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April 11, 2010

Latest Posts from Economist's View

Latest Posts from Economist's View


Richard Koo: Debts, Deficits, and Global Financial Stability

Posted: 11 Apr 2010 09:09 AM PDT

"Don’t Bet the Farm on the Housing Recovery"

Posted: 11 Apr 2010 12:42 AM PDT

Housing prices have been rising lately, but Robert Shiller says "conversations in barbershops and hotel lobbies" could cause housing prices to turn downward:

Don't Bet the Farm on the Housing Recovery, by Robert Shiller, Commentary, NY Times: Much hope has been pinned on the recovery in home prices that began about a year ago. A long-lasting housing recovery might provide a balm to ... the entire United States economy. But will the recovery be sustained?
Alas, the evidence is equivocal at best. The most obvious reason for hope is that, unlike stock prices, home prices tend to show a great deal of momentum. ... So, because home prices have been climbing of late, isn't it plausible that they'll keep doing so? If only it were that simple..., we need to worry about strong headwinds, as the government begins to withdraw its support of a still-troubled lending industry and as foreclosures are dumping millions of homes onto the market.
Consider some leading indicators. The National Association of Home Builders index of ... prospective home buyers ... has predicted market turning points... The index's current signals are negative. After peaking again in September 2009, it has been falling steadily, suggesting that home prices may have reached another downward turning point.
But why? Unfortunately, it is hard to pinpoint causes... The factors clearly include government economic policy, like interest-rate changes and tax credits. But these moves don't line up neatly with major turning points in the market.
Sociological processes may be driving these changes. Trends in news media coverage, for example, generate conversations in barbershops and hotel lobbies, which in turn alter the conventional wisdom about investing.
Consider ... the run-up to the 2006 turning point in home prices. In May 2005, two months before the peak in the N.A.H.B. traffic index, Consumer Reports magazine had a cover article ... that conveyed a very bullish sentiment. "Despite years of dire warnings from some economists that the housing boom is about to end, it hasn't," the magazine said. "Indeed, last year prices rose even more — about 11 percent nationally."
The article went on... "If you need a house, and can afford one, go ahead and buy." The article extended to the housing market the conventional wisdom that then prevailed about the stock market — namely, that it was quite efficient, without identifiable bubbles and bursts. According to this theory, there was an identifiable profit opportunity: buy and hold stocks, and by extension, housing, and watch your wealth grow.
But as 2005 continued, the conventional wisdom began to change..., a public case began to be built that we really were experiencing a housing bubble. By 2006 a variety of narratives, taken together, appear to have produced a different mind-set for many people — creating a tipping point that stopped the growth in demand for homes in its tracks.
The question now is whether a strong case has been built for a new bull market since the home-price turning point in May 2009. Though there is no way to be precise, I don't believe it has. ... On March 31, the Federal Reserve ended its program of buying more than $1 trillion of mortgage-backed securities, and the homebuyer tax credit expires on April 30.
Recent polls show that economic forecasters are largely bullish about the housing market for the next year or two. But one wonders about the basis for such a positive forecast.
Momentum may be on the forecasts' side. But until there is evidence that the fundamental thinking about housing has shifted in an optimistic direction, we cannot trust that momentum to continue.

"Demographics and Stock Market Fluctuations"

Posted: 11 Apr 2010 12:33 AM PDT

What role do demographics play in the evolution of long-horizon stock market returns and the dividend-price ratio?: 

Demographics and stock market fluctuations, by Carlo Favero, Arie Gozluklu, and Andrea Tamoni, Vox EU: Figure 1 shows 1-year and 20-year annualized US stock market returns (S&P500 index) over the course of nearly the last century. Returns are determined by a "slow-moving" information component and by a "noise" component. The noise component dominates the data at high frequencies, while the information component emerges when high-frequency observations are aggregated over time to construct long-horizon returns.

Figure 1

As the information component is naturally related to "fundamentals", Figure 1 helps understand the empirical evidence that fundamentals perform better in predicting returns as the predictive horizon gets longer. In particular, the dynamic dividend growth model (Campbell-Shiller 1988) suggests that the relevant fundamental to capture the information component in stock market returns is the dividend-price ratio. This variable regularly plays an important role in recent empirical literature that has replaced the long tradition of the efficient market hypothesis with a view of predictability of returns (see for example, Cochrane 2007). But there is an ongoing debate on the robustness of return predictability and its potential use from a portfolio allocation perspective (Boudoukh et al. 2008). The essence of this debate is captured by Figure 2 that reports the US dividend/price ratio along with the 20-Year annualised stock market returns.

