07 Sep 2010

"Optimistic" Thought Experiments and the 'Equity Premium Puzzle'

Peter Thiel, formerly of PayPal, more recently of the Founders Fund and Clarium Capital, has an interesting article in the Hoover Institution Policy Review, called “The Optimistic Thought Experiment.” The best one-sentence summary is probably his own: “In the long run, there are no good bets against globalization.”

However, the article is more interesting than just that, and even if you disagree with that particular conclusion – perhaps especially if you disagree with that particular conclusion – it’s worth a read.

The argument that I found most interesting is that, as a result of more powerful technologies and a more complex and interconnected world, a greater risk exists of “secular apocalypse,” a complete, system-wide failure of the current capitalist framework, than has ever existed in the past. What might have been local panics or crashes now reverberate globally, even as new failure modes have emerged.

This, in particular, struck me:

[T]he extreme valuations of recent times may be an indirect measure of the narrowness of the path set before us. Thus, to take but one recent example, in 1999 investors would not have risked as much on internet stocks if they still believed that there might be a future anywhere else. […] It is often claimed that the mass delusion reached its peak in March 2000; but what if the opposite also were true, and this was in certain respects a peak of clarity? Perhaps with unprecedented clarity, at the market’s peak investors and employees could see the farthest: They perceived that in the long run the Old Economy was surely doomed and believed that the New Economy, no matter what the risks, represented the only chance. Eventually, their hopes shifted elsewhere, to housing or China or hedge funds — but the unarticulated sense of anxiety has remained.

I am not sure exactly how convinced I am of this – it has a sort of exceptionalist tinge to it that I am intrinsically skeptical of – but it’s a very interesting theory. To some extent, casual observation bears it out: the last few years, we have seen speculative bubbles pop up in various places as investors have moved from one market to the next in search of returns.

Much has been made of the fact that some of these bubbles – real estate in particular – just never made a whole lot of sense, or at least not enough sense to justify the amount of money that was being pumped into them, or the fervor with which it was being pumped, not just by I-banks and hedge funds, but by individuals ‘flipping’ houses, taking on second homes, and getting involved in shady high-return investment schemes (which are still being advertised on sketchy hand-drawn yard signs at major intersections in my area).

Viewed through the lens of Thiel’s thought experiment’s premise, it starts to look a whole lot less irrational and a whole lot more rational – albeit desperate.

It also made me wonder about the long-standing arguments regarding the ‘equity premium’ (the premium paid by equities versus ‘risk-free’ investments like Treasuries). Some people argue, generally by analyzing U.S. market returns during the 20th century, that the equity premium is around 5-8%. However, others suggest that in the future, it might be more like 3-4% over cash. The jury is definitely still out on this, but it certainly seems like there is a developing consensus that the equity premium is in decline.

The equity premium has long been considered something of a mystery, because it’s higher than you’d expect given investor behavior. With an equity premium of 7% over bonds, you’d have to be almost ridiculously risk-averse to not buy equities. But if the premium is as low as some suggest it may be going forward, than the mystery might be the other way around: why hold equities when you can have less risky bonds instead, at a small discount?

My completely speculative theory is that perhaps this is due, in part, to the kind of attitude Thiel discusses. If investors suspect, consciously or unconsciously, that a scenario in which their S&P 500 fund becomes worthless would also be one where T-Bills or even cash are worthless (or, less extreme, that they’d lose significant value as well), then they might not agree that the difference in risk is great enough to justify the lower yield of the ‘safer’ investment.

Of course, the market could just be irrational. I’m not sure that anything other than time is going to tell.

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