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I wonder how much of the rally can be attributed to those who have been holding cash are moving back into equities. There has been a tonne of commentary lately about historically low valuations.

This rally does seem to have legs so I don't really know what to think. I recall reading that Q1 profits for TSX companies were done 92% year-over-year. Not very good. I suspect they will be even worse in Q2.

This could very easily be a bear market rally that will lose steam once companies either start issuing warnings or reporting profits that are worse than expected.

If we were having this discussion in July or August, then I'd be more inclined to think that we might be looking at a turning point. But it seems too soon.

There was a good analogy I heard on the radio this morning: The economy was in free-fall in 2008Q4, but now it seems that the parachute has deployed.

I know its offensive, but we call it a "dead cat bounce!" market psychology dictates that after a steep fall, there is a temporary upturn, also know as a sucker rally. This is just a correction to excessively bearish views. Everybody now agrees that the S&P earnings will be $65.00, with a p/e of 13, that gives a S&P500 target of 845 (closed at 822 yesterday), eventually the market will realize that $65 is too high, maybe earnings for 2009 will only be $45.00 (WAG by the way), when that time comes the downward trend will resume. Credit cards, Alt-As, commercial real estate have yet to work themselves through the system. Finally, because the crisis, correlation between financial markets is extremely high (near 1), as such any "American" rally will bleed into other markets.

Its not because we deplore market psychology that it doesn't exist!

One story that I've heard is that since inventories have been run down a lot we should see a large manufacturing rebound in the second half of the year. Of course, that still requires demand. In the absence of demand, when the wharehouse is empty you don't resume manufacturing, you start firing the sales force.

Similar comments apply to cleaning up the banking mess, at some point the continued job losses depress aggregate demand to the point that nobody wants to take out a loan and consume/invest even if they can get good terms.

On the other hand, the dollar falling is very good and commodities rallying is a sign that someone expects more inflation. I tend to think that although we are near the bottom in the real economy, there won't be any appearance of recovery until the end of the year and in the meantime earnings are going to suck. My view is that equities are in for another tumble before we get back to a true bull market.

I don't actually know how valuations look in Canada but the Shiller data on the SP500 has P/E of around 15 which is basically right at the long term average. By that measure (earnings are a 10 year MA) these valuations are nothing special.

(Changing to Adam P because of the other Adam at 8:51)

Dont' know which 2 questions you refer to. The first line includes 4 alone (recovery or no recovery, bear or bull market rally). The stock market rally, either way, was entirely driven/started by improved sentiment for banks - based on Q1 positive guidance from Citi and B of A, strong Bernanke presentation to Congress, and anticipation with follow through from Geithner. Everything else in the form of general reflation optimism flows from that.

About #4:
Watch the oil futures yield curve; it's probably the best-defined account of whether price fluctuations are due to supply or demand issues. Basically the market has remained in contango (shorter futures cheaper than longer ones) because too much oil was extracted and storing it is expensive, but if the oil supply tightens that'll be reflected there as well.

Other commodities are different for obvious reasons -- oil is both nonperishable and expensive to store. Gold is nonperishable but cheap to store. Bananas are cheap to store but don't last long. Oil is pretty because the yield curve says exactly what it's supposed to say.

During the depression there where many bear market rallies. If Ken Rogoff is to be believed, it could take 2 or 3 years for the economy to bottom out.

In my view, it's best to ignore the stock market and look to employment and corporate profits ... though I guess those are both lagging indicators so they won't help a trader. I'll be watching the level of excess reserves on deposit with the Fed. I think that when that number starts to come down, it'll indicate that the liquidity trap is dissipating, which I think is probably a necessary precursor to growth. I don't suppose the liquidity trap will dissipate until the financial system is fixed.

