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