Equity and bond markets

Hedge funds’ portfolios are often leveraged and they can be big winners or losers if this pays off. In this sense the US is also a hedge fund. In terms of its international assets, the US is long equities and short debt. This has been hugely to its advantage because equities have given much better returns, but this benefit carries large risks for the future.

 Read more

The damage done to the UK and US economies by buybacks in preference to capital investment was a central theme of my book The Road to Recovery, and it has found its way, not too often I hope, into these blogs. I have therefore been heartened by the growing interest shown by the financial press in this threat to our economies. The Economist recently devoted a major section to the issue, as did the Financial Times on October 12.

The change in the way managements are paid drives buybacks but this has yet to be widely appreciated. The US Federal Reserve’s quantitative easing programme was rightly underlined by my colleagues as adding the fuel of cheap debt but, without the preference for buybacks, low bond yields would have encouraged capital investment. This they markedly failed to do. An important paper, shortly to be published in the Review of Financial Studies, “Corporate Investment and Stock Market Listing: A Puzzle?” by John Asker, Joan Farre-Mensa and Alexander Ljungqvist demonstrates that a huge difference has appeared in recent years in the levels of investment by quoted and unquoted companies. Read more

Asset prices fall if investors’ liquidity preference rises or if their liquidity falls (ie, if investors need the money or want to have more cash in their portfolios). Liquidity depends on central banks; they can create it or soak it up. The US Federal Reserve seems unlikely to reduce liquidity unless inflation picks up, but is likely to stop creating it in October. Therefore, one way in which asset prices will fall is a rise in inflation or pre-emptive action by the Fed to stop it.

When the Fed creates liquidity, it takes a larger rise in liquidity preference than before to hit asset prices. The Fed is thus in the process of increasing the market’s sensitivity to rises in liquidity preference and, as small changes are the normal response of investors to new information, the volatility of the market is therefore likely to rise. In the absence of increased interest rates, large changes in liquidity preference, however, are likely to depend on falling profits. Read more

In a comment on my recent blog regarding the equity risk premium, “Le gun” asked for a guide to making long-term investment decisions and I promised to try.

In 2009 TengTeng Xu and I addressed this issue in a paper called “Investment and Spending Strategies for Endowments”. We were specific because the need for income and the investor’s time horizon should both be taken into account when deciding on a sensible policy for individual investors. We considered the use of only three asset classes: equities, long-dated bonds and short-term deposits (cash). We did not include property because we were unable to find suitable long-term data and dismissed commodities, including gold, as combining poor returns with high volatility. With regard to the possible portfolios, we came to several conclusions which I will adapt here for all long-term investors, rather than just endowments. Read more

Ed Balls, who has a high chance of being the UK’s next chancellor of the exchequer, has announced that the opposition Labour party is “examining the case for introducing an allowance for corporate equity, to redress the systemic bias in favour of debt finance”. This would be very sensible, but it needs to be done sensibly.

Allowing interest as a deduction before calculating the profit on which corporation tax should be paid encourages excessive debt, buybacks of equity in preference to long-term investment and debt-financed takeovers. The views of economists on its undesirability are one of the few instances on which they are almost all agreed. It is one of the rare exceptions to the old rule that “n economists = n+1 opinions”. Read more

In some of my more gamesome moments I have challenged my students to produce an article about the equity risk premium, which made a useful contribution to our understanding of the way financial markets work. So far the challenge has not been met. This may reflect the modesty and good manners of those I teach but also, I hope and believe, the fact they are too sensible to wish to defend the way this often ill-defined and generally useless concept has been habitually discussed. In practice, comments on the ERP seem to me to have been a source of confusion and error rather than illumination.

The ERP can be defined in at least two ways. One is the historic difference between the returns on bonds and equities and another is the expected difference in these returns. Alternatively, the “risk-free rate” can be used in place of bonds. Read more

A few weeks ago, I promised to write about claims that the stock market could be valued by comparing earnings yields to bond yields. This approach is sometimes called the “Fed model”. This was fashionable in the 1990s and seems to have some followers even today. It is not only nonsense but is the most egregious piece of “data mining” that I have encountered in the 60-plus years I have been studying financial marketsRead more

While it is sometimes useful to make a distinction between treasuries and central banks, they are fundamentally both part of government. When central banks buy bonds as part of quantitative easing, governments are in practice ceasing to fund, ie, they are issuing short-term rather than long-term debt. If this is potentially harmful, we need to worry; if not, we need to ask why have governments funded in the past? Read more

The US seems expensive relative to other major stock markets. As it is probable that cheaper markets will give better returns, this implies that investors should underweight US equities. This conclusion applies, however, only over the longer term. Timing matters and this involves other considerations.

Chart one illustrates that G5 stock markets are strongly correlated with the US and so, to a large extent, markets go up and down together. The chart also shows that this tendency has been strengthening over time. Read more

Cyclically adjusted price-earnings ratio (Cape) appears to be a valid way to measure the value of the US stock market, but this does not mean that it can sensibly be used for other indices. As I explained in a previous blogpost, Cape is only valid if it can pass two tests: first, that the real return on equities has been mean reverting; and second, that profit margins have also been mean reverting and have rotated quickly around their average.

Real returns on equities has been less strongly mean reverting in other markets than they had been in the US. This weakens the case for Cape in other major stock markets, but does not, I think, necessarily rule it out. Even if returns would otherwise have been mean reverting, they will not have been if countries had suffered unexpected and catastrophic losses, such as occurred in world wars. I had already explained in Growth and returns, another blogpost, that these losses were the probable explanation for the exceptionally low returns on equity investment in the first half of the 20th Century in countries such as Germany and Japan. Read more