US Risk in a Global Setting

1
WHU Campus for Finance Rationality of Stock
Markets and Empirical Finance January 2003
Rational International Investment
Campbell R. Harvey, Ph.D., Professor, Duke
University http//www.duke.edu/charvey
2
The Plan

• Returns, diversification and predictability
• Long horizon vs. short horizon
• Expected performance
• Prospect theory or skewness preference?
• Importance of GPRs
• The stock markets play a role in the world
  economy

3
The International Track Record
International Performance
Wilshire Mid Cap
Thirty Year Treasury STRIP
Twenty Year Treasury STRIP
Wilshire Large Cap
Wilshire 5000
Ten Year Treasury STRIP
Wilshire Small Cap
EAFE X-Japan
Seven Year Treasury STRIP
Credit
MBS
Five Year Treasury STRIP
Aggregate
Government
EAFE
Germany
Three Year Treasury STRIP
Two Year STRIP
One Year Treasury STRIP
Source Erb and Harvey (2002)
4
Returns and Diversification
Data from MSCI
5
Returns and Diversification
Data from IFC
6
Returns and Diversification
Data from MSCI
7
Returns and Diversification
Data from MSCI
8
Returns and Diversification
Data from MSCI
9
Returns and Diversification
Data from MSCI
10
Returns and Diversification
Data from IFC
11
US Business Cycle is Predictable
US Yield Curve Inverts Before Last Six US
Recessions(5-year US Treasury bond - 3-month US
Treasury bill)
Annual GDP growth or Yield Curve
Real annual GDP growth
Yield curve
Recession Correct
Recession Correct
Yield curve accurate in recent forecast
Recession Correct
2 Recessions Correct
Data though 1/12/03
12
Returns and Diversification
Data from IFC and MSCI
13
Returns and Diversification
Acrobat Document
Source Goetzmann, Li and Rouwenhorst (2002)
14
Returns and Diversification
Acrobat Document
Source Goetzmann, Li and Rouwenhorst (2002)
15
The Long Horizon
Data from Dimson, Marsh and Stauton (2002)
16
The Long Horizon
Data from Dimson, Marsh and Stauton (2002)
17
The Long Horizon
Data from Dimson, Marsh and Stauton (2002)
18
The Long Horizon
Data from Dimson, Marsh and Stauton (2002)
19
What to Expect
Data from Dimson, Marsh and Stauton (2002)
20
What to Expect
Data from MSCI. Japan divided by 10.
21
What to Expect
Price to Trailing Peak Earnings vs 5 Year Average
CPI
(overlapping annual data)
Price to Trailing Peak Earnings
Source Bloomberg, Standard Poors
Source Goldman Sachs (2002)
22
What to Expect

• Ten-year risk premium around 3.5 and stable
  whereas one-year risk premium quite variable

10-year premium
1-year premium
Source Graham and Harvey (2003)
23
What to Expect
U.S. Equity and Bond Returns are Positively
Correlated
Source Erb and Harvey (2002)
24
What to Expect
World Real Equity and Real Bond Returns are
Positively Correlated
Source Erb and Harvey (2002)
25
What to Expect
Inflation Negatively Related to Real US Bill
Returns
Source Erb and Harvey (2002)
26
What to Expect
Inflation Negatively Related to Real US
Intermediate Bond Returns
Source Erb and Harvey (2002)
27
What to Expect
Inflation Negatively Related to Real US Bond
Returns
Source Erb and Harvey (2002)
28
What to Expect
Inflation Negatively Related to Real US Equity
Returns
Source Erb and Harvey (2002)
29
What to Expect
Inflation Negatively Related to Real
International Bill Returns
Source Erb and Harvey (2002)
30
What to Expect
Inflation Negatively Related to Real
International Bill Returns
Source Erb and Harvey (2002)
31
What to Expect
Inflation Negatively Related to Real
International Equity Returns
Source Erb and Harvey (2002)
32
What to Expect
Inflation Negatively Related to Real
International Equity Returns
Source Erb and Harvey (2002)
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Rethinking Risk

• Traditional models maximize expected returns for
  some level of volatility
• Is volatility a complete measure of risk?

34
Rethinking Risk

• Much interest in prospect theory, downside risk,
  asymmetric volatility, semi-variance, extreme
  value analysis, regime-switching, jump processes,
  ...

35
Rethinking Risk

• In prospect theory (Kahneman and Tversky)
• Investor risk averse in the case of gains, as a
  small certain gain is preferred to a probable
  risky gain
• Investor risk seeking in the case of losses, as a
  probable risky loss is preferred to a small
  certain loss
• So investors do not evaluate outcomes based on
  true probabilities

36
Rethinking Risk

• Loss aversion is a special case
• Investor has a greater incremental utility
  penalty for losses than for an equally large gain
• Overall, investor looks risk averse

37
Rethinking Risk

• But, perhaps we can think of these situations in
  terms of preference for higher moments
• Most asset allocation work operates in two
  dimensions mean and variance -- but skew is
  important for investors.
• Examples

38
Rethinking Risk

• 1. The 1 lottery ticket. The expected value is
  0.45 (hence a -55) expected return.
• Why is price so high?
• Lottery delivers positive skew, people like
  positive skew and are willing to pay a premium

39
Rethinking Risk

• 2. High implied vol in out of the money OEX put
  options.
• Why is price so high?
• Option limits downside (reduces negative skew).
• Investors are willing to pay a premium for assets
  that reduce negative skew
• Is this loss aversion or skewness preference?

