Friday, December 11, 2015

Real economic growth is what moves equity prices.

Tom Clougherty, at Alt-M, builds on George Selgin's great post on the Fed's peculiar behavior in 2007 and 2008, where they sterilized their emergency lending activities by selling treasuries, which had the effect of creating tight monetary conditions.  He references this interesting piece at Cato, from Daniel Thornton, who was an advisor at the Federal Reserve Bank of St. Louis before he retired in 2014.

But, as much as I applaud how each of those pieces pushes back against both the idea that the Fed was accommodative in 2007 and 2008 and the idea that QE operated through the reduction of long term interest rates, I still see a tendency to fall back into some of the same assumptions.  From Thornton's piece:
If the Fed distorted asset prices between June and December 2003, one can only imagine what the FOMC’s zero-interest-rate policy over the period December 2008 to the present has done. And, of course, Kohn is correct: the intention of the policy is to distort asset prices in an attempt to reduce long-term yields. But such actions produce unintended distortions: a strong and persistent rise in equity prices, a marked change in the behavior of commodity prices, a resurgence in house prices and residential construction beyond what is warranted by economic fundamentals, and excessive risk taking, even by those who are least well situated to take it. These are the unintended consequences of QE and the FOMC’s zero-interest-rate policy.
I have written extensively in my ongoing series about how home prices were not high in 2003 because credit or artificially low short term rates had pushed them above levels justified by fundamental valuations.  I am pleased to see momentum in opinions about monetary policy that points out the hawkish policy decisions they were making before and during the financial crisis.  But, the idea that home prices were unjustified is so powerful and so palpable, that even in the midst of these questions, questioners tend to accept whatever assumptions are required to conclude that the housing and equity markets were overvalued because of monetary policy.  Thornton, for instance, in his article, sharply questions the idea that low long interest rates reflect expectations of loose policy that creates persistently low short term rates.  I agree with him that that model seems incoherent.  But, when it comes to explaining rising equity or housing markets, he seems surprisingly willing to accept that model.

I understand that this is difficult.  The idea of a housing bubble seems unassailable.  To attempt to argue against it would be reputationally risky - certainly too risky to entertain the idea in a sort of back-of-the-envelope initial line of questioning.  I believe that the reason I might get to be a voice in popularizing the idea that there wasn't a bubble may be because I have done such a smashing job of avoiding having any reputation to ruin.

So, in a way, the intellectual barriers to my narrative are strong.  Yet, on the other hand, Clougherty, Selgin, and Thornton have already accepted the fundamentals of my narrative in other contexts, so they don't need to be convinced to change their fundamental beliefs; they just need to be convinced to apply them more thoroughly.

I have plenty of posts in the housing series that go into the details of housing valuations.  In this post, I want to mention equities, because the same sort of assumptions seem to be feeding ideas about equities.  Most observers seem to attribute rising equity prices to monetary accommodation, credit expansion, and "reaching for yield".

Most analysis of equity pricing behavior uses price movements or total returns over a period of time.  I think this conflates income, capital gains, expected returns, and real shocks, and leads to a lot of confused analysis.  I believe that if we look only at expected (or "required") returns on equities, we find a surprisingly stable real implied yield on corporate equity over long periods of time.  Aswath Damodaran at NYU has developed an extensive data set of variables that allow us to analyze equity values back to 1960.

The Capital Asset Pricing Model gives us the following very simple equation for valuing equities:
In English, the required expected return on an equity is equal to the risk free return plus an equity risk premium.  For individual stocks, this premium would scale with "beta", which is the sensitivity of that stock to volatility of the broader market.  The market, by definition, has a beta of 1, and I generally prefer using 10 year treasury rates as the risk-free rate that is most relevant to equity values.  So, for the market as a whole, expected returns are simply the sum of the risk-free rate and the equity risk premium.

For returns on bonds, all we need to know is the coupon, because cash flows are fixed and expected inflation is paid as a portion of the interest rate. (A 5% bond might be earning, say, a 2% real yield plus a 3% inflation expectation.) But, equities (and homes) are real assets, so cash flows rise over time with inflation or real growth.  This means that to estimate the equity risk premium, we need to estimate the expected growth in cash flows.  For equities over the long term, this is the expected growth of net profits.

