May 2005 Musings on Finance

1
May 2005 Musings on Finance

• J. Bradford DeLong
• U.C. Berkeley and NBER
• http//www.j-bradford-delong.net/movable_type/
• May 26, 2005 GARP San Francisco Chapter

2
A Macroeconomists Look at Finance

• Is this useful?
• Macro possibly a fraudulent enterprise--an
  epicyclic set of just-so stories about past
  events that has no predictive power
• I have confidence because of three calls in the
  past decade deficit reduction in the mid-1990s,
  the need to cut interest rates rapidly when the
  NASDAQ crashed in 2000, European stagnation
• But I may be deluding myself
• And, in any event, finance is different from
  macro
• Very possible to get the macro right and still
  get the finance wrong.

3
Here to Make Three Relatively Disconnected Points

• Points that I, at least, think are interesting
• Point I the dot-com bubble was not that large
• Point II its very hard to be too optimistic
  about the very long-run outlook for equities
• And probably for debt as well
• Point III I simply cannot make the medium
  term--three to ten years--add up

4
The Dot-Com Bubble

• Looks impressive
• Backed up by impressive stories
• Palm and 3Com
• George Gilder my new subscribers will be very
  sad
• Lets do some calculations

5
The Bubble Started Relatively Late

• Conventional accounts start with the 1995
  Netscape IPO
• But investors in the Netscape IPO did very well
  indeed in the long run that was the companys
  independent histor
• And do well today
• Those who invested in the Nasdaq in September
  1995 and shadowed the index have earned real
  returns to date of 7.3 percent per year.
• At the end of 1996 Alan Greenspan was worried
• "How do we know when irrational exuberance has
  unduly escalated asset values?
• If you had invested in the Nasdaq while Mr
  Greenspan was writing his speech, you would have
  realised a real return from then until now of 8.1
  per cent per year.
• The answer to Greenspans implicit question of
  December 1996--"Are asset prices unduly escalated
  by irrational exuberance?" -- was No.

6
Broadly, Bad News for High-Tech Since 2000

• Since the start of 2000, the Nasdaq has been hit
  by two particular pieces of bad news
• the September 11 2001 terror attack
• that it has turned out to be surprisiingly hard
  to transform technical excellence in information
  and communications technology into durable
  profits.
• The major beneficiaries of high-tech innovation
  since 2000 have not been the workers,
  entrepreneurs and financiers of Silicon Valley,
  but users of their products and ideas
• The beneficiaries are companies like
  Wal-Mart--both its shareholders and its customers
• These two pieces of fundamental bad news were
  unknowable in the late 1990s

7
So When Did the Bubble Start? A Yardstick

• We need a yardstick
• We demand higher than average expected equity
  returns from a risky index like the Nasdaq
• We also suspect that actual returns have fallen
• Guess that these factors cancel each other out
• Realized Nasdaq real returns drop below 3 percent
  per year starting in October 1998
• Drop below zero starting in November 1998.
• Drop below 6.5 per year starting in April 1997

8
How Big Was the Bubble?

• Conclusion A bubble that lasts for at most three
  years, and possibly only one and a half.
• Does this mean Mr. Market is smart, or Mr. Market
  is dumb? You can spin it either way
• With
• Rapid technological change
• Very uncertain long-term consequences
• A population of investors vulnerable to
  irrational exuberance
• Even so, the market was still cranking out
  reasonable valuations until mid-1997 or
  late-1998--even though observers like Greenspan
  were very worried
• Alternatively, if you believed Dow 36,000 and
  bought the Nasdaq at its February 2000 peak
• Even with the recovery since late 2002, you are
  still down by half in real value

9
A Few Words About the Very Long-Term Outlook

• Current equity earnings yields of roughly 5.3
• Jeremy Siegel says subtract half a
  percentage-point for options and other water in
  the numbers
• Hard to see how from this starting point American
  equities can match their historical 6.5-7.0
  real return
• However, accounting earnings yields are not
  returns
• Companies with strong market positions can earn
  very high rates of return on reinvested earnings
  if economic growth is rapid

10
Will Very Long Run Economic Growth Be Rapid?

• The ongoing demographic transition says
  labor-force growth wont be that high
• Disagreements about the long-run productivity
  outlook
• Robert Gordon sees more of the 20th Century same
• SSA sees substantial slowing
• In either case, total growth unlikely to match
  20th Century pace

11
Impact of Slower Growth on Asset Returns

• Econ 1-level analysis--but thats all it needs
• Supply of capital by this generation of savers
• Demand for capital by next generation of
  businesses
• Depends strongly on rate of economic growth
  between then and now
• Slower growth moves demand for capital inward
• Produces lower asset returns
• Danger this is a macroeconomic model
• Calibration knocks two percentage points off
  returns

12
Ways Out?

• Reduced savings
• Because of feckless fiscal policy and large
  deficits
• But this slows growth as well
• Bequests
• People with fewer children save less because they
  dont have as many bequests to leave
• Greg Mankiw thinks this counterbalances the
  effects of slowed labor-force growth
• Greg Mankiw has drunk the koolaid
• Large-scale capital exports
• Huge trade surpluses
• Britain did it in the 1890s. Maybe we will do it
  in the 2040s
• But this is a scenario, not a forecast

13
The Medium Run Conundrum Domestic Side

• Why arent long-term interest rates higher?
• The savings-investment imbalance in the
  flow-of-funds
• Low personal savings plus big government budget
  deficits
• Normal investment
• Someday the capital inflow will end
• Bond markets ought to be pricing the end of the
  capital inflow now
• They arent

14
The Medium-Run Conundrum International Side

• Countries with big trade deficits ultimately see
  the values of their currencies fall
• U.S. has a big trade deficit--7 of GDP
• Required currency value fall at full employment
  from 30 to 70, depending on the model
• U.S. interest rates ought to have this expected
  depreciation premium built into them
• They dont

15
Alternative Views of This Conundrum

• Macroeconomists freak out
• Alan Greenspan and company speak of a
  conundrum
• Finance people arent as puzzled
• Treasury isnt printing long-term bonds
• Mortgage-backed securities arent of incredibly
  long duration right now
• China and Japan parking huge amounts of reserves
  in long-term Treasuries and close substitutes
• Should we be puzzled?
• Our macroeconomic bond market models
• Key off of short-term interest rates, and off of
  term-structure and interest-parity relationships
• Requires that somebody--a lot of somebodies--be
  trading on those term-structure and
  interest-parity relationships on a very large
  scale in order to make them true
• Apparently, people arent doing so does this
  mean there is money on the table?