What To Expect When You're Expecting... Default

Tyler Durden's picture

As markets twiddle their thumbs waiting on Washington to come up with a political solution to the Federal Debt Limit/budget debate, ConvergEx's Nick Colas decided it would be a good time to review the academic literature on how markets discount expectations in the first place. The thinking on this topic has evolved substantially over the years.

The initial thought, first developed in the 1960s, proposed that markets generally "Expected" the outcomes which subsequently occurred.  Since then, of course, Colas points out numerous market dislocations have forced a rethink. Behavioral finance posits that human nature skews perceptions of risk and return, causing everything from irrational risk aversion to asset price bubbles. Against this current backdrop of theoretical uncertainty, measures like the VIX are currently somnambulant. 

So, using the modern vernacular, WTF?  The bottom line, Colas explains, is that Wall Street thinks it has the current "Crisis" all figured out: a last minute deal with no Treasury default.  And just as we haven’t sold off materially during this drama, don’t expect a huge (+5%) lift afterwards.

Despite all this over-confidence, investors are backing away from T-Bills en masse as David Tepper is balls to the wall for a disingenuous rise in market multiples taking stocks higher... His proclamation that stocks will revert to their old normal of 18-20x P/E multiples is, however, entirely disingenuous (as @Not_Jim_Cramer points out below)...

Via ConvergEx's Nick Colas,

In light of Eugene Fama winning the Nobel Prize for Economics today, I would like to share my one personal intersection with the great man himself.  When I was an MBA student at the University of Chicago, Professor Fama taught a class in Corporation Finance/Capital Markets which was a required part of the curriculum for Ph.D. students and a popular Pass/Fail elective for the rest of us.

At the end of the first class, the following exchange occurred between Dr. Fama and a doctoral student:

Student: Professor, this may be a stupid question, but how do we really know… (Insert highly technical finance question here.  I didn’t understand it, but it sounded pretty smart.)


Professor Fama: Your initial assumption was correct.  Next question, please.  (There were no further questions, and he dismissed class.)

I didn’t take the class, even Pass/Fail.  To be fair, Gene Fama had the world by the tail when this brief conversation took place.  He had published a wide range of papers supporting the notion that markets were generally efficient and very hard to systematically beat.  His work found favor in classroom and the boardrooms of Wall Street.  Even now, his work on everything from the agency problem between shareholders and managers to risk and return in capital markets is widely cited in academic literature, to the tune of thousands of citations for scores of his papers.

The intellectual bedrock for Fama’s work that “Markets know best” actually predates him by several decades.  In the 1961 John Muth of Carnegie Mellon published “Rational Expectations and the Theory of Price Movements” which proposed that “The economy does not waste information.”  Muth’s paper centered on how businesses forecast demand, but the general principle could easily apply to investors in capital markets as well.  Markets of all kinds process information efficiently, discounting probabilities and potential outcomes, all without wasting a drop.

As with Mom’s old saying “It’s all fun and games until someone loses an eye,” economists and market observers had to change their tune after the tech stock and housing bubbles in the 1990s and 2000s.  That’s where Robert Shiller’s co-win for the Nobel today comes in, for his 1980 paper “Do Stock Prices Move too Much to be Justified by Subsequent Changes in Dividends?” and other work refutes the notion that markets tend to correctly anticipate future economic and fundamental outcomes.  His bestselling book, published in 2000, “Irrational Exuberance” isn’t just a nod to Alan Greenspan’s famous observation in 1996; it is also a challenge to Muth’s “Rational” expectations theory from 1961.

As a third axis to the discussion of market rationality/irrational exuberance, you have the work of Daniel Kahneman and Amos Tversky, with their work on “Prospect Theory”.  Yep, another Nobel for this one too, back in 2002.  Their research essentially showed that humans are lousy at working out what is statistically best for them.  One easy example: would you rather have $100 or flip a coin for a payoff of either $250 or nothing, depending on whether you correctly called “Heads” or “tails”?  The rational person would choose the coin flip, since the expected value is $125 and therefore greater than the $100 sure thing.  In reality, most people choose the $100 because the chance for a loss weighs more heavily on their decision than the potential for greater upside.

In short, how well markets “Expect” – or “discount”, if you prefer – future events is a topic which shifts with time and tide.  During strong bull markets, it is natural to think that capital markets are accurately reflecting the intelligence and wisdom of the people who invest in them and the corporate management which generates the business returns which drives stock prices.  When you get bubbles such as the dot com craze in the late 1990s or the U.S. residential housing market in the 2000s, another narrative takes hold.  The fault is not in our stars, but in ourselves, to quote Shakespeare.

