DeLong on the mother of all black swans

Brad DeLong has a post that is mildly critical of Shiller’s stock market model in almost precisely the same way that I am critical of Shiller’s stock market model.  The only difference is that DeLong knows more finance than I do, and makes the case far more effectively than I can.  I was intrigued by his conclusion:

That is a perspective very different from mine, which regards the failure of the CAPE to spend most of its time north of 25 as a mystery.

But given that it does not, it would be very rash for anybody who is not certain that they can wait out the market to invest more than they can afford to lose. And past performance is not only not a guarantee it may not be an indicator of future results. We have had one real Black Swan–World War I–in the past 130 years.

The first part refers to what DeLong and I think is the real mystery—not so much why stocks were so high in 1929, 2000, and now, but rather why they were so low 90% of the time.

I think WWI is a great black swan example, but without really disagreeing with DeLong I’d like to throw out another possible black swan—1968.  And no, I’m not thinking of all the assassinations and political turmoil in the US (as well as many other countries.)  It’s not clear that the political events of 1968 had much permanent effect; 1979 was the real turning point (see the PPS of this post.)  Instead I’m going to argue the shift from gold to fiat money was a black swan.

First let me digress with a bit of history.  It became illegal for Americans to redeem dollars for gold in 1933.  I seem to recall that in 1968 the gold window was closed to foreign individuals, and in 1971 the window was closed to foreign central banks.  (Someone correct me if I am wrong.)  So the gold standard sort of faded away over a 40-year period.  Then why pick 1968?

Even though Americans could not redeem dollars for gold in the 1960s, they could buy foreign currencies, and/or goods in foreign countries.  And there was a free market in gold in some foreign countries.  So up until 1968 gold continued to provide at least a weak anchor to the monetary system, at an international price of $35/oz.

My second point is that switching to a permanent fiat system was much more inconceivable to people in the old days than you might imagine.  Yes there were brief experiments like the greenbacks of the Civil War and the German paper money of 1920-23.  But even Keynes opposed a pure fiat regime, and viewed these historical examples as sort of pathological cases.  If you had told someone in 1968 that by 1980 the price of gold would be over $800/oz. they would have thought you were a lunatic.  It was $20.67/oz. in 1879.  It was still $20.67 an ounce in 1932.  It was $35/oz. in 1934.  It was still $35/oz. in early 1968. I recall that when gold was around $150/oz. in the 1970s, one of my economic professors at Wisconsin predicted the price would soon fall back into the $40s, as it was far overvalued.

DeLong identifies three periods when stock investors did poorly over the following 10 years—right before WWI, the late 1960s and early 1970s, and the late 1990s.  Even today I’m not sure exactly how much of the poor stock market performance of 1968-81 was due to the Great Inflation. Inflation did punish savers given that the IRS taxes nominal capital income.  But does that explain the entire underperformance?  Was there money illusion (confusing real and nominal interest rates) when discounting future profits?  I’m not sure.  I am confident, however, that moving to a fiat money regime was a black swan for the US 30-year Treasury bond market, and pretty much every other bond market as well.

PS.  And take a look at this excellent post over at MarginalRevolution.



25 Responses to “DeLong on the mother of all black swans”

  1. Gravatar of JP Koning JP Koning
    20. August 2014 at 08:03

    “Someone correct me if I am wrong.”

    The London gold pool stopped operating in the London gold market in March 1968 and allowed the price float. It quickly rose to $41 or so. Until 1971, central banks agreed to transact at the $35 price and could still redeem US dollars with gold.

  2. Gravatar of Kevin Erdmann Kevin Erdmann
    20. August 2014 at 08:40

    It makes sense that this was a black swan for bonds. The funny thing is that there was a substantial equity premium from the Great Depression until the mid-1960’s, and it has basically been low to non-existent since then, depending on your holding period. You would think that a bond black swan would have boosted the equity premium.

  3. Gravatar of Kevin Erdmann Kevin Erdmann
    20. August 2014 at 08:48

    The tendency that bond returns have had of very long term serial correlation, which seems to come from persistent epochs of Fed policy, still makes them a terrible vehicle for diversification, unless your hedging a mortgage.

