Behavioral theories of factor risk premia - Hard to measure causes of under and overreaction

Some of the most important risk premia are a result of investor market behavior and risk aversion and not just structural risk issues that require investor compensation. Given the association between risk premia and behavior, these premia at times can be fleeting or at least time varying as behavior changes. 

Time variation of returns will be associated with the degree of error expectations and under or over reaction to the market environment. There are systematic errors in expectations which arise when the macro or market environment is changing. For example, greater uncertainty may cause investors to have greater under reaction to market events based on risk aversion to loss. One-sided flow of information can create overconfidence. 

Most of the major risk premia have both risk-based and errors-based stories that are used as explanations; however, behavior stories may be harder to manage because they will be related to mistakes that can be corrected. Unfortunately, we don't know when behavioral errors will be closed.  

Nevertheless, it is useful to look at risk premia conditional on the risk sentiment environment. Macro risk factors can be measured within a framework, but measuring behavioral factors has to be focused on sentiment and excesses that create biases. 

Debt sustainability - this issue can again become important in the post-recovery period

Debt levels have exploded around the global. The growth has been most dramatic in developed countries like the US, but this debt explosion has been occurring across most countries. In the case of the US, the central bank has been a strong buyer of Treasuries, so the debt is not being held by private investors. Debt has been exchanged for reserves. There is a growing view through Modern Monetary Theory (MMT) that the monetizing debt is not a problem and if it becomes a problem through higher inflation, it can be solved through quick reversal of policies. 

Nevertheless, all countries may not be able to engage in the current debt policy extremes of the US nor may the US at some point. For most countries, debt sustainability will be an economic problem if certain extremes are reached. In the pre-MMT world there was a clear focus on debt through the strong arguments in This Time is Different: Eight Centuries of Financial Folly by Reinhart and Rogoff. However, any current emphasis on austerity has been relegated to a policy closet. Still, it is important for investors to score countries on this critical issue and be aware that it can serve as a catalyst for market sell-offs in specific countries. 

Country debt sustainability can be measured through a scorecard. Here are some of the most commonly used factors for assessing debt vulnerability:

1. Debt/GDP - As the debt to GDP exceeds 100% there is greater likelihood of a slowdown in growth based on the cost of maintaining the debt.

2. Primary balance (government revenue - expenses and interest costs) - Sustained negative balances especially during periods of robust growth calls into question the ability to pay principle.

3. Interest rate versus GDP growth - When rates exceed GDP growth, the cost of debt will not be able to be maintained.

4. Weighted average maturity of debt - More short-term debt increases the risk of rolling over principle when the debt matures.

5. Interest/revenue ratio - An increasing ratio will mean that other government expenses will be crowded-out by interest payments.

These factors must be weighed against the governance of the country, policy uncertainty, and the overall demographics which affect ability to pay. The likelihood debt will be a problem is also affected by the financial stability of the country and the external imbalances current account imbalances and foreign indebtedness. 

While there may not be an immediate debt crisis, tracking country difference will pay-off. There are limits to country borrowing, and those limits, if reached, can lead to large currency declines, rising rates, and equity selloffs over a short time period.

Words of Estimative Probability (WEP) - Words matter and poor precision leads to decision failures

 

Conveying probabilities and uncertainty is difficult especially if numbers are not used. Word choice matters. Words have different meanings and there is the potential for a disconnect between the sender of messages and the receiver. When words are used to convey probabilities, there is significant room for error. 

The current Afghanistan situation may be a perfect example of the problem of conveying assessments in words and deciding based on those possibly ambiguous assessments. We don't know the exact information given or the debates that were held concerning risks in Afghanistan, but if those sitting around a conference table used words like "probably not" or "little chance", it is likely that these had a range of probabilities and a range of understanding. 

The ambiguity in word choice was a key finding of the CIA analyst Sherman Kent who first studied words of estimative probability (WEP). He tried to get analysts to be more precise in their language in order to minimize ambiguity. He conducted surveys and developed a mapping of words to likelihood. We have written about this extensively in the context of investment committees. For investments there is not the risk of life with word choices for assessments, but the cost for wrong interpretations is real. 

Sherman Kent - My guy for precision in forecasting language

Sherman Kent - the godfather of precision in forecasting language

Language, perception, and numbers - The translation problem

What does failed intelligence tell us about investing

"Likely" or "Probable" - there is a difference in language when talking about recommendations in the new year

Recent research has replicated the work of Kent and has found similar results. For the new update on this work, see the posting by Wade Fagen-Ulmschneider from the University of Illinois. While finding similarity with Kent's work is good, this research shows that there is still a range of meaning for these words. We present the comparison with Kent's work and the range of probabilities for different word choice. Notice that the tail or extreme events have the highest level of ambiguity.

Someone can leave a committee meeting and have a very different interpretation for the likelihood of a given event. There can still be a high degree of ambiguity. Should investment committee members be given a scorecard on the words that could be used? That may not be a crazy idea. The key point is to ask analysts and committee members to offer precision with their estimates. This is not about the second decimal point but exacting specific information on what is being predicted and offering precision with the chances of an event occurring.

Of course, using probabilities has its own set of issues. What does it really mean to say that there is a 10% probability that a government will fail? Of course, there needs to be a time frame, but what is a 1/10 chance in next year really mean? This is the problem of uncertainty and subjective probabilities. We can say with countable data that there was a 10% probability that rates will rise by 75 bps in six months based on historical data, but that is very different than saying that there is a 20% that tapering will be announced at the September FOMC meeting. Learn to be precise in your assessments and that means defining clearly what is being handicapped. 

Money, money everywhere but in the loan market

With the Fed still buying $120 billion in Treasuries and mortgages every month, short rates still close to zero and real rates solidly negative, the loan market should be exploding with firms and households borrowing to take on new projects and funding consumption. Banks should be willing to lend given the strong deposits and excess reserves. That is the assumption, yet reality is different. 

Reality is different because credit markets are different. Banks will ration credit not on solely on price but on standards for lending and expected risks. If perceived risks are high, the price of credit will not matter. Similarly, borrowing will be based on expected return from an investment project. The discount rate is relevant, but cash flows dominate. Similarly, households will take on more debt only if there is the perception that future income will improve. While central banks can change the cost of credit and the supply of money, these variables may not control behavior in the credit markets. The credit question is always forward looking for both parties. Will the creditor be paid interest and principal, and will the borrower generate enough to pay interest and principal? 

Sustained growth is driven by business and consumer confidence and not just low interest rates. Right now, business and consumer confidence are declining which creates an economic headwind.