Many thanks to colleague David Parr for this animation on how the stock exchange works from the visual.ly site. Well worth a look.
Very good video from Ray Dalio in which he believes that the three main forces that drive most economic activity are:
1) trend line productivity growth,
2) the long-term debt cycle and
3) the short-term debt cycle.
What follows is an explanation of all three of these forces and how, by overlaying the archetypical short-term debt cycle on top of the archetypical long-term debt cycle and overlaying them both on top of the productivity trend line, one can derive a good template for tracking most economic/market movements. While these three forces apply to all countries’ economies, in this study we will look at the U.S. economy over the last 100 years or so as an example to convey the Template.
Another video by Paul Solman in which he discusses how the NYSE record high doesn’t reflect the fundamentals of the US economy. With interest rates at virtually 0% the US Federal Reserve is trying to lower unemployment by stimulating the economy. But, by doing so there has been a tendency for it to overstimulating the stock market in the process. And also lending to stock investors, whose margin debt to buy shares on credit has been hitting record highs. Last week the Dow ended above 16000, another record for the headline index of 30 major companies.
The last record was set in 2007, a few months before the Dow’s previous high watermark.But for all the talk of the Fed’s role there’s an alternative way to understand a record Dow and higher profits: a shift of power from workers to owners. The stock market would actually be much higher if the unemployment was much lower. I think the economy is still really fundamentally weak, and that slack that’s in the economy right now, with all the unemployed people, all the unemployed businesses, would actually bring up the stock market even further.
Recently John Cassidy in the New Yorker wrote a piece about Alan Greenspan’s new book “The Map and the Territory: Risk, Human Nature, and the Future of Forecasting” in which Greenspan admits to flaws in the neo-classical model that people and financial institutions act in their own self-interest. He has finally come round to admitting that people’s actions are often driven by “Animal Spirits” (originates from Keynes) and rather than behaving like calculators they respond to fear, greed, euphoria, and impatience. He identified 10 traits which he calls “Inbred Propensities”. It seems that during his tenure as Fed Chairman Greeenspan rarely mentioned Keynes although he studied it at Columbia University in the 1950’s. As John Cassidy points out by the time he met Ayan Rand he was of the neo-classical orthodox. The article is worth a look – plenty of good debate.
Remember the difference between the two schools of thought
Many thanks to A2 student Annie Huang for this article by Aditya Chakrabortty in The Guardian Newspaper. It discusses the fact that most major degrees in economics still focus on the neoclassical ideology and associates humans as perfectly rational walking calculators working out their utility for each purchase. The main model of consumer behaviour assumes that we never buy anything until we’ve calculated the impact on, for example, our retirement fund, and we’re so good at maths we use interest rates to compute our pleasure, over time, after buying something. He mentions the movie documentary “Inside Job” which showed how some of the best minds at American universities had been paid by Big Finance to produce research helping Big Finance. He tells the story of an economics lecturer being asked by students to discuss the Global Financial Crisis.
“US economist Philip Mirowski recounts how a colleague at his university was asked by students in spring 2009 to talk about the crisis. The world was apparently collapsing around them, and what better forum to discuss this in than a macroeconomics class. The response? “The students were curtly informed that it wasn’t on the syllabus, and there was nothing about it in the assigned textbook, and the instructor therefore did not wish to diverge from the set lesson plan. And he didn’t. In the 1970s at Cambridge “There were big debates, and students would study politics, the history of economic thought.” And now? “Nothing. No debates, no politics or history of economic thought and the courses are nearly all maths.”
Click below for the full article.
Also have a look at this video from the New Economics Foundation – again it debates the value of mathematical models and neoclassical theory. Does the market actually reach equilibrium? I like Steve Keen’s comment – “the pirate obsession of Economics – they love X marks the spot”. It also includes Joseph Stiglitz, Gillian Tett, David Tuckett, Stephen Kinsella, John Kay, David Weinstein, and Dirk Bezemer.
If lawmakers fail to avert a debt default, there could be a devastating impact on the national economy: mortgages soaring, consumers unable to borrow, the government forced to pay more to borrow more, plunging us deeper into debt. PBS Economics correspondent Paul Solman reports on how the bond market is anticipating the situation. Features former IMF Chief Economist and now MIT Professor Simon Johnson.
