Monthly Archives: July 2015

It’s a common proposition that prevailing market valuations are unreflective of underlying fundamentals. Some say that we’re living through an outright bubble and are in for a correction, and others that markets will be lethargic and stagnant over the next few months, without much room to grow at historical rates.

On the other hand, extremely low interest rates – not just in Treasuries, but safe(r) assets in general – suggest anxiety about future growth. If growth potential really is so fantastic, it doesn’t make sense to crowd into risk-free assets that have almost no claim on that growth. One explanation could be a decline in the risk premium, which militates in favor of the “lethargic and stagnant” view – that we’ve rerated valuations with a lower discount rate, but shouldn’t expect exceptional growth.

A decline in the risk premium would suggest a host of projects that were otherwise unprofitable become feasible, resulting in increased business investment across the board. This may be the case (and we can’t examine the counterfactual) but, somehow, this doesn’t sit well with the prevalence of cash and highly liquid assets piling up on corporate balance sheets.

One simple (if unsatisfying) explanation might be that markets aren’t efficient. There are two types of inefficient. The sort that persists temporarily, and that is bidded away as investors and arbitrageurs profit on the discrepancy, and the sort for which there isn’t an obvious correcting mechanism. The latter, I would argue, is rarer but one can definitely contrive explanations that make sense of the situation.

A possibility that I find appealing stems from a simple principal-agent dilemma. The risk profile for high-level managers (who are – as a baseline – compensated extremely well) aggressively pursuing projects that become viable on the margin is asymmetric. If lots of cash is lost, the manager risks his job. If it succeeds, given that it is a marginal investment, the effect on his bonus would be minimal. The literature on CEO salaries outlines incredible bonuses as an incentive to take big risks – but big risks with big payoffs (and big losses), not necessarily those that are merely better than nothing.

There is some real evidence that this sort of managerial kerfuffle is real:

Importantly, the hurdle rates are often left unchanged for years, even when interest rates drop. A paper included in the latest Reserve Bank Bulletin reports that some hurdle rates have not changed in years.

They were set when interest rates were “far higher than they are today”.

The bank’s findings match those of a survey by Deloitte that found that two-thirds of corporations recalculate their hurdle rate less frequently than they recalculate their cost of capital. Nearly half change their hurdle rate “very rarely”.

Among the reasons businesses give are that changes to the rate might “send the wrong message to staff proposing projects”. Another reason is that changes in the hurdle rate “require board approval”.  Or that keeping the rate high protects against the type of economic uncertainty likely to be present when interest rates are low.

One could argue that this risk aversion should befall investors and managers. Unfortunately, high-level managers have a much less diversified implicit portfolio (including the returns from their labor) than investors, and cannot diversify the idiosyncratic risk that emerges from projects that are profitable on the margin (wherever EV is all the investor would care about).

This outlines at least one possible case of “persistent inefficiency”. You might even argue that inefficiency is cyclical – spare me a few moments of speculative rambling before we get to real data. In a sense the “market” is like a public good. We put into it by performing due diligence on stocks, commodities, and countries to arbitrage any mispricing and more efficiently allocate capital. We take from it by holding its value as a given and using models to infer useful information. Implicit volatility. Inflation expectations. Future price probability distributions.

There’s a tension between the two that becomes especially pronounced when one takes from one pond and puts it into another pond. If you’re a fundamental investor discounting future cash flows, you might take the forward Treasury curve as a starting point to measuring the WACC. (In fact, unless Janet Yellen tells you what she’s up to, you don’t have much of a choice but to take the forward yield curve as a given).

There is some “fundamental” work that goes into generating the forward curve which currently underprices the Fed’s dot plot. The market is telling you that certain economic and geopolitical gravities are conspiring against the Fed’s chosen choice of action – to increase interest rates. It’s come to this conclusion under the guidance of thousands of macro investors who have studied these forces to the extent they can.

Then your value investors are taking this work and applying it to their valuations of individual companies. If the market is wrong, and the Fed is right, the discounted value of S&P cash flows would be lower than valuations imply. But David Einhorn and George Soros do very different things and, in a vague sense, rely on each other for their fundamental work.

This doesn’t really solve our problem. If markets are underpricing the Fed because they think its optimistic about wage growth and international stability, this would be reflected in lower earnings for American companies and be a “short equities, long bonds” moment.

But maybe there isn’t a paradox. And maybe markets aren’t really overpricing anything. That, at least, is the theory I’d like to forward.

