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I see your point now. However, it's important to note that the Fed's regime of low interest rates is temporary and everyone knows this. So yes, the market wil

I see your point now. However, it's important to note that the Fed's regime of low interest rates is temporary and everyone knows this. So yes, the market will discount investments that pay off in 1-2 years at a low interest rate. But since the low interest rates aren't expected to last, we shouldn't expect huge price increases for stocks whose investments will pay off in 5-10 years.

001sky 13y ago
At the risk of cross-threading the discussion, you need to account for 2nd and 3rd order impacts when trying to figure out where supply and demand will reach equilibrium. In particular, r->0 (asymptotically) is problematic because of somewhat opaque issues with DCF pricing. In particular, R(r) where R is the market discount rate and (r) is the risk free rate. Lets assume the fed is manipulating (r) and that R(r) is directionaly (+). That is fair enough. But R is also impacted by exogenous preferences setting (for risk, weath effects, substitution effects). While these preferences may be stable in theory at "normal r" (~econ 101 assumption), they are empirically not independent of (r) as r-->0 and so are not stable at all in our test case. In fact, as (r)-->0, it becomes more and more rational to take on extreme risk (especially so if (r) is temporarily/ artifically low. After all, you are playing with "free money". Now, lets assume that you have shifted gears in this way. Lets further assume you have a choice of two investment classes: (a) Low risk and (b) High Risk. Its clear you will weight your portfolio towards (b), purely through the change in preferences. This change in <preferences> will change R(r) and show up in your DCFs (ie, when implied by market pricing). In other words, the only way 'DCF' will make sense is when you plug in R'(r)=|=R(r). But now lets consider the subset of (b) in isolation. Given the result above, R'->0, stocks that have non-transparent, distant income will become relatively more attractive. That is to say, the current prices will look too low. So, you will overweight these stocks (bidding up prices). But not only will you in general bid up all assets (due to little r) you will bid up disporportionately equity vs debt and furthermore non-transparent risk equity vs lower-risk equity. As a result, you <should> expect huge price increases for stocks whose investments will pay off in 5-10 years. Or at least, so the theory goes.
- yetanotherphd 13y ago
  I think you are now the one doing the over-thinking. You are applying a model with fixed r, which is wrong because the current low interest rates are temporary. Forget the interaction between interest rates and risk preference for the moment. Isn't it the case that if interest rates are certain to return to normal in 2 years, then the values of an investment that returns in 5 years, and an investment that returns in 2 years, will be equally affected by current low interest rates?
  - 001sky 13y ago
    You are applying a model with fixed r No, this is not true. The whole point is that R=R(r). Its just that the relationship is ~chaotic, not linear. And it gets messy as either r or R --> 0. The fact that preferences are recursive on (r) should not be a surpirse, but I don't think mainstream Economists generally go there. On the topic of "temporary" vs Uncertain changes in (r), they are not the same. One is risk, the other is uncertainty. In general risk is priced a certain way (reasonably efficient), uncertainty is something you have preferences for (ie, you dont "price" it in the normal sense) and can only model indirectly in the first instance.[1] [1] eg, http://economistsview.typepad.com/economistsview/2010/06/risk-versus-uncertainty.html http://economistsview.typepad.com/economistsview/2010/06/ris...
7Figures2Commas 13y ago
> However, it's important to note that the Fed's regime of low interest rates is temporary and everyone knows this. The general consensus just a few short months ago was that the Fed would start tapering in September. It did not happen. There are credible observers and market participants who not only believe that tapering is not coming any time soon but that the Fed's asset purchases will actually increase. I don't necessarily agree, but I do believe that the Fed has positioned itself between a rock and a hard place, so I personally wouldn't make too many assumptions about timing and magnitude of increases or decreases in asset purchases. > So yes, the market will discount investments that pay off in 1-2 years at a low interest rate. But since the low interest rates aren't expected to last, we shouldn't expect huge price increases for stocks whose investments will pay off in 5-10 years. You make the mistake of assuming that investors are entirely rational. The empirical evidence clearly demonstrates that this is not the case. You should also consider that many (and perhaps the majority) of the participants in a good number of markets aren't really "investors" as most people define the term. John Williams, the President of the SF Fed, recently addressed asset price bubbles in a presentation[1]. It is well worth a read, and I would point you to the following: "For monetary policy, one implication of theories with endogenous asset price bubbles is that the time horizon over which policy affects the economy may be longer than typically thought. In particular, the policy response to cyclical movements in economic activity and inflation may have effects on investor beliefs and the behavior of asset prices that reach well into the future." [1] http://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2013/september/asset-price-bubbles-tomorrow-yesterday-never-today/Bubbles-Tomorrow-and-Bubbles-Yesterday-but-Never-Bubbles-Today.pdf http://www.frbsf.org/our-district/press/presidents-speeches/...

