On Policy Uncertainty…

Paul Krugman says that the notion that the weak economy is due to policy uncertainty has been thoroughly debunked. The Stanford/Chicago uncertainty index has considerably fallen:

chart3

Without any considerable boost to job growth:

PayrollJobs7.13

While policy uncertainty is concerned with policy in general, and not executive policy in particular, Krugman’s analysis is that “policy uncertainty” is a thinly-veiled attempt to blame Obama for the sluggishness of the recovery:

One of the remarkable things about the ongoing economic crisis is the endless search for explanations of something that’s actually quite simple — the sluggish pace of recovery. You have a large overhang of private debt; you have a still-depressed housing sector; and you have contractionary fiscal policy. Add to this the well-established fact that recovery tends to be slow after recessions caused not by tight money but by private-sector overreach, and there’s just no mystery that needs explaining.

Yet we’ve seen an endless series of analyses declaring that there is indeed a deep mystery, and it must be Obama’s Fault. Probably the most influential of these analyses was the claim that Obama was creating “uncertainty”, and this was holding everything back.

This crude notion of policy uncertainty is often attached to the notion of the Confidence Fairy; the idea that by running large deficits, government is crowding out private investment due to fears of future tax increases. The corollary of the Confidence Fairy view is that the only way to bring back private investment is to have large-scale austerity, to solidify expectations of lower future taxes. This view has been the basis for David Cameron’s economic policy in the UK, which can only be soberly judged as a large-scale failure.

Krugman is right to trash the Confidence Fairy — austerity at this point in the business cycle is a catastrophic error, because it sucks money out of the real economy. And he’s also right to trash those who view the sluggishness of the recovery as solely Obama’s fault. But he’s wrong, I think, to throw policy uncertainty out of the window entirely as a proximate cause of some of the problem’s we’re now facing.

Broadly, policy uncertainty goes both ways. That is simply because not all entrepreneurs in the private sector are looking for or worrying about tax cuts. People are heterogeneous. While there are some entrepreneurs worried about the future trajectory of taxes, many other entrepreneurs may be hoping for fiscal stimulus either because they would expect to receive orders from the government (for example, construction firms, defence contractors, universities, energy companies) or because they would be hoping that with stimulus, more people would have money in their pockets and they would be spending it.

While this, of course, cannot explain the crisis itself, nor the long and slow deleveraging since, having a deadlocked Congress erring on the side of austerity could be a major headache for many private enterprises. The fact that the more severe austerity experienced in Europe and Britain has actually led to bigger budget deficits there could result in even deeper and greater uncertainty for businesses. Put more simply, many businessmen could be reading Paul Krugman and others like him, agreeing with their interpretations, and worrying about the confused and deadlocked approach that the Federal government has taken to the post-2007 economy, and the dangers of austerity. This could contribute to the uptick in policy uncertainty measured by the Stanford/Chicago Index experienced since 2007 just as much as Wall Street Journal-reading Republicans worrying about the Confidence Fairy and taxes.

Advertisements

Dow 36,000 Is Back

51M8857Z3NL._SL500_

In a testament to just how euphoric stock markets are right now, James K. Glassman the co-author of the fabled Dow 36,000 — a book published in 1999 that claimed that stock prices could hit 36,000 by as soon as  2002 (and which quite understandably is now available for just 1 cent per copy) — has written a new column for Bloomberg View claiming that he might have been right all along:

When we wrote our book, we expected that the stock market, as represented by the 30 blue chips of the Dow, would rise to 36,000 for two reasons.

First, investors had mistakenly judged the risk in stocks to be greater than it really was. Here, we drew from the work of Jeremy Siegel of the Wharton School of the University of Pennsylvania. He showed that, over long periods, stocks were no more volatile, or risky, than bonds.

We saw indications that the risk aversion of investors was declining — as we believed it should. Lower perceived risk would mean higher stock valuation measures: rising price-to- earnings ratios, for instance.

Second, we assumed that real U.S. gross domestic product, the main driver of corporate profit growth, would rise at 2.5 percent a year — a bit below the historic post-World War II rate, but still a decent clip. We warned, however, that small changes in growth rates could have big effects on stock prices.

What’s happened since 1999?

First, investors have become more frightened of stocks, not less — as reflected in a higher equity risk premium, the excess return that investors demand from stocks over bonds.

