Should information about the past still matter to equity prices today?

Over the past two days the equity markets have taken a real beating. The S&P 500 has broken its trendline since March.


Then today the quarterly GDP number came out, and it was 3.5% annualized, when the survey was 3.3%. The market jumped on that news.


My colleague sent this Bloomberg to me:

geez...i guess people don't care that 3Q GDP already happened - not about the future....
To some extent he's right. Whatever happened in the past happened in the past and is not information about the future. And for asset valuation it is, after all, the future stream of cash flows that matters. It's not: "How well did this company do in the past" but "How well is this company going to do in the future" that should inform how much you should be willing to pay for a piece of it (i.e. a stock.)

However, I'm not sure if I totally agree. Here's a theory of why the GDP release today maybe should matter to the equity markets.

From quarter to quarter we aren't actually sure what economic activity is. We have a sense from various data releases and anecdotal evidence but we rely on official statistics and ultimately on the GDP number to aggregate all these statistics and anecdotal evidence and tell us what economic activity actually was (to the best extend possible--of course GDP is also just a representation of reality and we can't ever truly know economic activity but this is not a philosophy class.)

So what if the entire time the market assumed that economic activity was something and that we are at point A in the diagram below when in reality we are at point B.

That would probably inform your estimate of the future. Even if the economic growth number stayed the same, past, higher economic activity would mean higher profits today and in the future.

So is it possible that to that extent the GDP number today matters to market valuation even though it is backward looking and only tells us about what happened in the past?

Portfolio Management

If you, like many asset managers, manage against a benchmark then you have some sort of benchmark index, let's say the Dow Jones Index or the S&P 500 that you try to beat. So what you do is that you mimic the composition of the index (to a bigger or smaller extent) and then you go "overweight" or "underweight" certain stocks or industries or countries. So you'll say: "I think that in the current recession consumer staple stocks will do better than consumer discretionary stocks because in a recession people will trim down on their discretionary spending and stick with whatever is necessary." And if CS stocks are 20% of the index you might allocate 30% or your portfolio there. Conversely, if CD stocks are 15% of the index you might go underweight to 10%, i.e. "go underweight 5%."

If you wanted to, you could put that on a scatterplot like the following:



On the horizontal axis would be how much you are overweight or underweight (for let's say a certain sector) and on the vertical axis would be how much that sector out- or underperformed the broader market. You'd have a point for each time period, like for each month or quarter or over whatever investment horizon you make your decisions.

Your optimal graph would look something like this, where most of the time you are overweightin the sectors that outperform and underweight in the sectors that underperform.

If, however, you're an unnamed asset management firm then your graph looks like this:
I have no idea how that stacks up against other asset managers but there are essentially two possibilities:
a) This firm is not that great at selecting the right assets (and outperformance comes from something else, e.g. liquidating when the market tanks, luck, who knows?)
b) Everyone is like this corroborating a theory that asset prices operate in a very complex system and that nobody really has the means to make good educated guesses which assets are more likely to outperform.
c) Everyone is like this but the picture is misleading and even a small margin of better bets vs. worse bets leads to outperformance over the long-run.

The Demise of the Dollar

Just for fun, not for predictive power.

The Uncanny Valley

Wow, I found this super-interesting. Apparently, humans

"like to study other human faces, and they also can enjoy scrutinizing countenances that clearly are not human, such as a doll's or a cartoon figure's. But when an image falls in between -- close to human but clearly not -- it causes a feeling of revulsion. [...]

Despite the widespread acknowledgement of the uncanny valley as a valid phenomenon, there are no clear explanations for it, Ghazanfar said. One theory suggests that it is the outcome of a "disgust response" mechanism that allows humans to avoid disease. Another idea holds that the phenomenon is an indicator of humanity's highly evolved face processing abilities. Some have suggested the corpse-like appearance of some images elicits an innate fear of death. Still others have posited that the response illustrates what is perceived as a threat to human identity."

The same is apparently true with monkeys. How interesting. This was via Marginal Revolution.

Earnings season again

So it seems like the easiest way to keep up-to-date on a blog is to just go back to older post and see how things look now. For the past few weeks I have been very unconvinced that the rally in the equity markets is on solid footing. Here are some arguments, not particularly well thought-out:

• Yes, unemployment is a lagging indicator but two-thirds of the US GDP (as you'll remember form Econ 101 GDP=C+I+G+[X-IM]) comes from private consumption (C.) While government support for consumption (e.g. cash for clunkers) supports/supported consumption these programs run out. With close t0 10% unemployment and only a slowing in the new unemployment numbers at the margin (i.e. still more lay-offs every week, albeit fewer) I just don't see where those 2/3 of GDP are supposed to come from.
  
• It's not just unemployment. People are also saving more. The question here is, of course, what a new equilibrium savings rate would be. Right in the heart of the credit crisis we saw it jump back up to 6 percent, which is unlikely in the long run. But maybe something around 4 percent? I mean, that's still 100% more than in 2005 or 2006. Not only are people out of jobs the little money that they do earn they also don't spend.
  
