12/2/2014: The Origins of Stock Market Fluctuations

An exceptionally ambitious paper on drivers of stock markets changes over long time horizon. A must-read for my students in MSc Finance and certainly going on syllabus next year. Big paper, big conclusions.


"The Origins of Stock Market Fluctuations" by Daniel L. Greenwald, Martin Lettau, and Sydney C. Ludvigson (NBER Working Paper No. 19818, January 2014, http://www.nber.org/papers/w19818).

"Three mutually uncorrelated economic shocks that we measure empirically explain 85% of the quarterly variation in real stock market wealth since 1952."

This is an unbelievably strong statement. Traditionally, little attention is given "to understanding the real (adjusted for inflation) level of the stock market, i.e., stock price variation, or the cumulation of returns over many decades. The profession spends a lot of time debating which risk factors drive expected excess returns, but little time investigating why real stock market wealth has evolved to its current level compared to 30 years ago. To understand the latter, it is necessary to probe beyond the role of stationary risk factors and short-run expected returns, to study the primitive economic shocks from which all stock market (and risk factor) fluctuations originate."

"Stock market wealth evolves over time in response to the cumulation of both transitory expected return and permanent cash flow shocks. The crucial unanswered questions are, what are the economic sources of these shocks? And what have been their relative roles in evolution of the stock market over time?"

The authors use "a model to show that they are the observable empirical counterparts to three latent primitive shocks: a total factor productivity shock, a risk aversion shock that is unrelated to aggregate consumption and labor income, and a factors share shock that shifts the rewards of production between workers and shareholders."

And the core conclusions are: "On a quarterly basis, risk aversion shocks explain roughly 75% of variation in the log difference of stock market wealth, but the near-permanent factors share shocks plays an increasingly important role as the time horizon extends. We find that more than 100% of the increase since 1980 in the deterministically detrended log real value of the stock market, or a rise of 65%, is attributable to the cumulative effects of the factors share shock, which persistently redistributed rewards away from workers and toward shareholders over this period."

This is a huge result. "Indeed, without these shocks, today's stock market would be about 10% lower than it was in 1980. By contrast, technological progress that rewards both workers and shareholders plays a smaller role in historical stock market fluctuations at all horizons."

And on the risk aversion shocks? Uncorrelated with consumption or its second moments, these shocks "largely explain the long-horizon predictability of excess stock market returns found in data."

"These findings are hard to reconcile with models in which time-varying risk premia arise from habits or stochastic consumption volatility."

Massively important paper.

11/01/2012: Risk-off or 'Grab that Straw, Man'?

Another day, another historical marker falls under the weight of the euro area mess:

US Treasury auctioned off USD21bn of 10 year notes today achieving the yield of 1.90% - lowest on record for an auction. Cover was 3.19 times the offering, slightly ahead of 3.15 average for previous four 10 year notes auctions. Direct bidders demand was up to 17.4% of sales against the average 10%. 10 year secondary markets yields sliped to 1.91% from 1.97% pre-auction.

Here's the IMF illustration (all charts below are from Cottarelli November 2011 presentation) of the evolution of holdings of US debt:

Which, funnily enough, is pretty diversified when compared to that found in Europe:

But the US yields are, of course, purely irrational:

Then, again, not as irrational as those found in Japan:

Altogether elsewhere, vast... German bund auction - 5 year, €4 billion - attracted cover of 2.24 and the average yield of 0.9%. That is well below inflation - however measured - and even below expected inflation, accounting for the potential slowdown. In other words, investors are now so scared, they are paying German government money to store their cash. In the secondary markets, German 1 year bonds turned negative yield back at the end of November, for the first time in history. German 10-years are currently trading in the 1.87% yield territory. According to FT, 10 year bund yields fell from 3.49% in April 2011 to a low of 1.67% in September last year.

Risk-off raging as EU vacillates... or rather, as its leaders consider how to by-pass Belgian General strike that has derailed their January 30 summit.


Nice one, folks. The insolvent Rome burns, the leaders are having summits galore and the unions are demanding more insolvency, while country output shrinks due to striking.


