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Want to go deeper on the history of markets and conflict? Enroll in my latest online financial history course taught by experts like Niall Ferguson, Marc Andreessen and Tracy Alloway. Through 8+ hours of world class content you will learn:
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Russia’s 1917 revolution & the closing of its exchange for 75 years
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I am really excited about the articles linked in today’s newsletter, but the introduction will be a bit short, as I’m preparing for a guest lecture on the 1690’s Tech Bubble for Jim Chanos’ awesome “history of market fraud” class at Yale School of Management. I’ll share the slides in next week’s presentation!
“After the announcement of an armistice that ended World War I on November 11, 1918, most Americans feared that a deep depression was imminent. The thought was that the end of war-related spending, coupled with reduced European demand for U.S. exports, would lead to a collapse in economic activity. Although America did in fact experience a slight drop in real GNP of approximately 1% during the entirety of 1919, it was wholly attributable to economic weakness during the first few months of the year (which also happened to coincide with the third and final wave of influenza). For the remainder of the year, despite a more than 50% reduction in war-related government spending, strong exports and consumer spending more than filled the void. It is hard to imagine that this was not primarily attributable to post-war and post-pandemic euphoria. Americans were understandably eager to purchase luxuries and re-engage in activities that they had suppressed for years. Further, it was not as if they lacked cash. Enriched by record U.S. trade surpluses and increased propensity to save, the wealth of Americans increased substantially during the war years.
Improved consumer sentiment, however, was not the only factor at play in 1919. Spending was also fueled by cheap credit, as the Federal Reserve Banks maintained a highly accommodative monetary policy for too long. There were several explanations for this, the most significant of which appears to be pressure from the U.S. Treasury, which was concerned about servicing a floating rate portion of the war over the prior two years. In addition, both the Treasury and Federal Reserve Board were concerned about the impact of higher rediscount rates on the health of the financial system, as many banks had loaded their balance sheets with Liberty and Victory Bonds to fulfill their patriotic duty. Therefore, despite growing concerns about inflation and speculation, the Federal Reserve reluctantly delayed raising rediscount rates.
The consumer spending binge in 1919 did not last long, and it was followed by a short but severe depression that began in January 1920. The most significant catalyst of the downturn was aggressive (albeit delayed) tightening of monetary policy by the Federal Reserve Banks. Faced with inflation approaching 20%, the Federal Reserve Bank of New York raised the rediscount rate from 4.75% to 6.00% in January 1920, and then followed with a second increase to 7.00% in June 1920. In contrast to the standards employed today, the Federal Reserve Banks offered remarkably little advanced warning, and the magnitude and suddenness of these increases caught many in the financial community off guard. In terms of the outcome, if the goal was to reduce inflation, the Federal Reserve System certainly achieved its objective, as wholesale prices collapsed over the next year (see Figure 8). Unfortunately, higher rediscount rates also took a toll on stock prices, as reflected by the decline in the Dow-Jones Industrial Average (see Figure 9).”
Sounds pretty familiar, right? Well, without wasting any more time let’s get in to today’s Sunday Reads!
The first quarter of 2022 was rough. It is that simple. In times of uncertainty and risk due to inflation, war in Europe and more, investors want to hold assets that are not perfectly correlated. Historically, bonds have been the asset of choice for diversifying equity risk, because they are thought to be negatively correlated with stock market returns. As with many other long-time “rules” of investing, there is much more nuance to unpack. That said, this paper covers the correlation between stocks and bonds over one-hundred years.
Summary:
“The correlation between movements in equity prices and bond yields is an important input for portfolio asset allocation decisions. Throughout much of the 20th century, the correlation between equity prices and government bond yields in the United States and other countries, including Australia, fluctuated but tended to be negative. However, stock-bond yield correlations have been largely positive since the late 1990s, rose strongly during the global financial crisis and have since remained at a high level for a prolonged period. The more recent period of positive correlation in part reflects the pronounced and persistent effect of the financial crisis on the economic outlook, though it may also owe in part to an increase in the importance of uncertainty about real economic activity in driving both government bond yields and stock prices. Changes in US monetary policy look to have exerted an opposing force on the correlation at times, driving it lower.”
Visualizing History:
Notable Quote:
“The US stock-bond correlation has fluctuated around a slightly negative average level over most of the 20th century, with periods of high and variable inflation generally coinciding with strong negative correlations (Graph 2). This was especially the case between the 1970s and late 1980s, amid persistently high inflation, in part a result of significant increases in global oil prices. These developments also underpinned increased inflation uncertainty, as seen in relatively volatile inflation expectations over most of those two decades and the years that followed. These factors, in aggregate, were likely to have contributed to negative correlations via their influence on the common interest rate factor that drives equity prices and bond yields (consistent with the findings of the literature mentioned above).”
Whenever investors are faced with negative events affecting markets over the short-term, reviewing long term data can be beneficial.
Summary:
“We characterize the joint distribution of long-horizon returns on domestic stocks, international stocks, bonds, and bills. We study 38 developed countries with a sample period of 1890 to 2019, and our data formation procedures mitigate survivor and easy data biases. Bootstrap estimates of the joint distribution reveal substantial uncertainty in asset payoffs and large real loss probabilities over a 30-year horizon for domestic stocks (13%), bonds (27%), and bills (37%). The distribution features joint tail risk, such that simultaneous real losses across multiple asset classes over long horizons are not rare. The potential losses are most pronounced when current asset prices are high.”
I linked this paper in a previous Sunday Reads when it was originally published, but given all that has happened since I think this paper is worth re-visiting. As demonstrated in the introduction of today’s newsletter, the comparisons are eerily similar.