One problem we have with this question is that we have only had market rates on real bonds for about 20 years, so before the late 1990s, it is very difficult to separate inflation expectations from real growth expectations.  But, to the extent that we have data, I interpret Damodaran's work to be turning the CAPM on its head.  Real expected returns seem to be very stable.  Most of the changes in equity prices come from real shocks to corporate earnings and changes in growth expectations.

This means that "reaching for yield" does not describe market behavior.  And it means that if accommodative monetary policy is pushing market prices up, this is probably a sign that policy had been too tight, and accommodation is improving the broad prospects of the real economy.

Here is a graph comparing the required returns to equity (ERP + risk free rate) to treasury bond rates since 1961.  There are basically two eras here.  Before the mid-1990s, real rates fluctuated somewhat, but they were swamped by fluctuations in inflation.  This makes it appear as if ERP required returns on equities and risk free rates move together.  But this is confusion.  Equities (and homes) are real assets but treasury bonds are nominal assets.  Required returns to both are sensitive to inflation.  But, if expected real returns to equities are fairly constant over time, this means that when risk free rates rise, ERP would tend to fall at a similar scale.  When fluctuations in inflation are large, the positive relationship regarding inflation covers up this inverse relationship regarding real returns.

Since the late 1990s, we do have markets for real risk free rates.  But, inflation had settled down enough by the late 1980s that we can get a pretty good estimate of real rates back to at least 1990, simply by subtracting inflation from nominal rates.  Here I have used the GDP deflator as the inflation proxy.  So, we have the era before 1990 where fluctuations in inflation dominated, and we have the era since 1990, where inflation has been fairly stable and real risk free rates have dominated.  This means that during this period, if required total returns to equity are, indeed, stable, we should see a negative relationship between ERP and risk free rates.

Here is a scatterplot of ERP and 10 year risk free rates (minus inflation) since 1989, together with the scatterplot of ERP with the market rate on real 30 year bonds since 1999.  Here we see this strong inverse relationship.

Since 2008, Damodaran has estimated ERP on a monthly scale.  Here is a graph of monthly total required returns on equities (risk free rate + ERP).  After the disastrous events of September 2008, there was a brief bump in required returns to about 10%, which subsided back to the stable 8% nominal level by the summer of 2009.  So, the brief deep plunge of equity values that bottomed out in March 2009 was part of a brief shock away from the typical required level of returns.  But, later in 2009, required returns simply moved back to their normal range, and none of the subsequent gains had anything to do with "reaching for yield".  They have mostly reflected real recovery of nominal spending and corporate earnings.

Here are scatterplots, using market rates on TIPS bonds, of monthly ERP since September 2009, compared to both 10 year and 30 year real interest rates.  Again, we see a strong inverse relationship.

This suggests that changes in long term real interest rates have little or no effect on equity prices.  The ramifications of this are stark.  This means that gains in equity markets should be taken as a sign of optimal monetary policy.  To the extent that policy makers are calling on monetary policy to tighten up in order to rein in "overheated" asset markets, they are literally calling for monetary policy to tighten up until it has damaged broad, real economic growth.  Loose money or low rates do not cause equity markets to "overheat".  Even if monetary policy is inflationary, this will not lead to persistent increases in equity values, because the stable required returns on equities are real returns, not nominal returns, so equity prices should be unaffected by inflation expectations in the medium to long term.  And, clearly, when monetary policy was overly inflationary in the 1970s, stock prices were tempered.

This also speaks against the idea that low interest rates are related to leveraged corporate risk-taking.  If corporate assets have a stable discount rate, then low real interest rates should be taken as a much stronger signal of risk aversion - not risk-taking.  And, I do believe that this error in interpretation is one of the elements that led to the misidentification of high home prices with speculative over-reach.

Home prices do behave differently than equities, though.  Cash flows and discount rates on homes are more similar to real long term bonds, so home values can move up when long term real interest rates are low.  In my next post, I will return to that topic, with more of my analysis of how even that effect would be mitigated in the absence of the supply constraints which were the primary cause of home price appreciation in the 2000s.

PS:  These are the scatterplots above, using 1 year or 1 month changes in ERP and real risk free rates unstead of levels.  ERP is a necessarily noisy estimate, so first differences have low correlations, but the coefficients are still surprisingly strong.

PPS. On second thought, these scatterplots of the first differences may be adding more heat than light, since inertia in equity prices, and earnings and growth estimates, would naturally lead to an inverse relationship in the short term.


