Dynamism, Disconnects, and Diversification: Lessons from History J. Bradford DeLong Professor of Economics, U.C. Berkeley Research Associate, NBER DB Advisors Global Quantitative Strategies Conference: Investing in a Post- Crisis World: Do the Old Rules Still Apply? 60 Wall Street; October 21, 2009 CONFERENCE DRAFT
Do the old rules still apply? What can we say—from a historical perspective—about investing in a post-crisis world? We can say that the old rules do apply: lots of the old rules do apply. But there are lots of old rules—the question is: which old rules apply? I think that, looking forward, two things are fairly clear: that the old rules that apply in extraordinary times will be the nineteenth-century rules of Walter Bagehot’s Lombard Street and Charles Kindleberger’s Manias, Panics, and Crashes; and that the old rules that will apply in normal times will be the rules not so much of the past twenty years but instead of the forty years before that—the forty years from 1900s and 1950s and 1970s and 1980s—the years in which Wall Street lived in circumstances like those of the 1950s, lived in the shadow of the memory of the Great Depression. So let me take a brief historical tour of pieces of the nineteenth—starting with English novelist E.M. Forster’s great-aunt Marianne in 1825—to reinforce the points you heard very first this morning: that in unusual times volatility widens and all correlations head to one. Let me then jump forward to the Great Moderation and its recent unwinding. And then let
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me survey Wall Street in the two generations after of the Great Depression to reinforce the point that over the long haul bearing systematic risk is likely to be rewarded—highly rewarded, in fact excessively-highly rewarded from the perspective of all those who are not overleveraged. How do you know if you are overleveraged? Ex post, you know because you are bankrupt and out of business. Ex ante, the historical lesson is: who knows?
English Novelist E.M. Forster’s Great Aunt Marianne English novelist E.M. Forster’s favorite great-aunt was Marianne Thornton; he was her favorite great-nephew. She left him a legacy that provided the cushion he needed to make his life as a fiction writer; he was grateful, and to express that gratitude wrote a biography of her based heavily on her letters. For our purposes Marianne Thornton was an interesting subject because of her brother Henry and because the Thornton family was one of the leading banking families in England around 1800. As Forster wrote:1 [Although the] Bank… had… in 1815 it had passed out of Thornton control…. Henry [Thornton, Marianne’s brother,] longed to join it… in 1825 he became an active partner... in Pole, Thornton, and Co. It was said to be yielding £40,000 a year…
which was as large a share of the British economy then as $400M would be today. Young Henry—in his twenties—had no previous banking experience, yet he became one of five partners—at this point you should be dividing $400 million a year by five—in what …was regarded as one of the most stable and most extensive banking houses in London…. The active partner was Peter Free.... On the surface all was now serene. Young Henry must have stepped aboard the family ship 1
E. M. Forster (1956), Marianne Thornton: A Domestic Biography, 1797-1887 (New York: Harvest), p. 109 ff.
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with confidence and pride... Now let me turn the microphone over to Marianne Thornton, in her letters —return address given only as “Battersea Rise”—to her newly-married friend Hannah More: Battersea Rise, 7th December 1825 PRIVATE AND CONFIDENTIAL Dearest Mrs. H.M., There is just now a great pressure in the mercantile world, in the consequence of the breaking of so many of these scheming stock company bubbles…
Can you say “irrational exuberance”? …and Free had been inexcusably imprudent in not keeping more cash in the House…
Can you say “excessively leveraged”? but relying on that credit in them which had never been shaken, and which would enable them to borrow whenever they pleased...
