(part II of three, continued from Part I)

In order to explain the volatile behavior of the financial markets over the last few years one might well point to a series of large events—the Russian Debt default and the Long-Term Capital Management debacle; the liquidity bubble around Y2K fears; the terrorist attacks and threats of war; and the accounting/corporate governance scandals. Yet these events, while causing major dislocation in specific market sectors, have done little to interfere with aggregate growth in U.S. GDP and relatively low national unemployment. While we may be realizing higher specific risks than expected, our general economic risk has continued to decrease.

The 2000–2001 recession was one of the mildest ever. In fact, in every dimension, recessions have been getting milder through the twentieth century and into the twenty-first. In each case, unemployment has been lower and the peak-to-trough change in income has been smaller. In fact, the overall volatility in fundamental economic data has decreased markedly, as shown in the following chart:

In theory, the fundamental risks of financial markets (those reflecting earnings and growth) should reflect the aggregate risk in the economy. If this is the true picture of aggregate economic volatility, why should the markets-in aggregate-seem to discount so much more?

Endogenous Risk: "We have met the enemy, and he is us."

The academic world is hard at work examining bubbles, as they seem to contradict the accepted wisdom of Efficient Market Theory ("EMT") and the Capital Asset Pricing Model ("CAPM"). Noted "bubble-ologists" such as economists Mordecai Kurz of Stanford University, Robert Shiller of Yale, and Woody Brock of SED Inc., have taken issue with EMT and attempt to describe and explain market overshoot.

Professor Shiller, in his best-selling book "Irrational Exuberance", posits a variety of interesting explanations for seemingly "irrational" behavior. He maintains that the public, "learned and unlearned", suspected truths about the risk of stocks in the long run, during the run up to March 2000. Shiller is effective in debunking EMT and posting behavioral "irrationality", but his book does not quantitatively address or explain the overshoot phenomena he so eloquently describes. In fact, if irrationality is indeed at work, such a quantitative framework would be difficult to derive.

"Irrationality" is a fuzzy word. Presumably, true irrationality would be purely random, extinguishing hope for a unifying theory. A working theory for markets can only arise if investor behavior can be described as, at least, "purposeful", if not well-advised. This is where Professor Kurz' ideas begin. Kurz' "Theory of Rational Beliefs" is a general equilibrium model of market overshoot that shows how purposeful investor behavior can create pricing conditions entirely consistent with the recent behavior and pricing of markets.

Kurz describes a market where the distribution of serially-correlated belief systems (i.e. reinforced by the very price momentum they create) are the primary drivers of market volatility. Kurz model is successful in that it empirically describes the high levels of endogenous volatility in the market even as the underlying fundamental volatility of the economy has decreased. Efficient markets theory suggests that the equity risk premium should be relatively low, in turn suggesting that the corresponding risk free rate must be relatively high. These theoretically-derived returns are the exact opposite of recently observed market pricing¹. Kurz' model corresponds nicely to today's reality of risk-free rates below 1% and much larger premia on equity assets. Kurz' groundbreaking work should provide some insight into the "skin of the bubble", enhancing our ability to determine the actual boundaries of risk created by "Rational Beliefs" given the speed of information in our markets.

In order to understand how differing and fluctuating beliefs might still be viewed as "rational", we turn to Economist Woody Brock. Dr. Brock, to whom we owe our limited knowledge of Kurz, makes a living analyzing the "Economics of Uncertainty", which includes exploring the implications of the work of academics like Kurz to the money management community. Brock explains the core issue of endogenous volatility with the concept of "Pricing Model Uncertainty". In brief, he describes how investors use a model ("M") to convert fundamental news (such as GDP growth, default rates, etc.) into the price of a security. Efficient Markets Theory posits a fixed, known "M", with which Brock takes issue:

"In reality M is not fixed, and often cannot be known at all. This is particularly true in the case of currencies and, increasingly in the case of stocks: to see this, suppose that a clairvoyant back in 1995 had revealed to a group of investors the truth about earnings, interest rates and GDP over the next seven years. Armed with such invaluable knowledge, would any of the group have been able to foretell the behavior of the stock market over that time? No, and each would have agreed that the required map M from news to price does not exist."

Brock goes on to describe a variety of factors that have increased the volatility created by "model uncertainty" and lays an intuitive foundation for Kurz' theory.

All three of the aforementioned authors describe the lack of a fundamental basis for the dramatic changes in prices that have occurred in the last twenty years. They make the point that bubbles are created from non-stationary, self-correlated re-pricing of fundamentals, including risk. They describe the reality of markets being perceived as safer because they are going up or riskier because they are going down.

Not only, it seems, are we changing the risks in the market as we observe them, emerging economic theory points to investor belief systems as responsible for the vast majority of current risk in the market. We recommend you examine the work of the authors cited above and draw your own conclusions.

In the final installment of this series we draw some conclusions and give our view on the potential overshoot in the present market environment.

¹ Finance professionals refer to this as the "Equity Risk Premium Puzzle". Refer to: Mehra and Prescott, 1985, "The Equity Premium: A Puzzle", Journal of Monetary Economics, 15  or Kurz M., and A. Beltratti, 1997, "The Equity Premium is No Puzzle".