If, at a first pass, Price = Earnings/(Risk-free Rate + Risk Premium – Growth), then G_implied = D + RP – (E/P). To my surprise, the picture you get really isn’t that crazy.


The blue line is market implied earnings growth, and the red line is smoothed (realized) NGDP growth. I took a market risk premium of 4.5%. The two aren’t perfectly aligned for three key reasons:

  1. Primarily, the rough estimation I used is incorrect. We should discount by the forward curve instead of the spot rate. Today this would increase the implied growth rate but not meaningfully.
  2. Implied earnings growth is ex ante whereas NGDP growth is ex post. Markets aren’t always correct, there are always random, exogenous, and significant events (wars, draughts, etc.) that couldn’t be predicted before, after which the market corrects. This explains why the two series aren’t perfectly equal, but more in generally the same direction (after the information is released, the market revalues as necessary, changing the implied earnings growth).
  3. And implied earnings are a level above growth (of which profit is a component) because capital’s share of GDP is increasing (and profits, hence, grow faster than the economy itself).

Otherwise, as expected the two series track each other pretty well.

In the long-term, nominal earnings growth in the 4-5% range, or real growth in the 2-3% range does not seem absurd – especially if you believe an increasing share of the economy will accrue to capital owners. Those who argue that the Fed is keeping the market artificially inflated may want to look at how the curve shifts if the forward curve steepens a bit. We will likely be well into 2017 by the time interest rates are even 1%, and even a 1% increase in G_implied may not necessarily be absurd.

And that’s assuming the Fed’s decision isn’t endogenous to economic factors that influence earnings. Very likely, if the forward curve steepens, it is a result not of a negative supply shock (runaway inflation requiring an increase in interest rates, for example) as much as a positive demand shock, where better-than-expected global trade and growth result in an increase in earnings to maintain valuations at a higher interest rate.

This post was meant as a composite of a number of thoughts that I’ve been playing with recently, many of which deserve their own blog post. A particularly interesting tangent would consider the effect delayed IPOs and exclusion of public investors from lucrative returns has on this analysis. My initial guess is “not much”. While it is a deeply interesting, and important, trend, it doesn’t effect public valuations much. Most of Facebook and Uber’s returns might have been captured in the private market but the valuation is slash will be reflected in the public market. And that’s what we’re concerned about here, not returns specifically.

A constellation of seemingly contradictory events over the past five years – high unemployment, stagnant wages, anecdotal evidence of astounding technological growth, alleged robotization of everything, all ensconced in a grim uncertainty about the future – has brought about something incredible: prominent economists can now reasonably question the value of new technology.

This ranges from Martin Wolf’s generic essay questioning techno-optimists to a star-studded paper arguing that “under the right conditions, more supply produces […] less demand as the smart machines undermine their customer base”. Economists as prominent as Larry Summers and Paul Krugman have voiced their fears about robot-driven unemployment, and a general stagnation in living standards, if we don’t radically reassess our relationship with inequality and capital-driven growth.

I’m not here to necessarily disagree with any of these sentiments as much as explore their implications when taken to a logical conclusion. As a first pass, let’s start with a simple economy, consisting of capital owners and rentiers providing capital, high-skilled technology workers producing innovation, and low-skilled laborers producing commodity goods and services. Your production function in this world would look something like Y = A*F(K, B*G(K_r, L)) where F is of Cobb-Douglas form and G is any more general CES function, K is capital, L is labor, and K_r is innovation.

From one perspective, this is the crux of the problem. Go back to Piketty whose argument can be summarized as “when the capital stock increases by n%, the marginal return on capital decreases by less than n% and therefore K/Y increases”. Summers (in his review of the book) noted that no studies suggested that capital-labor elasticity, net of depreciation, was greater than 1. But once you have the slightly modified production function, what matters is the substitutability between K_r and L which, as I’ve written before, is governed as mu = 1 – 1/sigma where sigma is the classical elasticity of substitution between capital and labor, and mu is the robot-labor substitutability. As mu tends towards 1 (which, with improving technology, is not unreasonable) sigma grows without bound.

So we can stipulate that in the world of our robot overlords it isn’t unreasonable to expect that an unprecedented proportion of national output would accumulate to capital owners. But what does this say about living standards and employment? For one there will be a shift in employment among the unskilled laborers from highly substitutable commodities to services that benefit from human interaction (artisans coffeeshops, massage parlors, art vendors, street artists, and botanical gardeners for example).