Can you say “able to adjust his portfolio by trading at or very close to recent market prices whenever they pleased”? [Free, however,] was not however particularly uneasy till last Thursday and Friday…. On Saturday however—that dreadful Saturday I shall never forget—the run increased to a frightful degree, everybody came in to take out their balance, no one brought any in; one old steady customer, who had usually £30,000 there, drew it out without, as is usual, giving any warning…
Think “nine months’ normal earnings of the bank with not five minutes’ notice”: and in order to pay it the House was left literally empty.... Such a
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moment of peril completely turned [managing partner] Free's head; he insisted on proclaiming themselves bankrupts at once, and raved and self-accused himself…. Old Scott cried like a child of five years old, but could suggest nothing. Pole and Down were both out of town. Henry saw it all lay upon him.... [H]e found that during the next hour they would have to pay thirty-three thousand [pounds], and they should receive only twelve thousand. This was certain destruction, and he walked out, resolved to try one last resource…
Picture this guy: in his twenties, six months working in the banking industry, wandering the streets of London’s financial district, with nothing to offer in collateral, at 4 PM on a Saturday afternoon, looking to borrow cash. He finds another banker: John Smith [who] had been... particularly kind to Henry…. John Smith asked if he could give his word of honour... that the House was solvent. Henry said he could…. John Smith declared… he would apply to the Bank of England for them. Henry had little hope from this, for the Bank had never been known to do such a thing in the annals of Banking.… [T]he next morning at 8 o'clock [AM Sunday]]…. [A]ll the Bank of England directors who were in town.... John Smith began by saying that the failure of this House [of Pole, Thornton] would occasion so much ruin that he should really regard it as a national misfortune…
Can you say “too big to fail”? [H]e then turned to Henry and said, 'I think you give your word the House is solvent?' Henry said he could… he had brought the books.... 'Well then', said the Governor and the Deputy Governor of the Bank, 'you shall have four hundred thousand pounds by eight tomorrow morning, which will I think float you'. Henry said he could scarcely believe what he had heard.… He was off again in the dark on Monday morning to the Bank of England, where he found the Governor and Deputy Governor who for the sake of secrecy had no clerks there, and they began counting out the Bills for him. 'I hope this won't overset you my young man', said one of them, 'to see the Governor and Deputy Governor of the Bank [of England] acting as your two clerks. He went back to the banking house £400,000 richer than he left it on Saturday. For the first hour there was a little run, but the rumours that the Bank of England had taken them under its wing soon spread, and people brought back money as fast as they had taken it out on Saturday...
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1825 is the first time this happened. The first time that the financial system was large enough and integrated enough with the nascent industrial economy for a financial crisis to threaten to produce large-scale unemployment. It was the first time that as a result the crisis called forth aggressive public action to support and sustain market prices and market liquidity—by two guys in the Bank of England counting out banknotes and sending them out in a cart down Threadneedle Street (in violation of the Bank of England’s charter, I must say); by TARP and TALF and ARRA and a host of other alphabet-soup vehicles today. That is the first point: things change, but they remain the same. The place we have been over the past two and a half years is a place where we have been before—even though it is something we thought we had outgrown. So, now, what happened, and why did we think we had outgrown it? And for that I want to turn from English novelist E.M. Forster’s great-aunt Marianne to the University of Chicago’s Nobel Economics Prize Winner Robert Lucas.
The University of Chicago’s Nobel Economics Prize Winner Robert Lucas Back in 2003 Robert Lucas gave his presidential address to the American Economic Association. He talked about the origins of the economic subdiscipline of macroeconomics: Macroeconomics was born as… the intellectual response to the Great Depression… knowledge and expertise that we hoped would prevent [its] recurrence...
And about how this subdiscipline had been, to a remarkable extent at least for economics, an extraordinary intellectual and policy success: My thesis… is that macroeconomics… has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes…
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And back then I agreed with him.
Federal Reserve Chair Alan Greenspan The Federal Reserve, under Alan Greenspan, had adopted a policy pose I call “Greenspanism”: lighten the regulatory hand of the government on financial institutions, let them innovate, there will be episodes of irrational exuberance and those rich people who become irrationally exuberant will in the end lose lots of money, but the Federal Reserve has the power and the skill to keep financial turmoil limited and, especially, to keep financial turmoil from spilling over to the non-financial economy in the form of substantial output declines, large amounts of idle production capacity, and mass unemployment. As of 2003 the Greenspanist bet appeared a good one. The early 1980s had seen the opening of securities options trading in Chicago. O’Brien, Rubenstein, and my Berkeley colleague Hayne Leland had convinced a lot of mutual funds to buy their “portfolio insurance” dynamic options trading strategy (and a lot of others were following similar strategies on their own), and the stock market drops by a quarter in one day. But the Federal Reserve steps in. And you cannot see the 1987 crash as generating even a ripple in capacity utilization or unemployment. Similarly, 1990 saw S&Ls that appeared to have bad business judgment poorly regulated—in part because they were good at using congress to block their regulators—crash. The Treasury loses $150 billion, investors in S&Ls lose everything, the rest of us get a bunch of extra shopping malls (albeit half-empty ones) to shop in, and the Federal Reserve steps in and we see only a ripple in capacity utilization and unemployment. 