| Sujet: | Like a tightrope walker |
|---|---|
| Date : | Tue, 04 Oct 2011 16:46:45 +0200 |
| De : | Bernard Leclere |
| Pour : | Angela Merkel |
Dear Mrs. Chancellor,
The press echoed a speech you made in Berlin on September 20th, speech in which you are quoted as saying “A wrong philosophy of economic growth at all costs has spurred countries to take on debt and must end if policy makers want to leave the crisis behind “ (Bloomberg Sep 20, 2011).
I am writing to you because of your background in physics.
The word “philosophy” tells it all.
While one would expect economists to search for an increasing reliability on objective economic measures, the world is whirling in a vicious circle of what seems to be an infinite number of expectations. At the center of the circle, there is the subjectivity of the value of money (and of debt), subjectivity leading to a "leveraged" subjectivity of the value of assets ...
Some basic principles in economy are derived from Thermodynamic laws.
These laws indicate that a high level of debt is not the only culprit of excesses. Other excesses, like in equity prices, can have even damaging effects on growth, especially when the equity part of assets tends to contain an increasing number of assets of all kind, including real estate, gold, ... quoted on the stock market.
Contradicting valuations in equity prices are of course not, per se, a bad thing: they actually contribute to the fluidity of markets. Problems can however arise when valuations are either too high or too low. But, when is "too high" and "too low"? The fact and the matter is that nobody knows it for sure.
Nobody knows it because, according to us, there is something missing in the basic rules.
For equity prices valuations, agents are following rules which are taught in all schools.
The background of economists comes from classical physics:
- In a balance sheet, assets must always equal liabilities.
- At a national level, whatever the way one uses to calculate the GDP, be it the revenues or expenditure or production approach, the result must always be the same.
- …
The background of the corporate financial world comes from quantum physics:
- Risk theory based on statistics: risk linked to the volatility of (sometimes) arbitrary measures.
- …
We think that what is missing is to be found in a phenomenon observed in physics.
Economic and financial models can be compared to a tightrope walker:
- Pole = (macro)economy … (gravity/classical physics)
- Individual = financial models …(nuclear force/quantum physics)
- Rope = Black-Scholes formula …(electromagnetism)
What is missing?
The movement.
The movement is presently left to the workings of the … Invisible Hand of Adam Smith!
In the universe, the equilibrium movement of the tightrope walker has a name: the KMS (Kubo Martin Schwinger) state. The KMS concept is, according to us, a better metaphoric reference than the "Invisible Hand" because it can lead to the search of a concrete measurement tool.
A tightrope walker doesn’t look at his feet but at the point he is aiming at.
Stock markets do not have such a point in view. In theory, a stock market should follow the economy. In practice, by gauging its volatility, it doesn’t. It is even commonly recognized that it is not possible to compare any stock market measure to a central measure of the economy.
With this in mind, we have decided to design a new stock market metric with the hope to be able to compare it with a central measure of the economy, the nominal GDP.
We came up with a first index for the USA market: USA GDP Target Index.
The index is a "nominal GDP weighted" index in which constituents, i.e. domestic companies, are weighted according to their relative weight in the US nominal GDP. The approach gives an "economic touch" to the stock market metric which is not found in other indexes.
The results of the calculation of the USA GDP Target Index look as follows:
On the above graph, the reading of the index was made in conjunction with the nominal GDP, the Dow Jones Ind., the S&P500 composite and a statistical measure (i.e. one standard deviation) applied to the after-tax profits data of the corporate sector(1) .
To compare it with the previous image of the tightrope walker:
- The nominal GDP = the rope
- The GDP Target Index = the individual
- The envelope = pole
- The reverting effect of the GDP Target Index to the nominal GDP = KMS condition.
Equilibrium points seem to emerge on this graph (GDP Target Index close to the nominal GDP data) as well as what could be called "speculative" periods (GDP Target Index falling outside the envelope around the GDP). By opposition to other traditional indexes, the GDP Target Index pointed to over-valuations in 2006/2007 and 2010/2011.
Furthermore, according to us, a high level of symmetric divergence between the stock market and the GDP could be associated with a high level of stress in terms of financial instability, as defined by F. Mishkin and E. White(2) , while not stressing crashes seem to cluster round a symmetric divergence close to 0 (3).
If this assumption is correct, the GDP Target Index could give a good indication of investors excessive expectations and be used as a gauge for forthcoming situations of potentially high financial stress. The information it provides could then, if properly distributed, act as a simple and not expensive pressure regulating valve for the market, thereby hopefully reducing somewhat the dramatic loss of jobs often seen in periods of high financial instability.
We hope that you will find this information useful.
If it is the case, we would be glad to provide you additional information you may wish to require.
Looking forward to hearing from you.
Yours faithfully.
Bernard Leclère
(1) Profits data take into account profits made at home and abroad.
(2) Mishkin, F., White, E. What Should the Fed Do About Stock Market Crashes: A Historical Perspective.
(3) The equilibrium year which served as reference for the index divisor is the year 2000. This was based on the study of: McGrattan, E.R., Prescott, E.C., 2000. Is the Stock Market Overvalued ?. Quarterly Review Vol. 24 No. 4. Federal Reserve Bank of Minneapolis.
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