The main reason I’m personally confused is that 2 months ago I thought there was real uncertainty about whether we’d be able to keep the pandemic under control. Over the last 2 months that uncertainty has gradually been resolved in the negative, without much positive news about people’s willingness to throw in the towel rather than continuing to panic and do lockdowns, and yet over that period SPY has continued moving up.
I’m making no attempt at all to estimate prices based on fundamentals and I’m honestly not even sure how that exercise is supposed to work. Interest rates are very low and volatility isn’t that high so it seems like you would have extremely high equity prices if e.g. most investors were rational with plausible utility functions. But equity prices are never nearly as high as that kind of analysis would suggest.
Two months ago, many investors predicted that unemployment would remain high for a long time, presumably because that’s how a typical recession works. There’s been a fair amount of evidence since then that employment is able to recover from this atypical downturn much faster than those investors expected.
That’s not the whole story, but I’d guess it accounts for at least 1⁄3 of the SPY rise over the past 2 months.
One comment on the low interest rates issue: I generally think about the equity premium puzzle via a Volker fence model. The institutions which own Treasuries (e.g. banks) do so with massive amounts of cheap leverage, and those are the only assets they’re allowed to hold with that much leverage. For individuals without access to cheap leverage, it rarely makes sense to hold large amounts in Treasuries—stock returns are so much higher, because the cheap leverage of banks pushes down the returns on Treasuries. So we get this split model, where there’s one class of investors which determines Treasury rates and a mostly-separate class which determines equity prices, with a regulatory barrier between the two (namely, bank leverage regulations).
Epistemic status: properly checking the numbers on this is still on my todo list, but the qualitative predictions look realistic and it matches how financial institutions actually work in practice.
The institutions which own Treasuries (e.g. banks) do so with massive amounts of cheap leverage, and those are the only assets they’re allowed to hold with that much leverage.
I’m curious about this. What source of leverage do banks have access to, that cost less than interest on Treasuries? (I know there are retail deposit accounts that pay almost no interest, but I think those are actually pretty expensive for the banks to obtain, because they have to maintain a physical presence to get those customers. I doubt those banks can make a profit if they just put those deposits into Treasuries. You must be talking about something else?)
The money markets are the main direct source of cheap (short-term) liquidity for banks; the relevant interest rates are LIBOR, fed funds, and repo. My current understanding is that retail deposits are ultimately the main source of funds in these markets—some banks (think Bank of America) specialize in retail and net-lend into the overnight money markets, while others net-borrow.
That money goes into Treasuries by default—i.e. whenever banks don’t have anything higher-margin to put it into. That is a profitable activity, to my understanding, at least in the long term. It’s borrowing short-term (overnight) and lending long-term (Treasury term), thereby getting paid to assume interest rate risk, which is exactly the main business of a bank.
In case people want to know more about this stuff, most of my understanding comes from Perry Mehrling’s coursera course (which I recommend), as well as the first third of Stigum’s Money Markets.
True, though I would guess that bank holdings dwarf those, even looking at marginal investors. Banks not holding stocks is the more important side of this model, because that’s the part which allows Treasury yields to be systematically lower than they “should” be compared to stocks.
Seeing if I understand. If Christiano is right about the pandemic we will see continued panic and lockdowns leading to high savings. High savings decrease the cost of fincap ⇒ stonks go up. So until we observe increased consumption (barring other crazy shit) we can expect continued high stock prices. So lockdowns continuing suggests a higher future SPY, lower.
I personally am investing in the long term (I’m young), so I am cool with risk. I do not want to buy into the SPY right now because it is so high. I’m considering buying stocks that have been hit hard in the short term but with have higher longterm expected value.
The main reason I’m personally confused is that 2 months ago I thought there was real uncertainty about whether we’d be able to keep the pandemic under control. Over the last 2 months that uncertainty has gradually been resolved in the negative, without much positive news about people’s willingness to throw in the towel rather than continuing to panic and do lockdowns, and yet over that period SPY has continued moving up.
I’m making no attempt at all to estimate prices based on fundamentals and I’m honestly not even sure how that exercise is supposed to work. Interest rates are very low and volatility isn’t that high so it seems like you would have extremely high equity prices if e.g. most investors were rational with plausible utility functions. But equity prices are never nearly as high as that kind of analysis would suggest.
Two months ago, many investors predicted that unemployment would remain high for a long time, presumably because that’s how a typical recession works. There’s been a fair amount of evidence since then that employment is able to recover from this atypical downturn much faster than those investors expected.
That’s not the whole story, but I’d guess it accounts for at least 1⁄3 of the SPY rise over the past 2 months.
One comment on the low interest rates issue: I generally think about the equity premium puzzle via a Volker fence model. The institutions which own Treasuries (e.g. banks) do so with massive amounts of cheap leverage, and those are the only assets they’re allowed to hold with that much leverage. For individuals without access to cheap leverage, it rarely makes sense to hold large amounts in Treasuries—stock returns are so much higher, because the cheap leverage of banks pushes down the returns on Treasuries. So we get this split model, where there’s one class of investors which determines Treasury rates and a mostly-separate class which determines equity prices, with a regulatory barrier between the two (namely, bank leverage regulations).
Epistemic status: properly checking the numbers on this is still on my todo list, but the qualitative predictions look realistic and it matches how financial institutions actually work in practice.
I’m curious about this. What source of leverage do banks have access to, that cost less than interest on Treasuries? (I know there are retail deposit accounts that pay almost no interest, but I think those are actually pretty expensive for the banks to obtain, because they have to maintain a physical presence to get those customers. I doubt those banks can make a profit if they just put those deposits into Treasuries. You must be talking about something else?)
The money markets are the main direct source of cheap (short-term) liquidity for banks; the relevant interest rates are LIBOR, fed funds, and repo. My current understanding is that retail deposits are ultimately the main source of funds in these markets—some banks (think Bank of America) specialize in retail and net-lend into the overnight money markets, while others net-borrow.
That money goes into Treasuries by default—i.e. whenever banks don’t have anything higher-margin to put it into. That is a profitable activity, to my understanding, at least in the long term. It’s borrowing short-term (overnight) and lending long-term (Treasury term), thereby getting paid to assume interest rate risk, which is exactly the main business of a bank.
In case people want to know more about this stuff, most of my understanding comes from Perry Mehrling’s coursera course (which I recommend), as well as the first third of Stigum’s Money Markets.
Thanks! I’ve been hoping to come across something like this, to learn about the details of the modern banking system.
My impression is that most individual investors and pension funds put a significant part of their portfolio into bonds.
True, though I would guess that bank holdings dwarf those, even looking at marginal investors. Banks not holding stocks is the more important side of this model, because that’s the part which allows Treasury yields to be systematically lower than they “should” be compared to stocks.
Seeing if I understand. If Christiano is right about the pandemic we will see continued panic and lockdowns leading to high savings. High savings decrease the cost of fincap ⇒ stonks go up. So until we observe increased consumption (barring other crazy shit) we can expect continued high stock prices. So lockdowns continuing suggests a higher future SPY, lower.
I personally am investing in the long term (I’m young), so I am cool with risk. I do not want to buy into the SPY right now because it is so high. I’m considering buying stocks that have been hit hard in the short term but with have higher longterm expected value.