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 pre-bubble 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 pre-bubble activity" (what happens between the "pre-bubble" and the "bubble"? The "nascent bubble"? The "mid-bubble"? The "mid-non-bubble"?)
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:
- The Fed is intentionally pushing investors into risky assets, such as stocks and high yield bonds, in search of a wealth effect.
- 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.
- 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.