Tuesday, December 15, 2015

Hindsight is 20/200.

In financial analysis, one of the lures of technical analysis is hindsight bias.  When we look at a historical graph, and we can see when trend reversals happened, it is very easy to imagine that we could tell in real time that they were about to happen.  One test I like to perform on claims of technical indicators is to simply cover a graph up, and slowly reveal its movement over time, and to try to predict the trend changes that the indicator is supposed to reveal.  Most of the time, it fails.

But, we see an indicator with peaks and valleys, and our minds are very easily convinced that every time the indicator gets "too high" we will be able to forecast its collapse.

Here is a variation on that theme (HT: Todd Sullivan).  At any given time, there are thousands of warnings floating around about how a market collapse is around the corner because margin interest levels are getting too high.  They include graphs like this.

And, it seems pretty clear, looking at this graph, that high margin debt is a sign of overheating markets and a coming correction.

But, as Econompicdata points out, margin debt mostly just scales with equity values.... Of course it scales with equity values.  What would we expect?  Someone using margin debt as a cyclical indicator is basically just noticing that stocks tend to move up and down through business cycles.  Usually, if you start getting nervous a few years into an expansion, you don't have more than a few years to wait to see another correction, so if you are primed to associate corrections with "overheating", this pseudo-indicator will seem prescient.

There has been a lot of recent discussion about macroprudential regulation.  It kind of surprises me that in the year 2015, there seems to be a plurality in agreement that committees of technocrats can save us from ourselves.  Don't most informed people agree that a buy-and-hold passive investment strategy is the only rational option for the typical amateur investor (and most professional ones)?  If we support macroprudential regulation, shouldn't we believe that the committees in charge of that regulation could help us out-perform the market, by alerting us to excesses?  Is there anybody out there writing articles for financial journals where they find persistent anomalies where the actions of political appointees systematically disprove the Efficient Market Hypothesis?

Here is a recent article from the Wall Street Journal about one avenue of this new regulatory push - leveraged loans (HT: Evan Soltas).  I don't see any evidence here that this is anything different than the margin debt indicator.  What's worse, if some of our cyclical economic variations are due to pro-cyclical federal policies, then imagine what damage we are doing when we analyze business cycles and conclude that what we need to do is pull back on the reins sooner and harder.  Just for the sake of argument, imagine with me what that means if, in fact, pulling back on the reins has been our primary problem?

From the article:
“We learned a lesson” from the financial crisis, says one former regulator who pushed for a crackdown when leveraged loans surged in 2013 and standards slipped. “You can’t wait.”
 Um...2013?  Isn't the fact that we clearly didn't have an "overheating" episode in 2013 sort of a mark against this view?  Can evidence defeat these proposals?
In some ways, the reining in of leveraged loans goes all the way back to 2006, when the Fed, OCC, and FDIC cautioned that they had noticed “increasing credit risk” in a rapidly growing part of bank loan portfolios . . . But demand dried up when the financial crisis erupted. Citigroup suffered losses of $5 billion on its leveraged loan portfolio from mid-2007 to mid-2008. Across the industry, large lenders got stuck with more than $300 billion of leveraged loans and commitments they couldn’t sell.
Why do we assume that the problem was the proliferation of activity in 2006, and not the collapse in demand in 2007?  Just as with the margin debt above, it seems to me that there is a sense that what goes up must come down, and the eventual crash justifies our pessimism.  This is similar to the housing market, where a collapse was related to the worst economic crisis in generations, yet those who were calling for a bust still feel vindicated.  The suggestion that we should have tried to avoid this disaster is usually met with an indignant retort about kicking the can down the road toward an inevitably worse correction.

But, we don't have to imagine a counterfactual.  Several countries shared the "bubble" but not the bust, and those countries are generally doing ok - Canada, Australia, etc.  They shared in the global downturn, but they managed to do it without having double-digit delinquency rates on mortgage debt or a decade-long collapse in housing starts.  That's a pretty good first estimation of our counterfactual.  The consensus view in this country, as far as I can tell, is that it was good that we experienced the worst economic crisis in decades so that we wouldn't be in the terrible position of maybe, possibly, having a correction in the future.  If anyone thinks that makes sense, then I suggest you take out large short positions on the Canadian and Australian economic markets.  Because, if they even have a chance of eventually being sorry for having avoided the housing bust so far, they are in for one doozy of a collapse.  We have a whole decade's worth of stagnation in the housing stock that they have supposedly kicked down the road.