Summary:
“There is now increased debate with respect to the nature of a post-COVID economic recovery. Several financial writers have referenced the Roaring 20s as a historical period that may provide useful lessons. However, a deconstruction of the key economic drivers during the Roaring 20s suggests that this period provides few parallels to the circumstances in 2021. There are two historical periods, however, that do offer useful comparisons: the years 1919 and 1999. Drawing from the lessons from these two years, it seems plausible that a post-COVID recovery may combine a consumer spending rebound that is reminiscent of 1919 with increased speculation in the stock market that is reminiscent of 1999.
The paper concludes by encouraging investors to exercise caution, noting that neither the spending rebound in 1919 nor the speculative stock market bubble of 1999 lasted long. Therefore, it seems conceivable that after the initial, post-pandemic euphoria wears off, a similarly painful economic contraction and market correction could soon follow. Should this scenario occur, readers may benefit from considering this possibility and preparing psychologically for the consequences.”
Visualizing History:
Notable Quote:
“After the announcement of an armistice that ended World War I on November 11, 1918, most Americans feared that a deep depression was imminent. The thought was that the end of war-related spending, coupled with reduced European demand for U.S. exports, would lead to a collapse in economic activity. Although America did in fact experience a slight drop in real GNP of approximately 1% during the entirety of 1919, it was wholly attributable to economic weakness during the first few months of the year (which also happened to coincide with the third and final wave of influenza).
For the remainder of the year, despite a more than 50% reduction in war-related government spending, strong exports and consumer spending more than filled the void. It is hard to imagine that this was not primarily attributable to post-war and post-pandemic euphoria. Americans were understandably eager to purchase luxuries and re-engage in activities that they had suppressed for years. Further, it was not as if they lacked cash. Enriched by record U.S. trade surpluses and increased propensity to save, the wealth of Americans increased substantially during the war years.”
The first quarter of 2022 was a historically bad one for fixed income, with the Bloomberg U.S. Aggregate bond index posting its worst quarterly return since 1980 (-6%). With yields on government and corporate bonds fluctuating wildly in recent weeks, it’s worth looking at the historical relationship between stock earnings and bond yields.
Summary:
“Using historical data spanning almost 150 years, we examine whether there is a long-run equilibrium relationship between the stock’s earnings and bond yields. The novelty of our econometric methodology consists in using a vector error correction model where we allow multiple structural breaks in the equilibrium relationship. The results of our analysis suggest the existence of an equilibrium relationship over 1871–1932 and 1958–2017. On the two historical segments, our analysis finds that the stock’s earnings yield followed the bond yield in both the short run and long run, but not the other way around.
Perhaps the most important and surprising finding of our empirical study is that, after the break in 1932, a completely new equilibrium relationship re-emerged in 1958 that was later termed the “Fed model.” Our main argument for the emergence of a new equilibrium relationship is that a major “paradigm shift” in the stock valuation theory occurred in the late 1950s. To support our argument, we highlight the main historical events that potentially could have caused the transition from the old to the new paradigm. Finally, we identify the primary impetus for the paradigm shift.”
Visualizing History:
“The long-term bond yields versus the short-term interest rates. Vertical dashed lines show the location of the two major breakpoints in the relationship between the short-term and long-term interest rates.”
Notable Quote:
“Due to the rapid economic growth during the decades of the 1940s and 1950s, starting from approximately the mid-1950s, the investors became “obsessed with growth”. According to the GGM, the stock price depends heavily on the growth rate of dividends. The majority of financial analysts valued stocks on the basis of naïve extrapolation of recent dividend growth into the indefinite future. Such an approach to stock valuation pushed the stock prices continuously higher during the decade of the 1950s. However, as long as the dividend yield was larger than the bond yield, there was a general feeling that the stock market was not overvalued.
In 1954, the US government suddenly imposed high income taxes on stock dividends. Income on stock dividends was taxed at an individual’s income tax rate; from 1954 to 1963 the top marginal tax rate was 91%. In contrast, the tax rate on long-term capital gains was only 25%. Buying high paying dividend common stocks no longer made sense for wealthy investors. Therefore, high paying dividend stocks went out of favor, and stayed out of favor, beginning from the mid-1950s. As a consequence, from 1955, firms sharply reduced the amount of dividends.
In 1958, the stock dividend yield decreased below the bond yield. Since that time, the dividend yield has remained below the bond yield.”
Whether it be gold, government bonds or something else, investors have always searched for a “safe haven” to park their money in when times get tough. This paper details the long history and economics of safe assets, and how they have evolved over the years.
Summary:
“Safe assets play a critical role in an(y) economy. A safe asset is an asset that is (almost always) valued at face value without expensive and prolonged analysis. By design, there is no benefit to producing (private) information about its value, and this is common knowledge. Consequently, agents need not fear adverse selection when buying or selling safe assets. Safe assets can be easily used to exchange for goods or services or for another asset. These short-term safe assets can be money or money-like. A long-term safe asset can store value over time or be used as collateral. Much of human history can be written in terms of the search for and production of safe assets. But the most prevalent, privately produced short-term safe assets, bank debts, are subject to runs, and this has important implications for macroeconomics and for monetary policy.”
Visualizing History:
Holders of US Treasuries (% of Total Outstanding)
Notable Quote:
“The technological and legal infrastructure and institutions for producing safe assets had to develop and continue to change over time; the forms of safe assets have changed through human history. But the essential role of safe assets is a constant. There has always been a demand for safe assets, and a lack of safe assets constrains transactions and consumption smoothing. Sovereign debt is not always safe and can lead to sovereign debt crises. When there is a shortage of publicly produced safe assets, the private sector produces substitutes. This becomes a source of systemic fragility when the safe assets are debt.”
Why This is Relevant:
