What is an equity index really measuring?

Equity indices are designed to measure the performance of a specific sector, market, region or even the entire world. They are meant to provide an indication of the type of returns you can "expect" from equities over the longer term but they also tend to suffer from some serious shortcomings that can have serious consequences.

Most popular indices for example only capture the price performance of its constituents typically weighted by capitalization (S&P 500) or just price (Dow Jones Industrials). What they don't capture, however, is the impact of dividends, especially when they are reinvested. Total return indices do exist, but they are unfortunately much less common and therefore rarely used and so investors are much less aware of them.

Even more rare are indices that are adjusted for inflation. That type of information is just not published but the impact can be very significant.

To show just how significant the effect of dividends and inflation can be on the return of an index, researchers in the U.S. did the calculations on the Dow Jones Industrials index and here is what they discovered:

If dividends were included since the inception of the DJI in 1896, it would have a value of more than 1,300,000 which is more than 100 times its recent high of 13,000!

If it was adjusted for inflation over the same period, it would shrink to a value today of around 500 which his about 96% below its actual current value.

Finally, if we were to combine the impact of reinvested dividends and inflation, the figure would be around 47,000 or almost 4 times its current value! In other words, the impact of reinvested dividends seems to be substantially greater than the impact of inflation (assuming inflation is correctly measured of course!)

All this to say that it is important to be aware of what exactly is being measured (or not) when looking at an index. Just as in the differences between price weighted and capitalization weighted indices, the effect of including dividends and/or inflation can lead to substantial differences in the results.

Are ETFs boosting correlations?

I came across a recent study that points out to a sharp rise in correlations between stocks right about the time when the ETF market has experienced exponential growth. Is it possible that the popularity of ETFs has led to a jump in equity correlations? It does seem plausible if we consider the way ETFs trade.

When you want to purchase an ETF, you usually go to the secondary market where buyers and sellers congregate. When the purchase amount is significant, however, it needs to be created through the primary market and the way this is done is through one of the designated brokers that deal directly with the sponsor in the primary market. The broker uses the investment cash to purchase a basket of stocks that reflect all the constituents and their respective weights of the underlying index. This is then exchanged against an equivalent number of units of the ETF. In the event of a redemption, the exact opposite happens, whereby the broker exchanges units of the ETF for an equivalent basket of stocks representative of the index. Now imagine a bear market scenario where a whole lot of redemption activity is going on. In the case of a broad market index ETF, the broker will have to liquidate a large number of stocks right about the same time. In other words, all the constituents of the index will be experiencing selling pressure at around the same time which means an increase in the correlation between them.

This estimated general increase in correlations has led to a situation where you need to hold a larger number of stocks to achieve an optimal level of diversification. It also further emphasizes the importance of ensuring a broad level of diversification between different asset classes.

Just about right...

The Fed has kept monetary policy aggressively loose and intends to do at least until sometime next year. Of course, this will depend on how the economy unfolds. Loose monetary policy has been the necessary medicine to keep the economy afloat, ever since the housing market bubble popped in 2007 but it has largely been ineffective in part because the Fed found itself in a "liquidity trap". The transmission system between Fed policy and bank lending is broken but there are signs that it is healing.

Monetary policy, in "normal" times can be a potent tool, which is why it needs to be wielded carefully if price stability is to be maintained (one of the two mandates of the Federal Reserve). One tool that can help determine whether the target rate is set "correctly" is what is known as the "Taylor Rule" named after the U.S. economist John Taylor. In its basic form, the Taylor Rule is a linear equation that determines what the Fed target rate should be. To do this, it takes the current rate of inflation and compares it to the "optimal" rate of inflation. It does the same with growth by comparing current output or GDP to "potential" GDP. Basically, the required target rate changes if either of these two factors are currently above or below their optimal or potential levels.

The graph above compares the actual Fed Funds Rate (white line) to that of the Taylor Rule Estimate (blue line). It is interesting to note that overall, the actual target rate and its estimate seem to be relatively well correlated and that currently the Taylor rule estimate seems to agree almost fully with the target rate. In other words, the estimate seems to fully support Fed policy.

More stimulus posturing...

The Fed signaled yesterday that it would probably maintain rates close to zero until sometime in 2014, a revision from a previous statement targeting 2013! All this is good because stimulus is still very much needed but it doesn't really help when you find yourself in a "liquidity trap". The economy is far from being out of the woods, the debt burden as a percentage of GDP continues to rise, fuelled by a budget deficit that shows no sign of shrinking whilst growth sputters, putting pressure on the government to adopt a more drastic austerity plan. This sort of pattern is endemic across a large number of the developed economies and most particularly in the Euro-zone that is facing its biggest challenge to date.

In Europe, heavy handed austerity measures have been force fed to the more "sickly" members of the Euro-zone. It is hoped that by doing so, the deficit will shrink and eventually turn into a surplus which should help reduce the mountainous pile of debt and, in turn, cut the overburden of borrowing costs. Austerity does have a major drawback in that it stifles growth, so the question becomes: will the shrinkage of the deficit through austerity have a greater impact on debt than the economic slowdown resulting from the same austerity?

Patience is a virtue but if we take history as a guide, these highly unpopular measures have never survived long enough. They are more likely to be traded in for some form of financial repression down the road.

In denial...

Standard and Poors, one of the big three rating agencies, fired a shot straight at the Euro-zone debacle over the weekend by downgrading the debt ratings of several countries, most notable of which was France and Austria losing their respective triple A ratings. Market reaction was somewhat mooted, probably because it is already reflected in the price, but the main message of the announcement was that things are really starting to go from bad to worse. Markets have become accustomed to the fact that the European "powers" (the "usual suspects" that call the shots) are very adept at organizing hollow summits but keep on falling short of what is needed to stop the situation from getting out of control.