  1. Kevin, Ben Bernanke said that hot foreign money fueled the housing bubble. I think securitization did as well as it kept potential lending strong as banks could get rid of the securities and it freed up their balance sheets so more easy loans could be made. However, something happened, as Scott Sumner says you said, to make some nations vulnerable to a crash. What do you think happened? I think hot money went away somehow. I am not an economist, as I have told Scott over and over. But I annoy him and won't try to annoy you. :)

    1. I think the country came to a consensus that we had to have a housing bust. Policies emerged to ensure that it happened. The Alt-M posts I link to here get at part of the story, I think.

  2. Yes, about reputations, of one has sullied one's own, there is great latitude to tell it like it is, thereafter.

    Ergo, I say the following is the worst conflation of misrepresentations I have seen in one place in a long time, and a sure sign the tight-money crowd has lost its marbles:

    "If the Fed distorted asset prices between June and December 2003, one can only imagine what the FOMC’s zero-interest-rate policy over the period December 2008 to the present has done. And, of course, Kohn is correct: the intention of the policy is to distort asset prices in an attempt to reduce long-term yields. But such actions produce unintended distortions: a strong and persistent rise in equity prices, a marked change in the behavior of commodity prices, a resurgence in house prices and residential construction beyond what is warranted by economic fundamentals, and excessive risk taking, even by those who are least well situated to take it. These are the unintended consequences of QE and the FOMC’s zero-interest-rate policy."

    Where to begin?

    1. If low interest rates and QE lead to asset inflation, how to explain the 1990s, when PE's were much higher on the S&P 500? Or the 1960s?

    2. What has happened to the S&P 500 in the last year, when interest rates have been at historic nominal lows?

    3. "A marked change in commodity prices"? What even does this mean? There were no oil boom-busts before QE? Gold did not gyrate in the 1980s? This is so feeble---the tight money crowd forever said "loose money is seen in higher commodity prices." So, with thug states controlling oil, and China and India industrializing, and Indian and China middle classes buying gold for jewelry, and ethanol boosting corn prices, the tight-money fanatics had a great run. But caught up with demand. China's pace of industrialization slowed. Corn prices leveled. Now we seem commodities prices falling for years on end. Copper is back to 2005 price levels. So the tight-money crowd went Twilight Zone and says U.S. Federal Reserve policy is causing commodities prices to act funny. Egads, this is really weak. Gee, and I thought supply and demand played a role.

    3. "A resurgence in house prices." Yeah, funny about that. We have ubiquitous zoning in US cities, limiting the supply. The economy barely recovers, and prices for limited stock gets bid up. That's monetary policy for you. BTW, house prices did not judge much in the Dakotas and Texas through the oil boom. What does that tell you?

    4. "Residential construction beyond what is warranted." Based on demographics, or what some gnomes in the Fed think is warranted? Is this a joke? The US has been under-building for years. Is this under building of housing visible in current-day apartment markets? How about housing rents in NYC, SF, L.A.--or anywhere along the West Coast for that matter. Boston?

    5. "Excessive risk-taking." Now, this brings up "The Fed Should Be Mommy." You see, the free-market system is an inherently unstable platform on straw-stilts, and if ever interest rates go too low, the whole economy collapses. That is why state-run socialism, with the prudent stable allocation of capital, is better than free-markets when interest rates get too low :0.

    The tight-money crowd has been discredited, but zombie economics never dies. And how can it? The zombie crowd is entrenched in central banks globally, where they are protected from markets, and robust intellectual discourse.

    1. You know, I hadn't gotten that worked up about it, but reading your comment, I probably should have. You're right. One of the most damaging social currents now might be the populist Austrianism that has infected the right and created a bipartisan notion that markets easily become unstable.
      It's funny that so many hawks see the Fed as a statist institution and their inflation phobia as a liberty issue, because they are the ones who defend their position by claiming that they know prices better than markets do.

      On reputation, I think the tricky thing is that we direct ourselves subconsciously with little direct coercion. We have a natural intuition for knowing what our community accepts as ideas or villains. Human community would dissolve without this intuition. For personal development, it is important to find incremental challenges to our preconceptions. But, the problem is that just a few steps of change down any path of substance creates an awkwardness with our those we affiliate with, who aren't going to naturally follow us along each new conclusion that we reach. So all of us spend most of our mental effort going down paths we know are safe. We really don't have a choice. Going it alone is really lonely, and we are bound to end up getting things at least as wrong as the wider community does, even if we can easily identify some of their errors. So, I don't mean to be insulting when I mention reputations. I'm not trying to cast aspersions as much as I'm trying to find a way to productively consider human nature and how we tend to grapple with our tenuous grasp of truth.