And while there will be displacement within the unskilled population, they will – as a whole – very likely be much better than they were before. This statement isn’t the result of a careful empirical study as much as a reflection of certain fundamental, economic gravities. Let’s say robots replace workers in all manufactured goods and consumer durables production. The high standard of living in the United States isn’t derived from that employment itself as much as the collective result of that unemployment – a middle class that has multiple cars, microwaves, abundant food, television sets, carpets, furniture, and other staples of the modern home.

So the stagnationists need to further argue that the purchasing power for these products will somehow evaporate from the laboring masses. This is where it gets much harder. Because if millions of workers who once had the employment (and, therefore, the skills) to build said products and the products themselves clearly – within this population – there exists a supply and demand which, in equilibrium, creates prosperity for the masses.

As the largest consumer base in the world, this market also provides abundant profits (if at low margins) for the capitalists – the old fashioned kind who buy the old-school machines and factories necessary for the production of the goods thereof. So in this hypothetical world it will by definition be economically profitable for a capitalist to finance the sort of old-school capitalism that brought so much wealth to the middle-class. And this is as true globally as it is domestically (Chinese, assembly-line workers are  the victims of the sort of automation we’ve just described).

So here is a challenge for anyone who believes technology will result in both unemployment and a broad-based decline in living standards for the unskilled. Describe the precise mechanism in this world that will prevent the old equilibrium – that is both preferable both for the marginal capitalist and the working class as a whole – from reemerging. Or, if that isn’t your preferred interpretation of the economy, explain why supply or demand have somehow changed among this working class to make the question moot in the first case.

If you want an economic intuition for why this will be highly improbable, notice that this technology effectively means the marginal cost of production will fall to the commodity cost (which, itself when automated will, in the perpetual run, be the cost of recycling that unit of ore, or whatever). You would have to believe wages falling below this level at a mass-scale (something like a physical paralysis overcoming all that exist) for this explanation to remain reasonable.

This isn’t a model, it’s imprecise and unrigorous but is still a better interpretation of the world than some of the more formal models I’ve seen written on the subject. Take the Benzell, Kotlikoff, LaGarda, and Sachs paper which uses an OLG model with low and high tech workers to map certain equilibria in which technology decreases consumer purchasing power. Even if this is the best paper on the subject I’ve seen, the model is baked with not just incorrect assumptions but mechanics that are fundamentally divorced from the way technology operates. For example, mapping “code” as some sort of capital-like stock makes little sense. They stipulate that A_t = d * A_{t-1} z * H_{t-1} where A is the stock of code, d is the depreciation rate of code, z is the productivity of high skilled laborers and H is the quantity of high skilled laborers.

Expect code doesn’t depreciate it the way they model it as. The crux of the problem, they say, is:

Things change over time. As more durable code comes on line, the marginal productivity of code falls, making new code writers increasingly redundant.

Eventually the demand for code-writing high-tech workers is limited to those needed to cover the depreciation of legacy code, i.e., to retain, maintain, and update legacy code. The remaining high-tech workers find themselves working in the service sector. The upshot is that high-tech workers can end up potentially earning far less than in the initial steady state.

Their view of the world essentially requires one to believe that eventually we will have perfect code – code that never needs to be improved, rewritten, updated, redeployed, or debugged. There is some irony in 4 economists building such dramatic conclusions into their argument, but the problem here isn’t an assumption that code will eventually live on its own, updating itself, improving itself (presumably by using “machine learning”). It’s that what’s lacking from here is any imagination about what a world with perfect code would look like.

You would ave driverless cars moving everyone from point A to point B without a single accident. You might well have a revolutionized biotech industry that can run scalable tests virtually and suggest perfect medicine without any human work whatsoever. You might cure cancer and heart disease. You might identify markers of suicide and track and help those prone years before the fact.

Of course I’m just listing random, utopian ideas. None of these might happen, none of these might even be possible. The fact is we don’t know. If we knew it would already be here. This is why some startups work and others fail. And this is the problem with a lot of what Autor writes as well. To be able to divine the effect of technology on employment and have a say on the living standards thereof you need to make assumptions about what the world many years hence will look like. No one is capable of making these assumptions.

This is why Martin Wolf can write that the Roman can imagine the America of 1840 but neither of the two could imagine the America of 1940. Once you have technological growth, the logical conclusion is unknown. Economic models might have been contrived before, but they at least tried to abstract and understand dynamics that already existed, that we can fundamentally comprehend. You are kidding yourself if you think models that talk about code depreciation in a world where “the demand for code-writing high-tech workers is limited to those needed to cover the depreciation of legacy code, i.e., to retain, maintain, and update legacy code” are economics or science.

