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Why Identifying a Bubble Is So Much Trouble: John H. Cochrane September 22, 2011

Posted by kickoman in Economics & Finance.
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From ft.com
By John H. Cochrane Sep 22, 2011 7:01 AM GMT+0700 19

We seem to be surrounded by “bubbles” — tech stocks, real estate, and now maybe sovereign debt.

You might expect that any textbook would have a precise definition of this phenomenon; some set of characteristics that distinguish sensible high prices in good times from prices that are “too high” or in a “bubble.” Alas, “bubbles” seem to be in the eye of the beholder.

Does that mean it’s all just empty talk? No, and there is solid academic research that helps us to think about what “bubbles” might mean, and how both policy makers and investors might think about them.

Here are the central facts: High valuations are, on average, followed by many years of poor returns, and vice versa. High valuations are not, on average, followed by years of good cash-flow growth, or by ever-higher valuations.

This fact holds across markets:
– High stock price/dividend, price/earnings, or market/book ratios are on average followed by years of poor returns, not years of higher dividend and earnings growth, or permanently higher prices, and vice versa for low prices.

– High yield spreads (low prices) on long-term bonds are on average followed by good returns on long-term bonds, not by increases in short-term interest rates, and vice versa.

– High credit spreads (low prices) on low-grade debt are followed, on average, by good returns on that debt, not a proportionally high bankruptcy rate, and vice versa.

– High interest rates abroad relative to the U.S. are followed, on average, by good returns to U.S. investors in that debt, not by foreign exchange-rate depreciations, and vice versa.

– High house prices relative to rents are followed, on average, by flat or declining house prices over many years, not by increases in rents, and vice versa.

No one substantially disputes these facts. The question is: What does all this tell us about why prices are high or low in the first place?

The facts don’t support the theory that prices are high because people always expect a “greater fool” to pay a still higher price. If that were true, high prices would have no connection on average to subsequent returns or cash flows, and would correspond to forever higher prices. We just don’t see that.

The data also deny the simple discounted cash-flow view. If investors think that dividends and earnings will grow strongly in the future, they will be willing to buy a stock for a large multiple of today’s earnings. Although those bets won’t turn out right every time, on average, high price ratios today will be followed by good growth in dividends or earnings. They aren’t.

So what’s going on?

‘Macroeconomic Risk’
The “macroeconomic risk” view holds that the discount rate for a given cash flow can vary over time. Price booms come in good macroeconomic times, when the average investor is “searching for yield” and willing to take on some extra risk. Such investors bid up the price of unchanged cash flows.

Price busts come in horrible macroeconomic times, such as those we are enduring. In these periods, the average investor may rightly say, “I understand returns are better going forward, and there is the buying opportunity of a lifetime in junk bonds. But I’m about to lose my house and my job, the bankers are about to shut down my business, and I can’t take any extra risk right now.” Such investors drive prices down until the same prospective cash flows can deliver returns large enough to overcome their justified fear.

Over-Optimistic Investors
The “irrational” view is that investors’ required returns don’t change, but they simply get it wrong. Sometimes they get over-optimistic and bid up the price as if cash flows are going to be great. Sometimes they get irrationally depressed. In either case, they don’t learn from the centuries of experience.

“Macro risk” researchers note the strong connection of prices to economic events, captured by explicit and rejectable economic theories of discount-rate variation; they complain about ex-post storytelling. The “irrational” camp points to puzzling surveys. For example, investors who bought Amazon.com at the height of the tech boom reported mathematically impossible cash-flow forecasts.
But surveys are easy to misinterpret: “Expect” and “risk” in casual conversation have very different meanings than “conditional mean and variance” in our models. And economics was meant to explain behavior, not self-perception. Rats in mazes do a good job of obeying the laws of economics, but they’re not so good at responding to surveys.

Financial Frictions
A new view says market swings are all about financial frictions, not mass risk aversion or psychology. In the financial crisis many assets seemed to fall in value because of the run in the shadow banking system, or temporary illiquidity in markets. The question is whether this view can explain broad movements across many directly held assets like stocks, or whether it’s confined to specific smaller markets.

A final view is tantalizing. Every “bubble” has also featured a “trading frenzy,” from tulips in the 1600s to tech stocks in 1990 to condo-flipping in Miami in 2006. Perhaps traders hold high-priced assets despite low average returns because the assets are useful in helping them to profit from small bits of information, just as we hold money despite a low return because it’s useful for buying things. If so, the rest of us should stay away from “bubble” assets.

