July 18, 2024

Episode 314 - Professor Valentin Haddad: How Competitive is the Stock Market?

July 18, 2024

Valentin Haddad is an associate professor of finance at UCLA Anderson School of Management and a research fellow for the National Bureau of Economic Research’s asset pricing program. He joined the faculty from Princeton University.

Initially pursuing an education in science as an undergraduate in his native France, Haddad found his way to economics and was immediately convinced of the fit. “I responded to finance as a field of economics that combined sophisticated theory with a very practical, real-world-oriented approach,” he says. “It’s an area where quantitative methods are necessary, but so is an acute understanding of how people and institutions interact in the marketplace.”

In this episode, we sit down with Professor Valentin Haddad to unpack the intricacies of market elasticity, passive investing, and the dynamic nature of financial markets. Valentin is an Associate Professor of Finance at UCLA Anderson School of Management and a research fellow for the National Bureau of Economic Research’s Asset Pricing Program. His research focuses on how financial institutions trade, and manage risk, and their impact on market prices and the broader economy. Notably, his work challenges traditional assumptions, such as the perceived safety of life insurance companies' investments in Treasuries. In our conversation, we delve into the impact of index funds on the market, stock market bubbles around the development of new technology, and the response of investment-grade corporate bonds to the COVID-19 crisis. Discover the definition of demand elasticity, strategic interaction, and how market elasticity has changed over time. Explore how he defines a market bubble, ways stock market bubbles are related to new technology, and how to measure the value of innovation. We also discuss the impact of COVID-19 on investment-grade corporate bonds, the Federal Reserve’s response, the implications for bond safety, and much more. Tune in and join us as we uncover the mess of the market with Professor Valentin Haddad!

Key Points From This Episode:

(0:03:10) The impact of passive investing on financial markets, what investors’ demand elasticity is, and the role of index funds.

(0:06:07) Learn about strategic interactions, their influence on financial markets, and how they react to rising passive investing.

(0:10:10) Why active investors’ options are limited in a passive investment landscape and how demand elasticities influence asset prices.

(0:13:05) How individual investor elasticities are related to aggregate market elasticity and the ways investor elasticity has changed.

(0:20:54) Large and small stock elasticity trends, the implications of his research for asset prices, and the relationship between elasticity and information.

(0:25:32) His opinion on a bubble in large stocks forming due to flows into index funds and how market bubbles drive innovation.

(0:29:31) Potential measures to address the issues with index funds and how individual investors should be reacting to the situation.

(0:34:46) Unpack how he defines a market bubble, measuring the value of innovation, and their effect on the value of technology.

(0:42:29) What his research findings mean for innovation policy and what to consider before investing in innovative companies.

(0:46:33) Insights from his paper examing the impact of COVID-19 on fixed-income and the different market reactions.

(0:53:40) Explore the Fed’s intervention during the pandemic, what effect it had, and the safety that bonds offer during a crisis.

Read The Transcript:

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore: Welcome to Episode 314. And this week, Ben, another great guest, and such an interesting topic. The guest was Professor Valentin Haddad, who is the Associate Professor of Finance at UCLA Anderson School of Management. And boy, really, this one makes you think, but he's a great communicator, love the conversation, and elasticity information, prices, and noise in markets. Markets are messy. That might end up being the title, we'll see.

Then, the inelasticity around large stock prices, the impact of index funds, it just really makes you think. He said so many fascinating counterpoints that almost emulate their accidental findings in his research, which is so interesting. So, I'll let you tell more of the backstory again, then we'll talk about his credentials after.

Ben Felix: You set it up well. We talked about three big chunks. One was index funds, the effect on financial markets, which he's got a paper on. Then, we also talked about bubbles and the value of innovation, stock market bubbles around the development of new technology, an incredible paper on that. Then, we also talked about the response of the investment-grade corporate bond universe to the COVID-19 crisis, which was extreme. I mean, he talks about investment-grade corporate bonds, which is the safest corporate bonds. They dropped around 20% in the US during COVID. Why did that happen, and what does it mean for the safety of bonds?

Cameron Passmore: What was the impact of theq Fed even without doing much was really interesting.

Ben Felix: Was that a good thing for the Fed to have done? I thought his discussion around that was incredible. So, three topics, bits and pieces of each one reinforced the other, I think. As we were discussing them, I was noticing that it's happening in my brain at least. So, Valentin's another University of Chicago Booth School of Business graduate, he's got his Ph.D. and an MBA from Booth. He's at UCLA, like you mentioned.

I learned about Valentin from, actually Mike Green, because Mike references Valentin's paper on index funds and market elasticity, and the relative elasticity of large and small stocks. We'll let you wait for the episode to understand what I'm talking about. So Mike put me on to that paper. I read it; it was incredible. I asked Valentin a question about the paper, and I started poking around his other published research. I found all these interesting papers, so I asked him if you would like to come on our podcast, and he obviously agreed.

Cameron Passmore: So, with that, Ben, let's go to our conversation with Professor Valentin Haddad.

***

Ben Felix: Valentin Haddad. welcome to the Rational Reminder Podcast.

Valentin Haddad: Thank you for having me.

Ben Felix: Super excited to be talking to you. You've got this great paper on how passive investing is affecting financial markets, so I want to start there. Can you talk about how substantial the shift toward passive investing has been over the last 20 years?

Valentin Haddad: It's huge. There's different ways to look at it. One way is to just focus on mutual funds. Maybe not 20 years, but let's say 30 years ago, there were virtually no passive mutual funds. That's dealt by something like 15%, 20% of the market. I think that's just the tip of the iceberg, actually. There's a lot more in asset management, in like pension funds, and so on that have like slowly shifted away from active strategies. To give a number in our paper, we tried to just look at how people trade, and we'll trade like that passive, and we get something like 40% of the market as passive as this.

