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Discussion of “Hard Times” by John Y. Campbell, Stefano Giglio , and Christopher Polk

Discussion of “Hard Times” by John Y. Campbell, Stefano Giglio , and Christopher Polk. ASSA Meetings, Chicago IL January 2012 Jonathan A. Parker Kellogg School of Management, Northwestern University.

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Discussion of “Hard Times” by John Y. Campbell, Stefano Giglio , and Christopher Polk

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  1. Discussion of “Hard Times”by John Y. Campbell, Stefano Giglio, and Christopher Polk ASSA Meetings, Chicago IL January 2012 Jonathan A. Parker Kellogg School of Management, Northwestern University

  2. The idea: use historical relation between assets returns and subsequent cash flow and discount rate changes to infer whether the market expects a given market downturn to be followed by higher future discount rates or lower future cash flows Outline • The method • The data • The findings • Thoughts on the big question: interpretation

  3. 1. The methodOr what the Dickens is going on? Step 1: Campbell Shiller (1988): assume the Dividend-Price ratio is stationary Dt Pt Any deviations in ratio must lead to future changes in dividends or prices (returns) Log-linearize:

  4. Implies that an unexpected return leads to a change in expected future dividends or returns Shocks to stream of cash flows (CF) and discount rates (DR) • Can calculate NCF and NDR from any forecasting model, use a VAR • Applies to any asset with stationary dividend-price ratio (is this true of the market?)

  5. Optional: impose some restrictions on returns implied by optimization of • a representative agent • with KPEZW utility • who faces only risks spanned by the two shocks (e.g. no uninsurable labor income, no private equity, etc.) • and all returns are all jointly lognormal • and homoskedastic While all are violations of reality, they are common modeling assumptions and some models with these features can fit may asset pricing facts with heteroskedasticity • Time-variation in risk is large for the focal episodes, 2008 in particular • We are referred to Campbell, Giglio, Polk, and Turley (2011) for time-varying volatilities

  6. Great Expectations of returns: Expected returns determines by exposure to cash flow shocks and discount rate shocks • Decomposition of expected return as due to two different exposures • The more exposed to good cash flow news, the higher expected return and the lower price • The more exposed to good discount rate news (low rates in future) the higher expected return and the lower price • Beta’s can be calculated, used in regression with average returns (actually use as moment restrictions) • Restriction:Cross-section has expected returns  times more sensitive to CF than DR

  7. 2. Data For VAR • Excess log return on the CRSP value-weighted index • Log ratio of the S&P 500's price to the S&P 500's ten-year moving average of earnings • Yield difference between the log yield on the ten-year US constant-maturity bond and the log yield on the three-month US treasury • Difference in the log book-to-market ratios of small value and small growth stocks • Yield spread in percentage points between the log yield on Moody's BAA and AAA bonds For expected returns/cross-section: 6 portfolios measuring size (ME) and value (BE/ME) premia

  8. 3. Findings

  9. Time-Smoothed shocks to CF (left) and DR (right) unrestricted model (top) and restricted model (bottom)Note: shocks negatively correlated (-0.070 unrest. -0.577 rest.) Cash-Flow shocks • Positive in recovery from G.D. • Negative in 1980’s and 1990’s • Positive in 2000’s Discount rate shocks • Negative on market in G.D. • Positive in end of G.D. and WWII • Negative in early 1950’s & 1970’s • Positive in 1990’s internet boom Suggest one-sided smoother

  10. It was the best of times, it was the worst of times . . . Shaded areas: NBER recessions Dark lines: market peaks with two year-windows Hard times: cash flow news followed by disc rate (G.D. and 1937) Pure sentiment: discount rate news (end of WW II and 1961) Other: Sentiment followed by cash flow/ NBER recession

  11. 4. Interpretation/thoughts Not primitive shocks – and not claimed to be • Why are times with high future discount rates not hard times? • They are times when output today has become scarce relative to the future • If because of increased future cash flow, these are good times, if because of increased risk or anxiety, these are bad times • What about credit in the “credit episode”? • Institutional view: lowered constraints, low market risk aversion • Are there enough similar episodes to identify market expectations? • Is it reasonable to use the restricted model? • Is the paper proscriptive for a long-horizon, attentive, CRRA investor? • The decomposition is useful for refining models • My interest: identify structural shocks that map into each type of reduced form shock and generate facts for models • E.g. does a monetary policy shock hit mostly cash flow or discount rates?

  12. 5. Conclusion Old literature: are all business cycles alike? Answer: lots of similar comovement, but some differences This paper starts to build similar facts for stock market cycles, crashes in particular Main finding: different market declines in US history have had quite different implications for future cash flows that are visible in contemporaneous asset prices

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