Topic: Finance, Banking & Monetary Policy

The Reynolds Model of Stock Prices

Mark Hulbert’s latest Wall Street Journal column criticizes

the so-called Fed Model, which holds that P/E ratios should rise as interest rates decline, and vice versa. The strategy got its name in 1997, following a reference in a Federal Reserve report to the tendency of the S&P 500’s earnings yield—the inverse of its P/E ratio—to rise and fall with long-term interest rates.  During the 15 years before the Fed made that observation, the U.S. stock market’s P/E ratio did indeed tend to be higher when interest rates were low, and vice versa, Mr. [Javier] Estrada concedes. But, he points out, that relationship hasn’t held up as well since then, raising the possibility that the apparent correlation might have been just a coincidence.  Further doubts came when Mr. Estrada analyzed U.S. experience over the 100 years before 1980.

I may have discovered “the Fed Model” in March 1991– long before Ed Yardeni gave it that name after July 22,1997. The relationship between the inverted P/E ratio and bond yields was first depicted in the letter below to consulting clients (institutional investors), where I probably should have labeled it the “Reynolds Model.”

I agree with Estrada that it did not work very well before August 15, 1971, when the last remnants of the gold standards were abandoned. The gold standard did not permit the extreme gyrations in bond yields we have seen between Fed Chairmen Volcker and Bernanke.  Relatively steady bond yields of 2-5 percent from 1789 to 1970 under a gold standard obviously tell us little about stock market booms and busts at that time. Contrary to Hulbert and Estrada, however, the U.S. relationship between the e-p ratio and the 10 year bond yield remained remarkably tight from 1970 to 2008. From 1988 to 2008, the e-p ratio averaged 4.9 and the 10-year bond averaged 6 percent.

For reasons I recently discussed in Barron’s, the Reynolds Model also failed during recent years of “quantitative easing,” when the Fed began massive purchases of government bonds.  Today, the e-p ratio is slightly higher than the 1988-2008 average (5.4), which means the p-e ratio is lower, even though the 10-year bond is only half the recent norm. What the Reynolds Model tells us is the e-p ratio is not low, and the p-e ratio is likewise not high, unless the interest rate on 10-year bonds rises to at least 5 percent (which seems unlikely so long as nominal GDP keeps growing more slowly than that).

Stock prices have risen because of rising earnings, not because of a high multiple of stock prices to earnings.  Any downside risks are far more likely to come from shocks to earnings (such as another oil price spike) rather than some spontaneous decline in multiples.

S&P’s Dilemma: Rating your Regulator

In a court filing today, the rating agency Standard & Poor’s (S&P) claims that the federal case against them is motivated by retaliation for its 2011 decision to strip the United States of its “AAA” credit rating.  

It might be easy to dismiss this claim, but they aren’t the only ones in this situation. Before S&P’s U.S. downgrade, the smaller firm Egan-Jones, which relies on a subscriber model also downgraded the United States. Not long after, Egan-Jones was investigated by the SEC and ultimately barred for a time from rating U.S. debt. Let’s remember that Egan-Jones was ahead of the curve in spotting both the subprime bubble and the failures of WorldCom and Enron.

If you didn’t downgrade the United States, what happened? Basically nothing. We see what starts to look like a pattern here: downgrade the United States and expect some abuse. Don’t and you will be largely left alone. And as the recent IRS treatment of Tea Party groups has shown: this administration isn’t above targeting its enemies.

There are, as expected, several twisted ironies to the case. First, the Department of Justice is claiming to act on behalf of banks that suffered losses from holding rated securities. But who was it that imbedded ratings into the bank regulatory process? The bank regulators. If the DOJ wants to punish someone for bank losses on rated securities it should start with the Basel Committee. And then there’s the DOJ itself, which uses a flawed theory of disparate impact to pressure banks to make bad loans in the first place. The DOJ doesn’t have to go far to find the guilty: just try looking in a mirror.

The solution here is ultimately to get the federal government out of regulating the rating agencies. Our entire financial system is built on sovereign debt. The crisis in Europe shows what happens when you get the treatment of sovereign debt wrong (for a good summary of sovereign risk in bank regulation, see this BIS speech). The conflicts of interest between raters and regulators are ultimately a far greater threat to our system than any conflict between corporate issuers and raters.