I'm inclined to say that the rally is more than a bear market dead cat bounce. It seems like it may have some short term legs (reminds me of the "recovery" after Bear Stearns in Spring 08), but in the intermediate term we will slide back into serious bear market/deflation conditions. I'd say that the government response has had a real effect in the short term, but too small to shift the overall tide (and way too expensive to pursue on a scale that would shift the tide, as in that Goldman Sachs paper)

To use a kind of stretched metaphor, if the market is New Orleans, the Fed & Co. have turned on some large industrial sump pumps, but haven't actually fixed the broken levy. Initially the water level will recede, but it's only a matter of time before they are overwhelmed again. I'm not ready to start building a house there (longer term investing) because I don't think that the Fed can ever pump enough water to make it safe to live there while the levee is still broken. One little storm, and we're all under water again.

this all depends on what the FED/Treasury/government does next. It's becoming more and more like Kremlinology. There's only so much price-fixing you can do before you start actually ruining the markets you are trying to fix. I really liked this post from Accross The Curve:

Bob: continuing with your metaphor, what would be the break in the levee? What would it take to fix it?

Yes, I found that Across the Curve Post interesting too. But half of me doesn't want to make US Treasury bonds more liquid; they are liquid enough already. I want people to want to hold them less (so they want to hold something else instead).

anon1: the two questions were:
1. Are we seeing the first signs of recovery?
2. What caused it?
The rest are just multiple choice answers.

And, if it were just a moribund feline or ursine rally, would the US$ exchange rate be falling too?

see the irrepresible B Setser on Dollar fluctuations. He points to some strange stuff thats tricky to interpret.

On the other note, if the bizarre FDIC/Fed/Treas-P3 provides a serious windfall for some players in the short term, would it not goose stock markets?

BTW, I saw a Stephen Gordon on CBC TV news the other day. Where were the elbow patches?

If it was about the Quebec budget, then it could have been me. And I'll have you know that I was wearing my best sweatshirt for the occasion.

Oh goodie! A blog discussion that will help me loose even more money in the equity markets!

I agree with Adam, Stephen Gordon, Finance, Adam P that this is a bear market rally. Some how a true bottom and early recovery phase by September 2009 seems far too early.

I view the fed as reacting in panic mode. I strongly doubt that we have seen the full real economic impact of last autumn's financial sector meltdown. If post-war commodity-price-shock-driven recessions are any guide, real price declines in commodities have a ways to go yet.

As far as putting the household money where my mouth is, I intend to continue to nibble away at high-yield corporate debt, reduce excessively exposed positions by selling into strength, bet against energy prices, and look for high-return arbitrage opportunities (ex: Vernenex Energy's assets in Libya).

Sorry Adam P... I hijacked your name. I will use Adam M when commenting from now on.

You just did it again.


well, it's true that driving Greg out of the treasury market is what they are trying to do, but eventually you are going to want that liquidity back at some point, only to find the traders "once bitten, twice shy" wrt government effected markets. If you boot a bunch of people out of the market once, they will be wary of getting back in.

A good example of this is the terrible short-selling ban last year (a much worse policy). I had heard talks about it beforehand, but I just totally wrote it off, as I thought that no SEC chair would be so stupid as to enact a shorting ban that reduces liquidity during a liquidity crisis. I just didn't think that the government, despite the rhetoric, could actually do something so stupid, and I know I wasn't alone in assuming that.

I got caught while in a "market neutral" strategy, but none of my general liquidity hedging really worked, because the SEC just directly targeted the shorts, killing all the liquidity on the short side in a brutal short-squeeze (opening up a spread like in the 3com/palm example in Cochranes paper), but not in other parts of the market where I was hedged against that general liquidity risk (as it is usually a systemic, correlated risk). They basically set out to hurt the short-sellers in no uncertain terms, and "kill the bad hedge funds". They sure hurt the shorts, but a lot of us were market neutral or hedging, while the real nefarious stuff was going on in the unregulated CDS market (bear raiding). Also I've heard that a lot of big well-connected arbitrage funds (the "good" funds) got last-minute exemptions from the ban.