  3. Oh well, reputation, repu-shmation.

    One more thing: Thornton says the Fed held interest rates artificially low after 2008. Of course, there are many arguments that interest rates should have been negative after 2008 and maybe even now, but zero-bound prevents that. It is hard to know what is "artificial" on the low or high side.

    But the odd part Thornton's commentary is that almost no one says the Fed can do much about long-term rates. Institutions do not fork over money for 10 years based on what the Fed says or does in the short-run.

    So, 10-year Treasuries are now selling for 2% and pennies. If long-term rates are 2.00%, then what "should" be short-term rates? My guess would be close to zero anyway. If you had a college quiz, and the test asked, "If Nation Y has 10-year government bond rate of 2.00%, what do you expect the overnight rate to be?" What would be the answer? I mean, somewhere around zero. "Really, really low, lower than a morsel of snow," would be my answer.

    You can see why I did not get into Harvard.

    Thornton should seems to be on squishy ground.

    1. Yes. Exactly.

      Here's an example of this phenomenon. The story of the Golden Calf in the old testament could be accurately described thusly: it's The Grinch Who Stole Christmas if the Grinch went down and hacked a bunch of Whos to death at the end. For years I read that story and managed to ignore the moral issue of mass murder to find some other moral lesson. Nobody had to tell me to ignore the mass murder. I understood that intuitively. If I had noticed, others would have come up with weak but plausible reasons to ignore it. And it is a popular story. Even non-Christians reference that story. And we all somehow recognize that one of the lessons we will not take from it is that Moses committed genocide against his own people.

      Or another example. Recently Trump has gathered a lot of ire for policies that have been compared to the turning away of Jewish refugees in WW II and the internment of Japanese Americans. This is why it would be unconcionable to vote for him. But wouldn't it follow that, however bad Trump is, FDR is that much worse for having actually implemented those policies? Our intuitions about affiliations are so strong that few will even attend to this question. And if they are forced to, they will address it with weak but plausible responses. Nobody is going to come away from the rhetoric around Trump's candidacy with the lesson that FDR was worse than they had thought.

      All of us have POVs that are held up by weak but plausible pillars of support. One of the easiest things to do as an individual is to go around kicking out the pillars of POVs we don't affiliate with. It's easy to kick out our own pillars if we allow ourselves to. But by doing that we actually make ourselves seem less legitimate. Explaining that Moses committed genocide doesn't tend to lead others to think, "Oh, this is a reasonable fellow. I will update my priors based on his insights." They will more likely think you are a troublemaker or crazy. In a way, the weaker the pillar is, the crazier you will seem for kicking it over.

      If I get a chance to present the housing story to a wider audience, this is the dilemma I face. I think I can address a lot of it just by being empirically careful. I'm kicking down several pillars at once, and I'm undercutting POVs across the political spectrum. This makes the story more thorough, but it makes it long. How do I keep readers engaged long enough to see all the pillars fall? And how much do I interrupt the story to address all of the little stop-gap pillars that will be put up along the way? (Like claiming that NYC and SF are geographically constrained or that falling rates signify aggressive accommodation)

      If I can get this published, the reaction to it will be interesting. The variance of possible outcomes is high.

    2. Looking at this problem some more, if I get this into book form, if I begin the book with strong arguments that the "bubble" was caused by supply constraints, I expect many readers to look for ways to minimize the issue by recalling that, regardless of the supply issue, we know that banks were being reckless. I think I can kick out that pillar, too, but that issue is a little more subtle and complicated. Understanding the supply issue helps to make kicking out the reckless bank pillar more plausible, but taken one at a time, defending my supply argument by promising that I will address the banking issue later will make me seem less credible to someone who feels strongly about the malfeasance of banks, and who has actual, factual anecdotes to draw on. Setting up the story to pull readers through without triggering reactions of disbelief will be difficult, I think.

    3. And, it's not just an empirical challenge. Starting down the path of understanding the supply problem should eventually lead to a conclusion that bankers maybe aren't quite the villains they have been made out to be. Do I settle for getting the supply issue accepted by letting the implications about bankers remain unaddressed, so that readers accept my findings about supply while retaining their feelings toward bankers? Or do I press that implication, in which case readers might defend their conceptions about bankers by looking for ways to doubt my supply story?