There's another paper actually that did something kind of cool, that looked at how much people trade on days where we change the indices, when we have index accumulation. They also find a number like 40%, actually. So. that would be my best guess. But if I could do 50% or 30%, you would still say it's a big number.

Ben Felix: Yes, it's a big number. Who was the other paper by?

Valentin Haddad: [Inaudible 0:04:03] and Simon.

Ben Felix: Simone, okay. Yes, I thought so. We've got Simon’s book for later this year for an episode.

Valentin Haddad: Oh, great.

Ben Felix: Can you talk about what an investor's demand elasticity is?

Valentin Haddad: That's going to be closely related to this notion of being passive. So, what people call simple economics in general, is to say, "You want to buy apples, I'll give you a coupon, 10% off coupon. How many more apples do you buy?" Then, but stocks, you can ask the same question. Of course, you never get a coupon to buy stocks at a discount, but it would be something like. If you see the price of Apple is lower by 1%, and you have no idea. Up another stock, is low by 1%, and you don't know why it happened. How many more shares do you buy? How much more do you invest? That's an important notion because that's kind of thing as high investors are leaning against prices in a way, where you take advantage of good investment opportunities.

Cameron Passmore: How does the shift towards passive investing affect the demand elasticities of the investors who did become passive?

Valentin Haddad: It depends what those investors were doing before. But it looks in the data like most investors are providing elasticity. What I mean is, when there's some stock being shipped. Shipped, maybe not surprising. They tend to buy some. So, if you become passive, you just shut down this mechanism. You just say, "Well, I'm just going to put it into the index, no matter what happens to prices, I'm not going to trade" That just decreases the elasticity that those investors provides to zero.

Ben Felix: Okay. That's really interesting. So, we did an episode with Ralph Koijen a while ago. We talked about similar stuff about how demand elasticity may have changed over time. He said something related to what you just said, which is that it matters what people were doing before. You're saying that in your data, it looks like people are becoming less elastic when they shift into index funds.

Valentin Haddad: What we know is, for sure, at the end, once they have switched they are done providing any elasticity. The question is what they're doing before. The opposite of providing elasticity would be to be more transient in a way to buy more when the price goes up. We know some investors do that, but the typical institution doesn't seem to be doing that.

Ben Felix: What are strategic interactions between investors?

Valentin Haddad: That's the bottom line, is that elasticity become a little bit more tricky in a way, which is that how you trade is not like buying apples in the supermarket in a way. So, when you buy apples in the supermarket, it's just, "Well, I get a coupon. Do I really enjoy eating apples? I'm going to eat small apples." For stocks, it's free. We are all trying to like find good investment opportunities. So, it really matters how other people are trading as well. If you know that people are already very aggressive, already taking advantage of investment opportunities, then there is no points for you to be that aggressive. That's what we mean by strategic interaction. The fact that you choose how you trade is based on how other people are trading. So, it's not really just what you like to do, but how you react to others in the market.

Ben Felix: It's like an adaptive system.

Valentin Haddad: Yes, pretty much. In mechanics, we like to say like equilibrium, we adapt to each other, we react to each other.

Cameron Passmore: Really interesting. Why do strategic interactions matter in financial markets?

Valentin Haddad: One way to think about that is to say, we are a very sophisticated investor, or very active investor, providing a large market. Let's say, for whatever reason, they wake up one morning, they’re in an epiphany, and they want to become passive. They're not there in the markets. What you have to ask yourself well is, maybe somebody else is going to step in, somebody else is going to replace them. I think this is like looking for [inaudible 0:07:22] idea. This is idea that there's always somebody on the lookout for more, that will tell us, there are very strong strategic interaction. Often, we think about this as a very big reason for stability in financial markets. It's just an idea. So, the point of our research here was to go and see, does this process happen? Do we see the stabilization? That is, if you change how you trade coming on, those then come to replace you? Do I come to replace you? Or, did we just lose you in our markets and markets are different? That's why it matters what kind of stability.

Ben Felix: What is the expected strategic response to a rise in passive investing in a market with fierce competition?

Valentin Haddad: If you have this kind of old idea or traditional idea, I would say, fierce competition, then there would be a big strategic reaction pretty much, a one-to-one strategy reaction. That is to say, there was an active investor, they were providing some information some elasticity, believes somebody else is going to come to replace them. They were taking advantage of some investment. What if somebody comes to replace them?

So, [inaudible 0:08:21] one-to-one. Historically, in finance, we don't think very much about who's trading, who is doing what, and so on. We have decided that the market as a whole is the unit is what's stable. Underlying this idea is really this principle, let's say, well, if somebody changes, something else replace them, one-to-one. That's the starting point. That's what I think the idea nonetheless are in the back of our hand.

Ben Felix: The title of your paper, I guess, the premise of the paper is really looking at how fiercely competitive is the market actually.

Valentin Haddad: Yes, exactly. We're just wanting to know, well, to be honest, we all struggle in this world, as we come from this long tradition of an efficient market. So, it's not like we thought this was a crazy idea, but we just wanted to know, okay, can we put our hand on this? Can we see this in action and how big is it?

Cameron Passmore: If the market is fiercely competitive, how does the rise of passive investing affect asset prices?

Valentin Haddad: Well, the answer is deceivingly simple, like that is, it doesn't matter. It doesn't matter at all, because people become passive, somebody else is going to become active. Again, it's like magic market, like the market is stable no matter what, there will always be the same – that user is simple, and so a simple bench market, really is that, just nothing happens.

