levels seen in 2006 and 2007. While year over year comparisons will improve starting in October, it does not appear that predictions of a “V” shaped recovery can be supported by this indicator.
Obviously rail traffic is just one indicator of economic activity but it deserves special consideration given Mr. Buffett's recommendation and is something to keep in mind for those who are making investment decisions predicated on an assumption of rapid improvements in economic activity in the 4th quarter.
In general, making investment decisions based only on macroeconomic factors is not consistent with a value investing approach. However, the investment thesis for many companies can be influenced to some degree based on whether an investor is assuming a quick return to rapid growth or a longer period of relative stagnation in the economy. It is dangerous to look at average earnings of a company from 2005 to 2008 and assume a rapid return to those levels if the company is particularly exposed to macroeconomic factors.
The author of this post, Ravi Nagarajan, is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
September 17, 2009
Empirical Finance Newsletter, September 2009 (plus Stock Screen Results)
Our partners Wesley R. Gray of the University of Chicago and Andrew E. Kern of the University of Missouri present:
September 2009 — Empirical Finance Newsletter on Hedge Fund Activism, Corporate Governance, and Firm Performance, a paper by Alon Brav, Wei Jiang, Randall Thomas and Frank Partnoy
Abstract: Using a large hand-collected dataset of hedge fund activism in the U.S. over the period 2001 through 2005, we find that activist hedge funds act both as value investors and shareholder advocates. They target undervalued firms, and propose an array of strategic, operational, and financial remedies. Most tactics are non-confrontational, and attain success or partial success in two-thirds of the cases. However, hedge funds seldom seek control of target companies. The market reacts favorably to hedge fund activism, as the abnormal return upon announcement of potential activism is in the range of 5-7 percent, with no apparent reversal in the subsequent year. We show that this positive market reaction does not reflect anticipated wealth transfers from creditors to shareholders, but instead reflects anticipated improvement in performance. Indeed, target firms see moderate improvement in operational performance and considerably higher CEO turnover after activism. Our analysis provides important new evidence on the mechanisms and effects of informed shareholder monitoring.
Conclusions: The contribution of this paper is to show that activist hedge funds are good for corporations, shareholders and the economy generally: They are not short term traders, they encourage the efficient allocation of capital, they generate higher returns for shareholders and do not harm creditors in the process. In light of this evidence, it is difficult to understand the enmity shown by politicians and the media towards the activist hedge fund industry. Of course, it is less difficult to understand why an entrenched CEO who has successfully extracted wealth from the corporation at the expense of other stakeholders might show such enmity. And therein lies a possible explanation as to why activist hedge funds often get such a bad rap.
August 19, 2009
Unemployment Lasts Longer in "Flexible, Knowledge-based Economy"
Thanks to Adam Weinrich for this chart.
June 28, 2009
Tobin's Q No Longer Bullish on U.S. Equities
We estimate that Tobin’s Q increased from a March low of 0.33 to 0.72 as of June 26, roughly in line with an adjusted average of 0.71 for the period from 1900-2009. Our data shows that while Q declined sharply in 2008, it has increased from 0.55 at yearend 2008 and from 0.61 at the end of 1Q09. The numerator (market value) and denominator (replacement cost) of the Q ratio were up 11% and down 1%, respectively, in the first quarter.
Today’s Q ratio sends a neutral near-term and medium-term market signal, and a modestly bearish long-term market signal. Of the five other instances since 1900 when Q increased to 0.72 or below, it was higher one year later in three instances. Four out of five times, it was higher three years after the initial increase. Five years and ten years after the increase, it was higher in only one of five instances and unchanged in another instance.
Replacement cost declined 0.7% sequentially in 1Q09, a reversal from a sequential increase of 0.3% in 4Q08, reflecting deflationary forces at play in the U.S. economy, including rising unemployment, home price erosion, and financial deleveraging. We note that replacement cost has not recorded a full-year decline in any year since at least 1900. Further declines in replacement cost would therefore be very significant in a historical context. We will watch the recent deflationary trend closely, but we do not anticipate that replacement cost will in fact decrease for the full year 2009.
Print version:
Equities and Tobin's Q, by John Mihaljevic, CFA, June 28, 2009
Learn more John Mihaljevic's Equities and Tobin's Q quarterly report and update service.