I've entirely retreated from those kinds of trades recently, increased cash, decreased exposure, because I just can't be sure that the shorting ban doesn't come back in some form. They are still talking about it. There are lots of high return arb opportunities out there, but they are still there untaken because they are really risky. Those wide spreads can blow out wider if there's another short-sale restriction. So what you get in the end is inefficient pricing, because the arbs can't do their thing, for fear of another targeted SEC attack.. You can hedge for general risks, but you can't really hedge against the regulator stepping in, changing the rules and screwing you on purpose... again.

"The expiration of the Securities and Exchange Commission's short selling ban following legislative approval of the $700 billion financial bailout package could come at an opportune time for merger arb managers. Spreads have widened to the point where, according to Hennessee, many deals now offer annualized returns of more than 20%, or double the level of just a few months ago."(hedgeworld.com, October 2008)

There you go. 20% for the taking, just one string attached: if there are any more short-selling restrictions announced while you are holding, you're in deep deep trouble. How can you be sure they won't do it again? You can't.

""We can never say never," said Wheatley [regulator] when asked if Hong Kong could follow other global markets and ban short selling." - Mar. 23, 2009 - Reuters

How can you invest in that environment, let alone arbitrage? It reduces the market to a Kremlinology betting pool. traders stop researching real fundamentals and contributing that knowledge to the market pricing mechanism, but instead spend their time studying the width of Alan Greenspan's briefcase and trading rumors, or just withdraw their money because they don't want to play that game, as in Greg's case. Either way it leads to illiquidity and bad pricing that persists after the intervention ends.

bob: I understand what you are saying at a superficial level, but not at a deeper level, if you know what I mean. But it sounds important.

If the ban on short selling reduced liquidity of assets, it would mean that required yields would have to rise, so asset prices would fall. Which is not good, especially currently.

Another way of saying it: if the ban on short selling reduced the liquidity of most assets and so increased the demand for "cash" and reduced the demand for other, less liquid assets (as you say was your own reaction, and by "cash" you mean...money, short T-Bills, and close substitutes), that would cause asset prices to fall...

How should I think about the ban on short selling reducing liquidity? Is it that short selling is like allowing the personal inventory/buffer stock of traders to go negative, and thus prevent backwardation? Is it that with short selling allowed you can (in effect) buy and sell an asset even if you don't have any? (It increases the effective as if float?)

+1 for a bear market rally. Yes, it was much broader than I would have expected. But if something bad happens next week, and these days that's always a possibility, the SP500 will be right back at 680.

My test for when this bear market is over is when I feel confident that we've dealt with all the really, really bad news. For instance, I think there are a lot of sick and wounded hedge funds out there and while I'm unsympathetic I'm afraid of being in a market while they're still thrashing around.

hmm.. both I think

In the basic sense, if Tim buys a stock off the market to hold, there is just one transaction, but if Tim lends that security to Johnny, Johnny sells it, buys it back to cover and then gives it back to Tim, so 2 more transactions take place while Tim "holds" the stock, and collects interest on lending it out. If shorting is banned, those 2 transactions don't take place, and Tim doesn't collect his interest on the security, reducing both the liquidity and yield of his security.

If you follow the links in this article under short-selling ("click here for how short-selling works"), I think you will get a much better explanation (the article itself is also worth a read, very pertinent to the previous discussions here, with a nice slide-show to boot):

Liquidity risk and the current crisis
Lasse Heje Pedersen
15 November 2008

bob: another great find!

I have been reading through his survey paper (linked on the link you posted): http://pages.stern.nyu.edu/~lpederse/papers/LiquidityAssetPricing.pdf

That is an eye-opener for me.