  4. Gravatar of Colin Docherty Colin Docherty
    20. August 2014 at 09:09

    Not to be a stickler, but would you be able to link directly to DeLong’s post next time? He makes multiple posts per day, all very dense, and after a frustrating search effort, I finally rabbit holed my way to its true place — not on his personal blog, but on the equitable growth blog:

    Besides that small nitpick, fantastic post. As always, I feel a terrible shutter in my spine as I read your historical perspectives. Not only do I lose immediate workday productivity from reading your writings, but I also now feel a strong urge to delve deeply into the US gold standard pre-1968! Another one to add to the ever growing pile you put on my intellectual plate.

  5. Gravatar of Cy Cy
    20. August 2014 at 09:27

    Is there a reason you didn’t put a link to DeLong’s article?

  6. Gravatar of Ironman Ironman
    20. August 2014 at 09:54

    Order broke down in the stock market earlier than 1968 – more specifically, after April 1966, which was then followed by a series of disruptive events, which largely account for the underperformance of stock prices throughough much the period, which is really split into two parts: the chaotic period of 1966 to 1976 and a lackluster period of order that ran from 1976 to 1981.

  7. Gravatar of Kevin Erdmann Kevin Erdmann
    20. August 2014 at 10:03

    Ironman, I’ve always found those charts of the S&P500 and dividends, with the shifts between chaotic and ordered markets to be interesting.

  8. Gravatar of ssumner ssumner
    20. August 2014 at 10:11

    Thanks JP, That’s also what I recall.

    Kevin, Good points.

    Colin and Cy, I forget–but I’ve added it now.

  9. Gravatar of JP Koning JP Koning
    20. August 2014 at 10:42

    No problem.

    I agree with your point about the real mystery being why stocks were so low 90% of the time. Here’s an old post of mine on the perils of using CAPE, especially during the inflationary 60s and 70s. Firms can’t adjust their pre-tax income to account for the effects of inflation because historical cost accounting prevents this. They end up paying progressively more tax than they should.

  10. Gravatar of Chris Mahoney Chris Mahoney
    20. August 2014 at 10:44

    I’m not sure that it correct to say that stocks are underperforming when PE and prices are low. Low PEs mean that the return to holding equities is high (the earnings yield). Stockholders can be enriched at low valuations. The returns to owning stocks before the go-go years were very high, even if prices didn’t budge. As Buffett says: I buy stocks for the total return, not just price appreciation. I would also observe that stocks remain cheap today as measured by the equity risk premium, which at 5.45% (Damodaran) is quite high by historical comparison. I believe that the premium is high due to post-crash PTSD, which also happened after the Depression.

  11. Gravatar of Ironman Ironman
    20. August 2014 at 11:34

    Kevin: Thanks!

    Speaking of which, we’ve never looked at the period surrounding World War 1 in detail, so we’ll put that project into our near-term development queue.

    On the other hand, for anyone who wants to see 1925-1932, which is the farthest back we’ve gone with the data, here you go. As these events go, outside of the period from June 1929 through December 1930, stock prices behaved in an exceptionally orderly fashion.

  12. Gravatar of Doug M Doug M
    20. August 2014 at 13:53

    There was an intermediate step not mentioned… In the Kennedy Administration capital controls were introduced such that an people exchanging into or out of dollars were taxed when they reversed the transaction.

    “Was there money illusion (confusing real and nominal interest rates) when discounting future profits?”

    please explain what you mean more fully.

    going to Graham and Dodd.

    P = D/(k-g)
    P = Price, D = Last dividend payment, you can replace this with earnings or free cash flow if you like, it doesn’t change the principle.
    k is your required return… usually we use nominal (around 12%) but we could use real (call it 8%).
    g is dividend growth.
    1/(k-g) is 1/dividend yield (or P/E if you are using Earnings instead of dividends). Historically, this tends to be around 15-20.

    dP/di = D (dk/di – dg/di)/(k-g)^2
    change in price with repect to a change in inflation.

    = P * (dk/di – dg/di)/(k-g)
    dP/di / P = % change in price for a change in inflation.
    ~ 20 (dk/di – dg/di)

    so, if you expect the change required return to exactly match the change in earnings growth, then inflation has no impact on share prices. But if these numbers are just a little bit apart, you can see that share prices should be sensitive to small differences.

