CAPE, Future Expected Equity Returns, the Equity Premium, and Market Timing

Posted on by Brad DeLong

I think this, by the very sharp Justin Lahart is badly framed.

Shiller’s CAPE a hair over 27 is telling us that if we buy the S&P Composite and hold it to infinity, we can expect a real return to average 5%/year ±, where the ± can, of course, be substantial. But there is also a reasonable chance that in the next five years the CAPE valuation ratio will revert to 20–in which case you lose 25% on top of that if you have to sell then. And there is some chance that in the next ten years the CAPE will kiss the 15 it kissed in 2009–which means that if you have to sell then you could lose 45%.

The stock market is for prudent, patient investors–not for those who know they will have to sell soon and cannot stand the risk of price declines, or who do not have to sell soon but cannot stand the risk of scanning the newspaper and seeing a disappointing number.

But what other investment promises an expected return of 4%/year for the patient investor? And it is difficult to imagine that any other asset class is exposed to much risk: what will preserve its real value if the collective ownership of the productive capital of the world does not?

With interest rates at their current level of -2%/year real, a CAPE of 27 is not flashing “sell” unless you think the odds of CAPE reverting to 20 in the next year are a quarter or greater.

And, of course, Justin’s point is that the CAPE* that we should be watching is not 27, but rather 18, in which case the real return we should expect on average is not 5%±, but 7%±:

Justin Lahart: Shiller’s Powerful Market Indicator Is Sending a False Signal About Stocks This Time:

A popular valuation metric pioneered by Nobel Prize-winning economist Robert Shiller says that stocks are dangerously expensive. But it may be sending a false signal…

Shiller gained popular fame with his 2000… “Irrational Exuberance”… [and] in a 2005 edition of the book, Mr. Shiller said the housing market was in a bubble. It is a track record that makes Mr. Shiller hard to ignore…. The CAPE  is now at 27… well above its 50-year average of 20. The only times the CAPE has been higher were during the 2000 bubble and bust, and just prior to the 1929 crash….

An alternative CAPE, constructed by The Wall Street Journal… relies on a more consistent earnings measure: The Commerce Department’s quarterly data on total U.S. after-tax corporate profits… Federal Reserve data on the total value of the U.S. stocks, rather than the value of the S&P 500. The result: Stocks look much cheaper than Mr. Shiller’s data suggests….

The two measures tracked each other almost perfectly for decades until 2008, when banks and other businesses, required to follow the latest GAAP rules, suffered huge write-downs that cut earnings. The Commerce Department’s measure, which hasn’t changed, treats bad-debt expenses, asset write downs, and loan-loss provisions as capital losses… rather than cutting earnings. Since both of these measures rely on 10 years of earnings, the disparity stemming from the financial crisis has persisted….

A bigger issue, says Mr. Campbell, is that just because the CAPE is high doesn’t mean that stocks aren’t a better value than comparable, safe investments. Back in 2000, there were great alternatives to expensive stocks, such as 10-year Treasury inflation-protected securities offering a government-guaranteed yield of 4 percentage points above inflation. Today those bonds offer no premium. While stocks are currently expensive, Mr. Campbell says, it isn’t clear that they are a worse investment than their alternatives….

Aswath Damodaran… over the past 50-odd years, he couldn’t find a single way he could make CAPE beat a simple buy-and-hold strategy…. Shiller agrees that the CAPE can’t be used as a market-timing tool, per se…

And I wince at the graphic design of this chart:

Shiller s Powerful Market Indicator Is Sending a False Signal About Stocks This Time WSJ

DRAFT: Did Macroeconomic Policy Play a Different Role in the (Post-2009) Recovery?

Posted on by Brad DeLong
Federal reserve bank of boston Google Search

J. Bradford DeLong
U.C. Berkeley
October 15, 2016

Federal Reserve Bank of Boston
60th Economic Conference
The Elusive “Great” Recovery: Causes and Implications for Future Business Cycle Dynamics

Abstract: How has macroeconomic policy been different in this recovery? In banking and regulatory policy, it has been distinguished from earlier patterns—or from what we thought earlier patterns implied for a shock this large and this persistent—in a relative unwillingness to apply the “penalty rate” part of the Bagehot Rule and in a slowness to restructure housing finance that are, for me at least, different than I had expected. In fiscal policy, the prolonged reign of austerity in an environment in which both classical and Keynesian principles suggest that it is time to run up the debt is surprising and unexpected, to me at least. In monetary policy it is more difficult to say what has been different and surprising in this recovery. There have been so many aspects of monetary policy and our expectations of what policy would be during a prolonged excursion to the zero lower bound that it is hard enough merely to say what monetary policy has been, and too much to ask how it has been different from whatever baseline view of what the policy rule would be that we ought to have held back in 2008.

