PIMCO's McCulley On V's, U's and W's
We appreciate PIMCO's conceptual insights, however at this point it is now clear that the Chairman will keep interest rates at 0, in perpetuity or until the biggest stock market bubblr in the history of western markets finally implodes, whichever comes first (presumably the latter). In the meantime, it is time to finally order that Dow at 36,000 book you have been secretly eyeing. There is no risk, there is no inflation, there is no massive dementia crawling on all fours, chasing the carrot waved around by Goldman Sachs, around the corridors of the Marriner Eccles building: Bernanke said so, and Bernanke is never wrong. Furthermore, Bernanke will succeed with central planning where everyone failed.
The Uncomfortable Dance Between V’ers and U’ers
world, in investment committee meetings and on trading floors (and at
the Fed!), one question dominates discussion and debate:
How can it be that risk assets,
notably common stocks, have been roaring ahead, presumably discounting
a robust V-shaped economic recovery, while Treasury bonds are holding
their own with a bull flattening bias, presumably rejecting the
V-shaped hypothesis, instead discounting a U-shaped recovery as the
base case, with a W-shaped outcome the dominant risk case?
One of these markets is wrong, it is
commonly argued; the only question is which one. In the longer run, we
here at PIMCO certainly agree, siding with the U-shaped camp. But that
does not necessarily mean that one of the markets must necessarily
capitulate to the other in the months immediately ahead. And the
unifying explanation is simple: The Fed is committed to maintaining
“exceptionally low levels of the Federal funds rate for an extended
period.” The Fed is also openly committed to being extraordinarily
careful in reducing its elevated balance sheet, implying that a very
elevated level of excess reserves/liquidity will be sloshing through
the financial system for a long time.
To be sure, the Fed has been
communicating repeatedly, with academic flourish, the technical details
of its ability to eventually hike its policy rate, even with a bloated
balance sheet and massive excess reserves:
- Hiking, via its newly-granted
powers of last fall, the interest rate it pays on excess reserves
(IOER), which should act as a floor for the more visible Fed funds
- Reducing excess reserves
directly through massive reverse repurchases, including using tri-party
repo arrangements, effectively augmenting the universe of
counterparties beyond the capital-constrained primary dealers, to
include liquidity flush end users.
But the Fed has also gone out of its way
to communicate that discussions are about the “how” of its exit
strategies, not a signal as to the “when,” in the phraseology of the Financial Times’
Krishna Guha. Thus, not only is the price of Fed liquidity set to hover
near zero for an extended period, but the sheer volume of Fed-supplied
liquidity is also likely to be flush for an extended period. In turn,
as long as the Fed retains ownership of its longer-dated assets,
sterilizing their liquidity effect via reverse repos, the Fed will
remain not just the arbitrator of the Fed funds rate, but will also be
a holder of market risk previously borne by the private market.
Thus, while rich risk asset prices can
certainly be viewed as a consensus expectation for a strong recovery,
such lofty valuations can also be viewed as a consensus expectation
about the Fed’s commitment to erring on the side of being too late,
rather than too early, in starting a Fed funds tightening cycle.
Indeed, one could actually be agnostic, even antagonistic, about a
big-V recovery and still be favorably disposed to risk assets, in the short run.
Historically, what pounds risk asset prices is either a recession or
unexpected Fed tightening; or worse, both. Right now, it is hard to get
wrapped around the axle about recession, since we’ve just had one,
which might not even be over.
To be sure, the economy could have
back-to-back recessions, as was the case in 1980 and 1981–1982. But
that episode was associated with massive Fed tightening in 1979–1980,
followed by massive easing in the middle months of 1980, followed by
massive Fed tightening yet again, as Paul Volcker waged a two-step war
against inflation. Presently, the Fed is openly declaring that it will
maintain near-zero short rates for an “extended period,” in the context
of inflation below its implicit target.
Thus, as long as economic recovery
appears underway, even if stoked primarily by (1) policy stimulus and
(2) a turn in the inventory cycle, there is no urgent reason for
investors to run from risk assets. Put differently, investors can be
agnostic about (3) the strength of private demand growth until the one-off forces supporting growth exhaust themselves, as long as they don’t have fear of Fed tightening.
In turn, a bull flattening bias of the
Treasury curve, with longer-dated rates falling toward the near-zero
Fed policy rate, can be viewed as a consensus view that the level
of the output/unemployment gap plumbed during the recession is so great
that disinflationary forces in goods and services prices, and perhaps
even more important, wages, will be in train, even if growth surprises
on the upside. Accordingly, Treasury players, like their equity
brethren, need not fear the Fed, as there is no economic rationale for
an early turn to a tightening process.
Thus, both rich risk markets and the
lofty Treasury market can be viewed as rational in their own spheres,
even if they are seemingly irrational when compared to each other. The
tie that binds them, that allows them to co-exist, need not be a common
view regarding the prospective strength of the recovery, but rather a
common view as to the Fed’s friendly intent and reaction function.
But, you retort, this can’t go on forever
– at some point, risk assets will have to capitulate to reality if the
big-V does not unfold, no? Yes, but it is not quite as simple as that.