Thanks to David Parr for this piece from Bloomberg Business News. Apple has been criticised that its glory days are no longer but the iPhone 5s and 5c sold a record 9 million units during the first weekend after its launch. Put this in perspective if this single product were its own company in the Standard & Poor’s 500-stock index, IPhone Inc. would outsell 474 of those companies—ranking between Wells Fargo (WFC) ($90.5 billion) and Marathon Petroleum (MPC) ($84.9 billion). The iPhone’s $88.4 billion in annualized revenue tops 21 of the 30 component companies in the Dow Jones industrial average—it would be the ninth-biggest stock in the Dow 30:
Two delusions characterized the Great Crash of 2007-2008 which wiped $5 trillion off global GDP and $30 trillion off world stock markets, according to risk analyst Didier Sornette, author of ‘Why Stock Markets Crash: Critical Events in Complex Financial Systems’.
1. It could never happen: we had supposedly entered the age of “economic moderation” buttressed by never-ending growth, low unemployment and low financial volatility otherwise known as the ‘Goldilocks economy’—not too hot, not too cold, but just right.
2. We couldn’t possibly have seen the Crash coming: it was a rare ‘Black Swan’ event, an unpredictable outlier, a freak wave of economic destruction.
While the first myth has been comprehensively debunked, the second myth persists among economists, central bankers and policymakers around the world, the French economist told TEDGlobal 2013 conference in Edinburgh. We were somehow helpless in the face of “the wrath of the Gods…there was no responsibility.” See the TED Talk below – well worth a look.
Fed Chair Ben Bernanke recently testified before the House of Representatives Committee on Financial Services and acknowledged the troubling employment conditions. Unemployment rate at 7.6% remains well above its longer-run normal level, and rates of underemployment and long-term unemployment are still much too high. Bernanke indicated that he would continue quantitative easing because of the unemployment figures but this method doesn’t seem to be working when you consider the lack of job growth – see graph. The U.S. Federal Reserve is currently purchasing US$85 billion of agency mortgage-backed securities and Treasury securities each month as part of its quantitative easing programme. This programme places downward pressure on long-term interest rates, and is intended to promote economic activity. However the S&P* earnings per share (eps) has grown above 70% since the bottom of the last cycle but job growth has been under 5%.
*The S&P 500® is widely regarded as the best single gauge of large cap U.S. equities. There is over USD 5.58 trillion benchmarked to the index, with index assets comprising approximately USD 1.3 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalisation.
Stockmarkets are starting to reap the benefits of significant quantitative easing and record low interest rates by Central Banks worldwide. In the US for instance there have been three doses of QE and the Federal Reserve indicated that they will keep rates low until 2015 as well as buy $40bn worth of mortgage backed securities.
But this is not the primary reason for the positivity in markets. Central Bank interest rates form the basis of global rates in trading banks, bonds etc. and with 10-year Government Bonds, which is considered a safe investment, at low yield levels investors are looking elsewhere for greater returns on their money. Even Bond rates in the struggling economies of Europe have dropped (Table 1). This indicates that investors are more comfortable about these economies in that the country doesn’t have to offer higher yields on Bonds to attract investors. With this low return on the Bond market investors are attracted to the higher yields on stock markets (Table 2).
The above is a brief extract from an article published in this month’s econoMAX – click below to subscribe to econoMAX the online magazine of Tutor2u. Each month there are 8 articles of around 600 words on current economic issues.
Former Republican Presidential candidate John McCann and Democrat Elizabeth Warren have introduced a bill to reinstate the Glass-Steagall act which split investment and commercial banks. The reason for the repeal of the act 13 years ago was that financial services group wanted to offer a one-stop shop. Companies could access both syndicated loans and equity, individuals could buy insurance, mortgages, and stocks all in one place. However all this being said it was Lehman Brothers and Bear Stearns, who were purely investment banks, that brought the financial sector to its kness not financial supermarkets. This doesn’t consider the fact that both Citigroup and Bank of America owners of investment banks Soloman Smith Barney and Merrill Lynch respectively needed to be bailed out by the government. Also moral hazard was prevalent in that banks knew they were too big to fail therefore were encouraged to take more risks and where the rewards were greater but also the downsides. Over the last 10 years US banking has grown far more concentrated. In the mid-1990’s the biggest 5 banks accounted for about 13% of assets. By 2009 this was 38%.