Research has, at least, given a lot of structure to the “bubble” question. We know that variation in price ratios corresponds to discount-rate variation, not to changes in expected cash flows or the ability to find a greater fool. The challenge is to understand that discount-rate variation. A focused debate, based on clear facts and explicit theories, is real progress.

(John Cochrane is the AQR Capital Management Distinguished Service professor of finance at the University of Chicago Booth School of Business and a contributor to Business Class. A survey of much of the research mentioned in this essay is included in his recent article “Discount Rates,” in the Journal of Finance. The opinions expressed are his own.)

Why austerity is only cure for the eurozone September 6, 2011

Posted by kickoman in Economics & Finance.
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By Wolfgang Schäuble
from FT.com

In recent weeks, debt markets have undergone wild gyrations, leading some analysts and commentators to question the progress achieved in taming the sovereign debt crisis in the eurozone. More recently, economic data and forward-looking indicators have emerged that many economists think point to a faltering of the global recovery, compounding the general anxiety.

Instead of focusing minds, however, these developments have prompted a cacophony of prescriptions about what western governments should do next. There have been calls on regulators to rein in speculators, on the central banks to loosen monetary policy further, on the US and Germany to use their supposed “fiscal space” to encourage demand and on European Union leaders to take an immediate leap into a fiscal union and joint liability. Now more than ever is a time for clear messages and clear priorities.

Whatever role the markets may have played in catalysing the sovereign debt crisis in the eurozone, it is an undisputable fact that excessive state spending has led to unsustainable levels of debt and deficits that now threaten our economic welfare. Piling on more debt now will stunt rather than stimulate growth in the long run. Governments in and beyond the eurozone need not just to commit to fiscal consolidation and improved competitiveness – they need to start delivering on these now.

The recipe is as simple as it is hard to implement in practice: western democracies and other countries faced with high levels of debt and deficits need to cut expenditures, increase revenues and remove the structural hindrances in their economies, however politically painful. Some progress has already been achieved in this respect, but more needs to be done. Only this course of action can lead to sustainable growth as opposed to short-term volatile bursts or long-term economic decline.

There is some concern that fiscal consolidation, a smaller public sector and more flexible labour markets could undermine demand in these countries in the short term. I am not convinced that this is a foregone conclusion, but even if it were, there is a trade-off between short-term pain and long-term gain. An increase in consumer and investor confidence and a shortening of unemployment lines will in the medium term cancel out any short-term dip in consumption.

These efforts will inevitably bear fruit, but it will not come overnight. This time, we will have to take the longer view. For too long we have forsaken long-term gains for short-term gratification with the result we all know.

The members of the eurozone have and will continue to collectively provide conditional financial assistance to those countries that find themselves cut off from capital markets, buying them time to put their public finances on a sustainable footing and to improve their competitiveness. There are risks to this strategy. Yet the alternative, by allowing the crisis to infect the eurozone as a whole and threaten the euro, would be riskier still.

When markets become the bearer of bad news, there is a natural tendency to take aim at the messenger. The truth is that governments need the disciplining forces of markets. But markets, like the human beings they are made of, do not always act rationally. In uncertain times and absent a robust regulatory framework, their volatility can exacerbate a crisis.

There is a broad consensus now that more robust, crisis-resistant markets need strong regulation. But the process is laborious and momentum in the Group of 20 appears to be fading. In this context, it may become necessary for key countries to move ahead unilaterally in specific areas. Last year Germany introduced a limited yet controversial ban on naked short-selling. Today I would see the introduction of a financial transaction tax in Europe as another case for such a “pacemaker-approach” by a few, important pioneers.

One central lesson of the financial crisis was that markets could only function properly if risk-taking were not divorced from liability. The loosening of this bond was a central factor of the crisis. Likewise, the eurozone crisis unfolded after a decade during which economies with markedly different and, indeed, diverging fiscal profiles and competitiveness were all able to borrow at close to benchmark rates.

Hence my unease when some politicians and economists call on the eurozone to take a sudden leap into fiscal union and joint liability. Not only would such a step fail to durably solve the crisis by addressing only its most superficial symptoms, but it could make it worse in the medium term by removing a key incentive for the weaker members to forge ahead with much-needed reforms. It would also go against the very nature of European integration.

Europe has always moved forward one step at a time and it should continue to do so. This does not mean that fiscal policy in the eurozone should not gradually become more centralised. It should, as long as this process is legitimised by a strong democratic mandate. But strengthening the architecture of the eurozone will need time. It may need profound treaty changes, which will not happen overnight. But the direction is not disputed, and the determination of all member states to defend the common European currency is granted.