Without the big-V, Treasuries will tend to bull flatten, soothed by
rational expectations of an extended period of the Fed funds rate
pinched against zero. In turn, such a path for Treasuries would provide
valuation support for risk assets. How so?
All risk asset prices are analytically
the Net Present Value of expected growth in cash flows, discounted by
the appropriate-duration risk-free rate plus a risk premium. Thus,
expectations of a friendly-for-longer Fed policy would be supportive of
risk assets, as they (1) tend to pull down long-duration risk-free
rates, while also (2) pulling down the market-required risk premium
(which moves inversely with investors’ animal-spirited risk appetite,
which moves inversely with fears of Fed tightening).
To be sure, this fundamental valuation
framework – known as the Gordon Model – also implies that in real
terms, the positive P/E effect of low long-term risk-free rates is
moderated to the extent that the non-big-V scenario also implies lower
growth in real profits. There are no free lunches. But since real
long-term Treasury rates trade in real time, while “new-normalized”
real growth rates are uncertain, subject to animal-spirited conjecture,
friendly real long-term interest rates will tend to dominate the
formulation of P/Es.
Thus, ironically, the biggest
intermediate-term risk for risk assets is not that the big-V doesn’t
unfold, but that it does, inciting the Fed to bring the extended period
of a near-zero policy rate to a close. But again, you retort, doesn’t
that imply that in the absence of the big-V, risk asset prices could
levitate into bubble valuation space? Yes, it does mean that. And that
is a very, very uncomfortable proposition for those grounded in
fundamental analysis, as I am.
#003366;">The Efficient Market Hypothesis in Retreat
such discomfort is likely to be an enduring fact of life on the journey
to the New Normal. Recall, a core tenet of “fundamental analysis” is
the efficient market hypothesis, which presupposes that rational
investors will, given time, always pull nominal – and real – values
back toward their “fundamentally justified” levels. Yes, there will be
noise in real time, the hypothesis allows, but it also holds that
neither irrational gloom nor irrational exuberance will go to extremes:
momentum players will, in the end, always be trumped by value players,
before momentum players have done any great harm. Market failures,
capitalism’s equivalent of estrangement in families, are simply assumed
away. They are not supposed to happen; therefore, they won’t.
But they do. Such was the case with the Forward Minsky Journey1
that unfolded alongside the Great Moderation for twenty-five years
after the recession that ended in 1982. Ever-increasing private sector
leverage was applied on the presumption that the Great Moderation was a
perpetual motion machine, rather than an epoch that would eventually
implode on its own debt-deflationary pathologies, as Minsky envisaged.
Nominal asset prices, notably property, became bubbly-unmoored from
“fundamental” value, yet both borrowers and lenders were willing to
“validate” those unmoored levels with legally
binding nominal debt obligations – hedge debt units followed by
speculative debt units followed by Ponzi debt units.
It all blew up, of course, with not just
trillions of net worth destroyed, but also the wisdom of religious
belief in the efficient market hypothesis. Thus, as we look forward, a
huge amount of humility is warranted in projecting asset returns on the
basis of tight bands around what “fundamentals” suggest constitute fair
value. Yes, there is no substitute for fundamental analysis; it remains
at the core of investment management. But asset values can stray far,
very far, away from their putative “fair” levels, much, much further
than was the case during the middle-aged years of the Great Moderation.
The efficient market hypothesis may not be dead, but it is most
assuredly in retreat.
#003366;">Behavioral Economics and Finance in Ascendency
contrast, the insights of behavioral economics and finance are very
much in ascendency. This personally brings me great satisfaction, as
both of my macroeconomic heroes, John Maynard Keynes and Hyman Minsky,
were quintessentially behavioral economists, starting with the
proposition that developing a theory as to how the world does work is much more productive than developing a theory as to how the world should
work. That’s not to suggest that there is not room for both types of
theorizing. Indeed, one without the other is silliness, and both Keynes
and Minsky did both.
And the envelope between those two modes of theorizing is the fact that the future is inherently uncertain.
That might not sound like a profound assertion, and it isn’t. We all
intuitively know that. But the efficient market hypothesis conveniently
assumes away that reality, in what is technically called the “ergodic
axiom” – that past and current relationships between variables are
reliable predictors of future relationships between variables. This
assumption holds in astronomy, which is why astronomers can forecast
with incredible accuracy when the next lunar eclipse will unfold.
This assumption also holds in calculating
the risk of any given hand in a defined card game – there are 52 cards
in the deck and it is quite possible to calculate with great precision
the odds of winning the game, such as Blackjack or Poker. That doesn’t
mean that you can know with precision whether you will win, simply that
you can forecast the odds of any given player winning, given the cards
in their hands and other players’ hands, in the context of what cards
are left in the deck. Indeed, I find it amusing when television shows
broadcasting such games flash up the odds of any player winning after
each card is dealt. There is risk, but not uncertainty – we know there
are 52 cards in the game and we know what constitutes a winning hand.
The ergodic axiom holds.