1998 saw Michel Camdessus and Stanley Fischer at the IMF announce that nucleararmed ex-superpowers like Russia are not, in fact, too big to fail and the partners of Long Term Capital Management deeply, deeply regret their decision to return two-thirds of their capital to their ex-investors and their creditors regret their decision to lend people with $3 billion $100 billion with no collateral or oversight whatsoever—and the Federal Reserve steps
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in and you cannot see the 1998 crash as generating even a ripple in capacity utilization or unemployment. 2000 sees the bursting of the mother of all irrational exuberance bubbles. The stock market reaches its all-time peak a month after high McCain advisor Kevin Hassett and George W. Bush library director James Glassman double down their “Dow 36000” bet and promise substantial donations to charity if their stock market targets have not been reached by January 2010 (note: already stretching their three-to-five year horizon to a decade). As investors realize that internet technologies are wonderful but that making money off of them is hard—that practically all of the value is flowing to consumers through market competition—the market crashes. And the Federal Reserve steps in, and we see only a ripple in capacity utilization and unemployment. Treasury Assistant Secretary and then Federal Reserve Chair William McChesney Martin said, famously, that the purpose of the Federal Reserve was to take away the punchbowl before the party got going. His successor’s successor’s successor’s successor Alan Greenspan begged to differ: the Federal Reserve, Alan Greenspan thought, should—as long as there was no threat of an inflationary spiral in consumer prices—be willing to spike the punchbowl with the grain alcohol of 1% federal funds rates, because it can serve as a designated driver to make sure that everyone gets home. Four years ago I was a reluctant but convinced Greenspanist: one of those hooting at Raghuram Rajan at the Federal Reserve’s Jackson Hole conference when he argued that financial innovation and sophistication had exposed us to aggregate risks we did not understand and that global central banks might not be able to manage. (The only person I recall speaking up in support of Raghuram was Armenio Fraga.) Today—can you say “agonizing reappraisal”?
“V”s versus “L”s I believe that we can all agree that Greenspanism is wrong.
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We Can All Agree Now that Greenspanism Is Wrong
QuickTime™ and a decompressor are needed to see this picture.
And I believe we none of us expect a rapid return to normal levels of unemployment, of capacity utilization, and of the employment-topopulation ratio. Very few people expect a V-shaped recession as far as unemployment is concerned. We today generally forecast 3-4% per year real GDP growth starting sometime around last May, but we also generally forecast an unemployment rate that stays near 10% for the next eighteen months. When Christy Romer and Jared Bernstein ran the forecast numbers for the incoming Obama administration ten months ago they— trying to stay close to the middle of the private-sector forecast pack— projected that with the policies they hoped to enact the unemployment rate would be near 7% by the end of 2010. They got congress to pass more-orless what they asked for. Yet we today see ourselves as much more likely to see 10% unemployment than 7% unemployment as of the end of 2010. The reason for the slow recovery is, I think, clear. Recessions arise when asset prices crash, and when as a result businesses find it unprofitable to raise capital to expand capacity or even to continue operations at the previous scale. The substantial post-World War II recessions before 1990 were all produced by Federal Reserve decisions to raise interest rates to fight inflation, decisions that produce correlated falls in all asset prices
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from Treasuries to equities and real estate and beyond. And when those policies are reversed—when the Federal Reserve decides it has done enough or gone to far and reverses its high interest rate policies—all asset prices rise together in a correlated fashion, non-financial businesses find they can raise capital on more-or-less normal terms again, and we have a “V.” “V”s versus “L”s
That hasn’t happened since the start of the 1990s. Since the start of the 1990s, recessions have typically seen a negative correlation between returns on U.S. Treasury bonds—in the first, short-term, and in the second and third episodes, all—and returns on other asset classes. The configuration of asset prices wheels as the prime mover is not inflationfighting on the part of the central bank but instead a fall in risk tolerance on the part of the private market. And risk tolerance does not spring back to normal immediately after the recession trough is reached. And so asset prices do not recover as rapidly as they do when the prime impetus behind the recovery is the Federal Reserve lowering interest rates. And so we get an L more than a V. That’s what we got in the Great Depression. That’s what Japan got in the 1990s. That’s what we got to some extent in the early 1990s and to a greater extent in the early 2000s. And it looks like that is what we are getting now.
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So why does the risk tolerance of the private market collapse?
