Thursday, August 19, 2021

And yet another inflation illusion post...

Another inflation illusion post.  This time with math.

Again the issue here is that you can't just increase the discount rate when you are valuing a stock without paying attention to the top line growth rate.

Wednesday, June 2, 2021

Inflation is coming and so is inflation illusion.

Inflation illusion is a favorite topic of mine, read prior posts here.   It's a topic that comes back time and time again, usually whenever there is a hint of inflation.   Case in point - this article in Barrons

The key line: "Both higher yields and inflation itself erode the value of future cash flows, which makes stocks less valuable. "

This is basically inflation illusion - the idea that when bond yields increase, the discount rate for stocks should also increase, thus lowering the value of the cash flows generated by the stocks.

Here's why this is flawed logic:

The value of a firm's equity can be given as: Value=FCFE(1+g)/(R-g)

Where R = the nominal discount rate, FCFE is the free cash flow to equity and g = the nominal growth rate.   

When inflation increases, R will increase.  This alone will result in a reduction in the value of the stock.  However, inflation will also act upon g, the growth rate.  Across the economy we would expect, on average for g to increase by the increase in the inflation rate.   The net effect of R-g is that the impact of inflation gets cancelled out.

Ironically, the article above contains the line:

"That noise includes supply-chain constraints, which bring the cost of materials higher, incentivizing companies to raise prices."

Which basically says that the FCFE will increase - because prices are rising and therefore FCFE moves with inflation.

To be clear - I am not trying to beat up on a single, short, Barrons article.  Instead my point here is to show how common this mistake is.

Wednesday, March 24, 2021

The Fed Model is not dead...but really should be.

The Fed Model (not endorsed by the Fed) is one of those rules of thumb that investors use to value stocks, that while being intuitively appealing, is fundamentally flawed.  Recently, one of my MBA students shared another example of its application (which I'll get to in a moment).

First - what is the "Fed Model"?  Simply put, it argues that there is a relationship between the medium term Treasury yield (or some other interest rate) and the earnings yield or forward earnings yield for some basket of stocks (such as the S&P 500).

The idea is this:   Say the 10-year Treasury is yielding 4%, and the forward earnings yield of the S&P 500 is 4%, then stocks are fairly priced. (Note: the earnings yield is the inverse of the Price - earnings ratio).

If, due to inflation, the Treasury yield increases to say 5%, the Fed Model suggests that the earnings yield of the S&P 500 must adjust to 5% also.   This will result in the PE ratio of the S&P 500 falling from 25 (1/0.04) to 20 (1/0.05).   As earnings haven't changed, the price of the S&P 500 must fall from 25 to 20 or 20%.  Ouch!  You can see why investors who subscribe to the Fed Model get so upset about inflation.  In my example, a 1% increase in inflation takes 20% off the stock market.

But, it turns out that this is entirely flawed logic and suffers from my favorite behavioral finance error - "Inflation Illusion".    This is because the Fed Model ignores a key fact.   When inflation increases, the cash flows from a bond don't change.   The bond coupons are fixed.  But, the cash flows from stocks DO change.  Earnings will, on average, increase at roughly the rate of inflation.   The reason is simple - inflation occurs because companies that sell stuff put up prices, which results in higher sales (Sales = Price*Quantity) and are passed down to the bottom line.   As an exercise for the reader - make a simple income statement and increase all the costs and revenues by 1% and see what happens to the Net Income.

So when inflation increases, future earnings of the stocks will increase also.  The stock price will also adjust up to reflect inflation.  The result is that PE ratios and earnings yields stay the same, because both the price and earnings of the stock move in accordance with the higher inflation rate.  This means that the PE of the stock market can stay at 25 even if the Treasury yield is at 5%.   There's no misvaluation, because there is no fundamental reason why the Earnings yield must track the Treasury yield.

You may be wondering - why does the stock price increase in the presence of inflation?

Consider a simple dividend discount model.   Inflation is 0%, dividends grow at 2% a year and the discount rate is 5%.  Dividend today is $1.

Price = 1*(1+0.02)/(0.05-0.02)=34

Now assume 1% inflation.  Inflation increases the discount rate to 6% and the growth rate to 3%.

Price = 1*(1+0.02+0.01)/(0.05+0.01-0.02-0.01) = 34.33

The price change is:  34.33/34 -1 = 1% (rounded because we didn't compound the growth rates).

The takeaway:   When inflation occurs, all else equal, stock prices rise.

So on to that article.  It's here on CNBC and is firewalled , but the gist, according to Ned Davis Research, is that if the current 10-Year Treasury goes from 1.6% to 2%, this will result in a decline of as much as 20% in the Nasdaq index.   Unfortunately, this is exactly the Fed Model.   I've done the calculation, and yes, I get roughly the same number.  If you assume the following:

Nasdaq forward PE = 37, implying an E/P = 2.7%.  An increase of 0.4% in the E/P would result in a new Nasdaq forward PE of 32, and a price decline of about 13%.  

Unfortunately this analysis is entirely flawed.   It assumes Nasdaq earnings don't adjust with inflation.