They are speculation at worst and thought-provoking philosophy at best. So file this talk about robot driven stagnation next to Nick Bostrom’s paper that we are all human simulations.

Let me end this with a rejoinder – that the technology-capital driven world will actually be freer, more equal, and more egalitarian than the one we live in today. Code and soft intellectual property in general is so much harder to restrain in the hands of the few than factories, machines and physical land (which, in the capitalist world is defended by the government’s monopoly on violence to anyone who threatens the sanctity of property). If you describe me a world where 3D printers replace workers, and magically one where these workers don’t have any of the fruits from the 3D printers, are you telling me the code that generated the item can really be locked up forever?

Technology monopolies, one might say. But, as I’ve argued before, many technology monopolies are actually contestable markets. Google makes a profit by advertising goods to the consumer, but it’s not clear what the consumer’s costs are. (This is something I would love to see debated and modeled in a more convincing and clarifying manner). If Google decided to charge even $500/yr for its search I would be happy to bet would be irrelevant in under 2 years.

The burden of proof on future technology seems to lie with those who believe growth will be more exclusive, rather than inclusive.

Interfluidity has an excellent post on Greece and I don’t wish to repeat what he’s written much more fluently than I could. But I want to use something he said as a segue into a deeper conversation about how we should think about Greece (and sovereign default in general):

I’ll end this ramble with a discussion of a fashionable view that in fact, the Greece crisis is not about the money at all, it is merely about creditors wresting political control from the concededly fucked up Greek state in order to make reforms in the long term interest of the Greek public. Anyone familiar with corporate finance ought to be immediately skeptical of this claim. A state cannot be liquidated. In bankruptcy terms, it must be reorganized. Corporate bankruptcy laws wisely limit the control rights of unconverted creditors during reorganizations, because creditors have no interest in maximizing the value of firm assets. Their claim to any upside is capped, their downside is large, they seek the fastest possible exit that makes them mostly whole. The incentives of impaired creditors are simply not well aligned with maximizing the long-term value of an enterprise.

There’s no getting around the fact that Greece needs debt relief. The IMF has made this clear in no uncertain terms. If the fundamental purpose of finance is to align asymmetric incentives in an efficient way, creating an environment of trust, and hence lending and development, the Greek dilemma is more than a failure of European integration. It’s a failure of finance itself.

Where Steve Randy Waldman channels his fury at the political failure of European authorities, Michael Pettis has an extraordinarily prescient essay – from February! – begging Europeans to pay attention to financial distress and poorly aligned incentives. You have two ways of doing this. You can either tell Greece that you won’t roll over its debt unless it engages in a series of politically unpalatable policies to secure your principal or you can recognize that success is shared and create a debt structure that reflects this mutual enterprise.

Quite simply, the Greek government should sell optionality on its prosperity. As much as countries are not corporations one of the purposes of Chapter 11 is to ensure that senior creditors do not force an inefficient liquidation on the entire corporate structure. For example, selling assets to meet financing requirements even if the company has a really good ten-year plan. Or, for example, forcing a degree of austerity that would wreck domestic agency to make your initial investments whole.

And whatever you think about fiscal policy, that’s exactly what this is. Whether you like Syriza or not, that is the democratically-elected government of Greece and hence its representative. And, therefore, by proposing a restructuring scheme that forces the other party into capital controls that asphyxiate domestic business you are partaking in precisely the form of liquidation that Chapter 11 seeks to avoid.

At least in the case of a distressed shipping company – or whatever – it’s possible to see why someone would want this. The number of senior creditors are small, the upside is capped, and the benefits to immediate liquidation are obvious. In the case of forcing Greece to make whole its current capital commitments the benefits are distributed across millions of European tax payers, the costs are concentrated among the Greeks, and that’s not even considering the spillovers of financial distress and turmoil generated by the plan.

And don’t kid yourself that the referendum changes things. A “no” vote only exacerbates the above and the “yes” vote seems to be the precise definition of “kicking the can”. As I’ve written before, if you eventually default (and Greece will, in some fashion or form, default) it will always have been better to default one day before after the fact.

Senior creditors are, when they cannot be made whole, given the option to buy equity (at what would be a discounted price relative to normal liquidity conditions). Some will sell these and write-off their losses, furnishing a lucrative industry in special situations investing. Regardless, creditors painfully recognize their losses, and move to align their incentives with the firm, gaining optionality in the process.

