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Guest Post: Asset Valuation And Fed Policy: We've Seen This Movie Before

Tyler Durden's picture





 

Submitted by F.F.Wiley via Cyniconomics blog,

Everyone seems to have an opinion on asset valuation these days, even commentators who are normally quiet about such matters.  Some are seeing asset price bubbles, others are just on the lookout for bubbles, and still others wonder what all the fuss is about.

I’ll offer my two cents here – not to provide evidence of bubbles but to explain why I’d like to see the debate continue.

 

I’ll piggyback on Marginal Revolution’s Tyler Cowen, who reluctantly (it seems) entered the discussion this week with one of the more interesting and original contributions. Cowen shared this excerpt from Jesse Eisinger:

We are four years into the One Percent’s recovery. Now, we are in Round 3 of quantitative easing, the formal term for the Fed injecting hundreds of billions of dollars into the economy by purchasing longer-term assets like Treasury bonds and Fannie Mae and Freddie Mac paper. What’s that giving us? Overvalued stocks. Private equity firms racing to buy up Arizona real estate. Junk bond yields at record lows. Ratings shopping on structured financial products.

 

These are dangerous signs of prebubble activity.

And he concluded (among other points):

I don’t find most predictive discussions of bubbles interesting, while admitting that such claims often will prove in a manner correct ex post. “OK, the price fell, but was it a bubble? I mean was there froth, like on your Frappucino?” Or to quote Eisinger, it might also have been “dangerous signs of prebubble activity” (what happens between the “prebubble” and the “bubble”? The “nascent bubble”? The “midbubble”? The “midnonbubble”?)

 

Good news and improving conditions may well bring more bubbles or greater likelihood of bubbles, but that is hardly reason to dislike good news and improving conditions.

Cowen makes ten points in total, many of which are hard to disagree with. But I’ll take a stab at a different kind of message, or at least I’ll try to connect his and Eisinger’s thoughts while adding a few of my own.

First, most people would agree on the following:

  1. The Fed is intentionally pushing investors into risky assets, such as stocks and high yield bonds, in search of a wealth effect.
  2. Outside of the odd speech (such as Bernanke’s recent “we monitor a whole bunch of stuff” speech and Governor Jeremy Stein’s February talk about “overheating episodes” in credit markets), policymakers aren’t especially focused on fundamental values as a criterion for deciding how long and hard to push.
  3. Even if the Fed did include estimates of fundamental value in its “exit” criteria, that wouldn’t help anyone (who knows its track record) to sleep soundly at night.

It’s also hard to dispute that the Fed’s actions have unintended consequences. One of these is a change in the way that investors make decisions.

Assuming rational behavior while encouraging the opposite

Consider that policymakers reinforce the notion of a Bernanke “put” whenever they talk up the importance of a wealth effect or explain their reliance on the “portfolio balance channel” (Fedspeak for buying so much of a few assets that you push up the prices of all assets). When investors know that markets are being manipulated upward and risk may be truncated, they’re less likely to weigh asset prices against underlying fundamentals. On the contrary, they’ll probably chase returns.  They’ll rely more on natural instincts, which include biases and irrational behaviors that tend to be prevalent in bubbles.

It seems to me that discussions about bubbles are partly explained by these psychological factors. Yes, certain valuation indicators, such as yields on sub-investment grade bonds, have reached extremes that are catching our attention. But people may also be reacting to a whiff in the air that brings them back to the late 1990s and mid-2000s. And that whiff is related to less tangible factors – herding, anchoring, recency and optimism biases and so on – that economists who espouse the benefits of rational behavior shouldn’t be encouraging.

In any case, soaring asset prices and buoyant spirits aren’t reasons to “dislike good news and improving conditions,” as Cowen says. But it’s important to recognize when good news is linked to a greater likelihood of bad news in the future.

The Yin and Yang of Asset Prices

Consider that long-term investment performance is constrained by the same types of factors that constrain economic growth. For example, long-term earnings gains are linked to productivity gains, which are linked to technology and innovation. Therefore, earnings don’t outgrow the economy on a permanent basis, and nor do stock prices. Unusually large returns in any given year are counterbalanced by poor returns in some other year.

Howard Marks of Oaktree Capital Management put it like this in an article posted recently on ZeroHedge:

The better returns have been, the less likely they are – all other things being equal – to be good in the future. Generally speaking, I view an asset as having a certain quantum of return potential over its lifetime. The foundation for its return comes from its ability to produce cash flow … appreciation at a rate in excess of the cash flow growth accelerates into the present some appreciation that otherwise might have happened in the future … it isn’t just a windfall but also a warning sign.

Now, at this point some of you are shouting:

That’s not true, long-term unemployment causes workers’ skills to erode and weighs on the economy and productivity for years to come. By minimizing long-term unemployment, you can alter long-term growth rates of both economies and markets.