We are no longer in risk-aversion or even loss-aversion world, we are in a grab-anything-that-might-float world.

09/09/2011: VIX - another blow out

EU debt disaster and US own woes or just EU debt disaster, who knows, but VIX - that indicator of overall risk perceptions in the markets - is again above the psychologically important 40 mark.

Charts to illustrate:
Vix has gone to close at 40.50 today having opened at 35.53 and hitting the high of 40.74. In terms of historical comparatives:

• Intra-day high achieved today was 170th highest point reached by VIX since Jan 1, 1990, 147th highest reading since Jan 1, 2008 and 15th highest since Jan 1, 2010
• VIX closing level was 156th highest in history since Jan 1, 1990, 129th highest since Jan 1, 2008 and 8th highest since Jan 1, 2010. The latter being pretty impactful

Intra-day spread was pretty high, but not too remarkable, ranking as 179th highest since Jan 1, 1990, 102nd highest since Jan 1, 2008 and 49th highest since Jan 1, 2010, suggesting possible structural nature of elevated readings in VIX overall.
3 mo dynamic standard deviation of VIX index reached 8.981 - the highest level of volatility in VIX since January 1, 2010 and 90th highest since both Jan 1, 2008 and Jan 1, 1990. We are now clocking the highest level of VIX volatility (on 3mo dynamic basis) since February 2009.

Looking at semi-variance:
1mo dynamic semi-variance for VIX is now running at 15.73 - not dramatic, but showing persistently elevated trend since August 5, 2011. Today's reading was, nonetheless, only 27th highest since Jan 1, 2010. To flag that - below is the snapshot of short series range:Yep, folks, with VIX stuck at elevated levels with occasional blowouts like today, with European banks beefing up their deposits with ECB and Bank of Japan, with investors throwing money at Uncle Sam and Bundesbank (at negative interest rates) and demand for CHF undeterred by the threats of continued devaluations, what we are seeing is fundamentals-driven run for safety. Nothing irrational here, unless feeling sh***less scared is irrational...

Economics 31/01/2010: S&P, Gold and forward view on risk

Couple articles worth reading:

1) China bubble - here. In my view - the analyst is spot on - there is a massive bubble in Chinese economy. So large, when it goes, the entire global growth will be derailed. We are, in effect, now treading to closely to the 1932-1934 period of the Great Depression, when the markets forgot fear for a sustained Bear rally before rediscovering that risk mispriced is a disaster waiting to happen.

2) Gold - here. Great chart on 89% loss line.
A very promising direction on gold, of course, which is in line with (1) above.

Prepare for some fun. Take a look at VIX:
All supports are out at this stage and risk appetite is falling since the beginning of the year. Bonds rallying, S&P is taking on water. The only way from here for the likes of Gold is up, for DJA and S&P - down. Back to that 89% rule line in (2) above.

Economics 17/01/2010: Back to the future in risk-aversion?

Are markets settling for a renewed pressure of higher risk aversion strategies?

Given the fact that the US (and generally OECD) economic conditions remain extremely weak, the markets might be signaling a reversal of the risk attitudes - overdue after the rallies of the second half of 2009. The first signals came in from the bond markets, where even sick puppies, such as Ireland, have enjoyed some bounce in recent weeks. One can argue that the Greeks are getting away with a murder, as their CDS and spreads are following much shallower dynamic than one would have expected in light of continued concerns as to the credibility of their fiscal adjustment plans.

But the real ticker for troubles potentially brewing ahead is the overall markets behavior.

Here is one interesting chart:

 

For last week: TIPS up, bonds up, everything else - down. Not exactly a confidence game. And this is compounded by the January effect not playing out this year so far.

Now, VIX:

Now, not yet as pronounced as on level performance for the markets themselves, but note MCAD cross over and reduced divergence in the last 5 trading days, teamed up with S&P negative movement. Both suggest that VIX downward trend might be breaking.

Irish data is yet to show a clear trend/pattern or resistance breaks -

IFIN is pointing to a gently rising momentum in volatility, ISEQ broader index shows a gentle decline. Plus the highest frequency data I do have relates to daily close prices.  But, of course, there are lags relative to the US markets, so something to watch here.