Must-Read: Pascal Seppecher, Isabelle Salle, and Dany Lang: Is the Market Really a Good Teacher?

Must-Read: Pascal Seppecher, Isabelle Salle, and Dany Lang: Is the Market Really a Good Teacher?: “Our learning model is an ever-adapting process that puts a significant weight on exploration vis-à-vis exploitation…

…We show that decentralized market selection allows firms to collectively adapt their overall debt strategies to the changes in the macroeconomic environment so that the system sustains itself, but at the cost of recurrent deep downturns. We conclude that, in complex evolving economies, market processes do not lead to the selection of optimal behaviors, as the characterization of successful behaviors itself constantly evolves as a result of the market conditions that these behaviors contribute to shape. Heterogeneity in behavior remains essential to adaptation in such an ever-changing environment. We come to an evolutionary characterization of a crisis, as the point where the evolution of the macroeconomic system becomes faster than the adaptation capabilities of the agents that populate it, and the so-far selected performing behaviors suddenly cease to be, and become instead undesirable…

Must-Read: Pedro Bordalo, Nicola Gennaioli, and Andrei Shleifer: Diagnostic Expectations and Credit Cycles

Must-Read: Very clever indeed…

Pedro Bordalo, Nicola Gennaioli, and Andrei Shleifer: Diagnostic Expectations and Credit Cycles: “We present a model of credit cycles arising from diagnostic expectations…

…a belief formation mechanism based on Kahneman and Tversky’s (1972) representativeness heuristic. In this formulation, when forming their beliefs agents overweight future outcomes that have become more likely in light of incoming data. The model reconciles extrapolation and neglect of risk in a unified framework. Diagnostic expectations are forward looking, and as such are immune to the Lucas critique and nest rational expectations as a special case. In our model of credit cycles, credit spreads are excessively volatile, over-react to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.

Must-Read: Thomas Philippon

Must-Read: An absolutely key issue: why doesn’t the logic of cost-reduction via scale and technology work for finance as a whole? It certainly works for commissions…

Thomas Philippon: Finance vs. Wal-Mart: Why are Financial Services so Expensive?, in Rethinking the Financial Crisis, edited by Alan Blinder, Andrew Lo, and Robert Solow (Russell Sage Foundation, 2012): “Despite its fast computers and credit derivatives…

…the current financial system does not seem better at transferring funds from savers to borrowers than the financial system of 1910. “I would rather see Finance less proud and Industry more content…” –Winston Churchill, 1925

Must-read: Roger Farmer: “Pricing Assets in an Economy with Two Types of People”

Must-Read: Roger Farmer: Pricing Assets in an Economy with Two Types of People: “This paper constructs a general equilibrium model…

…with two types of people, where asset price fluctuations are caused by random shocks to the price level that reallocate consumption across generations…. Asset prices are volatile and price-earnings ratios are persistent, even though there is no fundamental uncertainty and financial markets are sequentially complete. I show that the model can explain a substantial risk premium while generating smooth time series for consumption and financial assets across types. In my model, asset price fluctuations are Pareto inefficient and there is a role for treasury or central bank intervention to stabilize asset prices.

Must-read: James Kwak: “Profits in Finance”

Must-Read: It used to be that we collectively paid Wall Street 1% per year of asset value–which was then some 3 years’ worth of GDP–to manage our investment and payments systems. Now we pay it more like 2% per year of asset value, which is now some 4 years’ worth of GDP. My guess is that, at a behavioral finance level, people “see” commissions but do not see either fees or price pressure effects.

Plus there is the cowboy-finance-creates-unmanageable-systemic-risk factor, plus the corporate-investment-banks-have-no-real-risk-managers factor. We are paying a very heavy price indeed for having disrupted our peculiarly regulated and oligopoly-ridden post-Great Depression New Deal financial system:

James Kwak: Profits in Finance: “Expense ratios on actively managed mutual funds have remained stubbornly high…

…Even though more people switch into index funds every year, their overall market share is still low—about $2 trillion out of a total of $18 trillion in U.S. mutual funds and ETFs. Actively managed stock mutual funds still have a weighted-average expense ratio of 86 basis points. Why do people pay 86 basis points for a product that is likely to trail the market, when they could pay 5 basis points for one that will track the market (with a $10,000 minimum investment)? It’s probably because they think the more expensive fund is better. This is a natural thing to believe. In most sectors of the economy, price does correlate with quality, albeit imperfectly…. And this is one area where I think marketing does have a major impact, both in the form of ordinary advertising and in the form of the propaganda you get with your 401(k) plan…. The persistence of high fees is partly due to the difficulty of convincing people that markets are nearly efficient and that most benchmark-beating returns are some product of (a) taking on more risk than the benchmark, (b) survivor bias, and (c) dumb luck.