My sense is (correct me if I'm wrong):
The liquidity literature is done by finance people in business schools, while money/macro is done by people in economics departments, and it's almost like 2 solitudes. The money/macro economists (as far as I know) ignore this literature. The finance people doing liquidity don't say much ("ignore" is too strong) about money/macro. It's sort of ridiculous: the money/macro people ignore liquidity (except for money); and the liquidity people ignore money. This is daft! We live in a monetary exchange economy because goods are not perfectly liquid, and money is the most liquid, and enters into every exchange.

There's a spectrum of assets, in terms of liquidity. The liquidity people in finance look at the spectrum but ignore the asset (money) at one extreme end of the spectrum. The money/macro people look at the extreme end of the spectrum, but ignore the rest of it (they implicitly assume it's flat, or has an exogenous slope).

What's your take?

Let me just explicate my last comment a little.

Nobody swaps stocks for bonds. First we swap stocks for money, second we swap money for bonds. And we do it this way (use monetary instead of barter exchange) because money is the most liquid asset. The liquidity people in finance seem to ignore that fact.

There is a curve, showing liquidity against yield (and against turnover, or "velocity"). The liquidity people in finance are doing great work in theorising and estimating that curve. It is very far from flat. Reading that literature survey confirms all my hunches. But they ignore the asset which is at the intercept of that curve: money, the medium of exchange. Money has a negative (real) yield. It pins down one end of that whole curve. There is a negative intercept. And so there is no analysis of how monetary policy (changing the quantity of money, or its real yield, which is minus the rate of inflation) might shift that whole curve. And the money/macro people do the same, because they only see the intercept, not how the rest of the curve is joined to it.

Exactly! That's a really good insight I think, and is clarifying these issues a bit for me.

Trying to put those two together is what I'm trying to do (as area number of other people). The two solitudes between financial economics and academic/monetary/macro economics is a real source of our current problems IMO. If economics were like oceanography, the finance guys would be standing on shore precisely measuring waves, in order to predict other waves, while academic economists are studying deep sea currents, but neither one are really collaborating, so the finance guys get surprised when a huge wave generated in the deep sea comes crashing in, and the macro guys ask, "Why would they build a beachhouse within reach of tidal waves?". The real problem is lack of communication I think.

My math isn't that strong, and TBH I can't make heads nor tails of Pedersen's Liquidity-Adjusted CAPM formula (still re-reading it now). It seems over-complicated, and like there are big macro variables missing. At the same time traditional macro doesn't seem to offer many answers in terms of how monetary policy affects the relative liquidity of asset classes and therefore affects prices through liquidity premiums.

I think you might see now what I mean by saying that the Fed easing drives up the liquidity premium part of oil's convenience yield.

I think maybe a rough Krugman-style sketch of the curve and intercept would be a helpful starting point, if you're up for making one.

Excess reserves are starting to drain out of the Fed.


Liquidity risk and the current crisis
Lasse Heje Pedersen
15 November 2008

Thanks bob for the reference. Interesting. To quibble with Pedersen, the housing bubble was not the "trigger" as in the "catalyst" of this crisis. The shock in energy prices specifically and commodity prices generally were the catalyst. The overbuild in consumer durables (houses and autos) constituted the neglected excess "inventories" or missed maintenance that threatened to and ultimately did unwind everything.

The process is akin to an automobile where the shocks on the front end should have been replaced a long time ago. Everything goes well on smooth pavement until a nasty pot-hole is struck. Then the other harder-to-maintain and decipher components break down. The automobile still works but now limps along and is not really safe until a whole bunch of components are replaced. (You can blame Akerlof for this crude stab at meaningful metaphor.)

Elsewhere, Pedersen has me thinking that major de-levering of quant strategies in August 2007 contributed to significant volatility in equity markets, particularly resource-levered equity during the same month. Wish I had seen that one coming....

"Money has a negative (real) yield."

That is correct, if money is held as a financial asset. But if money has a pure intermediation function, then the real yield is largely irrelevant me thinks. Maybe that is why the finance guys largely ignore it?