Ben Felix: So, the next question is, how well does that model of fierce competition hold up in your data?

Valentin Haddad: Not as well as you might think. Roughly, if you start on this data, everything should be compensated one to one. We find out about between 50% to sell opportunities are [inaudible 0:09:48]. What it means actually, it shifts. The rise of passive investing do change the market. So, let's talk about, two investors are leading from being active, only one replaces them by becoming more active in a way. That is large changes, and the market can change over time much more.

Cameron Passmore: Why would active investors be limited in their strategic response?

Valentin Haddad: It's hard to trade. If I tell you, whatever your competitor has left the market and you want to come in and replace them, all you have to figure out is how to trade. You have to figure out how to identify the small opportunities, you have to figure those things. That's one element, there's another element that is on maybe another mandate, so you can only do as an institution when you've been told to do. And you can kind of keep going down the line of – there are many frictions that make the world not as easy. First, you have to even know that your competitors have left.

[Inaudible 0:10:37] There is in finance, and I'm talking from the seat of academia. We imagined that everybody knows everything that's going on. But in practice, it's hard to keep track of those individuals who is doing what. All this is kind of slowing down how people react, you can also be concerned about liquidity. If you become too aggressive, then you're going to have too much pricing back. So, you don't want to do that either. All those forces are going to tend to slow you down from reacting to what other people do, to be very proactive as an investor.

Ben Felix: There's a kind of like a limit to arbitrage idea.

Valentin Haddad: Yes, limit to arbitrage is another one. Also, it's risky, so sure, you can find ways to get more profit, it's risky as well. There are many such limits.

Ben Felix: What role do demand elasticities play in determining equilibrium asset prices?

Valentin Haddad: We started from each other's, as our own demand elasticity versus demand elasticity. If you put all these together, that gets you to the market. That's how you would define demand elasticity for stock or for the overall stock market. What that's telling you is telling you how the market will react when there's a change in price. That's not justified by anything else. So, let's say, again, one morning, I wake up, I want to sell all my shares of Tesla, that's when I tend to pull the price down. On the demand elasticity of everybody else in the market is going to tell us how the market can absorb this.

Are people going to come back, and want to buy Tesla a lot when they see the price go down, or not very much? If the market is very elastic, nothing is going to happen. Because the moment I'm going to set, the price is going to drop a tiny, tiny bit, and everybody's going to buy a lot and is going to buy from it. If the market isn't very inelastic, and investors don't want to trade, don't want to upsell those positions, it's going to create a much bigger change in price. Because it's going to take a big discount for the investors to step in. The elasticity of the market is telling us how much the market are going to upsell stock, upsell selling pressure, all buying pressure is completely symmetric. So, it is telling us how much noise we can have in the market, and how much volatility we have in the market.

Ben Felix: If the market becomes less elastic because investors are becoming less elastic, it becomes more sensitive to trading activity or changes in price?

Valentin Haddad: Exactly. If we all become less elastic, you've got the same kind of noise, like noise trading, or people moving for whatever reason. Maybe, life happens, you have to sell some stocks. Then, the price will move more in response to that.

Ben Felix: Can you talk more about how individual investor elasticities are related to aggregate market elasticity?

Valentin Haddad: That's just the additions. At the start, we can strategically respond to each other. But at the end of the day, we each decide how we trade. If you add up how we all trade, that's how you get the elasticity of the market. So, it's simply an addition, pretty much. If price goes down by 1%, you're going to buy five shares, Cameron is going to buy 10 shares, I'm going to buy two shares. Well, that means together, we buy – now, I lost track, but maybe seventeen shares, I think. You just add up different results. That's why I was telling you those numbers, which fraction of investors are passive or active. That shows a big time in those calculations.

Cameron Passmore: What does the aggregate elasticity of an individual stock mean?

Valentin Haddad: That means, when the price of a given stock, let's say, a share of Apple. When the price of Apple drops by 1%, how much more do investors buy other Apple? This is showing the elasticity. It doesn't have to be the same answer, as it would be for the market of [inaudible 0:14:01]. When the S&P 500 drops 1%, how much people would buy of the overall market? So, this is something, for example, [inaudible 0:14:08] how the market will respond. In that study, we focused on stock-based. How do people respond to one stock moving and another stock price moving? That's where we focus.

Ben Felix: Okay. Interesting. So, you're looking less at aggregate market elasticity and more at individual stock elasticity.

Valentin Haddad: Yes. It's mostly known as like, do we have a boom or burst in the overall market? Do we start to see different stocks? Again, we don't quite go to mispricing, but in the back of your mind, that's what we have in mind. It's like, one stuck becomes mispriced relative to another one. Do individual price in your stock move more so than the market?

Ben Felix: Is it relating the individual stock elasticity, like relative to aggregate elasticity?

Valentin Haddad: That, we're not doing too much, actually. So, we're just trying to figure out how people trade individual stock. If you think, one is, as people switch to passive. I mean, there are many changes happening with this. But a big change is how you trade individual stocks. The first-order decision when you become passive is say, "I'm not going to choose stocks. I'm not going to make a decision across stocks." So that means, for a given stock, whether I was trying to trade the stock actively, is not doing it anymore. But the market is much more on the use, actually, because by becoming passive, now, maybe you try with the market more active. You may choose to come in, or come out of the market. That, we give a sign in the paper. We're not trying to think about people to make a decision for individual stocks.

Ben Felix: How did the elasticities of individual stocks vary in the cross-section?