Robert Lucas Again Let me go back to the very sharp Professor Robert Lucas again, this time not to his AEA presidential speech but rather to an interview he gave Tom Keene of Bloomberg seven months ago. LUCAS: Our economy’s got a remarkable ability to return to its long term growth trend. And for most of the depressions we’ve had or recessions, the return has been quick. Two or three, four years...
Lucas says that it is highly likely that the U.S. economy will be back to normal in three or four years, with a normal level of unemployment, a normal share of profits in national income—and a normal level of dividends and capital gains. This presumably means that stock prices will also be back to a normal multiple of long-run earnings, which means a year-2015 S&P of 1500 or so, compared to its March 2009 level of 700. But Lucas also tells Tom Keene: LUCAS: [T]here is no question that fear is what this liquidity crisis is. I mean the reason I got into money [with my portfolio] is that I got afraid to leave my pension fund in other securities. So I’m sitting there with a portfolio full of zero-yield stuff just because I’m afraid to do anything else. I think there are millions of people like me… KEENE: What will be the signal for Robert Lucas to go back into the markets?… LUCAS: I don’t know. Robert Rubin made a joke about that in the first session today. Nobody knows...
Investing in the S&P 500 for a six-year horizon is risky, certainly, but the expected return is high: 15% per year, if you believe Lucas’s forecast. And holding your money in cash is not all that safe either: the scenarios I can envision in which the S&P 500 is at a real value in 2015 corresponding to
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the value that 700 buys today are scenarios in which inflation has eaten away much of the value of cash. So what is Lucas doing holding his portfolio in cash? Has risk suddenly increased to an extraordinary extent to force the equity share of his portfolio down from 70% to 0% in spite of the huge jump in expected six-year returns? Risk has increased, but to that extent? Has his horizon shortened? No, he hasn’t boosted his consumption level. What is happening is that he, and millions of the other upper-middle class people like him who together deploy a majority of the net financial wealth of America, is behaving as if his tolerance for risk suddenly and utterly collapsed. Why? Because he is panicked. And he is not thinking that the economicforecasting part of his brain his things to tell his dig-a-hole-and-hide part of his brain, like: “Your horizon is not one week but six years.” My guess is that the salience of the 2000 and now 2007-2009 market crashes—the ones in which the structure of asset prices wheel, as the prices of U.S. Treasuries (and the dollar) rise while the prices of all other assets fall, and fall the more the more risky they are perceived to be—in the minds of America’s upper middle class will be high for a generation. And so their risk tolerance will be low. It will be much more like the years before the 1920s, when industrial, utility, and even railroad equities were seen as very risky investments in markets rife with insider trading and fraud that were not for normal people, or the years from 1945 to 1995 or so in which the memory of the Great Depression, somewhat reinforced by the oil shocks of the 1970s, limited the risk tolerance of middle America. What will such a structure of asset prices be like?
Robert Shiller and John Campbell Let’s start with what Harvard’s John Campbell and Yale’s Robert Shiller call the Graham ratio, after Warren Buffett’s guru Benjamin Graham, who said somewhere that a ten-year moving average of past earnings is a very good rough guide to what the permanent level of earnings is. And who said that the first question you should always ask to assess asset values is
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to compare them to the long-run cash flows you can expect—which, for equities, are reasonably well-captured by permanent earnings. The figure shows this Graham ratio for the S&P Composite index, linked back in the past to the Cowles Commission index for the years from 1870 up to just after World War I as the best proxy for a major market index back then that we have.
The Graham Ratio, 1880- 2009
Looking at this Graham ratio teaches three things: that major movements in it are reversed, that reversals are movements in prices not earnings, and that the average level is quite low relative to analogous measures for other assets.
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If You Are Very, Very Patient…
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If your horizon is long enough—twenty years, say, major movements are highly likely to be reversed. Whether the twentyyear fall from 1900-1920 from 20 to 5, the runup in the 1920s from 5 to 32, the collapse in the Great Depression, the runup from 1950 to 1965, the collapse from 1965 to 1980, or the runup from 1980 to 2000.
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When the Graham ratio strongly reverts toward its previous mean, it will not do so by having earnings fall (if the Graham ratio starts out low), or by having earnings rise steeply (if the Graham ratio starts out high). Instead, permanent earnings, generation after generation, in the United States grow—and outside the United States grow too save in countries that suffer hyperinflation, revolution, or massive destruction in war.
