Upcoming Featured Publication – Energy and Investing :”The Great Transformation”

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Human civilization faces a daunting problem – how to provide reliable energy to a growing world economy and a rising population that will surpass 10 billion before the end of the century without doing undo environmental damage.  What makes the problem so daunting is not the technological hurdles, though to be sure there are many, but the sheer size and scope of the problem.  The amount of investment required globally may well exceed $100 trillion (about five times the GDP of the United States) world-wide before the transformation away from fossil fuels is complete.  To help appreciate the magnitude of the undertaking, the Cornell Capital report on Energy and Investing which will be posted this weekend brings together data from wide ranging sources on global energy usage to first assess the scope of the great transformation required to replace reliance on carbon fuels.  It then turns to the question of what financial innovations will be required to fund what will be the largest infrastructure projects in history.

Efficient Markets?

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The efficient market hypothesis holds that the market prices of securities accurately reflect the fundamental value of those securities.  This implies that if no new fundamental arrives, prices should remain relatively constant.  It turns out this is not true, even in the case of the overall market, let alone for individual stocks.  Research by Summers and Poterba published in the Journal of Portfolio Managment in 1988 and a follow up article by Cornell (yes the Cornell of Cornell Capital) published in the same journal in 2012 looked at the 50 largest moves in the S&P 500 index of periods of 25 years.  Both papers found that the majority of the large moves were not associated with the release of any news related to valuation fundamentals.  That brings us to the current experience.  First, the S&P 500 dropped nearly 20% in close to record time only to be followed by one of the largest one day price increases (in points, not percent) in history.  And then the next day, the index dropped sharply erasing more than half of the previous day’s gain by midday before reversing again and finishing up on the day.  In all of this there has been basically no new fundamental news.  The only possible candidate is a 25 basis point increase in the Fed’s target interest rate, but that hardly qualifies as new news.  To begin, the action the Fed took was largely anticipated.  What’s more it is far from clear why changes in the Fed’s targets for very short-term interest, even if coming as a total surprise to the market, should have much impact on stock prices.  At best the relationship is complicated.  Among other things it depends on why the Fed is changing its target.  (For a detailed discussion of this issue see Damodaran.)

So why has the market been moving up and down so much?  The honest answer is we don’t know.  Markets can move dramatically on the basis of scant fundamental news leaving financial economists scratching their heads.  But in this regard, we financial economists have one step up on the financial media in that we know what we don’t know.  Whenever there is a sharp move in the market, the media feels the need to explain it somehow.  When there has not been the release of any fundamental news, those explanations are little more than speculation, often based on unverifiable guesss about market “psychology.”  It is best to pay them no mind.

Climate Change and the Stock Market

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No, I am not going to say how climate change impacts the stock market or even more far out how the stock market may impact climate change.  The point here is that the two phenomena share a statistical property that makes both controversial and difficult to interpret.

To get started, take a look at the chart below.  It plots the return on the market minus the return on 30-day Treasury bills over the 101-year period from 1927 to 2018.  The data are taken from Prof. Ken French’s website.  Basic analysis of risk and return predicts that the average return on the market would be significantly greater than the average return on Treasury bills – and it is.  But try to see that from the chart.  The problem is that the underlying relation, that the average return on the market exceeds that on 30-day Treasury bills by more than 8% per year, is dwarfed by the variability of the market returns.  It takes careful analysis and more than forty years of data to identify a statistically significant difference between the two returns.  Trying to draw conclusions from short-run variation in stock prices is a hopeless endeavor.

The same is true of climate change.  Serious long-run statistical analysis leads to the conclusion that human industrial activity has led to, and continues to lead to, a slow inexorable increase in average global temperatures.  This is analogous to the long-run difference between the return on the market and the return on Treasury bills.  But there is immense short-run and location dependent variation in weather.  The California drought, for example, may be due in some part to climate change, but most of it is probably due to random weather variation.  California had prolonged droughts well before the industrial revolution.  What makes interpreting the market or the climate so difficult and controversial is that we humans have short lives and shorter attention spans.  We want to understand things in terms of what is happening now, or at least in terms of what happened recently.  Unfortunately, in the case of the stock market and climate change that is not possible.  The only way to understand either is careful statistical analysis of long-run data.

Explaining Stock Market Moves After the Fact

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Whenever the market moves sharply, the media feel compelled to offer an explanation.  Sometimes this is reasonable.  For instance, a sudden increase in reported inflation is likely to be bad news for the market.  But much of the time, there is no logical explanation for why prices have moved.  Steve Ross, the seminal financial theorist, said it best before his untimely death in 2017.  Professor Ross put it this way,

It is one thing not to be able to predict what asset returns will be since they will depend on news, and news, by definition, is information that has yet to be revealed.  It is another, though, to observe the movement of prices and not know why they moved after the fact.  I am particularly troubled that contemporaneous news seems to explain so little of the contemporaneous prices.

By contemporaneous news, Professor Ross had in mind the revelation of actual value relevant information such as announcement of last month’s inflation rate, not ex-post speculation or what biologist Stephen Jay Gould called “just so stories.”  Examples of such just so stories include things like rising fear of inflation and panic selling.

When most of a company’s value is attributable to growth options the problem is compounded.  Market values rest not on what a company is doing today, but what it could do in the future.  As we have noted repeatedly in this blog, dreams of the future can evaporate for no apparent reason.  The last six weeks have been a good reminder of that.  Why they evaporated at this particular juncture is anybody’s guess.