The Syrian Pound Zigs and Zags

Following U.S. Secretary of State John Kerry’s saber-rattling statements on the 26th of August, the value of the Syrian pound (SYP) has zigged and zagged. Indeed, the SYP lost 24.7% of its value against the U.S. dollar in the two days following Kerry’s announcement (moving from 225 to 270 SYP/USD). Then, yesterday, we saw a sharp reversal in the course of the pound. Over the past two days, the SYP regained 25.58% of its value, bringing the black-market exchange rate back down to 215 SYP/USD. At this rate, the implied annual inflation rate is 209.85% (see the charts below the jump).

So, what caused the recent strengthening of the Syrian pound? We have to look no further than the eroding support for a U.S.-led strike against Syria. Yes, the United States has lost support from important allies, the United Kingdom, Canada, and Italy.

In addition, Syrian authorities have cracked down again on black-market currency trading. In the past week, the authorities have shut down a number of currency traders; made “friendly” reminders to the public of the penalties of trading on the black market—imprisonment of 10 years and a hefty fine; and warned Syrians to stay away from “counterfeit” dollars that have supposedly been circulating. The authorities’ “get tough” policy followed speculation that the SYP/USD rate would surpass the 300 mark.

I have established a page to track current black-market exchange-rate and implied inflation data for the Syrian pound, as well as for troubled currencies in Iran, Argentina, North Korea, and Venezuela. For more, see: The Troubled Currencies Project.

Federal Homeownership Policy: Money for Nothing

Earlier this week, the Los Angeles Times ran a column repeating the simplistic notion that since homeownership is “good” then subsidies for homeownership must therefore also be “good.” Never asked, or apparently even contemplated, is the question of whether all our various homeownership subsidies actually deliver homeownership. Let’s start with the ever popular mortgage interest deduction (MID). The chart below, reproduced from Glaeser and Shapiro, shows the value of the MID and the homeownership rate. Hard to see any relationship there, probably because there isn’t one. I discuss the MID in more detail here.  

 

Next would be Fannie Mae and Freddie Mac. The chart below shows the homeownership rate and the Fannie/Freddie share of the mortgage market. What should be immediately obvious is that the long run homeownership rate steadied out in the mid-60 percents when Fannie & Freddie were bit players, having a market share in the single digits. In no way can we say that Fannie & Freddie have increased the long-run trend rate of homeownership.   So even if one believes homeownership is worthy of subsidy, a questionable proposition on its own, it should be beyond question that our current system of homeownership subsidies has not delivered long run gains in the homeownership rate.

Troubled Currencies Project Update: Syria, Iran, and Egypt

Syria Since August 26,  when U.S. Secretary of State John Kerry began laying the groundwork for military intervention in Syria, the Syrian pound (SYP) has taken a beating on the black market. Indeed, the SYP has lost 24.07 percent of its value against the U.S. dollar (USD) in the two days since Kerry’s announcement. Currently, the exchange rate sits at 270 SYP/USD, yielding an implied annual inflation rate of 291.88 percent. In countries with troubled currencies, there is no better measure of economic expectations than the black-market exchange rate. The recent deterioration in the SYP/USD exchange rate clearly indicates that Syrians are anticipating Western military intervention in the near term. 

IranThe initial weeks of the Rouhani presidency have seen renewed economic confidence, as reflected by the Iranian rial’s (IRR) black-market exchange rate. The new central bank governor, Valiollah Seif, has stated that his primary concerns are to rein in inflation and boost economic stability. Over the past few weeks, the rial has strengthened on the black-market, and inflation has moderated somewhat. That said, recent international saber-rattling over Syria clearly has spooked the Iranian public. In the two days since Secretary Kerry first made his case for intervention in Syria, the value of the Iranian rial has dropped 4.74 percent on the black market, to 32,700 IRR/USD. This yields an implied annual inflation rate of 52.10 percent, up from 44.89 percent, prior to Kerry’s announcement.