Must-Reads: October 14, 2016

Posted on by Brad DeLong

Should Reads:

Must-Read: Simon Wren-Lewis: Very Serious People and the Deficit

Posted on by Brad DeLong

Must-Read: Back in 2010 there were people saying:

  • If you are not at the zero lower bound, fiscal policy is not necessary to stabilize the economy.
  • If you are at the zero lower bound, the situation is so dire that using fiscal policy to stabilize the economy will require running the debt up to dangerously high levels.

The question is why six years of interest rates at rock bottom have not led more people to change their views of what “dangerously high” means in terms of debt. It remains a mystery to me.

Simon Wren-Lewis: Very Serious People and the Deficit: “George Osborne argued explicitly that the economic consensus was now that monetary policy should deal with stabilising output and inflation, while fiscal policy makers should look after their own deficit…

…I have called this the consensus assignment. If he, or his advisors, absorbed this piece of conventional wisdom, so may VSPs and mediamacro. So the headline academic scribbling was governments should control deficits, not the economy, and they are bad at it…. VSPs and the media more generally [would have] a clear role in providing a public service to help counteract the wickedness of politicians… to constantly advocate deficit reduction to counter deficit bias….

A little knowledge can be a dangerous thing…. [We] knew the conventional assignment broke down when interest rates hit their lower bound. We knew that a liquidity trap was absolutely not the time to worry about deficits, and if you did so you would cause tremendous damage. And we were right.

Must-Read: Paul Krugman: Notes on Brexit and the Pound

Posted on by Brad DeLong

Must-Read: The argument for a Brexit recession always seemed to me to be that:

  1. The pound would need to drop a lot to generate enough exports to offset the fall in investment in the City that the prospect of downsizing London finance would generate.
  2. Perhaps the Bank of England would be unwilling to let the pound drop that far for fear of what it would do to inflation.
  3. Perhaps the drop in the pound would destabilize the pound’s role as a safe store of value and thus further erode the City’s comparative advantage, already under threat by the uncertain institutional consequences of Brexit.

Whether the pound and the domestic interest rate drop far enough to avoid a short-term Brexit recession thus always seemed to me to be a matter of policy choice and animal spirits…

Paul Krugman: Notes on Brexit and the Pound: “The much-hyped severe Brexit recession does not, so far, seem to be materializing…

…But we are seeing a large drop in the pound, which has steepened as it becomes likely that this will indeed be a very hard Brexit. How should we think about this?… I’m coming at it from the trade side–especially trade in financial services…. Financial services… are subject to both internal and external economies of scale, which tends to concentrate them in a handful of huge financial centers… one of which is, of course, the City of London. But now… those services [will move] away from the smaller economy (Britain) and into the larger (Europe). Britain therefore needs a weaker currency to offset this adverse impact. Does this make Britain poorer? Yes… the efficiency effect of barriers to trade… [and] a terms-of-trade effect…. A weaker pound shouldn’t be viewed as an additional cost from Brexit, it’s just part of the adjustment. And it would be a big mistake to prop up the pound: old notions of an equilibrium exchange rate no longer apply.

Must-Read: Loren Brandt, Debin Ma, and Thomas G. Rawski (2012): From Divergence to Convergence: Re-evaluating the History Behind China’s Economic Boom

Posted on by Brad DeLong

Must-Read: Loren Brandt, Debin Ma, and Thomas G. Rawski (2012): From Divergence to Convergence: Re-evaluating the History Behind China’s Economic Boom: “The Qing Empire (1644-1911), the world’s largest national economy prior to the 19th century, experienced a tripling of population during the 17th and 18th centuries with no signs of diminishing per capita income…

…In some regions, the standard of living may have matched levels recorded in advanced regions of Western Europe. However, with the Industrial Revolution a vast gap emerged between newly rich industrial nations and China’s lagging economy. Only with an unprecedented growth spurt beginning in the late 1970s has the gap separating China from the global leaders been substantially diminished, and China regained its former standing among the world’s largest economies.