Figure 2

The Figure shows the presence of some co-movement between the two variables. This is somewhat limited by the fact that the dividend-price shows a very high degree of persistence that does match the mean reversion of the returns. This high degree of persistence contradicts one of the crucial hypotheses of the dynamic dividend growth model that is based on the assumption that the dividend-price is a stationary variable. This degree of persistence is at the heart of the debate on the robustness of the statistical evidence on the predictability of stock market returns.

Is there a role for demographics?

Intuitive reasoning hints at demography as an important variable to determine the long-run behaviour of the stock market, while it is difficult to imagine a relationship between high-frequency fluctuations in stock market prices and a slow-moving trend determined by demographic factors.

In fact, a theoretical model by Geanakopoulos et al. (2004) predicts that a specific demographic variable – the ratio of middle-aged to young population – explains fluctuations in the dividend yield.

Geanakopoulos and his co-authors consider an overlapping generation model in which the demographic structure mimics the pattern of live births in the US, that have featured alternating twenty-year periods of boom and busts. They conjecture that the life-cycle portfolio behaviour – which suggests that agents should borrow when young, invest for retirement when middle-aged, and live off their investment once they are retired – plays an important role in determining equilibrium asset prices. Consumption smoothing by the agents, given the assumed demographic structure, requires that when the middle-aged to young population ratio is small, there will be excess demand for consumption by a large cohort of retirees and for the market to clear, equilibrium prices of financial assets should adjust, i.e. decrease. The result is that saving is encouraged for the middle-aged. As the dividend/price ratio is negatively related to fluctuations in prices, he model predicts a negative relation between this variable and the middle-aged-to-young ratio.

In a recent CEPR Discussion Paper (Favero et al. 2010), we take the Geanakopoulos et al. model to the data via the conjecture that fluctuations in the middle-aged-to-young ratio could capture a slowly evolving mean in the dividend price ratio within the dynamic dividend growth model. We find strong evidence in favour of using this variable together with the dividend/price ratio in long-run forecasting regressions for stock market returns, as Figure 3 and Figure 4 illustrate.

Figure 3

Figure 3 reports the dividend price ratio and the middle-aged-to-young ratio to show how, in line with the predictions of Geanakopoulos et al., a negative relation between the middle-aged-to-young ratio and the dividend price is present in the data. The demographic variable captures the slowly evolving information component in the fundamental. Does this help to predict long-horizon stock market returns? Yes. In fact, the econometric based yes, contained in our CEPR paper, is visually illustrated by Figure 4, which reports the middle-aged-to-young ratio, 10-year stock market returns, and the deviation of the dividend-price ratio from its slowly time varying mean captured by the middle-aged-to-young ratio.

Figure 4

Figure 4 also illustrates an additional interesting feature of the middle-aged-to-young ratio. Long-run forecasts for this (exogenous) variable are readily available. In fact, the Bureau of Census provides projections up to 2050 for the middle-aged-to-young ratio. In our paper we exploit the exogeneity and the predictability of the demographic ratio to project the equity risk premia up to 2050. Our simulations point to an average equity risk premium of about 5% for the next forty years.

The research agenda

The empirical evidence of a stable relation between a demographic variable and long-horizon US stock market returns naturally generates a number of interesting research questions.

  • First, the fact that a slow moving variable determined by demographics has very little impact on predictability of stock market returns at high frequency but a sizeable and strongly significant impact at low frequency has some obvious consequences on the slope of stock market risk, defined as the conditional variance and covariance per period of asset returns. Demographics should then become a natural input into the optimal asset allocation decision of a long-horizon investor.
  • Second, what about the bond market? If the middle-aged-to-young ratio plays an important role in capturing an information component that helps to predict long-horizon stock market returns it should also have a role in capturing a persistence components also in bond-yields.
  • Third, what is the international evidence? Our empirical results are so far limited to the US case only, but it is important to assess their robustness when the model is extended to other countries.

References

Boudoukh, Jacob, Mathew Richardson, and Robert F Whitelaw (2008), "The Myth of Long-Horizon Predictability", The Review of Financial Studies, 21(4):1577-1605.

Campbell, John Y and Robert Shiller (1988), "Stock Prices, Earnings, and Expected Dividends", Journal of Finance, 43:661-676.

Cochrane, John H (2007),"The Dog that Did Not Bark: A Defence of Return Predictability", Review of Financial Studies, 20, 5.