If you look at the 7 decades since Glass-Steagall there were hardly any bank runs but more importantly growth was constant. Before the crash of 1929 bank runs were endemic but with public bank deposits not being able to be used for investment banking the problem was overcome. Whether anything will come of this bill to reinstate Glass-Steagall is doubtful as the financial services lobby group still remains very influential in Washington.
I blogged on this issue last year and used the metaphor of an oil tanker to explain how the split between investment and commercial banks works.
To explain the root cause of the financial crisis George Soros uses an oil tanker as a metaphor. In the movie documentary “Inside Job” he basically said that markets are inherently unstable and there needs to be some sort of regulation along the way. The oil tanker has quite an vast frame and, in order to stop the movement of oil from making the tanker unstable, shipping manufacturers have designed them with approximately 8-12 compartments, depending on the size. This maintains the tanker’s stability in the water.
After the Deperession the Glass Stegal Act was passed in 1933. This act separated investment and commercial banking activities. At the time, “improper banking activity”, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors’ money. Therefore to use Soros’ metaphor, a compartment was put into the tanker to make it more stable.
However, in 1999 Gramm–Leach–Bliley Act effectively removed the separation that previously existed between investment banking which issued securities and commercial banks which accepted deposits. The deregulation also removed conflict of interest prohibitions between investment bankers serving as officers of commercial banks. Therefore, the tanker had a compartment/s removed which made it very unstable and it eventually capsized. Consequently the deregulation of financial markets has led to the end of compartmentalisation.
“The long run is a misleading guide to current affairs. In the long run we are all dead.”
Should investors focus on the short run or long run? The majority are looking at short run gains rather than a long term focus as they are most likely driven by instant financial rewards after the GFC.
Investors are also looking to see if the significant monetary expansion over the last 5 years will lead to inflationary pressures. Niels Jensen of Credit Writedowns has been writing on this for awhile and has come up with a couple of reasons why we shouldn’t be worried about it. Firstly many investors don’t seem to have grasped the difference between the monetary base and the money supply.
The monetary base is the total amount of a currency that is either circulated in the hands of the public or in the commercial bank deposits held in the central bank’s reserves.
The money supply is the entire stock of currency and other liquid instruments in a country’s economy as of a particular time. The money supply can include cash, coins and balances held in checking and savings accounts.
See above for some figures from Neils Jensen
As he points out it is the money supply, not the monetary base, which influences inflation. The chart below shows that there is no growth in bank lending despite the QE measures of printing money.
“As so aptly demonstrated in a recent IMF paper, the interaction between inflation and the economic cycle is very different today when compared to the 1975-1994 period. Whereas inflation back then was pro-cyclical, it is largely non-cyclical today with inflation well anchored around 2% regardless of the underlying economic conditions – see chart below. The obvious implication of this is that inflation should behave relatively well even as (if) economic fundamentals improve.” Source: Credit Writedowns
From Mary Holm’s column in the NZ Herald last weekend- here is the history of the best and worst returns from sharemarkets over the last 30 years.
The clear advantage of this is diversification. As our table shows, when one stock market is not performing well, that will usually be offset by another market.
There are some years, such as 2008, when there’s no good news anywhere. But look what happened the following year – with Japan’s respectable 9 per cent performance the worst of the pack.
A couple of other things to note about the table – which includes all the big sharemarkets plus Australia and New Zealand:
• New Zealand recorded the best returns in the early 1980s, and among the ugliest worst returns in the 1987 crash. This suggests that our market might be more volatile than many others – at least back then.
• Sometimes a country stays “best” or “worst” for two or three years. But then we find a country switching from one extreme to the other, such as India from 2008 to 2009 and the Australia/China swap from 2003 to 2004. There’s no predicting sharemarket trends.
