Stephen Gordon reminds us not to read the National Post

Terence Corcoran has a woefully bad article in the National Post this morning in which he seems to imply that the budget deficit has ballooned largely due to the home renovation tax credit (never mind the impact of the recession on revenues, that's just an excuse used by politicians in Corcoran's world) and "out of control" government spending. Strange that he doesn't mention the impact of bad policy like cutting the GST. Must have slipped his mind.

As usual when an out of his depth journalist makes a stupid economic argument, Stephen Gordon pounces.

Batttle of SFU Economists

Nice to see some star professors from my alma-mater (Simon Fraser University) contributing to the public debate over the effectiveness of fiscal stimlus.

Read skeptic David Andolfatto here: http://andolfatto.blogspot.com/

and stimulus proponents James Dean and Richard Lipsey here: http://blogs.ft.com/economistsforum/2009/05/will-stimulus-spending-stifle-recovery/

Minsky and Haircuts

Ezra Klein links to an interesting paper by Gary Gorton of Yale University. In that paper, Gorton describes how the subprime crisis is linked to runs on other structured products through the repo market. A sale and repurchase agreement ('repo' for short) involves a short term swap of collateral (t-bills, etc) for cash - the value of the transaction is discounted by some margin known as a haircut.

For example, Bank A wants to raise cash and pledges an asset worth $100 as collateral. Bank B takes the asset and gives Bank A $98 in cash. The $2 difference is the haircut and depends on the credit risk of the counterparty.

Here is where Hiram Minsky enters the picture - look at the graph below from Gorton's paper:


Klein makes the point that it is not the spike in haircuts demanded that is troubling, it is the period of extremely low haircuts just prior to the crisis. Minsky warned that such periods of calm betray extreme underestimation, and hence underpricing, of risk that eventually leads to crisis, asset fire-sales and flight to quality - a scenario that Paul McCulley of PIMCO termed a "Minsky Moment". A smaller scale example of a Minsky Moment is the collapse of the hedge fund LTCM in 1998. Followers of that story may recall that LTCM convinced its counterparties to allow them to borrow without taking a haircut on collateral. We all know how that ended.

I haven't seen any research exploiting the potential predictive information in haircuts, credit spreads, etc in detecting a rising probability of these Minsky Moments. Given the recent rediscovery and surging popularity of Minsky (I certainly had never heard his name in all my years studying economics) perhaps some enterprising economist is already working on it.

SMC call causes TSX to tank!

It seems clear to me that market participants, noting my optimism as as sure contrary indicator, are now in the mood to sell. TSX down 275 368!.

Is the TSX Fairly Valued?

Canada's stock market has been on somewhat of a roll lately, rising about 35% to 10,238 from a 2009 low of 7,566. In this post I'm going to attempt something fairly pointless - trying to figure out whether the TSX/S&P is overvalued, undervalued, or valued about right.

A common methodology used to make broad stock market calls involves assigning a multiple to a forward estimate of TSX earnings. TSX composite earnings as of December 2008 were about $830 and the forecast range for corporate earnings for 2009 is a decline of between 15%-31%, suggesting a 12 month forward estimate for 2009 of between $575-$699. The former seems much more likely to me.

What is the right multiple? Hard to say. Earnings multiples tend to get compressed in recessions before increasing as the economy recovers and investors regain confidence in equities. The TSX is currently trading at around 12x current earnings, which is similar to multiples observed in the beginnings of previous recessions.

The average TSX P/E ratio since 1956 is about 20x. Applying this long-run average P/E to the range of forward earnings estimates gives a market valuation at the end of 2009 of between 11,484 and 13,980 which implies that the market is currently between 11% and 27% undervalued.

I'm more sympathetic to the low-end of the corporate earnings forecasts so i'll conclude with a market call of 11,400-11,500 by the end of 2009.

What can we learn from past recession-recovery cycles?

Not much, unfortunately. This post began as an attempt to replicate a recent Macroeconomic Advisers (MA) research note that assessed the potential for a strong US recovery based on Milton Friedman’s plucking model. In brief, Friedman hypothesized that the economy was like a string attached to the underside of a upward slanted wooden board, with the board acting as a limit on the rate of growth. In a recession, the string is pulled (or plucked, hence the name) downward creating a gap between actual and potential growth. When the string is released, it will bounce back at a speed proportionate to how far downward it was pulled with the implication that growth in a recovery following a deep recession will be faster than growth following a mild recession.

One problem with trying to replicate the MA study is the low occurrence of recessions in Canada compared with the United States. As the figure shows, Canada had two very deep and prolonged recessions from 1961 to 2007 and a third that began in 2008 (the broken line represents my forecast to 2010).

To test the plucking theory with Canadian data I have plotted the magnitude of Canadian recoveries in the first 4 quarters after a business cycle trough against the depth of the recession. The plot reveals no consistent pattern for economic recoveries in Canada. Indeed, leaving out the blue square representing my forecast, it would be difficult to draw a meaningful regression line though the points below.

The 1981-1982 recession fits Friedman’s plucking theory – a deep recession followed by a robust recovery. However, the 1990-1991 recession was followed by a tepid recovery while healthy recoveries followed the relatively mild recessions of 1974-1975 and 1980. Though in the latter case the recovery was quickly snuffed out by the onset of the 1981-1982 recession.

It is often said that no two recessions are alike and from the above it would seem that sentiment would apply to recoveries as well. I do find it interesting that, in contrast to the results based on US data, the depth of Canadian recession provides little insight into the magnitude of the eventual recovery. Anyone have a theory why this might be the case?