  13. Gravatar of bill bill
    20. August 2014 at 14:20

    Shiller is very smart.
    But here’s two observations.
    1 – his CAPE his given a buy signal just once in the last 20 years (2009)
    2 – his irrational exuberance book was spectacularly timed. Trouble is that he started giving speeches around 1995 with those concepts. I’m glad I didn’t bail in 1995 or 1996.

  14. Gravatar of Tiago Tiago
    20. August 2014 at 16:59

    Random thought: I never understood why people use black swans as a metaphor for an unexpected event which changes everything. I mean, I can get the unexpected part, but how does a black swan change anything really? “Look over there, it’s a black swan” “Would you look at that, I thought there were only white swans. Live and learn.”

  15. Gravatar of CMA (@CMAMonetary) CMA (@CMAMonetary)
    20. August 2014 at 20:17

    Sorry off topic

    Is an asset purchase of a treasury long run non permanent because as the treasury expires the MB flows back to the fed?

  16. Gravatar of ssumner ssumner
    21. August 2014 at 07:53

    Doug, Perhaps they didn’t assume that share growth reflected inflation. I.e. they assumed the high nominal interest rates were high real interest rates.

    Bill, I’ve talked about both of those factors. Even worse, although his model gave a buy signal in 2009, he did not.

    Tiago, I guess you’d have to read the book to find out. I resume it’s along the lines of “I never would have imagined that, I assumed they were all white.”

  17. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    21. August 2014 at 09:15

    Jeff Frankel says NGDP targeting is, at least, good enough for them there foreigners;

    ‘Targeting Nominal GDP has been proposed in the context of major industrialised countries. (Frankel, 2012, gives other references to the literature.) But a good case can be made that the idea is in fact more applicable to countries further down the income ladder. The reason is that emerging market and developing countries tend to experience bigger terms of trade shocks and supply shocks than industrialised countries do. NGDP targets are robust with respect to precisely these kinds of shocks. ‘

  18. Gravatar of gofx gofx
    21. August 2014 at 10:23

    Scott, Off topic. FYI. Bhadari and Frankel on NGDP targeting in developing countries ( more shock prone). WWW. voxeu.ur 8-21-2014.

  19. Gravatar of Philippe Philippe
    21. August 2014 at 15:34


    “Keynes opposed a pure fiat regime”

    by pure fiat do you mean floating exchange rates?

  20. Gravatar of TallDave TallDave
    21. August 2014 at 17:51

    O/T: The wiki on the Corn Laws is somewhat fascinating. I didn’t realize opponents had founded The Economist.

  21. Gravatar of Major.Freedom Major.Freedom
    21. August 2014 at 19:10

    World War I as Fulfillment of Power and Intellectuals

  22. Gravatar of gofx gofx
    21. August 2014 at 19:36

    Off topic—–full link from previous message on Bhadari and Frankel

  23. Gravatar of ssumner ssumner
    22. August 2014 at 07:37

    Patrick and gofx, Thanks, I’ll do a post.

    Philippe, I mean a currency with no commodity backing.

  24. Gravatar of pnesbitt23 pnesbitt23
    23. August 2014 at 20:01

    “DeLong knows more finance than I do”

    Most economists (I have met) show little interest in the inner workings of the financial markets. Delong is different. I have always thought this was due to his closeness to his kid brother Chris who is a wall Street high flyer

    From NYT Dec 2013:

    Kenneth D. Brody, a co-founder of the hedge fund Taconic Capital Advisors, plans to retire from his full-time role by the end of the year, he told his investors on Tuesday.

    Mr. Brody, who turned 70 this year, will remain a principal and an adviser at the firm, as well as a “significant investor,” even as he steps away from his full-time responsibilities, he said in a letter reviewed by DealBook. The change is to take effect by Jan. 1.

    A veteran of Wall Street who spent 20 years at Goldman Sachs, Mr. Brody is handing the reins to Frank Brosens, 56, who co-founded Taconic with him 15 years ago. The firm’s chief investment officer, CHRIS DELONG, will work with Mr. Brosens in the day-to-day management of the investment team, Mr. Brody said.

  25. Gravatar of ssumner ssumner
    24. August 2014 at 06:12

    pnesbitt23, Thanks for the info.

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