October 22, 2013

What Debt Ceiling?

Curse of Chucky, Scream 2, Final Destination 5, Freddy vs. Jason... You know Halloween is nearly upon us when you can't surf channels without exposing yourself to or relishing in a multitude of horror flick sequels.

Propagating alarming situations seems to be all the rage in Washington, too. Last week, a last-minute deal raised America's debt ceiling, saving us from a debt default and ending the government shutdown - until next January. In the meantime, hoping to avoid a sequel just three months down the road, the members of Congress agreed to put their heads together and produce a 10-year budget plan by mid-December.

Like the hero or heroine of many a terror-filled fantasy, stock markets generally have proved resilient despite facing formidable challenges. Just last week, the Standard & Poor's 500 Index hit a new all-time high. According to Barron's:

"Since the rally began, in March 2009, there has been the flash crash, the Greek default drama, the U.S. debt-ceiling debacle, the Standard & Poor's credit-rating downgrade of the U.S., the sequester, and the great taper scare. Each of these, we were told, could have ushered in a new bear market. Instead, the S&P 500 squirmed out of the traps and headed higher. And, for its latest trick, the market had to avoid the double whammy of a government shutdown and a potential default."

The short-term resolution of budget and debt-ceiling issues doesn't mean markets have escaped the (choose one: axe-wielding maniac, flesh-eating demon, Stay-Puffed Marshmallow Man) quite yet. Looking ahead, they'll have to confront the menace of potentially contentious budget negotiations, the possible end of quantitative easing, and the phantasm of resolute fiscal policy.

Data as of 10/18/13	1-Week	Y-T-D	1-Year	3-Year	5-Year	10-Year
Standard & Poor's 500 (Domestic Stocks)	2.4%	22.3%	19.7%	13.5%	13.8%	5.3%
10-year Treasury Note (Yield Only)	2.6	NA	1.8	2.5	3.9	4.4
Gold (per ounce)	4.0	-22.3	-24.5	-1.3	10.6	13.4
DJ-UBS Commodity Index	0.7	-7.5	-12.8	-4.2	-1.5	0.3
DJ Equity All REIT TR Index	3.0	8.6	9.8	12.4	14.9	9.9

Nobel Laureates: Predicting Stock Prices

It may be the holy grail of investing... If you could accurately predict how share prices would move, you'd probably be quite wealthy. If you could offer insight that helps analysts and investors do a better job predicting such things, you might win the Nobel Prize. That's what happened last week when American economists Eugene Fama and Lars Peter Hansen from the University of Chicago, and Robert Shiller from Yale University, jointly received the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2013. They were recognized for their empirical analysis of asset prices.

Eugene Fama is best known for his work on the efficient frontier which demonstrated stock prices are extremely difficult to predict over the short term because new information is incorporated into prices very quickly. His research not only influenced future research, many credit the emergence of Index-linked investments to his theories.

Robert Shiller, a student of behavioral economics, challenged Fama's efficient markets hypothesis with the belief that markets are driven by human psychology which can and does create large and sustained pricing errors. Shiller established when the ratio of prices to dividends for stocks is high, prices tend to fall, and when the ratio is low, prices tend to increase.

Lars Peter Hansen developed the Generalized Method of Moments, or GMM, which proposed a "straightforward way to test the specification of the proposed model... Hansen's work is instrumental for testing the advanced versions of the propositions of Fama and Shiller... If you want to do serious analysis of whether changing risk premia can help rationalize observed asset price movements, Hansen's contributions will prove essential."

According to the Nobel committee, "There is no way to predict the price of stocks and bonds over the next few days or weeks. But, it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years...The Laureates have laid the foundation for the current understanding of asset prices. It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions."

Weekly Focus - Think About It

"Many men go fishing all of their lives without knowing that it is not fish they are after."

—Henry David Thoreau, American naturalist and author

Best regards,
Sean M. Dowling, CFP, EA
President, The Dowling Group Wealth Management

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