One obvious way to do this is to exchange a meaningful portion of the principal for GDP-indexed bonds. These have been discussed in detail elsewhere. It’s not clear that these are a bad idea, but it’s certainly not clear they’re a good idea, either – or the quickest and most obvious way to align European incentives. Argentina sold GDP-warrents in 2002 and investors were recognizing dramatic losses years after the fact (that’s not necessarily an indictment of the idea as much as that they are a straightforward salve). Not to mention Greece actually offered something like a GDP-bond in 2012 without any of the benefits proponents advocated (again, this might be an issue of magnitude but that’s not really the question).

Rather, Greece can sell calls on its export revenue. For one, this isn’t subject to the same measurement complexities that plague GDP (and when we’re talking billions of dollars in coupon payments, this matters). More importantly, exports are a much quicker and sensitive guide to adjustment performance than GDP, which can years to reflect structural improvements. Now the obvious flaw of export calls by themselves is that it’s not clear that the Greece government really cares about higher exports (even if its population does).

Here we can incorporate German sensibilities. Exports that fall below some benchmark on which the option is indexed incur a penalty in proportion to outstanding debt that would come out of a pool of “optional austerity” consisting of pensions, national assets, and defense spending. This would ensure that authorities engage in the sort of reforms – removing red tape, reallocating taxes, subsidizing the right things, and encouraging devaluation over unemployment – in a way that austerity resulting from failure would be predictable.

The final part is important. The IMF wants to give Greece a 20-year grace period before requiring any debt payments. What if we cut that in half, and indexed the coupon payments by an reverse exponential weighted average of net export performance over the next 10 years. This would allow Greece the freedom to implement policy that is responsible but not too responsible.

Maybe austerity is necessary and maybe it’s not. We can recognize the corruption of the Greek government without making a claim on how much austerity it needs. Michael Pettis has the key point:

The same process occurs within any economic entity, including a national economy. It is not an accident that in nearly every case in history in which countries have excessively high debt levels or have undergone debt crises, policymakers have never been able to keep their promise that, with forbearance from creditors and the implementation of the right reforms, the country can grow its way back into full solvency. Historical precedents are pretty clear on this point. Countries suffering from debt crises never regain growth until debt has been partially forgiven — explicitly or implicitly — and the uncertainty associated with its resolution has either been sharply reduced or eliminated.

And we shouldn’t expect Greece be any different. Without growth any Greek repayment schedule is doomed. Economically yes, but politically certainly. By opening a market determined pool of austerity as Greece misses its export (or other benchmark) targets, and offering the upside on any growth above that benchmark over the next 10 years, authorities will be forced to focus on a long-term economic salve. And, in this world, we let Greece grow and pay back what it can first, if that doesn’t work take a cut from its optional austerity pool, and if that doesn’t work let it default once and for all. And that’s basically what Eurocrats should have done decades ago.

Addendum: Tyler Cowen doesn’t agree with the Steve Randy Waldman post on what I think is weak reasoning. Germany is trying to maximize its return as senior creditor. In a Chapter 11 (not that this is the same, but follow the logic), the court’s responsibility is to maximize stakeholder value. To the extent this is more than a plain wealth transfer – that it will further depress demand in a region already rife with unemployment and poverty – further austerity does not meet the criterion. Sure, the German government has a responsibility to its taxpayers, but the per capita cost of a “stakeholder maximizing” agreement, I suspect, is not meaningfully important. (Yes, folks, the ECB’s monetary policy very likely had fiscal risks).

For Germans maybe it’s about setting precedent. For one, it really isn’t clear that Greek is strategically defaulting because it doesn’t feel like it (the austerity it has endured remains testament to its commitment to a European project). As IMF reports I’ve linked to before suggest, in most cases default isn’t costly precisely because markets don’t believe it sets some sort of precedent of irresponsibility.

Regardless, to the extent setting precedent is about the continuity of the European project, one can’t seriously argue that recent brinkmanship (on either side) has served greater service to further unity. Germany should allow this because there seems to be near-unanimous consensus that its preferred policy landscape is not maximizing the value of the European enterprise.

(On the criticism of American economists, he is right. Capital controls are a form of austerity – granted maybe an ideal form of austerity – requiring much short-term pain for potential long-term payoffs. It is easy to sit at Princeton and suggest that this is a good idea, when trade credit dries up and importers cannot purchase energy to turn on the lights it is quite a different matter).