Interesting post on the Credit Writedowns site by Aussie economist Steve Keen in which he explains why America has gone through ‘the Great Moderation’ since 2008. Below is a very good graph to justify his statement and part of his post.
the Great Moderation occured because Americans borrowed up big from 1993 till 2008, increasing private debt from $10 trillion to $40 trillion when GDP rose from $6 trillion to $14 trillion. It’s also why ‘the Great Recession’ occurred – because when Americans stopped borrowing and instead started to reduce their debt, demand (for both goods and services and assets like houses and shares) collapsed.
So contra Bernanke’s belief that the aggregate level of private debt doesn’t matter, it matters a great deal. That in turn means that Americans are very unlikely to spend more because of QE, because they’re already straining under a level of private debt that is unprecedented – even after several years of deleveraging, the level of private debt compared to GDP is higher than it ever was during the Great Depression.
Whilst away on hockey tour in Malaysia I was able to avail myself of the ‘The Straits Times’ newspaper which is published in Singapore. One article that particularly caught my attention was that concerning the creativity of algorithms. Most are oblivious to their creativity yet highly sophisticated algorithms have created music based on the works of great artists but in a style that is personalised and therefore indicative of you the individual. They are also replacing writers – Professor Phil Parker of the Insead Business School in Paris has published more than a million reports on Amazon in just a couple of years. Using a proprietary algorithm that produces a report in 10 – 20 minutes instead of about 4 weeks. The algorithm pulls information from the web, performs econometric analyses, creates tables, formats the report and publishes it as a Word document. Professor Parker has also developed algorithms to produce poems, videos and video games.
Although we could question the efficacy of algorithms on intangible dimensions such as “soul’ and “depth”, one area where they trounce human beings is stock trading. With up to 75% of trades on Wall Street done using computer programmes it is no wonder that algorithms execute trade at lightening speed and carry out numerous transactions every second. On the NYSE the average round-trip transaction time is 600 microseconds. To put into perspective if you blinked it takes you 300 milliseconds to complete the action – during that time NYSE executed 500 trades. This desire to improve efficiency in the market has led to extremely low costs of trading and very high stock liquidity. However it has also produced huge swings in stock prices. On 6th May 2010 – know as the ‘Flash Crash’ – the DJIA fell 9% in minutes but then recovered most of that loss in the subsequent few minutes.
The landscape of society was always made up by this uneasy relationship between nature and man. But now there is this third co-evolutionary force – Algorithms – and we will have to understand them as nature and in a way they are. Kevin Slavin Ted Talk
Another satirical clip from Clarke and Dawe of ABC in Australia, this time on the crisis in Cyprus. I like the idea of the spin cycle with this new model and the impact the crisis is having on Russian investment. Well worth a look
This is something that I have been covering with my Behavioural Economics students.
Behvaioural economists pay special attention to the causes of financial bubbles. Many explanations are offered, but key among them are herding, relative positioning and overconfidence. These psychological factors are sometimes referred to ‘Animal Spirits’ (from economist John Maynard Keynes) or ‘Irrational Exuberance’ (Alan Greenspan former US Fed Chairman) not only create bubbles but also greater volatility in the booms and busts.
1. Following the herd: Decision making in a world of uncertainty
People tend to follow the herd, especially information is uncertain, incomplete, and asymmetric (some people are more informed than others). Basically, in a world of bounded rationality (the limits of the human brain in processing and understanding information), herding makes sense to most people. Herding is a fast and frugal heuristic (short-cut) that has been used by both human and non-human animals across the millennia. Some behavioural economists see herding as irrational because people aren’t basing their decisions on objective criteria. If herding is seen as rational it can result in price cascades leading to excessive booms and busts in the prices of financial assets.
2. The role of relative positioning in investor behaviour.
Another cause of financial bubbles is relative positioning, which is a concern people have regrading their own economic and social status relative to other people. Any deterioration is a person’s relative positioning should reduce a person’s well-being. Many people will invest more as share prices increase for fear that otherwise their economic status will fall relative to those who are currently investing and making a lot of money, at least on paper (shares that they own). This fuels further increases in share values, but not on the basis of changes in the fundamental values of the assets. Relative positioning is similar to herding, but people aren’t following the leader. Instead they’re trying to protect their relative economic and social status by keeping up with others in their reference group who are already investing.