April 25, 2009
Milton Friedman's Remarks at Hoover Institution in 2006
While we don't agree with many of Milton Friedman's conclusions on economic policy, he is undoubtedly one of the foremost economic minds of the 20th century. If nothing else, Friedman's uncompromising views and the clarity with which he expresses them challenge us to underpin our own views with sound judgment.
Free to Choose: A Conversation with Milton Friedman, 2006 (video)
April 15, 2009
Century Management on Inflation Risks
April 10, 2009
Paul Krugman: The Global Economy
Robert Shiller: How Animal Spirits Drive the Economy (video)
April 08, 2009
LTCM's Robert Merton Wants You To Listen
Economics Nobel laureate of Long-Term Capital Management fame, Robert Merton, recently spoke about financial markets. Merton is clearly a genius in some areas but he has also been spectacularly blind-sided in the past. We would much rather listen to people like Warren Buffett and David Swensen. However, when we feel like delving deeper into some of the complex financial issues that got us into the financial mess we're in currently, Merton can clearly provide some insight.
March 25, 2009
Loss of dollar purchasing power since 1775
Sources and related resources:
March 22, 2009
Quantitative Easing
We suspect we'll be hearing a lot more about Quantitative Easing in the coming months and years.
Here's a good article to give you an overview of QE, the "nuclear option" of central bankers.
March 17, 2009
Tobin's Q Moderately Bullish on U.S. Equities
In the just-released quarterly issue of Equities and Tobin’s Q, John Mihaljevic, CFA, managing editor of The Manual of Ideas and former research assistant to Economics Nobel laureate James Tobin puts the so-called Q ratio in historical context and draws timely conclusions for equity investors:
- We estimate Tobin’s Q at 0.43, well below parity and well below an adjusted average of 0.76 for the period 1900-2008. Our data shows that Q declined sharply in 2008 and again YTD, down from 0.89 at yearend 2007 to 0.55 at yearend 2008 and to 0.43 as of March 15, 2009. The numerator (market value) and denominator (replacement cost) of the Q ratio were down 49% and up 5%, respectively, from yearend 2007 through March 15, 2009.
- No evidence of deflation can be observed in replacement cost, with the denominator of the Q ratio rising 5% in 2008, in line with the increase recorded in 2007. Replacement cost increased 0.3% sequentially in 4Q08, reflecting a slower pace than for the full year but notably no decrease. Absent major deflationary pressure on replacement cost, we expect Q to return to parity through an increase in the numerator, i.e., a rise in the market value of equities and other assets. How long this process may take is obviously a crucial question but also one that cannot be answered reliably.
- Despite the low value of today’s Q ratio, it sends only a modestly bullish signal for investors. Of the six other instances since 1900 when Q fell to 0.43 or below, it was higher one year later in three instances. Four out of six times, it was higher three years after the drop. Ten years after the drop, it was higher in all but one instance.
- We cannot overemphasize the possibility of Q reaching extreme levels. The ratio hit a low of 0.29 twice over the course of the past century—in 1948 and 1974. The ratio was 0.33 or lower in 1918-1921, 1932, and 1949.
- Those who argue that today’s Q sends an extremely bullish signal appear to focus solely on the level of Q, ignoring the direction of change. A ratio of 0.43 is highly bullish if Q is on the upswing, but when the ratio is on the downswing, a value of 0.43 is only modestly bullish.
- Those who argue that today’s Q sends an extremely bearish signal appear to be making three cognitive errors: (1) Undue focus on historical lows. While the low of 0.29 is materially below today’s Q, attempting to buy equities at or close to Q’s lows would have caused investors to miss out on decades of strong equity returns. (2) Ignorance of the fact that the relationship between Q and stock prices is not quite linear. We estimate that a 50% drop in Q from current levels would be accompanied by a one-third drop in stock market indices. (3) Ignorance of the fact that replacement cost, the denominator of the Q ratio, has increased each year since 1946.
For information on purchasing the full report, visit The Manual of Ideas.
Bernanke Admits to Printing Money (Video)
Around minute 8 of his 60 Minutes interview, Fed chairman Ben Bernanke admits to printing money and says it needs to be done. Of course, he believes we can avoid inflation despite the Fed's actions. We'll see.
Part 2:
March 15, 2009
FT on The Future of Capitalism
The Financial Times has launched a special in-depth section entitled "The Future of Capitalism."