My thinking on why finance guys ignore money is that most of the workhorse models are frictionless. Without trading frictions you don't need money, moreover most of these models posit a single consumption good which can just as easily serve as numeraire. Moreover, RBC style macro models also tend not to have money since in the absence of nominal frictions it's anyway neutral.

Here's a couple Cochrane links, some of my favorites on monetary theory:



The finance guys show that the more liquid an asset, the lower it's yield, and the shorter its holding period (the higher its turnover, or, to use the word that monetary theorists use, the higher its velocity of circulation). We can see money as just the extreme case, where it's very liquid, has a very low (negative) yield, and a very high turnover.

So one way of saying it is that they don't carry their theory through to apply it to money (when they draw diagrams showing the curve of yield against liquidity, they don't continue the curve to the axis).

Money does have a pure intermediation function, but that doesn't mean it is not also a financial asset, and will be held, even if briefly.

But the role of money as a medium of exchange seems to be implicit, rather than explicit, in their theories. It's sort of the silent, invisible, dance partner.

That's a criticism of the finance literature. But it's sort of a minor criticism, because, after all, they are finance guys, and not trying to be macroeconomists. (Though, as bob recognises, they need to be macroeconomists as well, in the real world.)

But then macroeconomists will happily discuss monetary policy in a world where all assets are perfectly liquid, and have the same (risk-adjusted) interest rate. Ummmm. So why does money exist? And will discuss the Geithner plan to fix banks etc. with lots of discussion of risk, but none of liquidity. Ummm. So why do banks exist? Or discuss quantitative easing in a liquidity trap with no discussion of liquidity. Ditto.

bob: " At the same time traditional macro doesn't seem to offer many answers in terms of how monetary policy affects the relative liquidity of asset classes and therefore affects prices through liquidity premiums." Replace "many" with "any", and I think you've got it!


"And will discuss the Geithner plan to fix banks etc. with lots of discussion of risk, but none of liquidity. Ummm. So why do banks exist? "

Surely your not claiming that we have banks becaue we have money or that the social function of banks has anything to do with money. The soviets had money and a state bank but were incapable of effectively allocating capital. On the other hand we have a competitive banking system and capital markets, we don't all keep our money on deposit at the fed. If banks were just there to distribute money then why have more than one?

In a frictionless world where there was no need for money and a consumption good was used as numeraire but in which there was substantial uncertainty as to which potential projects resulted in the optimal allocation of capital we would need banks even though we didn't need money.

In a world where Joseph Stalin decided where to direct capital investment but consumption was physically diffuse (a trading friction) then we would need money but no independent banks.

Adam P: I think it's important that banks' liabilities are more liquid than their assets, and some of their most liquid liabilities are also media of exchange. That's one of the reasons banks exist, and how they manage to make a living. They convert high yield illiquid assets into low yield liquid assets, and can earn a spread because people are prepared to pay for liquidity.

But fair enough, banks also risk-pool, and specialise in collecting information on investment risk and returns, so individual savers don't have to.

I basically agree with everything in your first paragraph. My point though is that none of it actually has anything to do with money per se. The credit intermediation function and the illiquidity of a bank's loan book are informational issues and would still be required in a moneyless world.

now that you got me thinking about it though, here's some stuff you might like if you haven't already read:



and others on Kiyotaki's website.

Adam, thanks for the link. great stuff. I'm just part-way through reading it, but it's really interesting so far

Adam: what bob said. Still reading them. Thanks.

There seem to be three relevant literatures.

1. What I think of as the "Microfoundations of money" literature. "Why do people use money and not barter?" "Why do people hold money when bonds pay interest?" Definitely academic economist. The Kiyotaki papers Adam links are within this approach. They are specially relevant here, because they go beyond money and look at imperfectly liquid bonds.

2. The finance literature on liquidity, that bob linked to, for example. More business school.

3. Standard macroeconomics/monetary policy. Economics departments and central banks.

We need something that's some sort of mix of all three.

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