By 2012, though, leveraged loans were bouncing back. Low interest rates and profit-hungry investors pushed total loan volume to $465.5 billion.

Some veteran regulators, including at the Fed, wanted to issue general guidelines and leave lending decisions up to the market, say people who participated in the discussions. If banks were selling the loans to willing investors, these regulators thought, then federal agencies shouldn’t intervene.

Other regulators were adamant about the need for a single, specific underwriting standard for all loans. They recalled how the Fed, OCC, and FDIC had published joint guidelines for risky mortgages in 2006 and 2007, but that was too late to ameliorate or avert the housing crash.  
Adamant about the need for a single, specific underwriting standard for all loans!  This is how we are going to be prudent - by enforcing a single standard on the entire market.  Who thinks that a monoculture is robust?  Where is this coming from?  And, those joint guidelines for risky mortgages in 2006 and 2007?  Were they really too late to avert a housing crash, or were they just in time to feed one?

I want to take a step back here, and think about ownership stakes in productive assets.  These are roughly divided between debt and equity.  Equity holders tend to accept the cyclical risk in exchange for a premium, or seen from the other side of the trade, debt holders accept a discount on their expected income in exchange for more certain cash flows.  As with most economic issues, there are supply and demand factors here that pull in different directions.  If investors are looking for more risk, they will tend to buy equities.  So, while financial intermediaries might feel more comfortable taking on leverage during an expansion, I think the idea that there is a pro-cyclical debt cycle is a little overblown.  It's a bit like those margin debt graphs - there is less there than meets the eye.

Here is a graph of total debt and household debt, as a proportion of GDP.  I don't see any cyclical behavior here at all.  If we want lower levels of debt, then cyclical macroprudential oversight isn't what we should promote.  Instead, we should stop favoring debt in secular tax and regulatory policies.

Here is a graph with several measures of corporate leverage.  Since equity values suffer the brunt of cyclical fluctuations, here we see that after a contraction, corporate leverage increases as a result of falling corporate asset values.  But, going into contractions, at least during the Great Moderation period, leverage has been level or declining.

The red line is debt/equity market values.  With this indicator, we can see how low equity values were in the 1970s, when interest rates and inflation were very high.  Inflationary monetary policy sharply reduced asset valuations.  Then, as inflation and interest rates have declined, firms have reduced their leverage, as measured by market values.  When contractions hit, leverage jumps out of equilibrium, and during expansions, firms generally have been pulling leverage back down as equities recover.

The blue line is a similar measure of leverage, using net worth instead of market value for equities.  If we worry that equities are becoming over-valued during expansions, causing the red line to understate leverage during expansions, this would correct for that.  Yet, we still see a long term decline in leverage since the early 1990s, as interest rates have fallen, and we still see counter-cyclical deleveraging during expansions.

Finally, the green line is a measure of debt / operating profit.  In this measure, we see a one time bump in the mid 1980s to a higher level, and a level trend since then.  This looks like it has a pro-cyclical pattern, but the purple line is a measure of corporate operating profits, and we can see from this that the apparent cyclicality comes from a drop in operating profits, which is a leading indicator of contractions.

Taking this all together, the one factor here that contributes to an increase in leverage going into a contraction is a decline in corporate profits.  The argument against managing nominal incomes in a way that might support corporate profits generally revolves around the idea that this encourages risk-taking and leverage.  But, there is no evidence here that there is any unusual rise in debt as expansions age.  If anything, we see the opposite trend.

This is basically the broken window fallacy applied to monetary policy and financial regulation.  We have to keep breaking windows so that nobody starts assuming that their windows won't break.  I would call this financial asceticism, and I would prefer not to be forced to practice it.


  1. Great points. If the world's most competitive money managers can't predict markets, do we really expect "technocrats" (a too-nice word for bureaucrats) not only to do so but also to take appropriate regulatory action? The question answers itself.