February 27, 2009
James Tobin's Ideas Guide Obama Policy
President Obama's stimulus plan bears the imprimatur of the late Yale economist and Nobel laureate James Tobin. The free market ideas of Milton Friedman and the so-called Chicago school of economics have been discredited in the near-collapse of our financial system, paving the way to Keynesian economics to reassert itself in economic policy. The Manual of Ideas publishes quarterly report entitled Equities and Tobin's Q, which translates some of Tobin's work into timely guidance for equity investors and market strategists. [more]February 14, 2009
Summers v. Krugman: Will Stimulus Work?
President Obama's top economic advisor Larry Summers and Economics Nobel laureate Paul Krugman disagree on the likely effectiveness of the stimulus plan that passed Congress last week. While Summers pledges that the Administration will "do what is necessary," Krugman argues that the $800 billion stimulus will offset only one-third of the anticipated decline in economic activity. [watch Summers interview] [watch Krugman interview]
February 09, 2009
Job Losses In Recent Recessions
Thanks to stumblr & bumblr for locating this chart.
February 06, 2009
Marc Faber Sounds Off On Economic Stimulus
Marc Faber makes some excellent points in a February 6th interview with Bloomberg.
February 03, 2009
Economist Lacy Hunt On Debt Deflation
Business Spectator's Isabelle Oderberg recently interviewed economist Dr Lacy Hunt of Hoisington Investment Management (link courtesy of Dah Hui Lau). Hunt is quite outspoken on the deflation of the debt bubble. Excerpt:
Isabelle Oderberg: How did we get ourselves into debt deflation?
LH: Well it's been a long time in the making. The debt to GDP ratio took out the highs of the 1930s and 2003. At that point in time total debt was just a little bit more than $3 of debt for every dollar of GDP. Today it is just under $3.60 of debt for every dollar of GDP and we are going to see that ratio move higher, in part because normal GDP in the United States is now falling and the difficulty of repaying this debt is going to be very difficult, because the loans are denominated in dollars and the assets that were borrowed against are dropping in value. The income generating capacity of these assets are also dropping and the US economy is in something called a debt deflation. A very rare situation. It only occurs every 3 to 8 or 9 decades. The last time that we experienced it was the 1930s in the United States. We experienced it in the 1870s and 1880s and Japan experienced a debt deflation post 1988 but it has happened historically. It is very rare and the two main things that identify it are setting a new peak in the debt to GDP ratio and also a lot of borrowing that is improperly financed and where there is little likelihood that the borrower can repay the principal and the interest of the loan.
IO: What scenario are we going to see now?
LH: These debt deflationary periods tend to last. They're very pernicious, they're very persistent and they tend to last a long time. Really, the only thing that brought the United States out of the post 1929 debt deflation was our participation in World War II. The debt deflation that ensued after the panic of 1873 lasted another 20 to 23 years and the Japanese, they had debt deflation which started 1989 and is still running for all practical purposes today. They last for a very long time.
IO: According to your quarterly review and outlook, we're now essentially in a 15-year process. Does that mean that it's going to take 15 to 20 years for this situation to actually stabilise or normalise?
LH: Well, there are other intervening events that could occur. If we would have very significant technological breakthroughs that might shorten the process, but one of the things that suggest it's long running is you can look at what happened to interest rates and stock prices after these prior debt manias. Post-1928 you had a negative risk premium for 20 years. Negative risk premium meaning the total return on treasury bonds exceeded the total return on the S&P 500. Post-1872 you had another 20 year period of a negative risk premium and we've seen a negative risk premium post-1988 in Japan. The low in interest rates after those previous debt bubbles occurred about 14 or 15 years later, for example the low post 1928 occurred in 1941 on the yearly average basis at 1.95 per cent. Once we went into World War II, then there were some very minuscule increases 20 years after 1928 interest rates were up slightly, but not very much from the lows that were reached in 1941 and that was also a characteristic of the Japanese situation and our situation in the US post 1872.
IO: So if we're in any way mirroring the '31 to '33 situation, is the S&P at risk currently of a bear market rally?
LH: Well, one of the things that has happened in these debt deflations is you get a number of false dawns. People believe that the normal business cycle is going to take control and you're going to get a cyclical recovery and the model that soon prevails is that you get three to 10 years of expansion. You have one year, maybe a year and a half of a recession or nasty economic conditions, but after a year and a half at most, the economy then has another expansion for 3 to 10 years.