So, to conclude - the Fed Model is still being peddled by Wall Street Firms, even though they may not call it as such.   But it's still wrong.   For an excellent take down of the model, see Cliff Asness's post at AQR here: - full article here:

Thursday, March 11, 2021

How does the weather impact HFT?

Sometimes I come across an academic research paper that is just so interesting I feel compelled to share it with my MBA students.  This is one of those papers.

Here's the basic set up:

High Frequency Traders (HFT) try to make money out of tiny price deviations between stocks traded in Chicago and New York.  Same stock, two trading locations.   If you can see the stock move in New York and can get a trade in in Chicago, you can capture a profit before Chicago figures out what's going on.

There are two ways to do this. 

1. Fiber optic cables.   Very fast

2. Microwaves.  A tiny bit faster.

You also need to know something else about stock trading (and this is an area I did quite a bit of work on in my earlier days) and that is that we can look at the bid-asked spread of a stock and infer from it something called the adverse selection cost of trading the stock.  The adverse selection cost measures uncertainty about the true value of the stock.   For example, if I tell you I have two cars I am selling  - they are identical, except one comes with a warranty the other doesn't - you'll pay more for the warranty car.  In effect the reduced price of the other car reflects an uncertainty cost  - the uncertainty of how good the car actually is.

OK so back to stocks - higher adverse selection cost means that there is more uncertainty about the true value of the stock.  Its true value could be higher, or lower.   High Frequency Traders contribute to this cost as they add risk to the market by being able to exploit mispricing at the expense of other market participants.

So how does this relate to the weather?  Well it turns out that microwaves don't work when it is raining hard or snowing.   So away go some of the HFT traders - just for a short while.   But during that time, the adverse selection component declines!

It's a testament to the ingenuity of the authors to devise an experiment to capture this effect.   And this isn't merely an academic exercise, millions of dollars if not billions are spent in the pursuit of HFT gains.

The paper is here if you are interested.  The intro is well written and quite accessible.  Not surprisingly, this paper wound up in the very top finance journal.

Wednesday, December 18, 2019

Beanie Babies

There are a lot of similarities between the boom and bust of the Beanie Baby market in the 1990s and booms and busts in financial markets.  They are often based on the so-called "greater fool theory" which is essentially "I know that I am a fool for buying this at this price, but I am counting on a greater fool to buy it from me in the future".

Anyhow, here's a fun article about the Beanie Baby market:

Friday, December 13, 2019

Alphabeticity Bias in 401(k) Investing

It's interesting how little biases creep into how people make investing choices.  For example, the alphabetical order of the 401K choices listed in a plan brochure (or website) can influence the choices that investors make.

This is discussed in a recent paper published in the Financial Review (an academic journal that I c0-edit). 

Here's the paper

And here's a link to a discussion in the WSJ.

There are several solutions to this problem.

  1. Don't have so many options on the plan in the first place.   If there are just 5 choices, people are more likely to work down the full list.
  2. Group choices in more logical groups.   For example, group by "equity" "bonds" "international".  And again, don't provide too many choices.
  3. Allow re-sorting of the list.

A nice discussion of cash - money in short term accounts

Friday, September 13, 2019

Austria's 100 year bond.

If you create a bond with a 2% coupon in a world where interest rates are 0.9%, you can bet that that bond is going to be very very volatile. 

Case in point - Austria's 100 year bond that matures in 2117.  (note: register for the economist and you can view a few articles for free).

My quick calculations show that this bond has a duration of about 56.  That's pretty high!  I'd be interested to know whether investors are buying this a straight bet on interest rates or whether they are using it as part of a portfolio.  You wouldn't need much of this bond to tilt the duration of your portfolio higher.

Here are my excel computations, with the predicted price change using duration alone (which is not terribly accurate in this case).  For bonus points - explain why this is the case...

Monday, June 10, 2019

Why stocks are good hedges for inflation.

I was quoted yesterday in the Wall Street Journal on why stocks are good hedges for inflation.
Article is here:

Quoting from the article:
The reason stocks are a decent inflation hedge is because corporate earnings grow faster when inflation is higher, and grow more slowly when inflation is lower, according to Richard Warr, a finance professor at North Carolina State University. Consider the growth rate of corporate earnings over all 10-year periods since 1871, according to data compiled by Yale University finance professor (and Nobel laureate) Robert Shiller. The volatility of those growth rates was 21% less on an inflation-adjusted basis than it was on a nominal basis, which Prof. Warr says is a good indication of the extent to which equities are able to hedge inflation.
To be sure, Prof. Warr adds, higher inflation does reduce the present value of the otherwise higher future earnings. But these two effects should more or less cancel each other out over time.
Prof. Warr acknowledges that, over shorter periods of a year or two, stocks often suffer when inflation heats up. His research suggests that is because many investors are guilty of what economists refer to as “inflation illusion.” That is, they focus only on the reduction in the present value of future earnings to which inflation leads, while ignoring the tendency for nominal earnings to grow faster when inflation is higher. So when inflation spikes upward, they sell stocks.
Since the inflation illusion is irrational, it is difficult to predict whether investors will be guilty of it the next time inflation heats up. But Prof. Warr says that if they do and their selling causes the stock market to drop, investors should treat it as a buying opportunity."