3. Overconfidence and underconfidence
Overconfidence is a belief, fed by emotions, that you can predict movements better than you actually can. When you’re overconfident, you’re not as smart as you think you are. Overconfidence tends to lead to great investment in financial assets that you would otherwise. Some economists argue that people invest in assets that they wouldn’t invest in if they considered more objective criteria and weren’t ruled by emotions.
Underconfidence is also emotionally driven. It’s a belief that you have a less capacity to understand and predict asset prices than you actually have. It tends to lead in panic-driven selling of financial assets, causing many people to dump assets they should keep, based on objective criteria.
Confidence is affected by the behaviour of others. Their confidence is often reinforced when people know that other people, including experts, and the rich and famous, are doing the same. In a world of bounded rationality, such behaviour may make sense – even though it can result in errors in decision making.
4. Institutional failure
After the recent Global Financial Crisis (started in 2007) economists have emphasised the role of institutions in affecting decision making. Investment decisions that can be bad for society but good for the individual can be a product of the institutional environment. If decision makers face little or no downside risk when making very risky decisions, they’ll take those risks. The recent GFC showed that eventhough corporate decision makers and brokers often bear little or no cost for potentially bad financial decisions or for providing poor financial advice, they still earn significant salaries/bonuses. Why not engage in these behaviours if you come out with a lot of cash. Some people will refrain from behaving this way for moral reasons. But history has shown that plenty of people will make decisions that harm society if those decisions benefit them personally.
This is a classic moral hazard problem where the individual or institution doesn’t bear the costs of the decision. Nothing irrational is happening here, but such behaviour can fuel bubbles and busts and can cause bankruptcies and liquidity crises. Also, if regulations are not well designed, rational decision makers can provide misleading information to clients. Credit rating agencies (Moody’s, Standard & Poor’s, Fitch) were giving AAA ratings (very safe) to financial assets when they were more like BB (junk status). The quality of regulation and its enforcement play an important role in influencing investment behaviour therefore it is imperative that there is more accurate information about investments.
Source: World Bank, The Economist.
This list of variables was in The Economist in February 2013. Notice the dominance of the Nordic countries – they have largely escaped the fallout from the Financial crisis. New Zealand tops the “Corruption Perceptions Index” and overall is lying 6th. Also note Switzerland being top in Competitiveness and Global Innovation.
Here is yet another graphic from The Economist showing the change in stock markets since the peak before the financial crisis in 2007/8. Although Dow Jones Industrial Average surpassed its previous peak (though it is still around 7% off once inflation is taken into account) – see previous post. As you can see some stockmarkets are still struggling and Greece is more than 80% below its peak in 2007.
The media last week were championing the fact that America most-cited benchmark, the Dow Jones Industrial Average (consists of the biggest 30 companies on Wall Street), had surpassed the peak that it reached prior to the Global Financial Crisis in 2008. Although the DJIA has doubled since March 2009 the American economy has only grown over the same period by 7% in real terms. Ultimately there is no real correlation between GDP growth and stock market returns The Economist stated main reason for this is that central banks worldwide have been forcing down the returns on Government bonds hoping to get investors to put money into more risky assets and therefore restore confidence amongst businesses and consumers.
Do the figures stack up?
Although the DIJA has hit a record high numerically, has inflation been factored into the calculation? If you look at the real figures (adjusted for inflation) the Dow Jones is approximately 9% below where it was in October 2007. Therefore the purchasing power of your shares in October 2007 is greater than that of today.
In real terms DIJA would be around 12,900 instead of the peak of 14,253.77 on Tuesday 5th March.
Justin Lahart in the Wall Street Journal stated last week that when you included the dividends earned (with investments in the DIJA) over the past five and half years and if they were reinvested the DIJA would be at 16,000. Adjusting for both inflation and dividends would put the DIJA around 15,000 – up approximately 5%.
Another consideration that he alluded to was that the DIJA doesn’t really reflect how well the average stock is doing. Companies with high market capitalisations like Apple are worth more than others also stocks like International Business Machines are worth more than others. Therefore stocks with the largest weightings have tended to weigh on the DIJA. If you put all stocks on the same footing since DIJA’s old record, and the index would have performed much better. The equal-weighted DIJA now stands at 16,683.44 which is 2,518.91 points higher than its 2007 high of 14,164.53 – see graph below.