The ongoing threat of a U.S. Treasury default is a useful case study on this point.  A few points here:

U.S. stocks are riding a multi-year wave of positive performance and the S&P 500 is finally higher than the two prior peaks in 2000 and 2007.  Money flows are starting to return to U.S. equity mutual funds, and exchange traded funds continue to gain assets in products dedicated to domestic stocks.


At the same time, the wounds of 2007-2008 are still fresh in investors’ minds.  Remember the lesson of Prospect Theory: losses feel worse than gains feel good.


Capital markets are therefore in a bit of a no-man’s land with respect to whether current prices appropriately reflect the risk of a U.S. Treasury default.  The pessimist will say that investors have been lured into a sense of complacency by the strong returns for U.S. equities over the last four years.  The optimist will point out that we’ve had a whole slew of rolling crises, from the 2007-2008 market meltdowns to several iterations of European banking system worries to the Fukushima nuclear disaster to constant handwringing over the true state of the Chinese economy.  Yes, the Federal Reserve has been in our corner, but the negative case for stocks is well understood. And investors have, for the most part, rejected it.


This is no academic discussion.  The price action in U.S. stocks has been uniformly good throughout the partial shutdown of the U.S. government and the threats of a default on U.S. sovereign debt later this week.  The CBOE VIX Index sits comfortably below 20, its long run average.  What expectations are built into asset prices is a critical question.

The bottom line is clear: U.S. stocks believe there is a zero percent chance of a Treasury default.  Not 1%, not even 0.1%.  No chance.  You can get to this conclusion any number of ways, using any decade’s predominant market narrative.

Rational Expectations/Efficient Markets (Muth/Fama): if there were even a 1% chance of a Treasury default, the VIX would be over 20 and stocks would be retreating, not advancing.  Too much of the world’s financial system is predicated on Treasuries as 100% reliable collateral to believe anything else.  Russian roulette with a 100 chamber revolver is still too dangerous a game.

Prospect theory (Kahneman/Tversky):  Event the remote chance of a loss due to a default would have outsized effects on risk assets like stocks, not just in the U.S. but around the world.  Remember that humans fear loss more than they celebrate the chance of an equivalent gain.

Robert Shiller’s long run P/E ratio for U.S. equities does show that stocks are overvalued (see here:   http://www.multpl.com/shiller-pe/).  You would think that the threat of a U.S. Treasury default would be just the kind of catalyst that could cause a pullback in an overvalued asset class.   So far, no pullback, of course.

Two final points here. 

First, since stocks currently discount no chance of a Treasury default, don’t look for a 10% pop on news of a deal.  A few percent, yes, but not much more. 

Second, if Congress and the President cannot come to an agreement by Friday, look out below.  Even a one-day “Technical” default simply isn’t reflected in stocks.  Under those circumstances, a 10% decline over a day or two would be a logical expectation, regardless of which decade’s philosophy you follow.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
LetThemEatRand's picture

I'm warming up a bowl of Gin.  Can't go wrong with that.  I'll add ice later when celebrating.

Arius's picture

gin sounds good!

the default is already priced in ... BTFD

LetThemEatRand's picture

For the eating of my asshole if I'm proven wrong on the debt ceiling.  In the right bar at the right time with the right waitress, you too would consider warm Gin asshole shots.  Especially 2 for 1.  Besides, I've already lost my ass shorting this market so it's more of a snack than a meal.

Spastica Rex's picture

Did you just maybe suffer a little stroke, or something?

TruthInSunshine's picture

They will pass some mangled bill that raises the debt ceiling & brings back the full force & inefficiency of the beast that is BigGov.Org in all its vast wastefulness & graft & union ass-kissing & banking/WallStreet goodies & MIC pork, probably just before midnight tomorrow.

Bank on it; the wankin' banksters are.

p.s. - Gotta' love how CNN, MSNBC, etc., are literally acting like it will be TEOTWAWKI if Obama doesn't get a blank check within 24 hours. A great, objective media we have in the USSA - NOT!

El Vaquero's picture

Would they actually default if they waited until Monday or Tuesday to come up with some deal, or would there just be some carnage in the markets?  If it's just carnage, I wouldn't be one bit surprised if they wait until Friday or even sometime next week.  Political points must be scored!

TruthInSunshine's picture


The lame Stream Media keeps repetitively stating that Thursday equals default day, and this is a complete lie.

Thursday is the day that the federal government has to look to the Treasury Department for cash on hand to fund operations and debt service, as it will no longer be able to borrow any amounts that would be necessitated by the fact that it continues to spend more than it takes in during any minute, hour, day, month, year or decade(s), like the out-of-control spendthrift that it has been for 43 years.