These fears may be perfectly reasonable. We wrote our book before the Sept. 11 attacks, the dot-com debacle, the 38 percent decline in stocks in 2008, the “flash crash” of 2010 that sent the Dow down 1,000 points in minutes, the Japanese tsunami and the euro crisis. There’s a good case to be made that, because of the instant interconnections wrought by new technology, unprecedented “black swan” events are increasing and markets are becoming more volatile as a result.

The heightened fears of investors are reflected in lower valuations. Currently, for example, the forward P/E ratio (based on estimated earnings for the next 12 months) of the Standard & Poor’s 500 Index is about 14. In other words, the earnings yield for a stock investment averages 7 percent (1/14), but the yield on a 10-year Treasury bond is only 1.9 percent — a huge gap. Judging from history, you would have to conclude that bonds are vastly overpriced, that stocks are exceptionally cheap or that investors are scared to death for a good reason. Maybe all three.

Explaining why Glassman and Hassett were wrong is simple. They believed that they had found a fundamental truth about how stocks should be valued — that stocks were really less risky than the market perceived them to be — and that the market would correct to meet their beliefs. The problem is that there is no fundamental truth about what stocks are worth. The fundamentals of a company are determined by profit and loss, but the market prices of stocks are created from the meeting of different parties with different subjective beliefs. A buyer of a stock at $10 might believe it will become worth $100, and the seller might believe it is really worth $5. The future performance of that stock will be determined by the future beliefs of market participants in light of the future performance of the firm. Market participants have for some reason always valued equities as a class within a certain P/E range:

P/E

With one exception — the peak during which Dow 36,000 was written — equities have traded roughly between 5 and 30 times earnings. That’s a large range.  Glassman and Hassett believed — and subsequently tried to convince markets — that they were pricing equities wrong, and that stocks should be priced at roughly 100 times earnings.  They failed. Markets just wouldn’t go there.

One significant issue with such predictions is that there are far too many unknown variables. They didn’t know future technology or energy trends. They didn’t know future geopolitical trends. They didn’t know future social or demographic trends. They didn’t know the shape or style of future financial markets. All of these trends are critical in determining market sentiment, and the financial, economic and material fundamentals that drive earnings. It was all a big extrapolation with a catchy-sounding number that they effectively pulled out of the air and dressed up in the false clothes of economic rigour. And the real economy — as Glassman candidly admits — just didn’t match up to their assumptions.

Glassman thinks that Dow 36,000 is attainable with a return to strong growth:

Let’s set investor fears aside for a moment. For investment gains over the long term, there is absolutely no substitute for faster economic growth.

To get it, we need policy changes that will create a better environment for businesses to increase revenue, profits and jobs: a rational tax system that keeps rates low and eliminates special deductions and credits; immigration laws that encourage the best and the brightest to move here and stay; entitlement reform to bring down costs and provide incentives for productive seniors to keep working; sensible environmental, workplace and financial regulation that allows entrepreneurship to thrive; a K-12 education system that boosts student achievement and holds teachers, administrators and politicians accountable …

Chime in and make your own list, because it’s time to focus on what counts in an economy: growth. Even with relatively high risk aversion (let’s say, what we have now), faster growth would significantly increase stock prices.

How fast can the U.S. grow? Four percent is attainable, but I’d settle for 3 percent. Get there quickly, and we’ll get to Dow 36,000 quickly, too.

Back in the real world, we have the opposite problem. Stocks are soaring, on the back of a very weak economy. In fact, the fact that Glassman is being given a platform again to talk about the possibility of huge future stock gains is probably testament to just how overvalued stocks are. The market has more than doubled since the trough in 2009 on the back of the idea that Bernanke will do whatever it takes. But that illusion could easily be shattered, because there are many kinds of negative shocks that central bankers cannot prevent or control. To justify present valuations in the next two years, we would need a significant uptick in American and probably also global growth. Instead we have what may be the biggest housing bubble in history, declining global growth, North Korean threats to start a nuclear war, and so on. And all the while the market is setting new nominal highs.

The uber-optimistic atmosphere permeating much of the financial press is frightening to me. The resurrection of the Dow 36,000 zombie is a symbolically significant event that likely signals much the same thing as it did first time around: a correction.