Home > Uncategorized > Rational markets (not)

Rational markets (not)

h/t: Erwan Mahé

David Lucca and Emanuel Moench could have been rich beyond measure. Instead, they published this (but see also this about endochronic properties of processes):

For many years, economists have struggled to explain the “equity premium puzzle”—the fact that the average return on stocks is larger than what would be expected to compensate for their riskiness. In this post, which draws on our recent New York Fed staff report, we deepen the puzzle further. We show that since 1994, more than 80 percent of the equity premium on U.S. stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee (FOMC) announcements (which occur only eight times a year)—a phenomenon we call the pre-FOMC announcement “drift.”…

      1. Since 1994, there has been a large and statistically significant excess return on equities on days of scheduled FOMC announcements.
      2. This return is earned ahead of the announcement, so it is not related to the immediate realization of monetary policy actions.

6a01348793456c970c0177432bf020970d-800wiOur sample period starts in 1994, when the Federal Reserve began announcing its target for the federal funds rate regularly at around 2:15 p.m

An International Perspective
Does this striking result apply only to U.S. stocks? While we do not find similar responses of major international stock indexes ahead of their respective central bank monetary policy announcements, we observe that several indexes do display a pre-FOMC announcement drift, as the chart below shows. Cumulative returns rise for the British FTSE 100, German DAX, French CAC 40, Swiss SMI, Spanish IBEX, and Canadian TSE index when each exchange is open for trading over windows of time around each FOMC announcement in our sample

In the Staff Report, we attempt to account for standard measures considered in the economic literature that proxy for different sources of risk, such as volatility and liquidity, but they also fail to explain the return. Finally, we consider alternative theories that feature political risk, investors with capacity constraints in processing information, as well as models where stock market participation varies over time. Although these theories can help qualitatively explain the existence of a price drift ahead of FOMC announcements, they are counterfactual in some dimension of the empirical evidence.

Our findings suggest that the pre-FOMC announcement drift may be key to understanding the equity premium puzzle since 1994. However, at this point, the drift remains a puzzle.

  1. December 15, 2015 at 10:18 pm

    “For many years, economists have struggled to explain the “equity premium puzzle”—the fact that the average return on stocks is larger than what would be expected to compensate for their riskiness.”

    This problem needs to be stated better. There should be no mystery in equities going up in price/revenues terms when you have politicians dedicated to decreasing the ability of the middle class to provide revenues and increasing the ability of the upper class to buy equities. Is this accounted for properly in the dilemma?

    Regarding the graph:

    I don’t know what that red line is a graph of, but the one thing we can be sure it is *not* a graph of is “the S&P index without FOMC days” in any normal sense that a stock trader would use the terms. It is physically impossible to take the returns of a stock market index and pull out a subset of returns that takes your initial investment to 0 unless you make the strange assumption that dipping a dollar means the same in a 1000 dollar instrument and a 10 dollar instrument. Anybody with experience in investments would not consider this a reasonable assumption and it should not be used in an investment analysis context.

  2. BC
    December 15, 2015 at 11:06 pm

    The described hypothetical return is a result of gaming of equity index futures, increasingly since 2009-11 by TBTE banks’ offshore shadow banking pass-through entities utilizing high-frequency trading with increasing leverage (50-80:1 vs. 25-30:1 in 2006-07 prior to the Bear Stearns, Lehman, and AIG implosions).

    Secular Bear Markets

    As an aside, historically, secular bear markets wipe out all real, currency-adjusted equity index price gains of the preceding secular bull market, leaving the typical investor/speculator at the end of the secular bear market with a total return equal to the average dividend less fees and taxes.

    The reflationary effect on asset prices and returns of falling nominal interest rates since the early 1980s (the Long Wave Downwave to date) was the strongest such period since the Civil War to the late 1890s.

    Based on that historical precedent, the major western equity markets are priced for an average real total return of ~0% for the next 7-10 years, and perhaps longer were deflation occur and persist, whereas there exists a 35-50% cyclical drawdown risk during the period.

    However, pension fund managers are expecting 6.5-7% returns for the period.

    A Fed Rate Hike: Too Late

    The Fed raising rates even modestly risks an outsized disruption to the term structure of the hopelessly levered carry trade that has already begun unwinding for emerging market and junk debt markets. Every major financial crisis in history began in the debt markets, and the one currently unfolding is no exception apart from the fact that it is the largest debt bubble in world history by far.

    OFR’s Financial Stability Report


    “In the Financial Stability Report, the OFR assessed vulnerabilities and resilience in the financial system, highlighting these areas of concern:

    Credit risks are elevated and rising for U.S. nonfinancial businesses and in many emerging markets. In the U.S., nonfinancial business debt is growing rapidly, boosting leverage; in relation to gross domestic product, it is at a historically elevated level.

    Persistently low interest rates and suppressed risk premiums in U.S. fixed-income markets contribute to excessive risk-taking and borrowing that could pose financial stability risks.

    The resilience of the financial system has improved significantly since the financial crisis, but it is uneven. Vulnerabilities persist and some new ones have emerged. Financial activity and risks have migrated outside the regulatory perimeter, market liquidity appears to have become more fragile in recent years, and interconnections among financial firms and markets are evolving in ways not fully understood.

    Central clearing of derivatives has benefits for risk management, but concentrates risk in central counterparties, or CCPs, and may transmit or amplify stress in new ways.

    Derivatives data reported to registered swap data repositories still have significant room for improvement. Further development of the framework to standardize and validate data is essential to improve data quality.

    Enhanced capital and leverage requirements have made banks more resilient, but they also can have unintended consequences. OFR analysis shows areas where these requirements may increase incentives for risk-taking by large, complex banking firms.”

    Largest Debt Bubble in World History

    Obviously, it is certainly the case that the BIS, IMF, CCoC, and OFR officials are aware of the leverage and outsized risks, but they are powerless to do anything except issue cautious pronouncements that few bother to heed because they don’t get paid to care (or they’re paid not to care and lever up until they can’t).

    Not only have the lessons about what led to the GFC and the 1930s debt-deflationary crisis not be learned and actions taken to prevent a recurrence, but those who profited from creating the previous bubbles that nearly wiped out the global banking and financial systems have done it yet again, only this time BIGGER. This implies that the next crisis will be larger and the world’s central banks’ response larger in kind.


    How much will the Fed have to print this time? What percent of GDP will the monetary base and Fed balance sheet reach? 40%? 50%? More? How much will it costs to bail out banks, student loans, subprime auto loans, underwater mortgage paper, munis, and the lenders to shale oil and tar companies?



    Bank commercial and industrial loan delinquencies and charge-offs are increasing YoY, accelerating since Q2. The Fed chooses to raise rates now?

    Of course, the Fed will get the blame, which is part of its function to run political cover for the TBTE banksters’ license to steal via fractional reserve banking, hyper-financialization, unspeakable leverage to bank capital, wages, and GDP, and their captured politicos and regulatory regime.

    Same as it ever was . . . , and it’s about to happen again.

  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.