EgyptSince the fall of the Morsi government, public confidence and support for the military regime has boosted the value of the Egyptian pound (EGP). Prior to the military takeover, the black-market exchange rate sat at 7.6 EGP/USD. Since Morsi’s ouster, the pound has appreciated by 7.34 percent, to 7.08 EGP/USD. This yields a current implied annual inflation rate of 18.62 percent, down from 27.85 percent in the final days of the Morsi government. In recent weeks, the Central Bank has been auctioning off up to $40 million in foreign exchange, three times per week. This rather modest sum has adequately met the demand for foreign exchange at rates close to the official exchange rate of 6.99 EGP/USD.

 

For more information on troubled currencies in these countries and others, see The Troubled Currencies Project.

Imaginary Squabbles Part 5: Comparing Krugman’s 2005 Housing Bubble Forecasts to Mine

New York Times columnist Paul Krugman has recycled another phony argument about something I wrote many years ago. 

He begins by citing Matt O’Brien who found that Fed governor Janet Yellen in October 2005 was predicting there would be no great impact on the economy “were the house-price bubble to deflate.” O’Brien concludes that, “Back in 2005, she didn’t appreciate how much shadow banks relied on AAA-rated mortgage-backed-securities (MBS) as collateral to fund their day-to-day operations—or how much even this supposedly high-quality collateral could go bust if housing did.” But that is “What Janet Yellen and Everyone Else Got Wrong,” as Krugman’s column is rightly titiled. Nobody in 2005 grasped what a precarious house-of-cards was being built, worldwide, on U.S. mortgage-backed securities. 

O’Brien found another quote suggesting Yellen did get it right by December 2007. Yet the recession had already started by then, and blogger Bill McBride and others were worrying that rising unemployment would cause mass foreclosures (not the other way around).

“We had a monstrous housing bubble,” writes Krugman, “and Janet Yellen recognized it in real time [December 2007]…. It’s important to notice that just being willing to see the obvious here puts Janet Yellen way ahead of a lot of people who still presume to give us advice on the economy.”   

He links to a 2008 list of 28 people who were supposedly way behind Yellen in “being willing to see” that house prices had fallen 21.6 percent by December 2007, even though nearly all of those 28 references were from 2003–2005. My name is at the top of that list, of course. But why am I on it while Krugman and Yellen are not?

The “Unofficial List of Pundits/Experts Who Were Wrong on the Housing Bubble,” was compiled by a finance lawyer who blogs as “Economics of Contempt.” He worked as a legislative aide to a House Democrat and dealt with derivatives at Lehman Brothers. The list of 28 could find no investment bankers who got it wrong, even at Lehman or Bear Stearns, but it did find a lot of conservatives and libertartians.   

Obama’s Housing Speech: The Good, The Bad, & The Ugly

Yesterday, President Obama went to what was perhaps ground-zero of the housing crisis: Phoenix. He laid out his vision for the role of housing in building a middle class, as well as his solutions for avoiding bubbles.    

On the rhetorical side, the president certainly laid out some principles that anyone would be hard-pressed to disagree with. For instance, he characterized the business mode of Fannie Mae and Freddie Mac as “heads we win, tails you lose”–which of course it was. The president was correct in calling it “wrong.”  If only then-Senator Obama had aided the efforts to reform Fannie and Freddie by Senator Richard Shelby and others, perhaps this mess could have been avoided. But, hey–better late than never.  

The president is also correct in highlighting the issue of local barriers that increase the cost of housing. Both Cato’s Randy O’Toole and I have written regularly on this topic. You don’t get bubbles without supply constraints. But then every president since Reagan, at least, has pointed to this problem and yet it has only gotten worse. If the president has a substantial plan to bring down regulatory barriers in places like California, then I would love to see it.

Perhaps most importantly, the president recognized that what we had was a housing bubble, and the solution isn’t to “just re-inflate” it. As the president urged, we must “turn the page on the bubble-and-bust mentality” behind the housing crisis. That was the good, and again I applaud the president for recognizing those facts.  

Unfortunately, what details we have of his vision are not exactly consistent with these facts–which are bad and ugly. The president wants “no more leaving taxpayers on the hook for irresponsibility or bad decisions,” but then he implies that government should continue to stand behind risk in the housing market. The primary purpose of FHA, which the president commends, is to allow lenders to pass along the costs of their mistakes to the taxpayer.  

Mr. President, there is only one way to take the taxpayer off the hook:  get the government out of the mortgage market.  Anything short of that will continue to undermine the incentive for lenders to make responsible loans.