When we have these very rare debt bubbles occurring at these long irregular intervals, the normal business cycle model doesn't really apply. We do get some false dawns. Some intermittent cyclical recoveries but the unwinding of the debt process proves to be very very long and difficult. One of the reasons for that is that borrowers don't know anything about paying back loans in harder times, which is what's now beginning to occur and as a consequence there is a major behavioural shift or there has been historically in which consumers decide to live inside of their means as opposed to living outside of their means and normally the saving rate goes up for a long time.
After the experience of the 1930s the savings rate in the United States rose irregularly into the early 1980s and it's been in a decline since then irregularly to extremely low levels, virtually the same low levels that we reached in the 1930s and if history is a guide and there are not many data points we're now beginning to see an upturn in the saving rates that will last for a very long time.
January 31, 2009
Kenneth Rogoff on What Is Coming Next
Harvard economics professor Kenneth Rogoff has published a paper (13-page PDF file) and study (82-page PDF file) examining the potential aftermath of the financial implosion we've experienced in recent months. Here's an overview of the two most recent publications, both of which provide a level of analysis and insight that is rarely found in analyses of the ongoing crisis.
The Aftermath of Financial Crises (with Carmen M. Reinhart), manuscript, Harvard University, December 2008. Paper prepared for the American Economic Association Meetings in San Francisco, January 3, 2009.
Introduction:
A year ago, we (Carmen M. Reinhart and Kenneth S. Rogoff, 2008a) presented a historical analysis comparing the run-up to the 2007 U.S. subprime financial crisis with the antecedents of other banking crises in advanced economies since World War II. We showed that standard indicators for the United States, such as asset price inflation, rising leverage, large sustained current account deficits, and a slowing trajectory of economic growth, exhibited virtually all the signs of a country on the verge of a financial crisis—indeed, a severe one. In this paper, we engage in a similar comparative historical analysis that is focused on the aftermath of systemic banking crises.
In our earlier analysis, we deliberately excluded emerging market countries from the comparison set, in order not to appear to engage in hyperbole. After all, the United States is a highly sophisticated global financial center. What can advanced economies possibly have in common with emerging markets when it comes to banking crises? In fact, as Reinhart and Rogoff (2008b) demonstrate, the antecedents and aftermath of banking crises in rich countries and emerging markets have a surprising amount in common. There are broadly similar patterns in housing and equity prices, unemployment, government revenues and debt. Furthermore, the frequency or incidence of crises does not differ much historically, even if comparisons are limited to the post–World War II period (provided the ongoing late-2000s global financial crisis is taken into account). Thus, this study of the aftermath of severe financial crises includes a number of recent emerging market cases to expand the relevant set of comparators. Also included in the comparisons are two prewar developed country episodes for which we have housing price and other relevant data.
Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics.
- First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years.
- Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment.
- Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs are difficult to measure, and there is considerable divergence among estimates from competing studies. But even upper-bound estimates pale next to actual measured rises in public debt. In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn.
Banking Crises: An Equal Opportunity Menace (with Carmen M. Reinhart), manuscript, Harvard University, December 2008. Also available as NBER Working Paper No. 14587, December 2008.
Abstract:
The historical frequency of banking crises is quite similar in high- and middle-to-low income countries, with quantitative and qualitative parallels in both the run-ups and the aftermath. We establish these regularities using a unique dataset spanning from Denmark’s financial panic during the Napoleonic War to the ongoing global financial crisis sparked by subprime mortgage defaults in the United States.
Banking crises dramatically weaken fiscal positions in both groups, with government revenues invariably contracting, and fiscal expenditures often expanding sharply. Three years after a financial crisis central government debt increases, on average, by about 86 percent. Thus the fiscal burden of banking crisis extends far beyond the commonly cited cost of the bailouts.
Our new dataset includes housing price data for emerging markets; these allow us to show that the real estate price cycles around banking crises are similar in duration and amplitude to those in advanced economies, with the busts averaging four to six years. Corroborating earlier work, we find that systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike.
Introduction:
Until very recently, the study of banking crises has typically focused either on earlier historical experiences in advanced countries, mainly the banking panics before World War II, or else has focused on modern-day emerging market experiences. This dichotomy is perhaps shaped by the belief that for advanced economies, destabilizing, systemic, multi-country financial crises were a relic of the past. Of course, the recent global financial crisis emanating out of the United States and Europe has dashed this misconception, albeit at great social cost.