40
Rethinking Risk

• 3. Some stocks that trade with seemingly too
  high P/E multiples
• Why is price so high?
• Enormous upside potential (some of which is not
  well understood)
• Investors are willing to pay a premium for assets
  that produce positive skew
• Note Expected returns could be small or
  negative!

41
Rethinking Risk
Source Harvey and Siddique (2000)
42
Rethinking Risk
Data from MSCI
43
Rethinking Risk
Data from IFC
44
Rethinking Risk
Data from MSCI
45
Rethinking Risk
Data from IFC
46
Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
Source Agarwal and Naik (2002)
47
Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
Source Agarwal and Naik (2002)
48
Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
Source Agarwal and Naik (2002)
49
Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
Source Agarwal and Naik (2002)
50
Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
Source Figure 5 from Mitchell Pulvino (2000)
51
Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
6
4
2
0
-15
-10
-5
0
5
10
Event Driven Index Returns
-2
-4
LOWESS fit
-6
-8
Russell 3000 Index Returns
Source Agarwal and Naik (2002)
52
Rethinking Risk
Skewness has potential to explain one of the
unsolved anomalies in finance the profitability
of momentum trading
Momentum portfolios
53
Rethinking Risk

• Harvey, Liechty, Liechty and Müller (2002)
  Portfolio Selection with Higher Moments provide
  a new approach to portfolio selection which
  accounts for
• Higher moments
• Estimation errors in the inputs

54
The Evolution of World Risk

• The U.S. has become much more risky
• High sensitivity to some GPRs
• Disagreement on strength of economy
• Financial information less credible

55
The Evolution of World Risk
ICRG Political Risk
Data from PRS
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The Evolution of World Risk
ICRG Political Risk
Data from PRS
57
The Evolution of World Risk
ICRG Political Risk
Data from PRS
58
The Evolution of World Risk
Risk Ratings December 2002
Data from PRS
59
The Evolution of World Risk
Risk Ratings May 2001
Data from PRS
60
The Evolution of World Risk
Higher risk means equity investors require a
higher rate of return
Risk Ratings from Institutional Investor
61
The Evolution of World Risk

• Equation implies an increase in the medium-term
  risk premium
• This helps explain the recent decline in the
  equity market
• This helps explain the recent behavior of the
  U.S. dollar
• This helps explain the slow down in real
  investment (hurdle rates are up)

62
Stock Markets and the Real Economy

• Efficiently functioning stock markets make a
  difference in the real economy
• There is now substantial cross-country evidence
  on the impact of stock market development on the
  real economy

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Stock Markets and the Real Economy

• Market integration has a fundamental influence on
  asset prices

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Stock Markets and the Real Economy
Asset Prices and Market Integration
Prices
Segmented
Integrated
PI
PS
Return to Integration
Time
High Expected Announcement
Implementation Low Expected Returns
of Liberalization
Returns
65
Stock Markets and the Real Economy
Average Annual Geometric Returns
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Stock Markets and the Real Economy
Correlation with World
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Stock Markets and the Real Economy

• Implications
• Lower cost of capital
• More investment, employment
• More economic growth
• Geert Bekaert, Campbell Harvey and Chris
  Lundblad, Does Financial Liberalization Spur
  Growth?
• Not just an emerging markets effect Euro also
  increased integration

68
Stock Markets and the Real Economy

• Findings
• Liberalization increases real growth by 1 per
  year for five years which is a large number
• The liberalization effect is robust to
• different definitions of liberalization dates
• to business cycle or interest rate controls
• allowing for intensity of liberalization
• ...and independent of capital account
  liberalization

69
Stock Markets and the Real Economy

• Findings
• We control
• macroeconomic reforms
• financial development
• other regulatory reforms
• ...and effect is intact

70
Stock Markets and the Real Economy

• But is there a cost?
• Foreign speculators
• Economic crises
• Irrational contagion

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Stock Markets and the Real Economy

• But is there a cost?
• Liberalization may lead to hot speculative
  capital and induce capital flight (Stiglitz
  others)
• One can always point to a particular country to
  support this idea
• What about looking at a broad cross section?

72
Stock Markets and the Real Economy

• But is there a cost?
• Geert Bekaert, Campbell Harvey and Chris
  Lundblad, Growth Volatility and Equity Market
  Liberalization, 2002.
• No evidence that GDP growth volatility increases
  after markets open up

73
Stock Markets and the Real Economy
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Conclusions

• Predictability arises naturally from business
  cycle fluctuations it need not be confused with
  irrationality
• While the research is very important, the case
  has not yet been made for widespread application
  of behavioral models
• Stock markets, in general, play a positive role
  not just for investors and corporations but the
  economy

75
Readings

• My articles on www.duke.edu/charvey
• The Drivers of Expected Returns in International
  Markets (2000)
• Global Tactical Asset Allocation (2001) with
  Magnus Dahlquist
• The Term Structure of Equity Risk Premia (2002)
  with Claude Erb
• Characterizing Systematic Risk of Hedge Funds
  with Buy-and-Hold and Option-Based Strategies,
  (2002) Vikas Agarwal and Naranyan Y. Naik
• Portfolio Selection with Higher Moments, with
  John Liechty, Merrill Liechty, and Peter Müller
• Does Financial Liberalization Spur Growth? with
  Geert Bekaert, and Chris Lundblad
• Growth Volatility and Equity Market
  Liberalization with Geert Bekaert, and Chris
  Lundblad