Valentin Haddad: They tend to be not so big. That's the first result that we found that quite a few people have found, as well actually using different ways. So, it turns out, if you think about pricing back in a way, how much the price of a stock moves when you start selling that suddenly is quite large, actually. There's one thing we found, as we are trying to find a strategy interaction, is actually size matters quite a bit. So, somehow, large stocks tend to be less elastic, which might be actually quite surprising. Because I think we all have in the back of our mind, some idea like, large stocks are more liquid. [Inaudible 0:16:04], what exactly does elasticity mean? So, let me try to take you maybe throughout that, because it's something that I find kind of fascinating, and it took me some time to wrap my head around this.

I think the reason we think large stocks are more liquid is, we think if I sell $100 of a large stock, and we'll have much less price impact than I sell $100 of a small stock. That's a fact, just to be clear. Elasticity doesn't really think in those terms. It's thinking [inaudible 0:16:30]. It thinks more about like, "Well, what if I sell 1% of the market capitalization of a large stock, how much price impact will I have compared to selling 1% of the market capitalization of a small stock? Here, you start to realize that well, it could be larger. It could be even much larger because if you think about large stock, many people buy large stock but large stocks are large. It's more like, what is the composition of investor? In large stock, you have a lot of passive forms, like the big passive players, of course, something like the market. So, a lot of large stock.

Not many people actually are willing to trade against you, if you want to sell large stock. That's kind of how you can see that it could be small. We went a little bit into the data, and we tried to see, let's say, within your portfolio, we zoom on one institution, and we say, "Well, within this portfolio, how much does the institution trade the small position that it has? So, the last position that it has." We see institutions change a lot in their small position, not so much in their large position in a way, because that goes back to where we talked about limits to arbitrage, mandates, and so on. Is that, if you start moving around something that's like 10%, your portfolio, you move it to 20%, you're completely changing the profile of your portfolio. If something is 1% your portfolio, you make it 2%, that's fine. You're taking advantage of this investment opportunity, but you're not really changing your portfolio. So, there's many things that suggest that actually people will trade less aggressively in large stocks, and the market will be less elastic.

Ben Felix: The large stocks are held by people who are less aggressive with their large holdings, I guess, in terms of how much they trade them.

Valentin Haddad: At first, other large stocks are held more by passive investors. If you think they're very, very big players, Vanguard, State Farm, BlackRock. They're much more highly represented in large stocks than in small stocks. In large stocks, pretty much, they hold the market share. In small stocks, sometimes they don't hold them as much, because we have a lot of indices that are zooming in on the larger stock, and so on.

Already, we have more large investors. Those players, they don't react to prices at all. They're not all explicitly indexing, but mostly, they don't react to prices. So that means that, again, if we go back to our discussion of elasticity, there's not much less elasticity going on in those large stocks. Again, in number of investors, many more investors in dollars, many more dollars, but those stocks are so large that if you sold 1% of a large stock, you will hit too many passive investors.

Cameron Passmore: How have aggregate elasticity changed over time in your sample?

Valentin Haddad: We find a trend that goes with the rise of passive investing. So, we find that elasticity that have been going down without them. To go back to how we think about it, some of it is [inaudible 0:19:01]. We have passive investors, they have zero elasticity. They're going to make more and more passive investors, means, go on low elasticity. That's part of what happens in our sample, but there's another part actually, that we didn't know for sure was going to happen. But we found that, even active investors tend to become less active, have been trading less and less actively. That trend actually is less kind of steady in the data.

What we find, we find that pretty much up until the crisis, the 2008 crisis, we would see investors, active investors tend to be – thinks to becoming more active. After that, we've seen a decrease in active investors are trading. So, everybody, with people becoming formerly passive, otherwise, not trading actively at all. But even, more active investor seems to slowly be trading down. So that's suggesting that elasticity are slowly going down in the market.

Ben Felix: Interesting. So. it's not necessarily just a story about index funds. It's like active funds are becoming whatever, closet index funds or something like that.

Valentin Haddad: I think some you use that indexing. I think there's been more and more discussion over how even active funds are penalized for tracking, having poor tracking overall. It looks like there's been a shift in the industry towards trading less actively. The one limitation to that, that's something that research is not quite out yet. If you went to the very, very extreme of activity, you would get hedge funds in a way, [inaudible 0:20:23] long-short investors. Those typically, like in our data, we don't see very well, and we don't really know. So, it could be that those last most active investors are becoming more active. In terms like, Citadel, Jane Street, more and more sophisticated computer or sophisticated algorithms, whatever happens behind closed doors in those funds. That's possible, but for virtually, everybody else, the shift has been to trade less and less actively.

Ben Felix: You talked about how the large stocks are less elastic than the small stocks. What is the trend in that been like over time?

Valentin Haddad: There's no distinct pattern, actually for large stock or small stocks. Everything I described about the market is becoming less and less active in a way. It's true also in large stocks. Large stock started less active to start with, so maybe it's a little bit less pronounced, but it's kind of a parallel movement across stock sizes. So, demand for our stock is more inelastic, and more so than 20 years ago, but just pretty much buy as much as you change.

Ben Felix: What do you think the implications are of your findings for how passive investing is affecting asset prices?

Valentin Haddad: There's quite a few. So, there's some we can understand, there are some that are to measure or to completely get a grasp on. The simple one we understand is that, it’s pretty much the definition of elasticity. The noise will have a bigger effect on markets. So, that would tell us that this fall, this shift of passive investing is going to push in the wholesale prices to be more volatile. That, we see some evidence in the data, so we try to look at, the stocks always in demand is less elastic tend to be more volatile. So that, we have a good sense that it's going to tend to push variety to individual stocks. The funds that are a little bit more ambiguous, I would think is whatever information for example, something people discuss a lot is, price is more or less informative.

