Handcuff Volunteers and the Rally of 2013

The S&P500 is up by 26% for the year-to-date, despite the fact that employment growth is anemic, the labor participation rate is at its lowest point in thirty five years, and inflation-adjusted GDP growth is experiencing a long-term slowing (see chart below).  GDP turns negative in recessions—this is the definition of a recession—but has historically recovered much faster than we have seen in the post 2008 years. Real GDP

The standard measure of inflation, the CPI-U, has risen by 1.2% over the past year, a signal of weak demand for goods and services.  The Federal Reserve Board is looking for a 2% annual inflation rate as a sign of robust economic recovery.  This is not because inflation is good, but rather that inflation signals demand for goods and services that outstrips production—and this is the driver of growth.

If the stock market rally of 2013 seems to defy economics, how do we explain it?  One explanation is that the Fed is forcing investors to move money from safer assets (e.g. Treasury bonds and CDs) into riskier assets (e.g. stocks and real estate) because of the historically-low rates of return that are available from low-risk assets.  Howard Marks, the billionaire founder of Oaktree Capital, is the champion of this perspective.  If you need returns greater than those provided by low-risk assets, you are essentially forced to buy higher-risk assets even if you know that the fundamentals are shaky.  You take on risk for the chance to achieve higher returns because the alternative provided by low-risk assets is a guarantee of inadequate returns.  Marks refers to investors in this situation as handcuff volunteers.

This effect is clearly in evidence among pension plans, some of the largest institutional investors.  Pension plans have estimates of the future costs of providing income to plan participants when they retire, and the investment returns that they need to achieve in order to meet these costs.  If bond yields are low as a result of low interest rates (which are controlled by the Fed), pension plans have to invest more aggressively in order to have a chance of meeting their return targets.  CalPERS, the largest U.S. pension plan, assumes that its investments will return an average of 7.5% in the future.  More specifically, CalPERS needs this rate of return in order to meet its obligations.  How can CalPERS possibly make 7.5% per year when 10-year Treasury bonds are yielding 2.6%?  The answer, of course, is that CalPERS has to take a chance by investing more aggressively.  Many pension plans are in this same situation.  Joshua Rauh, a Stanford professor, has made the argument that public pension plans have a clear incentive to take on investment risk for this reason, even though this approach makes them more likely to fail spectacularly in the future.  The alternative to investing more aggressively and hoping for the best is to raise taxes or require employee contributions to pension plans, neither of which is politically popular.  Pension plans are the ultimate example of handcuff volunteers.

Along with investors who are being driven to invest in higher-risk assets, we have the standard performance-chasing dynamic that drives rallies.  Having watched the S&P500 gains so much from 2009 through 2012, investors are rotating back into stocks because they don’t want to miss out.

This explanation for 2013’s dramatic stock market gains is the only one that really makes sense to me.  Lacking robust job creation or economic growth, the best explanation is that investors are responding to the Fed’s stimulus and taking on risk in order to have a chance to achieve returns that are necessary to meet their goals.