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Hello. As I write, Tropical Storm Henri is beating down on me in eastern Long Island. What it looks like, in practice, is rain. If the newsletter arrives in your inbox at the normal time, it means that my electricity is not cut. Today’s column is even geekier than usual, so non-nerds might not miss it if it never appears.
The inelastic markets assumption, where buybacks may be even bigger than we thought
Regular readers will know how much it pains me to acknowledge the work of rival media outlets, but here’s a reluctant nod to The Economist, who recently brought to light a very interesting article on what makes stock prices move. , by Xavier Gabaix and Ralph Koijen, of Harvard and the University of Chicago. But I think there is more to be said on paper, so there you go.
One thing we can be absolutely sure about with the stock markets (because of the work of people like Robert Shiller) is that they overshoot. The fundamental factor used to make sense of stock price (some version of future cash flow) goes up and down, but stocks go up and down a lot more. We usually explain this by saying something like “people are irrational and they get over-excited or unduly pessimistic”.
And that is certainly true on the whole. But how does it work? Naive people say things like “people are excited so they buy stocks and the money is pouring into the market”. At this point, the sophisticated people who write Wall Street newsletters have a satisfied laugh, because everyone knows that every time someone buys a stock someone else is selling it, so the idea of ” the money invested in stocks ”is for the dope.
What Gabaix and Koijen do is make sense of the idea of new money entering the market and then argue that those flows affect prices – a lot. This is a big deal, given that the standard picture is one in which stock prices only reflect information (or at least beliefs) about fundamental value, not supply and demand.
The central idea of Gabaix and Koijen regarding flows is that most buyers of stocks are very price insensitive; that is, on the stock market, the price elasticity of demand is very low. Big buyers are institutions working under strict mandates governing the composition of their portfolio, whether it’s 100 percent stocks, or 70/30 stocks and bonds, or whatever. When an investor gives such a fund a new $ 1 to invest in stocks (“the money coming in”), the fund must operate it according to its mandate. The fundamentals have nothing to do with it.
On the classic model, this purchase can move the price away from the fundamental value but (the market being efficient) the sellers make it fall quickly. But there is – to exaggerate only slightly – no such vendor. There are just a bunch of other funds working under inflexible mandates.
Hedge funds, for example, simply do not hold enough stocks to modulate the price impact of these flows (the authors seem to assume, chimerically, that hedge funds are value arbitrageurs, rather than arbitrageurs. chasing momentum like everyone else). The flows therefore only drive up prices. Gabaix and Koijen argue – using both an economic model and evidence comparing flows to prices – that a flow of $ 1 can drive the market value up three to eight times more.
What is good about this model is that it replaces the aerial explanations that address either “fundamentals” or “animal spirits” with something more concrete:
The mystery of seemingly random stock market movements, difficult to relate to fundamentals, is replaced by the more manageable problem of understanding the determinants of flows in inelastic markets. ..
we can replace the “dark matter” of asset pricing (where price movements are explained by latent forces that are difficult to measure) by tangible flows and demand shocks from different investors
Of course, the fundamentals, at times, can affect the flow – but mapping the psychology and sociology of how and when it happens seems more scientific than talking about “efficiency.”
One area where Gabaix and Koijen’s model has very interesting implications is that of share buybacks, as they are by far the main source of influx. Here’s a (a little hard to read, sorry) chart from Citigroup, comparing the net redemption flows to equity mutual funds and ETFs since 2005:
It is no exaggeration to say that redemptions are the only significant flows over time. Now Gabaix and Koijen seem to think – for technical reasons that I frankly don’t understand – that the market response to buybacks is less dramatic than for fund flows, but it is still significant.
Most people think buyouts are good for investors because (a) they increase companies’ financial leverage, increasing returns (b) they increase earnings per share growth, and (c) they signal management confidence . But it may be simpler than that: they just increase the price of the shares.
Gabaix and Koijen point out that the elasticity of demand for individual stocks can be very different from that of the very inelastic market at large (we know this because not all companies that do a lot of buybacks see their stocks increase, even if that certainly seems to help). But if you think flows have a direct impact on prices, then it’s probably important to know which sectors are buying back a ton of stocks. Here is a table of the composition of redemptions in the S&P 500, by sector, of the great Howard Silverblatt of the S&P Dow Jones indices. Look at information technology!
Why have tech stocks recently dominated the market? Maybe it has less to do with growth prospects and more to do with the industry making up about a third of all buyouts.
I have a lot of questions for Gabaix and Koijen. I’ll try to reach them on the phone and report back to them.
Another reflection on aging and inflation
I’ve been chatting about Goodhart and Pradhan’s demographic argument for an upcoming hike in interest rates and inflation for a few days now. Some of you are probably fed up with all of this. But I got a note from my friend Andrew Smithers, an economist and frequent correspondent for Unhedged, who made a point that I think is important.
Smithers argues that the greatest risk of the demographic change described by G&P – which is, fundamentally, a labor supply shock as the world ages – is that it increases the likelihood of a very bad central bank policy error.
The inclusion of China and Eastern Europe in the global workforce thirty or forty years ago had the effect of increasing labor supply and lowering its unit price. These changes have been accompanied by a drop in inflation expectations and a drop in the unemployment rate without accelerating inflation (Nairu), which is the lowest possible level of employment before inflation died down. ‘increases. The aging of the world’s population will have the opposite effect.
In a world with a higher Nairu, employment and participation rates must be lower if inflation is to be avoided (a rather anti-intuitive impact of a labor supply shock). , but it is). But it’s an adjustment the economy can make without too much trauma. The trauma arises if policy makers do not take note of what has happened:
If, as unfortunately seems possible, central banks do not allow it, inflation expectations will accelerate and the level of unemployment needed to contain them again will be even higher than demographic change alone.
The picture is that the Fed is not getting the demographic change rating, so it lets inflation run a bit, and inflation expectations are rising. The rate tightening then necessary to get expectations under control will be Paul Volker’s style, with one key difference: the stock market was much cheaper back then, and the debt level was much lower, so it will be more. ugly this time.
A good read
Will the Fed’s reduction in bond purchases push yields up or down. Will it hurt or help stocks? James Mackintosh goes over the possibilities and the uncertainties, and there are many here.
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