The way I say, telling the stories of elasticity, often, people have been thinking about information in a way that is, active investors provide information, [inaudible 0:22:13]. So, are we losing information? That's really hard to do. In our paper, we try to look at some measures or information that other people have come up with. We don't find much, but it's really hard to tell that nothing is happening, that the measures we use are not that precise. If I asked you guys, how would you tell if the price is informative or not? It's really hard to tell. Researchers actually found some pretty clever ways to try to get at that, but it's very noisy. So, I'm not quite sure.

I think, in terms of concern, that would be the main concern. The flip side of that, though, I think is, if you're an investor, a more active investor, is telling us, there might be more investment opportunities out there. Actually, that is the whole idea in finance called the Grossman [inaudible 0:22:57]. This idea that if nobody's acquiring information, then markets are very inefficient. Then, you should step in, in a way. So, if everybody is becoming passive, there's more gains for being not passive.

I guess, our results suggest that this is kind of happening in a way that is like, "Well, maybe there are gains to be more passive and more active somewhere. Again, that goes back to our previous conversation like, "Well, why don't everybody become active?" It's hard, it's difficult, it's challenging. This is the flip side in a way, that well, maybe markets are a bit less efficient, but there are more in small opportunities.

Ben Felix: You drew a distinction there between informational efficiency, which is hard to measure, and elasticity. Is there a relationship between those two things though, like if the market becomes much less elastic, even if we can measure that it's still informationally efficient? Doesn't the inelasticity introduce something like noise or I don't know what you call it?

Valentin Haddad: The elasticity just measures how you react to the price. It doesn't really tell us why you react to the price. Typically, we think that if you are more informed, you can understand why prices are moving. So, when you see the price move for no informational reason, you're going to step in aggressively because you know that's what it is. If I'm [inaudible 0:24:03] informed, I see the price drop, I don't know if it's because there was bad news about the stock or because it's a good deal. So, will tend to not affect very much.

That creates this connection, this very natural connection between elasticity and information [inaudible 0:24:16]. That's why we think that informed investors are more active. They get signal, they trade based on their signal. When they see the price move for a wrong reason, they come in aggressively, but it doesn't have to be. I can just be aggressive because maybe I don't know much. I know, I'm just an aggressive, aggressive investor. I'm not very afraid of risk. This distinction makes that it's not so easy to know.

Now, the other thing you ask in a way is like, well, with the consequences beyond price informativeness matter? I think the answer is yes. I think it kind of depends on what we mean by price informativeness. So, there are two parts. Again, one part is, is the information into prices? The other part is, is only the information into prices? Is there noise as well? The price moves one to one when we have good news, bad news. Like these markets are [inaudible 0:25:05]. There's been noise around this. People make mistakes. It might be that the information is still there, but that we have more noise. The noise is bad, of course, because the noise is really a risk for investors that coming in and out of the market, and so on. Those two aspects might be somewhat dependent,

Ben Felix: You explained that well. Connected the dots for me.

Cameron Passmore: This is a really interesting conversation. Do your findings support the concept of a bubble in large stocks due to flows into index funds?

Valentin Haddad: There's been a lot of discussion on that. I have mixed feelings about this. I'm going to give you the research answer which is that, we don't really know. Which is not very satisfying as an answer.

Cameron Passmore: No.

Valentin Haddad: So, let me try to say, [inaudible 0:25:45]. What our findings say, they say two things. Large stock is not that elastic, and even less so than it used to be. That's telling us that the potential irrational flows into large stock to have a big price impact. That's true. I think, another piece of the puzzle that suggests this could happen is that, as we said, passive investors are tilted towards large stock. So, they will tend to come in more into large stock. That's not about elasticity. That's just telling you about dollars coming into those stocks. There's more investors coming into large stocks. There's been a shift away from smaller stocks.

If you put those two together in the study, well, that's going to push the price of those large stocks up potentially too much. The reason I'm going to be unsure is, we don't know if that's the case. We don't know if the prices were right before. We don't have a good sense of the magnitude of those flows. There's a bunch of ingredients that tells you it's possible. I think, a few years ago, people would have dismissed these kinds of stories. I think by now, we have a grasp that this is possible. But are we seeing clear evidence of that is difficult to tell.

If we think about the large stocks these days, is possible that also by balancing, these are very, very highly valued, and companies that are very highly valued relative to their output right now. Nonprofits today. Is it a [inaudible 0:27:03]? I guess it's too early for me to call it [inaudible 0:27:06]. So, I will not go there. There are some ingredients that say it could be possible. I tried maybe two things to this [inaudible 0:27:13] elasticity, but it's not communicated to me that it's a very large number.

Ben Felix: Does this start to tie into your other research on bubble and innovation, do you think?

Valentin Haddad: A little bit, yes. In that other research, in a way, we're not thinking about what styles [inaudible 0:27:31] in a way? In the other work, we're thinking more about people speculating, people having different views on stocks. The story today for, why passive investing, credibility in large stock is small. We have flows of money, flow of money into large stocks most, just because passive investing invests more into large stock.

Ben Felix: I was thinking about alternative explanations for the valuations of those large stocks being so high right now? Could be index funds, but it could be innovation.

Valentin Haddad: That'd be the next one, I think for stock pricing. It does two things. They are going the same direction, but with different long-term consequences. That was the [inaudible 0:28:07] of the paper we have on bubbles and value of innovation. The starting point always is that innovation is good, is valuable. So, when we have lots of innovation, we see these firms getting very highly valued. In recent years, we've seen design of electric cars. These days, I guess we talked about Nvidia, and GPU for AI. The other side of innovation, and that's what got us thinking in another paper was, that speculation often comes with innovation.