Must-read: Matthew Klein: “Private Equity’s Mark-to-Make-Believe Problem”

Must-Read: Matthew Klein: Private Equity’s Mark-to-Make-Believe Problem: “No asset is inherently worth anything…

…just some multiple of the income you think it will produce over time. Both the earnings forecast and the multiple can change at a moment’s notice–sometimes because the outlook for the future has genuinely changed, but often for other reasons…. One sensible response is nihilism: the great appeal of buy-and-hold passive investing is you don’t need to have any opinions…. Others… still try to earn a living betting some of today’s market prices will change, often but not always because they think the average opinion is improperly interpreting the available information. Then there are those, such as private equity firms, who invest in illiquid assets. ‘Illiquid’ in this case means ‘thing that’s almost never traded’, which in practice means ‘we won’t pretend to know what it’s ‘worth’ in the absence of a market, but here’s a number if it makes you feel better’. (This is distinct from the other meaning of ‘illiquid’… which is ‘oh of course we’re good for the money, we just don’t have it on us right now’, usually in response to questions such as ‘I’m not getting back what I lent you because you blew it retaining junior tranches in subprime mortgage bonds, am I?’)…

Must-read: Yuka Hayashi and Anna Prior: “U.S. Unveils Retirement-Savings Revamp, but With a Few Concessions to Industry”

Must-Read: IMHO, long, long overdue…

Yuka Hayashi and Anna Prior: U.S. Unveils Retirement-Savings Revamp, but With a Few Concessions to Industry: “The Obama administration Wednesday rolled out a long-anticipated new rule aimed at transforming the way the financial industry delivers retirement-savings advice…

…Administration officials intend it as a direct attack on what they consider ‘a business model [that] rests on bilking hard-working Americans out of their retirement money,’ Jeff Zients, director of the White House National Economic Council, told reporters Tuesday. About $14 trillion in retirement savings could be affected… which requires stockbrokers providing retirement advice to act as ‘fiduciaries’ who will serve their clients’ ‘best interest.’ That is stricter than the current standard, which only says they need to offer ‘suitable’ recommendations…. Still… the financial industry… has fought the regulation since it was first proposed six years ago, [and] the final version includes a number of modifications… extending the implementation period… giving advisers more flexibility to keep touting their firm’s own mutual funds… curbing the paperwork and disclosure requirements…. Those fixes… could also give opposing companies and skeptical lawmakers more time to try to dilute the rule further or even try to kill it altogether under the new administration…. The new rule will be the centerpiece of President Barack Obama’s efforts to help middle-class families build retirement savings in an era when few have guaranteed pension benefits…

Today’s economic history: John Law in Venice

Economista Dentata: John Law in Venice: “John Law, like all the best people…

…spent some time in Venice (he actually died there in 1729). Being John Law, of course he ended up playing with money… (and not just in the Ridotto):

He would sit behind a table, at his elbow a pile of coins worth 10,000 gold pistoles. Law knew that many tourists, especially from France or England, would not be able to resist the temptation to gamble with him, so that they could boast of this fact when they returned home. He extended an open invitation to all-comers: for an outlay of one gold pistole, he was willing to gamble his entire 10,000, if his opponent could roll six dice and get each one to come up a six.

Well worth a bet, they thought, even at odds of 10,000:1–and one by one the extra gold pistoles came rolling in.  (Law was well aware that the real odds were in fact an even more unlikely 46,656:1).

From ‘The Spirit of Venice’ by Paul Strathern p. 306

Must-read: Olivier Blanchard and Joseph E. Gagnon: “Are US Stocks Overvalued?”

Must-Read: I think that this is completely right: expected returns on U.S. stocks right now are lower than average, but the gap between expected returns on stocks and on other assets is significantly higher than average:

Olivier Blanchard and Joseph E. Gagnon: Are US Stocks Overvalued?: “Are stocks obviously overvalued?…

…The answer is no, and the reason is straightforward…. What matters for the valuation of stocks is the relation between future growth and future interest rates. Put another way, the equity premium… has if anything increased relative to where it was before the crisis…. The Shiller P/E ratio reached 26 late last year and is currently around 24, compared with a 60-year average of 20. This elevated Shiller P/E measure is commonly cited as an indicator that stocks may be overpriced, including by Shiller himself….

The deviations of the P/E from its historical average are in fact quite modest. But suppose that we see them as significant, that we believe they indicate the expected return on stocks is unusually low relative to history. Is it low with respect to the expected return on other assets?… [But] in all six cases, the equity premium is higher in 2015 than in 2005. Put another way, stock prices were more undervalued in 2015 than they were in 2005….

If you accept current forecasts, and you accept the notion that stocks were not overvalued in the mid-2000s, then you have to conclude that stocks are not overvalued today. If anything, the evidence from 150 years of data is that the equity premium tends to be high after a financial crisis, and then to slowly decline over the following decades, presumably as memories of the crisis gradually dissipate. If this is the case, then stocks look quite attractive for the long run…

Must-read: Barry Ritholtz: “Hedge Funds Scramble to Reassure Investors”

Must-Read: Barry Ritholtz: Hedge Funds Scramble to Reassure Investors: “Why is it that in the face of underperformance…

…investors still seem to love hedge funds?… This rather astonishing figure:

The 20 most profitable hedge funds for investors earned $15 billion last year while the rest of the industry collectively lost $99 billion. Those top managers have made 48 percent of the $835 billion in profits that the hedge fund industry has generated since its inception….

I suspect that… a large part of the reason for [the] inflows[is] an ill-advised pursuit of market-beating alpha by investors who seem to be desperate to find the next James Simons…. There are no signs of it slowing down. That isn’t to say a rotation within the hedge fund firmament is not taking place… the disappointed limited partners in hedge funds also seem to be a fickle group. Like speed daters looking for Mr. or Ms. Right, they table hop in pursuit of the one manager who has the secret sauce to make the wealthy accredited investor even wealthier.