As this paper will demonstrate, banking crises have long been an equal opportunity menace. We develop this finding using a core sample of sixty-six countries (plus a broader extended sample for some exercises). We examine banking crises ranging from Denmark’s financial panic during the Napoleonic War to the current “first global financial crisis of the 21st century.” The incidence of banking crises proves to be remarkably similar in the high- and middle-to-low-income countries. Indeed, the tally of crises is particularly high for the world’s financial centers: the United Kingdom, the United States, and France. Perhaps more surprising still are the qualitative and quantitative parallels across disparate income groups. These parallels arise despite the relatively pristine modern sovereign default records of the rich countries.
Three features of our expansive dataset are of particular note.
- First, our data on global banking crises go back to 1800, extending the careful study of Bordo, et al. (2001) that covers back to 1880.
- Second, to our knowledge, we are the first to examine the patterns of housing prices around major banking crises in emerging markets, including Asia, Europe and Latin America. Our emerging market data set facilitates comparisons, across both duration and magnitude, with the better-documented housing price cycles in the advanced economies, which have long been known to play a central role in financial crises. We find that real estate price cycles around banking crises are similar in duration and amplitude across the two groups of countries. This result is surprising given that almost all other macroeconomic and financial time series (income, consumption, government spending, interest rates, etc.) exhibit higher volatility in emerging markets.
- Third, our analysis employs the comprehensive historical data on central government tax revenues and debt compiled in Reinhart and Rogoff (2008). These new data afford a new perspective on the tax and debt consequences of the banking crises (Previously, the kind of historical data on debt necessary to analyze the aftermath of banking crises across countries was virtually non-existent for years prior to 1990.)
We find that banking crises almost invariably lead to sharp declines in tax revenues as well significant increases in government spending (a share of which is presumably dissipative). On average, government debt rises by 86 percent during the three years following a banking crisis. These indirect fiscal consequences are thus an order of magnitude larger than the usual bank bailout costs that are the centerpiece of most previous studies. That fact that the magnitudes are comparable in advanced and emerging market economies is also quite remarkable. Obviously, both the bailout costs and the fiscal costs depend on a host of political and economic factors, including especially the policy response as well as the severity of the real shock which, typically, triggers the crisis.
The paper proceeds as follows. Section II provides an overview of the history of banking crises, with particular emphasis on the post-1900 experience. We also document the incidence and frequency of banking crises by country and by region. We discuss the links between banking crises, financial liberalization, the degree of capital mobility, and sovereign debt crises and discuss international financial contagion.
Section III examines some of the common features in the run-up to banking crises across countries and regions over time. The focus is on the systematic links between cycles in international capital flows, credit, and asset prices—specifically, home and equity prices. The next section examines some of the common features of the aftermath of banking crises. We document the toll that the crisis takes on output and government revenues, as well as the typically profound effect on the evolution of government debt during the years following the crisis. The concluding section takes up the question of “graduation.” Specifically, to what extent do countries ever “graduate” from (stop experiencing) serial major financial crises as they seem to graduate from serial sovereign debt crises?
The Harvard Economics Department hosts a collection of Kenneth Rogoff's recent writings.
January 28, 2009
Stiglitz at Davos: We Need More Investment, Not More Consumption
Economics Nobel laureate Joseph Stiglitz spoke to Bloomberg at Davos. Stiglitz favors quick government action the bailout. He also calls the IMF and U.S. Fed hypocritical.
Watch the interview.
Keynes on The Great Slump of 1930
Economist John Maynard Keynes (1883-1946) wrote an essay in 1930 entitled The Great Slump. While the structure of the economy of the 1930s was quite different from that of the U.S. economy today, there are some parallels in terms of ordinary people's perception of the crises. Wrote Keynes:
The world has been slow to realize that we are living this year in the shadow of one of the greatest economic catastrophes of modern history. But now that the man in the street has become aware of what is happening, he, not knowing the why and wherefore, is as full to-day of what may prove excessive fears as, previously, when the trouble was first coming on, he was lacking in what would have been a reasonable anxiety. He begins to doubt the future. Is he now awakening from a pleasant dream to face the darkness of facts? Or dropping off into a nightmare which will pass away?