We want to know who is the winner. It's like, every day we see articles about, is OpenAI going to be the thing we all use, or is it going to be the Google solution, the [inaudible 0:28:44] from Facebook. This is kind of like messiness of innovation that naturally creates speculation. It's like, "Well, we all try to guess to be informed about who's going to win, and we found views on this." We don't know too much about two years ago, none of us knew anything about AI, pretty much. So today, I bet we all have opinions about which company is going to be the leader in AI. So, out of these disagreements, kind of speculation, and bubbles can come out of this phenomenon as well. That would be the other side of innovation. We're totally high-stock prices because of speculation and partly high-stock prices because the innovation is good.

Ben Felix: We're going to come back to that in a sec. Your research on that is super, super interesting. We're going to dig into it more. But before we go there, what regulatory interventions do you think, if any, do you think makes sense to address what's going on with index funds?

Valentin Haddad: The first thing I'll say is there's one dimension we haven't talked a lot about, and maybe it's my fault. The first I'll talk about index funds is where a bunch of people are investing in random stocks and forget about how the market works, just for their own personal consequences, taking a lot of risks, and I'm not doing that. I'm a finance professor, like what every finance professor has always stood for the past 50 years, is we should all invest in index funds.

So, I first saw that this is a massive game of welfare, a massive positive of passive funds. Even if my research points that there can be other consequences, and some of those consequences might be negative, I think we should not forget the elephant in the room. That is, for many individuals' life, this has been progress. My sense is a question of regulation, and so they're not quite yet fall today. They're on the horizon. It's like, if passive funds become more 5%, 10% to 40%, if it will go to 60%, 70%, 80%. This might become a prime. We might see bigger spikes in volatility. We're at GameStop a few years ago, in the past month, as well. Those things might multiply, might happen more frequently, and might become a concern. I've been thinking about doing research on this to try to know when it's going to become too much. But I think it's hard to forget the part of the trade-off that it's just, the vast amount of people are just much better off out of more passive investing. The market might be a little bit different, and we should pay attention to that. But that's not necessarily the dominant effect. This example of maybe [inaudible 0:30:56] on large stocks. Of course, if you die at a massive crash, it could have big consequences.

If the stock market crash, it could really be cleaner on passive fund, maybe. But I think it's way too early to think – I mean, this is not impossible, but it's very, very possible at this stage, at least in my mind. I hope I've not been wrong too fast.

Ben Felix: You mentioned that we hadn't talked about the benefits of index funds yet. I would say that's a key message of our last – this is episode 314 of our podcast. I think the reason we didn't ask what that specifically is because we've talked about it so much already. We definitely agree with that message.

Valentin Haddad: That doesn't mean we shouldn't worry about market crashes that are not always look rational are big for them. Even booms, and busts, mispricing, all these things are big consequences. They can make firms invest in the wrong direction. I think these concerns with passive investing are meaningful. I don't think it's quite yet the time for a very strong regulatory call. Regulators should keep track of this evolution. I think a few years ago, there was a proposal to get rid of stocks in the filings or the publication of stocks in their filings. We can't tell anymore what large investors are doing or what most investors are doing. I think this type of information is important and is quite relevant to keep track of. But in terms of corrective action of preventing people from investing passively, I don't think that time has come yet.

Cameron Passmore: Just to finish up on this section, what do you think individual investors should do with this information?

Valentin Haddad: It depends on how informed they think they are, I would say

Ben Felix: That's such a good answer.

Valentin Haddad: That goes back to this like two-sided aspect. Of course, you can become passive. If anything, that's telling you, because markets have become more fragile. If you don't know too much, you should become more passive. The more other people are passive, the more markets are messy, and how to understand, the more as somebody who's not informed, you should go and be passive. Uninformed doesn't mean that you know nothing. That sounds like demeaning. It's the people who are very informed markets are extremely sophisticated. So, it's small, relatively uninformed. The flip side again is, there are more opportunities, they might be hard to find. But there are more opportunities.

Actually, for a long time, we think trading in traditional stocks is not a great idea. The more I look at these results, the more I think, "Well, maybe it's not that bad an idea that you focus on something you try to learn about it." Of course, it's not an idea for everybody, and you need to have a way to get information. Sorry, I don't mean to say no. We should live in a world where everybody's trying to pick stocks. But there's something to this to try to identify situations that large groups are into this. So that means, again, less investors around trying to identify these situations than before. So, there has to be some spots in the market that are profitable. I'm not going to tell you how to find them. I don't know how to find them, but maybe somebody can know how to find them.

Ben Felix: Somebody's going to find them, maybe. Maybe not the active funds. Maybe if index funds are growing, active funds are becoming less active. Maybe there are more opportunities for informed individual investors.

Valentin Haddad: Is to be able to kind of [inaudible 0:33:53]. If you think about what happened with GameStop, to me, it's around the US that there was a bubble on GameStop and so on. That is like, the short squeeze that happened, this idea that like while a bunch of investors can go and targets this short and break this shop. You couldn't imagine a few years ago, a couple of IT investors do it. This was something that was led by individual investors. We can have debates on whether shorts squeeze should happen, whether they should be forbidden.

This is not my point. My point is, this was possible that this happened. I think, if you ask most people before it happened, whether this is possible, I think they will say, "No way." For two reasons, I think investors cannot matter for anything, but we also have said, if there was a good deal to be made there, active investors would take advantage of it.

Ben Felix: All right, I want to move on to the bubbles and innovation research. I love this topic and this paper is very cool. How do you define bubbles in your research?