This essay develops an integrated framework… to explain how deeply embedded political and economic institutions that had contributed to a long process of extensive growth subsequently prevented China from capturing the benefits associated with new technologies and information arising from the Industrial Revolution. During the 20th century, the gradual erosion of these historic constraints and of new obstacles created by socialist planning eventually opened the door to China’s current boom. Our analysis links China’s recent economic development to important elements of its past, while using the success of the last three decades to provide fresh perspectives on the critical obstacles undermining earlier modernization efforts, and their removal over the last century and a half….

What circumstances enabled the hesitant reforms of the late 1970s which restored no more than a small fraction of the market arrangements stifled by socialist policies during the previous three decades, to launch the economy on a steep and durable growth path? How could several hundred million Chinese villagers escape from “absolute poverty” within 10-15 years following the onset of economic reform during the late 1970s with, if anything, declining external support as former collective institutions withered away? How did the number of so-called “township-village” (TVE) enterprises jump from 1.5 million to nearly 20 million, including many with substantial overseas sales, between 1978 and 1990 without encountering a shortage of capable managers and accountants? How did millions of firms conduct business, often on a large scale, without well-developed systems of commercial law or property rights?…

This essay is written in the conviction thathistorical legacies rooted in the decades and centuries prior to the establishment of the People’s Republic in 1949 continue to exert powerful influence upon the evolution of China’s economy. Prior to the industrial revolution, China led the world in both economic size and in many dimensions of technology…

Must-Read: Nick Bunker: How Much Bigger Can the U.S. Labor Force Get?

Posted on by Brad DeLong

Must-Read: Nick Bunker: How Much Bigger Can the U.S. Labor Force Get?: “The White House’s Council of Economic Advisers puts about half of the decline in [labor force] participation from 2007 to 2014 into the “aging” category…

…But several structural factors can be addressed through policy actions…. Alan Krueger… tries to understand what is depressing participation for men and women who are in prime working ages of 25 to 54…. [For] prime-age men, health problems seem to be a huge barrier…. For prime-age women… the importance of family-friendly policies, or rather the lack thereof…. There is still the possibility that cyclical forces are pushing down the labor force participation rate…. Wage growth hasn’t been particularly strong during this recovery, which points to continued weaknesses in the demand…

Must-Read: Mark Thoma: This Nobel Prize for Economics Is Well Deserved

Posted on by Brad DeLong

Must-Read: Mark Thoma: This Nobel Prize for Economics Is Well Deserved: “Most people have probably never even heard of “contract theory”… Oliver Hart and Bengt Holmström…

…When should workers be paid a bonus based on performance? What’s the best way to structure the contract specifying the terms for paying a bonus? Should managers have stock options as part of their contracts, or is some other arrangement preferable? When should insurance companies require co-payments, and what’s the best co-pay schedule?… People often find themselves in situations in which they must trust that someone else will act in their best interest, so contracts are a way of creating incentives that avoid conflicts of interest and specify how to share any risks…. The optimal construction of these “pay for performance” contracts is a harder problem than it might appear at first glance…. Holmström’s work has wide application… whenever contracting arrangements between people or firms are needed. 

Hart’s… main contribution is more difficult to describe…. It’s not possible to specify all possible contingencies… “incomplete contracting” theory….

The main idea is that a contract that cannot explicitly specify what the parties should do in future eventualities, must instead specify who has the right to decide what to do when the parties cannot agree…. In complex contracting situations, allocating decision rights therefore becomes an alternative to paying for performance.

Since decision rights and ownership rights go hand in hand, Hart’s contributions also deliver a theory of property rights that has wide applications…

How much bigger can the U.S. labor force get?

Posted on by Bridget Ansel

The U.S. labor market continues to recover from the still lingering effects of the Great Recession, but the question on the minds of many economists and analysts is how long can the healing continue? Or, in other words, has the U.S. economy hit “full employment,” where all the workers who can be drawn into the labor market by a stronger economy are now finding jobs? Understanding trends in the labor force participation rate is key for answering this question. Knowing whether the share of the population actively participating in the labor market can grow much further or whether it will trend down can help determine how low the unemployment rate might go.

First, a quick reminder on how the labor force participation rate affects the unemployment rate. The unemployment rate is calculated by taking the number of unemployed workers and dividing it by the labor force, the sum of the number of unemployed and those with a job. So knowing how much the denominator in that situation is going to change will impact the overall unemployment rate. For more on this, read Equitable Growth Senior Director for Policy Elisabeth Jacob’s testimony on trends in the labor force participation rate.

