Financial asset overshooting and the disconnect with the real world

Are current financial markets irrational? Are equities and bonds in a financial bubble? These are some of the main questions to be discussed at the beginning of this year. There are many ways to address this question, but a continued theme is the disconnect between financial assets and the real world. We are not going to answer directly the initial questions; however, I will shed some light on the disconnect between the financial and real world from some key recent research on the topic. 

The model of a leading macro researcher Ricardo Caballero with the help of Alp Simsek provides some useful insights on this topic in their paper "Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect". They take the simple argument that the Fed wants to minimize the output gap that exists in the economy. This output gap will be affected by increases in wealth through financial prices, with a lag. If the Fed can push financial prices higher than normal, overshoot, then the gain in extra wealth will help reduce the output gap and provide a faster path to recovery. The words trickle down are not used, yet this is the direction of this work. Push up prices and the output gap can be closed. Push up prices early and the Fed can preempt output gaps. As long as the link between the financial and real world is lagged there will be a disconnect between the financial and real economy.  

Financial prices are something that the Fed can control immediately through their policy activities and raising these prices can support higher aggregate demand. The Fed is acting on multiple fronts but allowing for inflated asset prices is a clear policy choice priority. 

This conclusion should not be a surprise. It should be viewed as a tailwind for all asset allocation decisions. Because this works with a lag, Fed activity today can increase financial prices immediately under the hope that Main Street will be positively affected tomorrow. Higher asset prices with a weak economy can occur and be the result of policy action and not irrationality. The end result is a disconnect between Wall Street and Main Street. The trickle down affect has timing differences.     

The "risky shift" effect - A problem with group decisions and a reason for preferring models

 

Many studies of group behavior shows that groups prone to risk behavior will take more risk after discussion within the group and those that are prone to caution will get more cautious after discussion. The group will reinforce their behavior in either direction if individuals have similar views going into a discussion. The crowd moves to extremes. This is called the "risky shift" effect or phenomenon.

There is strong meme concerning the madness of crowds and crowd behavior. History is replete with examples, yet less has been written about the crowd behavior moving to more conservative positions. Additionally, the crowd stories focus on group frenzy, yet the move to extremes can occur even in a hushed board room or the conference room of asset management firms where a small group may be assembled. The impact of this effect has really not been studied much within asset management groups.

The reasons for this phenomenon are varied. Some suggest it is associated with diffuse responsibility, more confident participants persuade others, and greater social status of following the group. An individual's risk sensitivity shifts within a group. This is group think in a risk dimension. 

Forget the wisdom of crowds when everyone is thinking the same. Put the group in a room with no diversity and watch the feedback loop go to the extreme. The move to extremes is not just for the positive but also for the negative.

Quantitative models have an edge because they will not suffer from the risky shift effect. There will not be a move to risk extremes because the risk is programmed into position-taking. You will get exactly what you want, no more or no less.  

Small and large firms behave differently over the business cycle

The business cycle affects firms differently based on size. Large firms as measured by the top 1% in size are less sensitive to the business cycle than small firms. However, since these larger firms have high and rising concentration, the impact of small firms is less on the aggregate economy. Small firms may disappear and will not be missed by the economy as a whole as industries become more concentrated. Yet, the impact of small firm failure and growing concentration is not to be dismissed. The impact of economic shocks on firms of different sizes is an important area of research and understanding this affect will be important for those investing in small firms.

Unfortunately, the standard financial accelerator argument that the cyclicality of firms by size is based on financing constraints and frictions does not seem to be as clear-cut as measured by a recent study in the American Economic Review, (November 2020) "Small and Large Firms Over the Business Cycle". While financial constraints may have an impact on firms of different sizes, the relationship between size and financing may be less clear. This is important because current monetary policy is supposed to be geared to helping small firms, yet the premise that credit is the main problem is not substantiated in a close examination of the data. The authors are careful with their analysis. Financial constraints and credit channels may be important but the differential between small and large firm effects is more complex than described by financial accelerator models. 

The negative impact of a recession on sales based on size is significant, but the authors find that the difference in cyclicality of these firms is not based traditional proxies for financial strength. Policies that try and target financing for small business may not be as effective as thought from earlier research which focuses on the financial constraint channel. What seems to be important factors on the size effect are economies of scope and customer capital. Small firms, by being more focused, are more vulnerable to an economic downturn. More concentrated firms by region and product are more susceptible to economic shocks regardless of their financial situation.

2020 commodities - Almost all markets above average price for the year

The global recession has not stopped many commodities from having a good year. There is not a bubble in commodities like financial assets. Commodity returns show strength in demand and the impact of some localized supply shocks. All commodity prices are above their 2020 averages. The only exception is the natural gas market which is seeing the effects of milder weather along with lower overall energy demand. 

The only sector that has stayed somewhat rangebound after the March shock is energy. Precious metals have gained on overall market uncertainty and higher inflation expectations. Industrial metals have done well given the strong rebound in China. Agriculture markets both in grains and tropicals have performed well. Food demand has maintained and some weather shocks have provided added lift. 

Any strength in 2021 global growth will allow for continued increase demand in all sectors. Given current prices do not reflect speculative excess, commodity markets offer investors good diversification and upside returns.