Valentin Haddad: Indirectly, we don't try to be the true [inaudible 0:34:49] that we know it's going to be about learning events. We use the method that someone in our research group came up with and say well, if it looks like a bubble, if it sounds like a bubble if it smells like a bubble, then there's a good chance it's a bubble. Of course, we tried to be not forward-looking. So, it's all based on backward-looking measures that we don't [inaudible 0:35:06] in a way and just define it all by the [inaudible 0:35:09].

We look at industries where there's s been a big, big price ramp-up over the past three years, and at the same time, has been be increasing trading volume altogether. So, what other people have shown is that, this is not a perfect way to detect a bubble. There will be lots of false positive. But on average, this is much more likely to be a bubble than it typically [inaudible 0:35:31] this kind of titles. It's a way to say – well, all of us will look at markets and say, it's a bubble, or it's likely to be a bubble, that's what we call bubbles in the data. In our theory for a bubble is why people speculate, disagree, and make prices being too high.

Ben Felix: You're taking industry portfolios, and then defining a bubble as an industry that's had a big price run-up at a big increase in trading volume.

Valentin Haddad: I should have looked at the monitor recently, but I think in the past two years, almost a big run-up. I think it need to be both a big run-up for the industry and relative to the index. We cannot be just at the whole index is climbing it.

Cameron Passmore: How do you measure the value of an innovation?

Valentin Haddad: We leverage some research, but other people have done, but that's kind of a cool idea. First, we should think of, how to measure the value of innovation. Something like ChatGPT comes out, we all have suddenly, it's extremely valuable. But how valuable is it? One simple way to define that is saying, "Well, what are the consequences of this innovation?" So, you're going to see – keep track of all the profits that OpenAI is going to make. That's the way you can pull the private value of innovation. So, to the innovator, there are social value also, that all people will make more profits. So, you can think about this in your head, measuring the profits of OpenA is okay, the other people's profits from this innovation already gets tricky. But you can start thinking through that.

The idea that we're leveraging up, and that is something that we're going to criticize is to say, well, you can try to use the stock market. You could say, well, the day when OpenAI released ChatGPT. So, formally, what we do is take a day while the USPTO approves a patent by a firm, and looks at how much the price of that firm goes up when this patent is approved. The total market capitalization is telling us how much value was created by this patent being approved and released. That's also the reason that you pay a lot of attention to those releases. That's the way to measure the value of the innovation.

Ben Felix: That's the market value of innovation.

Valentin Haddad: That's what we call, yes. So, in the beta, we try to separate those two values. In the ideal world, those two numbers are the same in a way. The actual realized value – not actual realized value. Expected realized value and the market value. We try to measure the two together to see, well, do they always line up? I mean, [inaudible 0:37:40] innovation. So, that's when we really need those measures, there's a lot of speculation and we start to worry that market prices might be off.

Ben Felix: How does the market value of innovation change during bubble periods?

Valentin Haddad: Because we all know during a bubble, the market values go up. That's not what we measure. We measure how much the price changes after the release of innovation. But it turns out, those are big as well, the market does price everything bigger. So, we see these big reactions to innovation. Part of which should not be unexpected, and that we're in big waves of innovation, the innovations are better. So, we should see the markets value of those innovations better. When we've kind of find out, both to kind of theory and try to look at different measures is that, it looks like it's too much. So, it looks like this price increase are larger than what's justified by those subsequent performance of those innovation.

Ben Felix: That is super interesting. So, the market tends to respond positively to patents, but during bubbles, the response is more extreme.

Valentin Haddad: Yes. If you look at, for example, how do the profits of a firm respond to a patent. It also responds positively subsequently, but not more so after all or during. So, it's thinking of this disconnect. The market starts to value things a lot, even though they don't have better consequences.

Ben Felix: What effect does innovation have on real outcomes?

Valentin Haddad: What we find is that, the market, although values innovation relative to the gain they provide in terms of actual real outcomes, profits, sales.

Ben Felix: They produce good real outcomes, but when you look back, the stock prices react more positively than they should have.

Valentin Haddad: Yes. Exactly.

Cameron Passmore: How are competitors of the innovative firm affected by the innovation?

Valentin Haddad: That to us was, that really made us think that it has to be a bubble. When I do an innovation and you're my competitors, this becomes a bad news for you, typically. Because they warn you, you can be the main innovation, but, first of all, I step ahead of you. So, competitors tend to suffer. If you look at a bubble, you see this phenomenon, you see the stock price of competitors drop, and when your patent is approved, and you also see subsequently the sales of those competitor, and the profits of those competitors will go down. If you look during bubbles, in the real outcomes, you see that the sales will suffer, you'll see that other outcome will suffer. But then, you don't see a stock price reaction. The market is giving too much credit to the firm they innovated, but it's not punishing the firms that are suffering, that are kind of the losers of these innovation process.

Ben Felix: Well, that's because they're in the same bubble industry.

Valentin Haddad: The way we studied this is actually by trying to dissect a little bit, what does it mean to be on a bubble? How do bubble pricing work? So, maybe it's trying to be like – bubbles are not just a big mess where people value everything. The overvaluation is an outcome. But we thought maybe that was kind of method to this madness of the bubble. Looking at [inaudible 0:40:38] was something based on disagreement, that different investors have different views on who are going to be the winners. If we go back, well, talking a little bit about AI. I might believe that OpenAI is the other ones that are going to be the big successful innovators. You might believe that Meta is going to get all the profits.

What this does is that, what I'm going to be doing, invest in OpenAI naturally, and Cameron is going to invest in Meta. We start to get the specialization of investment, when it's kind of like fan clubs for value stocks. And of course, the fan clubs of each stock is investing in that stock. So, now, if you start thinking what happens when you get good news about open AI, the people who are valuing it are people like me who love OpenAI. Then, the stock price of OpenAI is going to climb up like crazy, because I already knew open AI was amazing. I get this good news, it's so amazing.