Views on labor force participation today vary on the extent to which structural forces or cyclical effects from the Great Recession of 2007-2009 are still affecting the participation rate. Many economists and analysts point to the role of structural forces or trends that long predate the Great Recession. But the long-term trend that gets cited the most is the aging of the working population as the Baby Boomer generation reaches retirement. The estimates on the effects of aging can vary quite a bit, but an estimate by the White House’s Council of Economic Advisers puts about half of the decline in participation from 2007 to 2014 into the “aging” category. When it comes to a policy response, it’s hard to change the age distribution of the population in the short run.

The importance of structural forces and demographics might give an impression that labor force participation or other trends are immutable and have to simply be endured. Regardless of how much slack remains in the labor market (the recent slight increase in the rate may be a sign of remaining slack), several structural factors can be addressed through policy actions.

Consider a new paper by Princeton University economist and former Council of Economic Advisers chairman Alan Krueger. The paper takes a direct look at the labor force participation rate and tries to understand what is depressing participation for men and women who are in prime working ages of 25 to 54. When it comes to prime-age men, health problems seem to be a huge barrier to labor market participation. According to the paper, almost 50 percent of men in this age group are taking medicine to control pain, and about 40 percent of this group say health issues are preventing them from taking a job. This is structural force that is not directly related to the Great Recession, but it certainly is amenable to a policy response.

As Krueger notes, such a trend means increased health insurance may help this trend or policymakers may want to look at pain-management interventions. When it comes to trends for prime-age women, there’s research pointing to the importance of family-friendly policies, or rather the lack thereof. Other countries have seen rising labor force participation rates for women, but we haven’t seen that in the United States as Krueger points out. Policies that help provide childcare and paid family and medical leave seem likely to help push back against these trends, as Equitable Growth’s executive director and chief economist, Heather Boushey, details in her recently published book, “Finding Time: The Economics of Work-Life Conflicts.” And paid leave may also help male employment by allowing workers to take time off for their own health problems.

Of course, there is still the possibility that cyclical forces are pushing down the labor force participation rate. As Matt Yglesias notes at Vox, wage growth hasn’t been particularly strong during this recovery, which points to continued weaknesses in the demand for labor among employers. He also points out that a stronger economy could make some of these structural forces seem less structural as employers would be less picky about which workers they hire. The only way we’ll really know is if policymakers, especially at the Federal Reserve, continue to be patient and help the current recovery continue.

Must-Read: Boston Fed: 60th Economic Conference: The Elusive “Great” Recovery: Causes and Implications for Future Business Cycle Dynamic

Posted on by Brad DeLong

Must-Read: Boston Fed: 60th Economic Conference: The Elusive “Great” Recovery: Causes and Implications for Future Business Cycle Dynamics

October 14:

  • 7:30 am: Registration & Breakfast
  • 8:30 am: Welcome and Opening Remarks, Eric S. Rosengren
  • Morning Moderator: Joe Peek
  • 9:00 am: Why Has GDP Growth Been So Slow to Recover? James H. Stock, Peter Ireland, Lucrezia Reichlin
  • 11:00 am: Why Has the Unemployment Rate Fared Better than GDP Growth? Robert E. Hall, John G. Fernald, Laurence M. Ball
  • 12:30 pm: Luncheon: The Honorable Janet L. Yellen
  • Afternoon Moderator: Christopher L. Foote
  • 2:30 pm: Where Have All the Workers Gone? Alan B. Krueger, Gabriel Chodorow-Reich, Peter Diamond
  • 4:15 pm: Why Has Consumer Spending Remained Moderate and the Saving Rate Increased? Luigi Pistaferri, Karen Dynan, Atif R. Mian
  • 5:45 pm: Reception
    Saturday, October 15

October 15:

  • 8:00 am: Breakfast
  • Morning Moderator: Ricardo P. C. Nunes
  • 9:00 am: Why Has Inflation Remained Low for So Long? Robert G. King, Truman F. Bewley, Jeffrey C. Fuhrer
  • 11:00 am: J. Bradford DeLong, Olivier Blanchard, N. Gregory Mankiw
  • 12:30 am: Luncheon
  • 1:30 pm: Adjournment