In investment markets, however, the
ergodic axiom doesn’t hold, even though it is implicitly assumed in the
efficient market hypothesis (but ironically, not in the legal
disclaimers of all investment presentations, which state that past
results are not necessarily indicative of future results!). In
investment markets, genuine uncertainty exists: We can’t assume that we
know how many cards will be in the future deck or what will constitute
a winning hand. That’s not risk, but rather uncertainty.
And how do we deal with it? As Keynes explained in Chapter 12 of the General Theory, we deal with it by falling back on convention, or rules of thumb. In his words:
“Certain classes of investment are
governed by the average expectation of those who deal on the Stock
Exchange as revealed in the price of shares, rather than by the genuine
expectations of the professional entrepreneur. How then are these
highly significant daily, even hourly, revaluations of existing
investments carried out in practice?
In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention.
The essence of this convention – though it does not, of course, work
out so simply – lies in assuming that the existing state of affairs
will continue indefinitely, except in so far as we have specific
reasons to expect a change. This does not really mean that we really
believe that the existing state of affairs will continue indefinitely.
We know from extensive experience that this is most unlikely.
The actual results of an investment
over a long term of years very seldom agree with the initial
expectation. Nor can we rationalize our behavior by arguing that to a
man in a state of ignorance; errors in either direction are equally
probable, so that there remains a mean actuarial expectation based on
equi-probabilities. For it can easily be shown that the assumption of
arithmetically equal probabilities based on a state of ignorance leads
us to absurdities.
We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in
relation to our existing knowledge of the facts which will influence
the yield of the investment, and that it will only change in proportion
to changes in this knowledge; though, philosophically speaking, it
cannot be uniquely correct, since our existing knowledge does not
provide a sufficient basis for a calculated mathematically expectation.
In point of fact, all sorts of considerations enter into market
valuations which are in no way relevant to the prospective yield.
Nevertheless the above conventional
method of calculation will be compatible with a considerable measure of
continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.
For if there exist organized investment markets and if we can rely on
maintenance of the convention, an investor can legitimately encourage
himself with the idea that the only risk he runs is that of a genuine
change in the news over the near future, as to the likelihood
of which he can attempt to form his own judgment, and which is unlikely
to be large. For, assuming that the convention holds good, it is only
these changes which can affect the value of his investment, and he need
not lose his sleep merely because he has not any notion what his
investment will be worth ten years hence.
Thus investment becomes reasonably
‘safe’ for the individual investor over short periods, and hence over a
succession of short periods however many, if he can fairly rely on
there being no breakdown in the convention and on his therefore having
an opportunity to revise his judgment and change his investment, before
there has been time for much to happen. Investments which are ‘fixed’
for the community are thus made ‘liquid’ for the individual.”
Those few paragraphs, my friends, are the
foundation of modern behavioral economics and finance. Human beings,
including investment managers, face both risk and uncertainty, and deal
with uncertainty by resorting to conventions, notably that yesterday is
the best predictor of today, and that today is the best predictor of
tomorrow. George Soros calls it reflexivity.
But when that comforting convention
is overwhelmed by a new reality, all hell breaks loose. Uncertainty can
no longer be simply assumed away. And when that happens, human beings
tend to disengage, eschewing investment in favor of building up cash
reserves. And if this proclivity becomes both widespread and profound,
we find ourselves in Keynes’ Liquidity Trap – there is plenty of money
around, but risk-averse investors, infected with uncertainty, refuse to
“put it to work” – on either Wall Street or Main Street. Such was the
case a year ago, following the fateful decision to let Lehman Brothers
fall into a watery grave.
The way out of that lacuna was for (1)
the fiscal authority to step into the breech and borrow money from the
newly risk-averse, putting it to work to recapitalize the banking
system and on Main Street in support of aggregate demand; and for (2)
the monetary authority to drive the interest rate on money to zero and
promise to hold it there for an extended period, making holding cash
very painful while reducing uncertainty, re-exciting investors’ risk
and monetary authorities around the world have done exactly that over
the last year, and since April, in the words of the G-20, it has
“worked.” Well, at least on Wall Street, where risk appetite is in full
bloom. Whether or not that renewed risk appetite finds its way to Main
Street is the key question beyond the immediate horizon.
We here at PIMCO think it will, but only
in a muted way, not a big-V way. We also recognize, however, that
markets can stray quite far from “fundamentally justified” values, if
there is a strong belief in a friendly convention, one with staying
power. And right now, that convention is a strong belief in a very
friendly Fed for an extended period. Thus, the strongest case for risk
assets holding their ground is, ironically, that the big-V doesn’t
unfold, because if it were to unfold, it would break the comforting
conventional presumption of an extended friendly Fed.
Simply put, big-V’ers should be wary of
what they wish for. U’ers, meanwhile, must be mindful of just how
bubbly risk asset valuations can get, as long as non-big-V data unfold,
keeping the Fed friendly. But that’s no reason, in our view, to chase
risk assets from currently lofty valuations. To the contrary, the time
has come to begin paring exposure to risk assets, and if their prices
continue to rise, paring at an accelerated pace.
October 22, 2009