Market Behavior
*NEW*
The National
Bureau of Economic Research, a major source for these notes, publishes monthly a
review of research projects in process or under development, N B E R Reporter.
The latest issue, Summer 2005, has an extended discussion by Jeremy Stein of
Harvard on latest research in the area of behavioral finance. Stein is one of
my favorite contributors that research, and this is a lively summary. The
Reporter is well worth receiving regularly.
What explains
the stock market’s reaction to Federal Reserve policy? By Ben Bernanke and Kenneth
Kuttner, Journal of Finance, Vol. LX, No. 3, June 2005. Although
the findings are not a source of surprise in this carefully researched and
tightly-packed article of 34 pages, the lead author was a Governor of the Fed and
subsequently became Chairman of the Council of the Economic Advisors; his co-author
is on the Fed staff. Hence, the findings have extra authority. The analysis
documents a relatively strong and consistent response of the stock market to
unexpected policy actions (my italics). Unexpected inaction of the FOMC
produces smaller responses. Industry sector responses to unexpected policy actions
differ, and “seem broadly consistent with the predictions of the standard CAPM.”
But “monetary surprises are responsible for only a small portion of the overall
variability of stock prices.” Stocks are claims on real assets and, under
conditions of monetary neutrality, should not be responsive to changes in monetary
policy. The authors suggest – but do not conclude – that the expected equity risk
premium is the prism through which investors respond to changes in monetary policy.
Evidence on
rationality in commercial property markets: An interpretation and critique, by
Patric Hendershott, Robert Hendershott, and Bryan MacGregor, Working Paper # 11329,
National Bureau of Economic Research, 1050 Massachusetts Avenue, Cambridge, MA 02138,
May 2005. The general case for irrationality is that real asset prices have
moved too much given the future real cash flows the assets are likely to produce under
reasonable conditions. It follows that, under irrationality, mean reversion in real
cash flows is not reflected in investor valuations, resulting in high asset values
when real cash flows are high and vice versa. This study looked at the worldwide
commercial property boom in the late 1980s and early 1990s for symptoms of
irrationality and concluded that, “real prices got so far out of line with real cash
flows in these markets as to leave little doubt as to irrational pricing” – with the
possible exception of the U.K. property market.
The long-term
interest rate conundrum: Not unraveled yet? by Tao Wu, Federal Reserve Bank of San
Francisco Economic Letter, April 29, 2005. This analysis of the persistence
of low long-term interest rates as the Fed has raised the short-term rate over an
extended period of time explores whether the tremendous increase in purchases of U.S.
Treasury securities by Asian central banks explains the conundrum. If so, a decision
by these banks to diversify could lead to a sharp rise in Treasury yields, even under
conditions that might produce the opposite result. After a thorough analysis of the
relationships involved, the paper concludes that there is little solid evidence
suggesting a persistent relationship between U.S. Treasury yields and foreign central
bank purchases. Foreign official purchases account for only a small fraction of the
total credit flow in the U.S.
Systemic risk and
hedge funds, by Nicholas Chan, Mila Getmansky, Shane Haas, and Andrew Lo, National
Bureau of Economic Research, 1050 Massachusetts Avenue, Cambridge, MA 02138, March
2005. Based on evidence that the hedge fund industry has a “symbiotic
relationship” with the banking sector, and many banks now operate proprietary trading
units organized much like hedge funds, new systemic risks are in process of building
up. Based on a number of new and ingenious new risk measures such as illiquidity risk
exposure, and nonlinear factor models for hedge-fund and banking-sector indexes,
preliminary findings suggest systemic risk is currently on the rise, along with a
challenging period of lower hedge fund expected returns.
Diversification
discount or premium? New evidence from the Business Information Tracking
Series, by Belén Villalonga, Journal of Finance, April 2004.
Conventional wisdom tells us that diversification tends to reduce share values.
Acquirer shares usually decline at such announcements. Investors can compose
their own diversification and do not need company managements to do that risk
management function for them. Oh, really? This study shows that most
companies engaging in large diversification programs already sold at a
discount, and that many of the companies they buy were also selling at
discounts at the time of acquisition. In fact, the acquirers shares tend to
gain in value over time as a consequence of the diversification program.
Equity
style returns and institutional investor flows, by Kenneth Froot and Melvyn
Teo, Working Paper #10355, National Bureau of Economic Research, 1050
Massachusetts Avenue, Cambridge, MA 02138, March 2004. Investors
trade stocks in groups organized by style. The direction of such trading
predicts what returns are going to be by style. Individual stock returns are
also heavily influenced by the style group to which investors have assigned
them.
Which
risks have been best rewarded? By Antti Ilmanen, Rory Byrne, Heinz Gunasekera,
and Robert Minikin, Journal of Portfolio Management, Winter 2004.