• There is a very scary housing picture. Mortgages are in default and haven't even hit the foreclosure stage yet b/c... well, what does a bank want with a house? The mortgages in default now are increasingly of higher quality. It's not just the sub-prime people anymore. The ratio of going into default once a mortgage payment is 30, 60, 90 days overdue keeps rising, and the rate of people staying out of default once they have done a reworking of the terms of the mortgage keeps declining. So the housing picture could still get a lot worse. People won't have as much equity and banks similarly won't have a lot of collateral they can rely on.
  
• Banks are rationing credit. The credit markets aren't frozen but we're seeing a lot of pruning at the lower end of the credit spectrum.
  
• Currently there is a lot of G (government spending.) That's going to end sometime.

Some positives:

• Export might pick up, seeing that the USD is extremely weak.
• ummmm.....

But the stock market has rallied in the face of all of this, up over 63% since the low in March and 20% since the beginning of the year. Last earnings season was very positive since a lot of companies beat analysts' earnings estimates through a combination of cost-cutting, accounting gimmicks corrections (i.e. "extraordinary items"), and a genuine bottom coming in underneath plummeting sales. But, as we all know, cost-cutting is not sustainable over the long run. You can only trim so much fat before you're cutting into flesh and only so much flesh before you hit the bone. Similarly you can't keep having "infrequent" or "extraordinary" items. Once you have them twice, in a row they're not really all that "extraordinary" or "infrequent" anymore.

Since then I have essentially said that this next earnings season will give guidance and show that the market has gotten ahead of itself. Companies will disappoint and the market will correct. Except, an astounding 78% of the S&P 500 companies have beaten consensus estimates so far. What the hell? No wonder the Dow is close to breaking 10,000. Argh!

Finding the odd one.... nevermind. there is no odd-one out anymore

A little while ago I was looking at the co-movement of local equity markets and currency markets. I singled out Mexico and Korea as being "susceptible to repricing" and asked "What do the currency markets know that the equity markets don't yet reflect (or vice-versa)?" Turns out it seems that it's more vice-versa, at least in Mexico's case.

Mexico had looked like this:
Now it looks like this:
The equity markets kept grinding higher and the Peso, after its sell-off has followed suit.

Here is what Korea looked like:
Here's what it looks like now:
Here the Won had kept appreciating while the equity markets sold off. Now they're back (although Korea is the worst-performing market in the MSCI Emerging Markets month-to-date.)

Maybe the way to play this sort of thing is through a relative value trade.

The NY Times Needs to get a copyreader

This is from an article that I just came across on the NYT via the Huffington Post (from, like, a year ago):

A little more than a month later, the funds, filled with some of the most explosive and high-risk securities available, imploded, evaporating $1.6 billion of investor assets and setting off a financial chain reaction that has rattled global markets, caused more than $350 billion in write-downs, cost a number of executives their jobs and culminated in the demise of Bear Stearns itself.

The Times needs a copy-reader. "[T]he funds, filled with some of the most explosive [...] securities available, imploded"? Imploding is the exact opposite of exploding. Unless, of course, the securities were highly explosive but failed to deliver and the whole thing just imploded instead.

Ahhh.... the joys of stickling on a Wednesday morning....

Dani Rodrik does it again

Dani Rodrik's latest Project Syndicate post is fantastic. Among the many very good passages is this one:

"Financial markets discipline governments. This is one of the most commonly stated benefits of financial markets, yet the claim is patently false. When markets are in a euphoric state, they are in no position to exert discipline on any borrower, let alone a government with a reasonable credit rating. If in doubt, ask scores of emerging-market governments that had no difficulty borrowing in international markets, typically in the run-up to an eventual payments crisis.

In many of these cases – Turkey during the 1990’s is a good example – financial markets enabled irresponsible governments to embark on unsustainable borrowing sprees. When “market discipline” comes, it is usually too late, too severe, and applied indiscriminately."[bold emphasis mine]

I whole-heartedly agree. As to his larger point: I wonder what appointing a finance skeptic to head the Fed would look like? Who would he have in mind?

Find the odd one out

I just looked at some of the major EM local stock markets versus their currencies. In general I would expect them to be moving together quite well. After all usually EM stock markets and EM currencies are both seen as risk assets and when it's risk on they both appreciate and when it's risk off they both depreciate, not to mention that you need local currency to buy local stock.

The data bear out this relationship for the most part. Bovespa, for example shows strong co-movement with the Real.

The Sensex is a little less well correlated, probably b/c of investment regulations.

In Russia we see a little bit of a divergence in June but since then the two have recoupled.

Here are some of the biggest other markets. Turkey:

Taiwan:

Thailand:

South Africa:

They all seem to price in similar things for the respective country. However, in Mexico we've seen a decisive break downwards at the end of August while the market, probably on the back of US strength, has mostly ground higher with just a recent correction.

And in Korea the market has sold off while the Won has kept appreciating.

To my eye the last two markets seem susceptible to repricing. What do the currency markets know that the equity markets don't yet reflect (or vice-versa)?