Without lifting the debt ceiling, and by cutting expenditures, and prioritizing payments due creditors, there's probably a 10 day to 14 day buffer period still before there's any actual default.


mvsjcl's picture

"...regardless of which decade’s philosophy you follow."


If you follow any other philosophy excepting one that espouses the conviction that the "market" is totally rigged and manipulated, then you're either a fool or complicit in the thuggery of the fool.



Ying-Yang's picture

OFF TOPIC but important

Obamacare's Website Is Crashing Because It Doesn't Want You To Know How Costly Its Plans Are


GetZeeGold's picture



Pretty sure Obama is wanting a default here.....something about America's chickens coming home to roost.


Sometimes you just got a break a few eggs.


Barry brings default and pain to the entire world......you begged him for it.....so be it.

rivoniaboy's picture

Well said @end the fed.

 Lets keep out eye on the ball here folks,at last count the total US debt was 16.8 Trillion.Yes thats TRILLION.How the hell can this ever end well?

Totally and utterly screwed!

j0nx's picture

Let them pass all they want and let the sheep bleat that the tea party are terrorists and are holding us all hostage. It's extra time for you to prep and make plans and plans for those plans and plans for when the plans don't work out because soon enough we will be right back in this situation and the shit really will hit the fan. The math don't lie and the light at the end of the tunnel is another train barreling down on us.

LetThemEatRand's picture

"Did you just maybe suffer a little stroke, or something?"

That's entirely possible, but I also threw down the gauntlet a few days ago that I would eat my own asshole if the debt ceiling were meaningfully breached.  A Gin soaked ass would help if I lose that bet.

zhandax's picture

Finally, a use for gin.  The only times I ever drank it was when rebuilding carburetors (it doubles as cleaner).  The last time I encountered a carburetor was on a friend's houseboat in the mid-nineties.

Zero Point's picture

Dude. Ice cold G&T on a hot day? That's good shit.

Dunno about stewed ass and gin though, might give that a miss.

I certainly wouldn't be getting too ready to eat my ass yet though, I can't see why the money flow would stop now.

Mind you, this is nonsensical world where nothing has to make sense, so fuck it.

Ass and gin it is, make mine a double shot of Mila Jovavich's.

dcohen's picture

A deal is already priced in, but not slowing growth.

LetThemEatRand's picture

I reluctantly admit that I have SPXU from a few weeks ago before it killed what was left of my hope and spare change.

johngaltfla's picture

You have to have large ones to play there. But I'm not at all distressed. Check out hhe 3 year SPY chart and failure to correct meaningfully and then the last times we've gone stupid like that...a la 1987....

LetThemEatRand's picture

I keep thinking the Fed is head faking.  The shoe shine boy is buying.  At some point they must relent.

johngaltfla's picture

Eventually, the technicals win.

LetThemEatRand's picture

Yeah, after I'm doing a Rocket Man Downey Less Than Zero head fake in the bathroom!

HardlyZero's picture

Mix in some MZZ and QID and you have a breakfast of champions...predict Monday will be a major stock market capituation, assuming there are no weak hands in the Congress, and they let the cards fall, and Paper Tiger stocks gets shredded.

zhandax's picture

Isn't that a tall assumption there?  Most of these thieves only know two things to do with their hand, and the polite one is to hold it out for 'contributions'.

JFKFC's picture

Indeed, I was killing it with UVXY (2x leveraged VIX) until last Wednesday, when Washington figured out that saying you're close to a deal is as good, if not better, than actually having a deal.

There is nothing rational, efficient or sane about the markets today.

ParkAveFlasher's picture

Fuck ETFs, ETNs, 2X, 3X, etc.  Note the volume trading there.  Those exits are covered.  To hell with swinging for the fences on index moves.  Your trade will be tagged, targeted, and sheared before you can whip out your straightedge.


Expect "crisis".... DUH !   REALLY !    With a chimporama coming down on you from all sides, what do you think ?

hedgeless_horseman's picture



I expect our leaders to come up with a half-past-midnight bi-partisan way to kick the can down the road, for the children's sake.  They will come up with a bullshit acronym like TARP.

F.U.C.K.I.T. Spending Program

Future Usury of Children Keynesian Interstate Temporary Spending Program

knukles's picture


For Unlimited Children's Material Enhancement

Also referred to euphuistically as Expand the Free Shit Army Democratic Vote Forever Act

PS There's a NY congressman on CNBCAsia saying that Obiecare insurance rates in NY are falling by some 50%
Holy Deceitful Horseshit

adr's picture

I actually applied the Fuckyo medical plan twice this year. An asshole dentist sent me a $150 bill for what was supposed to be a free consultation. He got the Fuckyo medical payment plan. ie Not a dime from me.