He need not be doubtful. The other was not a dream. This is a nightmare, which will pass away with the morning. For the resources of nature and men's devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life—high, I mean, compared with, say, twenty years ago—and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time.
I doubt whether I can hope, in these articles, to bring what is in my mind into fully effective touch with the mind of the reader. I shall be saying too much for the layman, too little for the expert. For—though no one will believe it—economics is a technical and difficult subject. It is even becoming a science. However, I will do my best—at the cost of leaving out, because it is too complicated, much that is necessary to a complete understanding of contemporary events.
January 25, 2009
World Economic Forum at Davos on the Future of the Global Financial System
This year's World Economic Forum meeting at Davos, Switzerland takes place from January 28th to February 1st. The Forum has just published an interesting report entitled "The Future of the Global Financial System: A Near-Term Outlook and Long-Term Scenarios."
The 88-page report puts the current crisis in perspective by providing some interesting charts and statistics. The conclusions of the report are not earth-shattering, but the report does provide some long-term scenarios intended to spur thought and debate.
The World Economic Forum has also published worthwhile briefing materials in preparation for this year's Davos meeting.
We will be bringing you highlights of this year's meeting at Davos in real time right here at The Ideas Report For Serious Investors, so stay tuned in the coming days.
Visit the World Economic Forum website.
January 21, 2009
CBO's Budget and Economic Outlook: 2009-2019
The Congressional Budget Office recently published testimony entitled, The Budget and Economic Outlook: 2009-2019. We've been critical of the CBO's TARP accounting, but the budget outlook report contains some interesting economic data series.
We disagree, however, with the CBO's estimate that the economy will grow by 1.5% in 2010. This strikes us as too optimistic given the enormity of the challenges before us and the negative cascading effects that have yet to play out.
January 17, 2009
Empirical Finance Research Newsletter: What Can Investors Learn From The Latest Academic Studies?
The Manual of Ideas is pleased to partner with Empirical Finance LLC to bring our readers unique insight into the latest finance-related academic literature, with a clear emphasis on putting academic insight to work in real-world investment portfolios.
Starting today, we are bringing you the monthly Empirical Finance Research Newsletter and related content free of charge. Wesley Gray of the University of Chicago Booth School of Business and Andrew Kern of the University of Missouri are authors of Empirical Finance Research Newsletter. They are intimately familiar with the latest finance literature and espouse a Buffett-style investment approach. Value-oriented investors will find Wes and Andy's investment mindset to be quite compatible.
Wes Gray and Andy Kern also recently published a paper examining the performance of stocks recommended by members of the exclusive Value Investors Club. Their paper has already garnered tremendous attention in the industry.
To receive alerts when future issues of the Empirical Finance Research Newsletter become available, be sure to submit your email address on the website devoted to the Newsletter (not necessary if you are already a member of The Manual of Ideas email list).
December 16, 2008
The Manual of Ideas Launches Tobin's Q Research Service
Our quarterly Tobin's Q report and update service was formally announced this morning:
Equities and Tobin's Q, 1900-2008 — Evaluating the Market Outlook in the Context of a Century of History, A Report By John Mihaljevic, CFA, Former Research Assistant to Economics Nobel Laureate James Tobin
The Manual of Ideas is launching a new quarterly report for investment managers and equity strategists entitled, "Equities and Tobin's Q — Evaluating the Market Outlook in the Context of a Century of History." The report is authored by John Mihaljevic, managing editor of The Manual of Ideas, and draws on his past experience as James Tobin's research assistant at Yale to provide unique perspective into this important indicator of future stock market performance. You can buy the current report or subscribe for the quarterly report and update service here.
The Debate: Is Today's Q Giving a Bullish or Bearish Signal for Equities?
Disagreement between leading investment managers and strategists has been remarkable. Consider the diametrically opposed views of two prominent figures:
Bill Gross, the outspoken Managing Director of PIMCO, a leading global investment firm with more than $790 billion in assets under management, asserts that the "Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation..."
Meanwhile, Russell Napier, Strategist at CLSA, a leading international brokerage and investment group, claims that the Q ratio supports his expectation of a "horrific" market bottom and another 55% drop in the S&P 500 Index by 2014.
What Is Q Really Saying?
Find out in Tobin's Q and The Outlook for Equities. The report is uniquely equipped to answer this crucial question for equity strategists and portfolio managers:
* Authored by former James Tobin associate. John Mihaljevic is an Economics graduate of Yale who served as Professor Tobin's research assistant from 1996-98. One of Mr. Mihaljevic's key projects while serving in this capacity was to develop and implement a new technique of estimating Tobin's Q.