I don’t mean to diminish the relevance of this effect, known as “hysteresis.” It should certainly be considered.

But how do you know that today’s reduction in unemployment isn’t eventually offset by an increase once stimulus is removed or simply overwhelmed by natural economic forces? My answer is: “You don’t.”

There’s a sound argument that heavily manipulated economies and short-term policies can lead to more hysteresis over the long-term, not less. It’s certainly not hard to come up with examples of horrendous unemployment rates in some parts of the world being preceded by interventionist and short-term policies.

Here in the U.S., you only have look at the last two business cycles to see the long-term repercussions of the Fed’s penchant for allowing (encouraging?) asset price bubbles. Have we forgotten so quickly? It should be clear that bubbles contribute to economic volatility, which discourages hiring, and that’s not a good outcome for the long-term unemployed.

Where did all the long-term thinkers go?

It seems to me that trade-offs between short-term performance and long-term stability are largely ignored these days. At one time, politicians were best known for short-termism but central bankers were more balanced. Just look at former Fed Chairman Paul Volcker, who traded off a deep recession in 1981-82 for long-term benefits that lasted several decades.

Fast forward to today, and the policy approach is completely different. As trade-offs go, we often hear about inflation and unemployment, which is understandable considering the Fed’s dual mandate. But policies are clearly linked to the present and immediate future. Today’s core inflation rate is compared to a 2% target, while today’s unemployment rate is judged against a recently established 6.5% threshold.

Financial stability and even asset valuation are mentioned (see the Bernanke and Stein speeches linked above), but only in vague terms and without connecting that part of the discussion to real policy decisions. Lip service, you might say.

And how about the moral hazard risks that the Fed continues to reinforce through policies that enrich large financial institutions above everyone else? Once again, we seem to hear only lip service.

It’s not far-fetched to conclude that the Fed would accept bubble risks at any price level for risky assets, as long as this approach fit their near-term inflation and unemployment targets and today’s data.

I’m reminded of a commencement speech delivered by Mike Burry, the hedge fund manager who predicted the financial crisis with remarkable precision. He offers the following suggestion to UCLA’s economics graduates:

Life is well and long enough for you to come to regret any activity or habit involving exchange of long-term risk for short-term benefit. This is what many if not most Americans did during the refinancing and consumption boom of [the] last decade. And it was what our government did in egging on the boom … Of course, when you encounter the opposite – the short-term risk exchanged for long-term benefit – consider hitting that button again and again.

As sensible as this advice sounds, policymakers seem determined to continue their short-term focus.

Is policymaking still stuck in the flawed “general equilibrium” framework?

It’s not hard to find explanations for short-termism – one only needs to look at our behavioral biases, such as those that I referenced above.  But we should also pin some blame on the “general equilibrium” models that underpin conventional macroeconomic theory, as I discussed here. Instead of recognizing the economy’s inherent cyclicality, conventional economists tend to focus on restoring their notion of equilibrium, while saying little about what comes next.

Recall that this was the mindset during the housing boom, when policymakers showed great confidence that we could achieve equilibrium through a combination of:

  • Low interest rates (the Fed Funds rate was held at 1% until mid-2004 and increased only gradually from there) to keep core inflation within a targeted range
  • The presumed efficiency of financial markets and rational behaviors of participants in those markets

Setting aside the details that core inflation wasn’t the right objective, our financial markets weren’t (and still aren’t) structured to be efficient, and consistently rational behavior is a pipe dream, history shows over and over that the idea of a stable equilibrium is deeply flawed. And don’t get me wrong, I’m no enemy of the free market competition that equilibrium theorists advocate. But the benefits of free markets happen to be paired with a natural cycle of expansion and contraction. Policies focused on the short-term tend to exacerbate that cycle, as we saw when decades of stabilization policies and moral hazard exploded in the Global Financial Crisis.

Maybe if macroeconomics were rooted in the reality of a perpetual cycle – where expansions eventually lead to recessions (stability breeds instability) and then back to expansions – we would see more economists and policymakers balancing near-term benefits against long-term costs.

Or, another way of saying the same thing is that mainstream economists should pay more attention to Austrians and others who’ve long rejected core assumptions that are consistently proven wrong.  (I recommend the Burry speech on this topic also, which you can pick up half way through to hear the fascinating story of his interactions with our economic and political elite and the reasoning behind his plea for mainstream economists to please check their premises.)

But in the absence of such an approach, it’s good to see commentators flagging the risks of bubbles alongside other risks to existing policies. (I discussed a few of them here.) And I hope the discussion continues. It shows that we can take a broader and more meaningful look at a policy framework that seems constrained by narrow and short-term concepts, such as core inflation targets, wealth effects and portfolio balance channels.