    4. Did you ever see this chart, Kevin? It shows that the banks indeed took over from government mortgage pools and the GSE's and loaned out money to people who were not qualified to receive the loans. Ball don't lie, Kevin: And that bubble of private lending corresponds to the heyday of securitization and the rule of NY Fed president, Timothy Geithner, who was in on the process and refused to stop people like Henry Paulson from spreading bogus AAA rated MBSs to everyone on the planet. And they both got to be Treasury Secretary. Fancy that!

    5. You're assuming the conclusion. There is nothing in that chart about how qualified the borrowers were. This was one of the first surprising things I happened upon in my housing series. There was not a decline in borrower quality or debt service obligations during the run-up in home prices.

    6. So you see the massive increase of lending in 2004, 2005, 2006. So, that may have been limited to a few states, but the amount of loans were overwhelming. You live in the wrong city. You can't understand what really happened. As far as credit quality over the entire US, you may be onto something. But I taxi cab drivers were bragging they had multiple houses. And they could qualify you by liar loans. Liar means you don't tell the real deal about your finances. The massive lending only had to happen in a few states like Cali and Nevada and Arizona and Florida and Georgia. Also helocs were big and the only thing that saved some of these people was low interest rates and the Fed knows this.

    7. Sorry, I was thinking of Sumner. I don't know if you live in the wrong city. :) He does. He said banks are very regulated, but we know underwriting went out the window in the bubble.

    8. By the way, I think you do a good job in those articles of digging up some useful stuff. You lose me when you turn everything into a conspiracy, though.

      I think system-wide defaults are mostly the product of federal policy - monetary policy mostly. Given this, I think default risk should lie with the GSE's and they should be public entities. It's not a perfect world, but it's probably the best we can do in the current governance context.

      But, that being said, I wouldn't want to see public control of GSE's used to limit mortgage availability like it is now. Given the supply constraints, mortgages needed to be expanding in the 2000s. Limiting them is a policy that hurts lower income households and benefits wealthier households.

    9. I don't dispute some of your facts, but the price boom, the residential investment boom, the housing start boom, and the private securitization boom did not coincide. They are all separate issues, and I think it is important to keep them separate. The private securitization boom, for instance, happened after homeownership rates had peaked. They were not related to an expansion of the pool of owners, so as obvious as it seems that they must have been, there really isn't much evidence that they were associated with "predatory" lending to households that were previously not served.

      I think you have seen some of the same things I have seen, such as the fact that any effects of the CRA, etc., were much earlier. Most of the rise in homeownership happened well before home prices began to climb steeply in 2004-2005. It looks like you also noticed the sharp decline in GSE activity after 2003. You see a lot of the empirical stuff that I have been finding. I think our main difference is that you look at things as a conspiracy and I don't. I doubt we will bridge that gap through conversation.

      BTW, securitization had generally peaked as a proportion of mortgages outstanding by the time Clinton was president.

    10. So, Scott, if you could answer my email? :) I will continue to read your articles and hopefully comment from time to time. As you find things through the numbers that support my contentions I will cite you. Interesting you say securitization peaked by the time Clinton was president. Certainly it was securitization that makes sense of the chart of the Fed. If you can get rid of loans like crazy you can write more. Barry Ritholz, who I agreed with in the beginning has some great info on the abuse of MBSs.

  4. Kevin: keep at it. Your observations about housing markets are sound. By the way there is also a biblical prescription to build churches only out of unhewn stone. I presume this was to avoid architectural idolatry. I guess we can ignore that one!

    1. But Benjamin, if you run across a libertarian you can alwasy tell him that Sodom, according to Ezekiel, was destroyed because the rich society ignored the poor. The religion of self will say God is a thief. I even wrote an article on Business Insider before they took away my pen, talking about God being a thief for letting poor Hebrews eat from the corners of the farmers' fields. :)

  5. Gary-- Biblical texts, of course, pre-date free market capitalism.

    Much of the commentary of Jesus Christ is anti-capitalistic.

    Quoting scripture accurately is not a good idea in the here and now.

    1. So, Ben, you believe life without God is the New Normal. Don't count on it even if it looks that way. Everything reverts to the mean. :) BTW, I quoted Kevin in the article linked to my name that was just published on Talkmarkets. Share it and get the word out on Kevin. We don't agree on a lot but we do agree on a lot of things.