Discussion of “Hard Times”

by John Y. Campbell, Stefano Giglio, and Christopher

Polk

ASSA Meetings, Chicago ILJanuary 2012

Jonathan A. ParkerKellogg School of Management, Northwestern University

The idea: use historical relation between assets returns and subsequent cash flow and discount rate changes to infer whether the market expects a given market downturn to be followed by higher future discount rates or lower future cash flows

Outline1. The method2. The data 3. The findings4. Thoughts on the big question: interpretation

1. The methodOr what the Dickens is going on?

Step 1: Campbell Shiller (1988): assume the Dividend-Price ratio is stationary

DtPt

Any deviations in ratio must lead to future changes in dividends or prices (returns)Log-linearize:

Implies that an unexpected return leads to a change in expected future dividends or returns

Shocks to stream of cash flows (CF) and discount rates (DR)• Can calculate NCF and NDR from any forecasting

model, use a VAR• Applies to any asset with stationary dividend-

price ratio (is this true of the market?)

Optional: impose some restrictions on returns implied by optimization of • a representative agent • with KPEZW utility • who faces only risks spanned by the two shocks (e.g. no

uninsurable labor income, no private equity, etc.)• and all returns are all jointly lognormal• and homoskedastic

While all are violations of reality, they are common modeling assumptions and some models with these features can fit may asset pricing facts with heteroskedasticity

– Time-variation in risk is large for the focal episodes, 2008 in particular

– We are referred to Campbell, Giglio, Polk, and Turley (2011) for time-varying volatilities

Great Expectations of returns:

Expected returns determines by exposure to cash flow shocks and discount rate shocks• Decomposition of expected return as due to two

different exposures – The more exposed to good cash flow news, the higher

expected return and the lower price– The more exposed to good discount rate news (low rates in

future) the higher expected return and the lower price • Beta’s can be calculated, used in regression with average

returns (actually use as moment restrictions)• Restriction: Cross-section has expected returns times

more sensitive to CF than DR

2. Data

For VAR1. Excess log return on the CRSP value-weighted index2. Log ratio of the S&P 500's price to the S&P 500's ten-year moving

average of earnings3. Yield difference between the log yield on the ten-year US constant-

maturity bond and the log yield on the three-month US treasury4. Difference in the log book-to-market ratios of small value and small

growth stocks5. Yield spread in percentage points between the log yield on

Moody's BAA and AAA bondsFor expected returns/cross-section: 6 portfolios measuring size (ME) and value (BE/ME) premia

3. Findings

Time-Smoothed shocks to CF (left) and DR (right) unrestricted model (top) and restricted model (bottom)

Note: shocks negatively correlated (-0.070 unrest. -0.577 rest.)

Cash-Flow shocks- Positive in recovery from G.D. - Negative in 1980’s and 1990’s- Positive in 2000’s

Discount rate shocks - Negative on market in G.D.- Positive in end of G.D. and WWII - Negative in early 1950’s & 1970’s- Positive in 1990’s internet boomSuggest one-sided smoother

It was the best of times, it was the worst of times . . .

Shaded areas: NBER recessionsDark lines: market peaks with two year-windows

Hard times: cash flow news followed by disc rate (G.D. and 1937)Pure sentiment: discount rate news (end of WW II and 1961)Other: Sentiment followed by cash flow/ NBER recession

4. Interpretation/thoughtsNot primitive shocks – and not claimed to be

- Why are times with high future discount rates not hard times? - They are times when output today has become scarce relative to the future- If because of increased future cash flow, these are good times, if because of

increased risk or anxiety, these are bad times- What about credit in the “credit episode”?

- Institutional view: lowered constraints, low market risk aversion- Are there enough similar episodes to identify market expectations?- Is it reasonable to use the restricted model?

- Is the paper proscriptive for a long-horizon, attentive, CRRA investor?- The decomposition is useful for refining models

- My interest: identify structural shocks that map into each type of reduced form shock and generate facts for models- E.g. does a monetary policy shock hit mostly cash flow or discount rates?

5. Conclusion

Old literature: are all business cycles alike?Answer: lots of similar comovement, but some

differencesThis paper starts to build similar facts for stock

market cycles, crashes in particularMain finding: different market declines in US

history have had quite different implications for future cash flows that are visible in contemporaneous asset prices