Favero, Carlo A, Arie E Gozluklu and Andrea Tamoni (2009) "Demographic Trends, the Dividend-Price Ratio and the Predictability of Long-Run Stock Market Returns" , CEPR working paper 7734, forthcoming in the Journal of Financial and Quantitative Analysis.

Geanakoplos, John, Michael Magill and Martine Quinzii (2004), "Demography and the Long Run Behaviour of the Stock Market", Brookings Papers on Economic Activities, 1: 241-325.

[Traveling home from the UK today - this *should* post automatically.]

"What's Up With the Young Folks?"

Posted: 11 Apr 2010 12:24 AM PDT

What explains declining labor force participation of teens over the last decade? Any ideas beyond those given below?:

What's up with the young folks?, by John Robertson, macroblog: ...One important element in interpreting unemployment data is the trend in labor force participation, and it appears as if there are some significant open questions about what the trend looks like.

After growing during the 1980s and 1990s, the aggregate labor force participation rate (the percentage of the working-age population active in the labor market employed or looking for work) peaked in the late 1990s and is currently at levels last seen in the 1980s. But this change pales in comparison to changes in labor force participation among America's youth (those folks in the 16- to 24-year-old age range).

During the 1980s participation in the labor market for youth averaged around 68 percent, a rate noticeably higher than for older individuals. The youth participation rate declined sharply to a level at or below the level for older individuals prior to the 1990–91 recession and then remained relatively stable during the 1990s. However, over the past decade youth labor market participation has been on a steep downward trend and currently stands at a little over 55 percent, compared with about 67 percent for older individuals. Moreover, the most recent recession has seen youth participation rates decline at a rate similar to that seen in the early 2000s. In contrast, the labor force participation by individuals over 24 years of age has varied much less, implying that the decline in youth labor force participation has been a major contributor to the reduction in the overall rate of labor force participation (see the above chart).

It also appears that the decline in youth participation is most dramatic among teenagers, and for that group it is an equally sized decline for both males and females (see the next two charts).


Because schooling is an important activity for young people, the changing pattern of school enrollment is an obvious potential source of change in the labor force attachment of youths. In fact, the proportion of those between 16 and 24 enrolled in school has risen from about 42 percent in the late 1980s to nearly 57 percent in 2008 (BLS, October supplement to the Current Population Survey).

But being in school does not preclude labor market participation. In fact, increasing school enrollment is unlikely to be the only explanation because the increase in the school enrollment rate this decade is less than last decade. Between 1989 and 1998 enrollment increased from 48 percent to 54 percent whereas it increased from 54 percent to 57 percent between 1999 and 2008.

The big change appears to be that those in school have become increasingly less attached to the labor market. The percentage of school enrollees aged between 16 and 24 who are also participating in the labor market was relatively stable between 1989 and 1998 at around 51 percent. However, labor market participation by those in school declined between 1999 and 2008 from 50 percent to 42 percent. In contrast, labor force participation by those aged between 16 and 24 not enrolled in school has declined only modestly—from 82 percent to 80 percent between 1989 and 2008.

There are economic returns (benefits less costs) to both labor market experience and education. The decreased attachment to the labor market of school enrollees likely reflects, at least in part, factors such as the increased lifetime economic returns to education relative to alternative uses of time. As such, a widening wage premium on education is probably an important influence on youths' schooling choices, including schooling intensity. An example would be enrolling in educational programs during the summer instead of looking for summer employment.

It would be good news if increasing long-term rewards to engaging intensively in schooling was the important factor underlying the declining labor force participation by America's youth. Some alternative explanations for the decline could be much more troubling for America's future.

[Traveling home from the UK today - automatic post.]

links for 2010-04-10

Posted: 10 Apr 2010 11:01 PM PDT

"Barack Obama is Not a Socialist"

Posted: 10 Apr 2010 05:58 PM PDT

Ron Paul:

Ron Paul: Barack Obama is Not a Socialist, Washington Wire: Republicans and tea party activists are fond of accusing President Barack Obama of being a socialist, but today party gadfly Ron Paul said they had it wrong.
"In the technical sense, in the economic definition, he is not a socialist," the Texas Republican said to a smattering of applause at the Southern Republican Leadership Conference.

"He's a corporatist," Paul quickly added, meaning the president takes "care of corporations and corporations take over and run the country." ...

This isn't as easy to refute as it ought to be. Hopefully, the end result of financial reform will diminish the truth of this charge substantially, if not entirely, but we shall see.

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