* Q estimation method used in report was developed in conjunction with James Tobin. Mr. Mihaljevic developed the technique applied in the report in 1996 with the assistance of Professor Tobin, updating the latter's previous method of calculating the Q ratio.
* Historical context reaching back more than 100 years. Tobin's Q and The Outlook for Equities includes data from 1900-2008, enabling the report author to put the current Q ratio in historical context, including the Panic of 1907 and the Great Depression.
About the Author — John Mihaljevic, CFA
Mr. Mihaljevic served as James Tobin's research assistant from 1996-98. In this capacity, Mr. Mihaljevic assisted Professor Tobin in developing a new Q estimation methodology and in periodically updating data related to the Q ratio. Mr. Mihaljevic also assisted Professor Tobin on a variety of macroeconomic research projects at the Cowles Foundation, including researching and editing Money, Credit and Capital, published by McGraw-Hill/Irwin in 1997.
Mr. Mihaljevic is a Chartered Financial Analyst and a summa cum laude graduate of Yale University, having earned distinction in Economics, his major course of study. In addition to working for and studying under James Tobin, Mr. Mihaljevic also studied under Yale Chief Investment Officer David Swensen and Sterling Professor of Economics William Nordhaus.
Mr. Mihaljevic has worked as an investment banker, equity research analyst and investment manager. He currently served as managing member of Mihaljevic Capital Management LLC and managing editor of The Manual of Ideas.
About the Report
In Equities and Tobin's Q, 1900-2008, Mr. Mihaljevic updates on a quarterly basis the Q estimation technique he developed with Professor Tobin in 1996-97. The inaugural report includes Flow of Funds data released by the Federal Reserve on December 11, discusses implications for equity investors, and puts the Q ratio in historical context. The report includes the following:
* Latest estimate of Tobin's Q, using data released by the Federal Reserve on December 11
* Implications for equity investors, based on placing the current Q ratio in historical context and interpreting it as James Tobin might have done
* Charts showing Q going back to 1900, including a comparison of three Q estimation methods: (1) Blanchard, Rhee and Summers, (2) Tobin (old), and (3) Tobin (new) -- Mr. Mihaljevic's calculation, developed jointly with Tobin in mid-1990s
* More than 100 years of Q data (1900-2008), provided in Excel via password-protected download link
* Subscription-based quarterly update service includes ongoing Tobin's Q updates based on the Fed's quarterly Flows of Funds release and other data, as well as commentary putting the latest ratio in historical context and evaluating implications for future market performance
About Tobin's Q
Tobin conceptualized the Q ratio as a measure of over- or undervaluation of publicly traded assets. In its simplest form, Q equals market value divided by replacement cost. If the market value of an asset exceeds the cost of replacing it (Q>1), there is an incentive to recreate that asset and immediately sell it in the market at a premium to cost. As a result, incremental real investment will tend to force high Q ratios back down to parity. No straightforward balancing mechanism exists in the case of low Q ratios, i.e., when the market is valuing an asset below its replacement cost (Q<1). When Q is less than parity, the market seems to be saying that the deployed real assets will not earn a sufficient rate of return and that, therefore, the owners of such assets must accept a discount to the replacement value if they desire to sell their assets in the market. If the real assets can be sold off at replacement cost, for example via an asset liquidation, such an action would be beneficial to shareholders because it would drive the q ratio back up toward parity. In the case of the stock market as a whole, rather than a single firm, the conclusion that assets should be liquidated does not typically apply. A low Q ratio for the entire market does not mean that blanket redeployment of resources across the economy will create value. Instead, when market-wide Q is less than parity, investors are probably being overly pessimistic about future asset returns. Several studies have shown that stock market investments at times when the q ratio was less than parity have produced above-average long-term returns.
December 14, 2008
Joseph Stiglitz on What the Government Should Do on Housing (Video)
Watch Economics Nobel Laureate Joseph Stiglitz speak on current macroeconomic issues (presented on November 14th). Watch a highlight of his speech or the entire event. We also recommend browsing around the FORA.tv website, as it contains a lot of great content on economics and public policy.
For Stiglitz fans, we also recommend watching his Authors@Google talk on globalization in October 2006.