001sky 13y ago

At the risk of cross-threading the discussion, you need to account for 2nd and 3rd order impacts when trying to figure out where supply and demand will reach equilibrium. In particular, r->0 (asymptotically) is problematic because of somewhat opaque issues with DCF pricing. In particular, R(r) where R is the market discount rate and (r) is the risk free rate. Lets assume the fed is manipulating (r) and that R(r) is directionaly (+). That is fair enough. But R is also impacted by exogenous preferences setting (for risk, weath effects, substitution effects). While these preferences may be stable in theory at "normal r" (~econ 101 assumption), they are empirically not independent of (r) as r-->0 and so are not stable at all in our test case. In fact, as (r)-->0, it becomes more and more rational to take on extreme risk (especially so if (r) is temporarily/ artifically low. After all, you are playing with "free money". Now, lets assume that you have shifted gears in this way. Lets further assume you have a choice of two investment classes: (a) Low risk and (b) High Risk. Its clear you will weight your portfolio towards (b), purely through the change in preferences. This change in <preferences> will change R(r) and show up in your DCFs (ie, when implied by market pricing). In other words, the only way 'DCF' will make sense is when you plug in R'(r)=|=R(r). But now lets consider the subset of (b) in isolation. Given the result above, R'->0, stocks that have non-transparent, distant income will become relatively more attractive. That is to say, the current prices will look too low. So, you will overweight these stocks (bidding up prices). But not only will you in general bid up all assets (due to little r) you will bid up disporportionately equity vs debt and furthermore non-transparent risk equity vs lower-risk equity. As a result, you <should> expect huge price increases for stocks whose investments will pay off in 5-10 years. Or at least, so the theory goes.

yetanotherphd 13y ago
I think you are now the one doing the over-thinking. You are applying a model with fixed r, which is wrong because the current low interest rates are temporary. Forget the interaction between interest rates and risk preference for the moment. Isn't it the case that if interest rates are certain to return to normal in 2 years, then the values of an investment that returns in 5 years, and an investment that returns in 2 years, will be equally affected by current low interest rates?
- 001sky 13y ago
  You are applying a model with fixed r No, this is not true. The whole point is that R=R(r). Its just that the relationship is ~chaotic, not linear. And it gets messy as either r or R --> 0. The fact that preferences are recursive on (r) should not be a surpirse, but I don't think mainstream Economists generally go there. On the topic of "temporary" vs Uncertain changes in (r), they are not the same. One is risk, the other is uncertainty. In general risk is priced a certain way (reasonably efficient), uncertainty is something you have preferences for (ie, you dont "price" it in the normal sense) and can only model indirectly in the first instance.[1] [1] eg, http://economistsview.typepad.com/economistsview/2010/06/risk-versus-uncertainty.html http://economistsview.typepad.com/economistsview/2010/06/ris...

7Figures2Commas 13y ago

> However, it's important to note that the Fed's regime of low interest rates is temporary and everyone knows this. The general consensus just a few short months ago was that the Fed would start tapering in September. It did not happen. There are credible observers and market participants who not only believe that tapering is not coming any time soon but that the Fed's asset purchases will actually increase. I don't necessarily agree, but I do believe that the Fed has positioned itself between a rock and a hard place, so I personally wouldn't make too many assumptions about timing and magnitude of increases or decreases in asset purchases. > So yes, the market will discount investments that pay off in 1-2 years at a low interest rate. But since the low interest rates aren't expected to last, we shouldn't expect huge price increases for stocks whose investments will pay off in 5-10 years. You make the mistake of assuming that investors are entirely rational. The empirical evidence clearly demonstrates that this is not the case. You should also consider that many (and perhaps the majority) of the participants in a good number of markets aren't really "investors" as most people define the term. John Williams, the President of the SF Fed, recently addressed asset price bubbles in a presentation[1]. It is well worth a read, and I would point you to the following: "For monetary policy, one implication of theories with endogenous asset price bubbles is that the time horizon over which policy affects the economy may be longer than typically thought. In particular, the policy response to cyclical movements in economic activity and inflation may have effects on investor beliefs and the behavior of asset prices that reach well into the future." [1] http://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2013/september/asset-price-bubbles-tomorrow-yesterday-never-today/Bubbles-Tomorrow-and-Bubbles-Yesterday-but-Never-Bubbles-Today.pdf http://www.frbsf.org/our-district/press/presidents-speeches/...