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The average level of equity prices relative to the potential available cash flows earned by these equities is on average low. In fact, it is so low on average that diversified investments in equities only fail to outperform safe assets—whatever they are—when price-tolagged-average-earnings at the aggregate are above twenty-five or so.
Back at the end of the 1970s when Shiller began running these regressions they were at the edge of statistical significance: the standard sneer at a conference was that Robert Shiller has run fifty regressions on aggregate returns and found one that is significant at the 5% level. Now we have thirty years more of data than when Bob Shiller was a young, green assistant professor desperate to get tenure. And rather than being significant at the 5% level they are now significant at the 0.5% level. Patience is, however, very very important for this. You have to have a horizon long enough to outlast the large movements in risk tolerance of America’s upper middle class in order for every equity and risk-bearing strategy to benefit from this long-run pressure toward mean-reversion. Shorter-term portfolios gain an edge from mean reversion, yes, but those that profit most are those that predict moves in fundamentals and moves in market-wide risk tolerance. Nevertheless, patience is highly likely to win out in the end. My view is that you cannot expect the professionals to fill up the risk-bearing gap when the people with portfolios of $1 to $10 million as a group turn them into cash, and won’t be enticed out now matter how high expected returns get—indeed, whose demand curves slope the wrong way so that the lower asset prices drop to produce higher long-run returns, the more scared they become. The true professionals are, after all, highly enough leveraged as it is: Goldman Sachs has been one step from blowing up three times in the past century—at the start of the 1930s with the collapse of the Goldman Sachs Trading Company, in 1970 when they and their clients were caught in the Penn Central bankruptcy, and in 2008 when their hedging of subprime risk
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had exposed them to lots of AIG risk that they did not understand and had not hedged. If You Are Patient, But Not Very, Very Patient…
And a ten-year horizon is not long enough. People have lost money in inflation-adjusted terms investing in a diversified portfolio of the U.S. stock market over ten years—even when prices have not been obviously out-of-whack relative to permanent earnings.
The Bottom Line Ten or fifteen years ago, academic economists speculated about the longrun flattening of the CAPM line and the forthcoming reduction in the equity return premium. Investors in the 1950s had feared a return of the
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Great Depression—but the success of macroeconomics that Lucas trumpeted (and that I agreed with) in 2003 made that extremely unlikely. Investors in the 1970s feared a breakout into high inflation that might end in confiscatory taxation—remember windfall profits taxes?—on profits that were not really there, were simply artifacts of how IRS reporting interacted with inflation. But the end of the 1970s saw the Federal Reserve granted a baton to do whatever was necessary to control consumer price inflation. Economists in the 1990s weren’t—with a few exceptions— forecasting Dow 36,000 in three to five years. But they were implicitly forecasting that Graham ratios today would typically be much closer to 30 (and thus that real long-term average returns on value-weighted diversified U.S. equities would be a number like 3.3% per year) to the post-World War II average or today’s value of 17, and thus that real long-term average returns on value-weighted diversified U.S. equities would be much more like 6% per year. Now I think we have to draw a different lesson. To the extent—and I think it is a substantial extent—that the financial turmoil and the 401k impairment of the past decade has returned America’s upper middle class to an attitude toward equities much more like that of the 1900s or 1950s or 1970s than today, we can look at asset markets in which all kinds of risk are amply rewarded. But this risk is, we now know, risky. Three times in the past century economists and policymakers have confidently predicted that they had the business and financial cycles licked: in the 1920s (when Yale’s Irving Fisher said that modern monetary management plus the success of the war on drugs—Prohibition—had pushed equity prices to a permanently high plateau), in the 1960s (when the Department of Commerce changed the title of its Business Cycle Digest to the Business Conditions Digest), and in the 2000s (with all the papers on the Great Moderation reaching its apex in the Greenspan retirement year of 2005). Economists and policymakers are, if anything, even more prone to irrational exuberance than investors. Don’t believe that bearing risk is not going to be highly, highly rewarded over the course of the rest of your careers. It will be highly valued—unless
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the salience of the memory of 2000 and 2007-2009 is magically erased from popular culture and the brains of America’s and the world’s uppermiddle class. And it won’t be magically erased. And, after all, what else are you going to do? It’s not as though inflationhedged government bonds will even pay your expenses: TIPS Yields
But, also, don’t believe economists and policymakers the next time they say that the business cycle is licked, that there is a “Great Moderation” in progress: fool me once, shame on you; fool me four times… shame on me.
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