Greek bonds are trading as if they have defaulted already (which they technically have) and there is still no agreement on what the so called "haircut" should be, but, maybe more worryingly, countries in the "too big to fail" camp such as Italy have been flirting with a whopping 7% yield on 10 years making it very costly to refinance at a time of austerity.

What the "authorities" don't seem to be paying much attention to is that even if what needs to be done to put an end to this mess is clear and will be deployed as a last resort, the delay itself will make it far more costly to intervene and there is a growing chance that it doesn't work at all.

It is clear that the treaty and the whole setup is not designed to function in this type of environment, it is a major flaw that the original architects didn't think through but, if they play their cards right, the Euro-zone that possibly emerges from this crisis situation will be far more robust in construction.

The impossible targets...

It is no wonder that the euro-zone peripheral countries are having such a difficult time getting their acts together, they are basically shooting themselves on the foot.
They don't have access to monetary policy tools that could help them inflate their way out of the debt conundrum, they don't have a federated political system that would automatically inject much needed cash into their economies, they don't have an independent central bank to rely on as "lender of last resort" that would put a cap on borrowing costs. To make matters worse, they cannot even resort to the tools that they do have at their disposal such as fiscal stimulus plans. These are severely constrained due mainly to outside imposed hard core austerity measures. They are in fact so severe that they risk triggering uprisings, threatening to plunge the whole continent into a deep recession with significant long term consequences.
To provide you an idea of what I am talking about, I recently came across some of the austerity measures that will be imposed on Greek citizens. I found them worrying to say the least.
According to the plan:

• Wages would be cut on average by 15%
• Pensions would be cut on average by 20%
• VAT would be increased by 4%
• A "solidarity" tax of between 2 and 5% would be levied
• The income tax threshold would drop from 12,000 EUR to 5,000 EUR
• Property tax would jump from 3 EUR to 5 EUR per square meter

There were additional measures which I don't recall but, even without them, this would be more than sufficient to trigger widespread rioting were it to be enforced.

In the end, when push comes to shove, it is likely that European authorities will take extraordinary measures to avert a total meltdown. What they are not really paying attention to, however, is that the more they wait, the more costly it will be.

Lender of last resort...

There is a reason why the Euro-zone seems unable to get itself out of the quagmire. It is dealing with the growing problem in a passive-reactive manner. There is a discernable pattern here:

1. the crisis shows signs of brewing
2. the core members of the zone get together to discuss the problem
3. at the meeting they announce that they have reached an agreement to boost the limit of the "bailout" fund
4. the markets react favorably for a day or two until the cycle is repeated again.

With a moving target in a deteriorating environment, it is difficult to see how readjusting the size of the bailout could ever work. Most of what is going on is psychological to begin with. The markets are very much aware that the tools the euro-zone members have at their disposal are insufficient to tackle the problem.

Psychology works in funny ways, we tend to overshoot all the time. In a stable environment, greed takes the upper hand whilst fear tends to reign when markets are in turmoil. In both cases there are exaggerations and the degree of the exaggeration depends very much on the circumstances of the time. It seems clear to me at least that the current approach has failed but what is more worrying is that the window of opportunity for the zone to extricate itself out of the quagmire is rapidly narrowing. Soon the only option on the table to avoid a meltdown will be to take out the heavy weapons.

The ECB, unlike many other central banks, does not have a mandate as lender of last resort and it may unwilling to use this option to avoid encouraging the risk of "moral hazard" down the line but it may end up being the only effective way to quash the psychological effect. The reason why this would work is because the human mind is much less effective in dealing with the concept of infinity: If you announce that you are taking a stance in the markets and you have close to unlimited resources to defend your stance, it will be far more credible than if you announce the ceiling of your resources from the very beginning. The Swiss National Bank's intervention in defense of the Swiss franc is a perfect example of this!

From idiosyncratic to systemic...

It is crucial to distinguish idiosyncratic risk from systemic risk. The former is related to risk that originates from or is inherent to a specific entity such as a firm, whilst the latter is risk that is exogenous to the firm. The reason why making a clear distinction between the two risks is so important is because their expected antidotes are so different. Idiosyncratic risk is normally handled by the management team of the firm and only involves outside intervention in situations of "too big to fail" where repercussions in terms of systemic risk become all too real. Systemic risk, on the other hand, is usually beyond the scope of management, it is more within the domain of policymakers.
Applying the distinction to the current Euro-zone crisis, we began with a form of risk when the peripheral members started to ring the alarm bells in the first half of 2010 that was borderline idiosyncratic but still relatively contained. This explains why the initial response to this "mini" crisis was relatively muted: the creation of a fund that would aim at bailing out heavily indebted nations that were having difficulty with their payments. The risk started to take on a more systemic form when the number of troubled countries began to increase and as it began to involve countries that had economies that were far bigger than the first wave. The EU response to this was mainly to increase the size of the "bailout" fund but not much else when what they really should have been doing was to approach the problem from a completely different angle. But herein lies the problem: the Euro-zone in its current incarnation was never designed to handle such challenges.

It seems to me that the original architects of the Euro-zone project are now paying a heavy price for having suppressed the major risks or negative points that were outlined in the independent study on the creation of a Euro-zone that had been commissioned by the core governments of the project. As we can see from the CDS graph of Italy, it is just another example of too little, too late.