A doctor fucked up my insurance payment and billed the wrong insurance company and tried to stick me with a $500 bill. Not my fault his office is run by idiots. He got the Fuckyo medical plan too. I got a letter saying I'd be sent to collection. I called and said, "I don't care and I'm not paying for your mistake."

The Fuckyo medical plan is genious. About time doctors get paid what their worth. Maybe an assistant anesthesiologist won't be able to make $250k anymore.

El Vaquero's picture

Collections calls are fun though.

El Vaquero's picture

I got junked for that?  But seriously, they are fun.  Debt collectors are easy to fuck with, and most of them deserve it.  I haven't had a call from one for a couple of years, and I miss them (not really, becuase that means I'm about to step into a shitfest, unless they're looking for somebody who doesn't live with me, then it's good times.)  I can tell them that I'm on WebRecon and they shit a brick. 

scatterbrains's picture

you're probably right but let me enjoy the fantasy that the hard corp conservatives in congress have been conspiring with the Military to stage a coup over the criminals that are destroying our country...and that by design there will be no deal.

boeing747's picture

Let's talk about if indeed Default happens, where does .gov get emergency funding from?

a) turn Fort.Knox golds over to Fed as collateral, get special funding.

b) Withhold 10% of all saving accounts over $1 million as temp funding.

c) Immediately auction off federal buildings&lands.

AlaricBalth's picture

"a) turn Fort.Knox golds over to Fed as collateral, get special funding."

Surely you meant to sarc that, right?

During USMA artillery training at Fort Knox one summer, the joke was maybe we should fire a round at the gold depository and see how large of an empty hole we could uncover.

mvsjcl's picture

b) Withhold 10% of all saving accounts over $1 million as temp funding.


Savings account? What the fuck is that?

Running On Bingo Fuel's picture

Is inflation not a type of default? Oh anyway it doesn't matter everyone is so use to getting screwed it just doesn't matter anymore.

Metal on a one year downward spiral. WTF! Anyway. Whatever. Does Kyle still have his nickles?

Gaffing_Nome's picture


Summary totalé following your lead, this.:


"...The title is a phrase spoken by Winston Smith to Julia in George Orwell's novel 1984, the basis for the second half of Bowie's album. This is Bowie's interpretation of the couple's capture, and Winston's thoughts about the whole affair. He recognizes that they probably should have ended it while they could, before it was too late. However it is too late, as the song says, "...because of all we've seen, because of all we've said, we are the dead..."

Atomizer's picture

Let’s roll back the hands of time to 2011. Shall we?

Dow Jones Crashes 8/8/2011

Dow crashes despite debt ceiling deal


Blah, blah blah.

fonzannoon's picture

that was the last good actual dip.

Atomizer's picture

Yes it was. Let’s see how closely Obama follows the same speech given back then.

xtop23's picture

I can see it now;

"Let me be perfectly clear.....pays its bills....fair share......main street......right thing to do...... reach across the aisle....... for our children's future."

Is it 2016 yet? Seriously. I know nothing will change as we scream, " 'Merica, FUCK YEAH!" and Bo n' Luke jump into a brick wall of mathematical certainty.

I just want some other oligarch water carrier to do it. I'm absolutely sick of this fucking guy.

Atomizer's picture

We compromised last time, the Kenyan hasn’t lived up to his end of the bargain. Same rhetoric, different year.

q99x2's picture

I expect that everyone by now expects not to get repaid. So who cares.

On the one side they have hungry EBT cardholders with drugs and guns. On the other side you have banker with a computer to print as much as anyone ever dreamed.

We know what will happen.

Same old.

adr's picture

Don't expect 5% up, expect 25% up. Why the hell not.

Neflix $900 a share. Not like the price means anything anymore. Fuck, make the new benchmark $10k a share. Priceline can maybe make it there next year.

Analysts can try to claim that the market is priced correctly, or future growth justifies current p/e ratios, but they're wrong. 

The growth doesn't exist and claimed revenue is about as realistic as the DDD tits on a Vegas stripper.

You can claim unicorns exist all you want, but I'll still tell you they don't. 

In fact if I got on TV and told people unicorns exist, I'd be laughed off the stage. Yet if I got on TV and claimed Tesla is underpriced and worth $275 a share. I'd receive nods and most likely be applauded. Honestly, I'd believe the guy claiming unicorns are real over a guy claiming Tesla is worth $275 a share.


Spastica Rex's picture

I wonder if  the past 20 years skews that dataset?

Skateboarder's picture

The author has been living under a rock and doesn't know about HFT.