 


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Sun, 05/26/2013 - 16:10 | Link to Comment hungrydweller
hungrydweller's picture

When everyone is yelling "BUBBLES!" we're not there yet.  When more people start saying "Is it too late to get in?" then we're there.

Sun, 05/26/2013 - 16:30 | Link to Comment HedgeAccordingly
HedgeAccordingly's picture

The table has been set.. but inflation has not showed.... http://hedge.ly/xGa8XL 

Mon, 05/27/2013 - 08:59 | Link to Comment Zero Govt
Zero Govt's picture

when I say "AAPL $1,000" then you go short the exchanges

 

Mon, 05/27/2013 - 11:04 | Link to Comment auntiesocial
auntiesocial's picture

2 points for the pic alone... LOL. grab your ankles.

Sun, 05/26/2013 - 16:10 | Link to Comment buzzsaw99
buzzsaw99's picture

wordy, pointless, hackneyed

Sun, 05/26/2013 - 16:51 | Link to Comment PiltdownMan
PiltdownMan's picture

Tough call.

US house prices are BOOMING while mortgage purchase apps are flat and lumber is falling. Classic market disconnect. See here:

http://confoundedinterest.wordpress.com/2013/05/24/uh-oh-mortgage-rates-...

Mon, 05/27/2013 - 11:09 | Link to Comment auntiesocial
auntiesocial's picture

true story. this is a real conversation yeaterday from a real estate agent "selling' albeit pathetically to a customer within earshot of anyone willing to listen. 

1. the market is down. it's moving but it is not as good as 2005-2006. you are not going to get as much money for your home.

2. i can't keep inventory. every house i have sells. i normally have 6-8 listings at all times but right now i only have one. all the other ones sold with multiple offers...

3. i can't sell my own personal rental. i am upside down on it. i would sell it if i could...

insert lying bitch bitchslap

Sun, 05/26/2013 - 16:16 | Link to Comment Tulpa
Tulpa's picture

Americans have been trained to think in the short-term, and even more importantly elections happen in the short term.  That's the problem.

Imagine Ron Paul (or insert your favorite politician if you don't like him) became president and set about fixing the myriads of problems in our fiscal/monetary/economic policies.  The short term pain would be humungous.  20% unemployment is a possibility, Dow 3000 is a possibility; you'd almost certainly see big banks fail and entire industries disappear overnight.  Just think about all the companies that would immediately go bankrupt, and all the individuals whose profession and expertise would become irrelevant, if the tax code were simplified.  Our policy landscape is incredibly stupid and getting stupider by the day it seems, but the entire system is predicated on that stupidity.

Of course in the long-term this would solve a lot of problems, but in the short-term the opposition party would use all this pain to score political points, and his own party in Congress would desert him to save their own skins in the elections two years later.  He'd be a lame duck within six months of taking office.  THAT's why nothing long-term is ever fixed.

Sun, 05/26/2013 - 16:29 | Link to Comment Jayda1850
Jayda1850's picture

That is the entire issue with government. it creates distortions, then cottage industries build up around these distortions thus making them permanent.

Sun, 05/26/2013 - 16:31 | Link to Comment orez65
orez65's picture

Too long ... blah blah ... for its substance.

This crisis doesn't have to do with short term vs long term.

It's just the Fed trying to keep the FIAT MONEY FRAUD from collapsing

99.9% of the politicians don't have a fucking clue of what's happening.

As long as Krugman keeps telling them that the solution is to spend more money they are "comfy".

Sun, 05/26/2013 - 16:45 | Link to Comment formadesika3
formadesika3's picture

Dictum that "when the music plays you have to dance" only applies to pros. DIYers can choose to sit it out.

Sun, 05/26/2013 - 17:50 | Link to Comment Headbanger
Headbanger's picture

That's all well and good. But I think what's both laughable and tragic as well is that all this talk is way too late now as the whole system is about to plunge off a cliff into the abyss. The next phase for all these experts will be the finger pointing and butt covering for sure!

Sun, 05/26/2013 - 20:01 | Link to Comment Jack Burton
Jack Burton's picture

Bernanke is an enemy of the people, HE is the kind Gulags were made for. Have a show trial and send him to the Gulag!

Mon, 05/27/2013 - 06:02 | Link to Comment AmCockerSpaniel
AmCockerSpaniel's picture

This is just a venue for us to vent on, and not to learn from.

Mon, 05/27/2013 - 09:21 | Link to Comment Zero Govt
Zero Govt's picture

stop talkin about Reggie the Rooster that way ...ZH is not just about Apple-haters jealous of the most successful, profitable and brilliant company to date or accountants contravining mountains of maths to call monopolist garbage Goofball and Microshite and not Apple the true Champions of the Consumer Age

what's Reggie Rooster, the sqwaking cock that never shuts up, got to learn huh?!