This paper analyzes the consistency of rewards for bearing risks in the
capital markets from 1985 to early 2002. Equity risk and duration risk were
well rewarded; investing in credit was not such a good idea. This is an
elaborate study, worth careful reading.
Inflation
illusion and stock prices, by John Campbell and Tuomo Vuolteenaho, Working
Paper #10263, National Bureau of Economic Research, 1050 Massachusetts Avenue,
Cambridge, MA 02138, January 2004. This paper begins by decomposing
the S&P 500 dividend yield into (1) a rational forecast of long-run real
dividend growth, (2) residual mispricing attributed to the market’s forecast
of dividend growth deviating from the rational forecast, and (3) the
subjectively expected risk premium. On the basis of this analysis, the
authors find that the level of inflation explains almost eighty percent of
the time-series variation in stock mispricing – coincident with the
Modigliani-Cohn hypothesis that stocks should be hedges against inflation but
investors fail to understand and misprice them [See Franco Modigliani and
Richard Cohn, “Inflation, rational valuation, and the market,” Financial
Analysts Journal, 1979].
Technological
change and the stock market, by John Laitner and Dmitry Stolyarov, Journal of
Finance, September 2003.
Why did Tobin’s q, normally above 1.0, drop below that level during 1974-1984.
Inflation is the usual choice as the villain. The analysis here shows that
periodic arrivals of new technologies, such as the microprocessor in the
1970s, renders old capital – real as well as human – obsolete, causing the
stock market to drop. In addition to the interesting presentation of the
main point, the authors provide a full table of the elements of the q ratio
from 1953 to 2001 – most helpful to have in your data bank.
What
moves sovereign bond markets? The effects of economic news in U.S. and
German yields, by Linda Goldberg and Deborah Leonard, Current Issues,
Federal Reserve Bank of New York, September 2003.
The largest moves of yields in Germany result more recently from economic
news in the U.S. than news in Germany, while German news has little impact
on U.S. fixed-income markets. Labor market conditions, real GDP growth,
and consumer sentiment in the U.S. are the prime movers of German bond markets.
Capital
investment and stock returns, by Sheridan Titman, K.C. John Wei, and Feixue
Xie, Working paper #9951, National Bureau of Economic Research, 1050
Massachusetts Avenue, Cambridge, MA 02138, September 2003.
Everybody applauds growth, but the stocks of companies that increase
capital investment subsequently lag market returns. These results apply
especially to firms in the best position to spend money on capital
investment because they have higher cash flows and lower debt ratios.
Empire building is a cause of investor underreaction.
Winning
isn’t everything: corruption in sumo
wrestling, by Mark Duggan and Steven Levitt, American Economic Review,
Vol.92, No. 3. This article documents corruption – rigging of
matches - among Japan’s elite sumo wrestlers, in that under certain
conditions one wrestler will allow his opponent to win a match under
the nonlinearity in incentives for wrestlers who achieve a winning
record. The details are most interesting, but depressing. “[I]f
corrupt practices thrive here, one suspects that no institution is
safe. Sumo wrestlin is the national sport of Jpaan, with a 2000-year
tradition and a focus on honor, ritual, and history that may be unparalleled
in athletics.
Anomalies
and market efficiency, by G. William Schwert, Working Paper 9277,
National Bureau of Economic
Research, 1050 Massachusetts
Avenue, Cambridge, MA 02138, October 2002. This analysis by one of
the most authoritative academics in the field of investment research
argues that anomalies may be “more apparent than real.” In
a wide-ranging survey of many different kinds of anomalies, some less
well-known than others, Schwert concludes that the evidence on anomalies
strongly supports the conclusion that they tend to self-destruct. Schwert
believes these arguments demonstrate that anomalies support rather
than disprove the Efficient Market Hypothesis.
Equity
volatility and corporate bond yields, by John Campbell and Glen
Taksler, Working Paper 8961, National
Bureau
of Economic Research, May 2002. This is a fascinating paper, which
aims to explain why corporate bond yield spreads versus governments
grew wider in the 1990s even though the rising stock market should
have implied more optimism about corporate finances and therefore diminishing
yield spreads. But Merton and others have explained that corporate
bonds are in essence riskless bonds plus a put that bondholders issue
to the owners of the company’s equity. The more volatile an equity
issue, the greater the value of that put, which tends to depress bond
prices relative to riskless securities. Although overall equity market
volatility shows no uptrend during the 1990s, significant increases
in the volatility of individual issues has occurred. Q.E.D.
“Valuation Ratios and the Long-Run Stock Market
Outlook: An Update,” by John Campbell and Robert Shiller, National
Bureau of Economic Research Working Paper #8221. Based on data from
1871 to 2000 for the U.S. and since 1970 for twelve countries, Campbell
and Shiller show how P/Es and dividend yields fail to forecast any
form of growth but do effectively forecast stock prices. The analysis
here is the genesis of Shiller’s book, Irrational Exuberance.