Let us hope his GOOG retainer is handsome before Farmer Tyler takes him down the wood shed and blows his f'n brains out

Mon, 05/27/2013 - 08:55 | Link to Comment Zero Govt
Zero Govt's picture

"...look at former Fed Chairman Paul Volcker, who traded off a deep recession in 1981-82 for long-term benefits that lasted several decades..."

Cough, choke, splutter!!!

Volcker caused the f'n recession, well deepened it by screwing already hard-pressed business and society with higher interest rates which was money-for-nothing for greedy scum bwankers who rode Volckers high interest, V-Max your banking profits, make the economy bleed and suffer kamakazi policy

you've never known a good central bwanker, they are one and all various shades of big shit anti-free market monopolist corruption

Tue, 05/28/2013 - 10:39 | Link to Comment rex-lacrymarum
rex-lacrymarum's picture

Just prior to coming across the final paragraph I was planning to recommend to the writer to read the Theory of Money and Credit as well as Human Action by Ludwig von Mises. Indeed, the market process cannot be satisfactorily captured by equilibrium theory. One characteristic of the market economy is unceasing change - it may move toward equilibrium, but can never reach it; by the time the supposed 'state of rest' is attained, fresh changes have already occcurred and the equilibrium state has already shifted again. The market is the resultant of the purposive actions and choices of men cooperating and adapting their conduct to continually changing conditions according to their individual value judgments. It is a process actuated by human volition and as such cannot be properly represented by systems of equations.

What happened in the development of economic theory was that the causal-realist approach by Austrian economists working in the tradition of Carl Menger (i.e., Böhm-Bawerk, von Mises, later Rothbard, and today Salerno, Hoppe, Block et al.) was abandoned in favor of Walrasian equilibrium theory and Marshallian price theory due to a number of (unfortunate) historical events. There was a big temporal gap between Böhm-Bawerk and von Mises that was filled by Friedrich Wieser in Vienna, whose torch was later carried by the idiosyncratic Schumpeter and more importantly, Hayek. Wieser's conception of price theory followed the Walrasian general equilibrium approach rather than Menger's causal-realist approach. It took until the publication of Mises' 'Nationalökonomie' in 1940 for Menger's and Böhm-Bawerk's trailblazing work to be revived, continued and more importantly, elaborated and perfected. Unfortunately Mises' brilliant rejection of the Walrasian general equilibrium approach and his successful elaboration of Menger's price theory and the full integration of value theory with monetary theory was dogged by bad luck. His Swiss publisher went bankrupt and due to the upheavals in Europe at the time it took another nine years for the work to be published in English. By that time competing theories had already conquered the economic mainstream. Interestingly, it was Hayek's influence at the LSE in the 1930s that weakened the resolve of the last Mengerian hold-out there, Lionel Robbins. 

The problem in a nutshell is that economic theorizing cannot be accomplished without creating models that abstract from reality. A static economy or an evenly rotating economy are useful mental tools when trying to elucidate economic laws. For instance, the evenly rotating economy in which nothing changes and in which all uncertainty about the future is removed (it is in short in 'perfect equilibrium') is extremely useful for investigating and elucidating capital theory. It would be a nigh impossible task to try to deal with the problems of capital theory without this aid. But the evently rotating economy does not depict the real world, even though the laws that can be deduced with its help are indeed operative in the real world. Many economists began to regard such models as being truly representative of the real world of action and change. There also seems to be an idea that the equilibrated world of the models is in fact worth striving for. Mathematical modeling also implicitly suggests that economic planning (in the sense of macro-economic planning by policymakers) is in theory possible, if only the 'data' are sufficiently accurate. That is however erroneous on a very fundamental level. Interventionism by central planning agencies such as the central bank represents a special case of the socialist calculation problem. The agency is so to speak a socialist island adrift in the sea of the market economy that surrounds it -  the same economy that it is supposed to at least partially 'plan' and the existence of which enables it to observe market prices. However,  it can still not escape the fact that it cannot possibly appraise opportunity costs or the future state of market data correctly. It does not even know what is relevant for the present, never mind what is relevant with respect to its future-oriented conduct. It faces insurmountable problems in terms of economic calculation and the gathering and integration of the widely dispersed knowledge in the economy into its 'plan'. Central bankers always blather on about the need to observe 'incoming data' to guide their decisions, but they might as well just throw darts. 

As to bubbles and psychology, while it is true that certain psychological effects are observable during asset bubbles ('herding'), it should be stressed that no bubbles are possible without a preceding or concomitant expansion in the supply of money and credit.  Artificially lowering interest rates below the natural level of society-wide time preferences is a sine qua non for the emegence of economic booms and the associated asset bubbles. It is therefore vain to concentrate on 'bubble psychology', interesting though it may be. It is a side-show to the true underlying cause of bubbles. 

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