You're the one that [inaudible 0:41:26] for Meta. You hear about OpenAI, and you go, "Well OpenAI sucks. Who cares? I know Meta is going to be the best, so they can innovate. It doesn't matter to me. Why would I worry?" It is a bit like, we're going to run a race, and we each think we're the best in the race in a way. If Cameron thinks he's going to win, and I break my leg, he still thinks he's going to win. If I get better shoes, and I run faster, he still thinks he's going to win. That's how you get that, the competitors don't respond in a ways, that everybody has strong belief into their own firm, and competitors don't worry, and the firm that innovates gets all the gains.

Ben Felix: That's really interesting. It's like the cult of Tesla concept.

Valentin Haddad: Yes, exactly. Yes. You see both the cult of Tesla, and the competitors don't suffer that much. So the cult of Tesla is going up so much. It's not like we show for Tesla specifically. But if you apply this, so the color of this light is so good. But people like Ford so much, people who invest in Ford like Ford so much. They think electric cars don't matter. So, Ford didn't suffer too much.

Cameron Passmore: What are the implications of this research for innovation policy?

Valentin Haddad: It depends how much innovation you think we should have. Maybe the most common view is, innovation is always good in the end. What underlies that view is this idea that there's always going to be good spillovers to innovation. We get better computers, that's going to be good [inaudible 0:42:42] or whether I can have a better computer. But over time, all of us will get more computing power, everything will get better. And of course, when you show the person trading the computer, you don't get gains from those spillovers. There's a common view that there is just not enough innovation. So meaning, that few bubbles are kind of good news, because they amplify the incentives for innovation, they create more incentive for innovation. You can ride a bubble, and get extra gain in terms of market capitalization. That's the positive view.

So to say, well, as innovation policy, you should be aware there's a bubble. You shouldn't overestimate how much innovation is going on. But at the same time, it's good news that innovation is stimulated. The flip side is that the bubble can create over-investment. If you're not necessarily so convinced that we always need more innovation, we always need more investment. If we go back to Tesla, for example. We said, it's great. This huge Tesla, completely accelerated with the amount of electric car. The issue though is, it doesn't belong. So, people will lose their job, Tesla will suffer subsequently compared to the peak. We see sales go down, we see jobs being lost, and these are real consequences that are some fragilities, and we should also be concerned.

The first alarm message or policy maker was more, watch out in a way. You can gain from bubbles, but at the end, the end of the bubble comes. The long-term gains of innovation are still there, but many people who partake in the bubble are going to suffer a lot. So, you would have to balance those aspects.

Ben Felix: What are the implications for investors hoping to earn high returns by investing in innovative firms?

Valentin Haddad: Be careful. This is an extremely common pattern. We went back to a lot of history actually, like we tried to read a lot about this. When we talk about the bubble, [inaudible 0:44:22] bubble, things that are like bubble on goods that don't matter, like [inaudible 0:44:27]. But it turns out, a lot of bubbles look more like tech bubbles. There's something new and exciting. It's clearly good, it's clearly valuable, and people rush to try to develop the technology. Sometimes you win because the technology comes to fruition. But often, there's overvaluation along the way, prices drop subsequently.

The other thing to me that it's important to realize is it's really difficult to pick winners. As AI has been developing, that's what keeps coming to my mind. OpenAI is a nice and huge firm, and I have nothing negative to say about them. I don't know that much to be honest. It depends who win in four years. Is OpenAI going to be the leader of AI? Who knows? I was thinking like, go back to the beginning of online commerce. We saw like eBay was going to be the big online commerce. I think eBay was a cheerleader. [Inaudible 0:45:15] one.

Even if you're betting on the right technology, I think we have a bias of like – thinking we can identify who's going to win, and that's something to avoid. I will say, if you want to bet on AI today, that is risky, because of [inaudible 0:45:31] bubble, I would say. But also, don't try to pick winners, you will have lots of failures along the way.

Ben Felix: There tends to be crazy skewness in technology bubbles, it's like what you said. If you're right about the industry, it's going to be one firm that drives most of the value creation, and you can't know which one is going to be.

Valentin Haddad: People have different biases or different priors in our devaluated. I think many people would say, open AI is the first one. So, they're going to be ahead of everybody else. I think historically, there is no evidence that this is true, but many people would think like that, I would say. Maybe a lot of people would think, "Well, for example with Meta or Google, they have a long track record of success in technology, so they will be able to take them over." That's also possible. But again, not clear that that happens. Often, we see new firms come out. That part I think is the part that amplifies the bubble in a way, and is quite dangerous for investors. I think that investors often don't realize.

Ben Felix: All right. I want to move on to one more paper of yours that's in the review of financial studies on fixed income during COVID-19. Another just fascinating paper. Can you talk about what happened in the US investment-grade corporate bond market in March of 2020?

Valentin Haddad: It blew up. COVID was a terrible time for humanity, I think. Something that happened is that, starting in late February, March 2020, as the pandemic was expanding, markets started to crash. This is a really unprecedented crash due to experience. The one I think many people paid attention to at that time, just because we're used to follow the stock market was the stock market. So, the stock market drops a bit more than 30%, and maybe even quite a bit more than 30%. Although, a few weeks, if you go back to 2008, for example, it was a massive stock market drawdown, but it took six months, nine months. The bottom of the market was in March then, six months later. This was just a few weeks.

That's already a pretty strong event. But what we found out is that, if you look at corporate bond [inaudible 0:47:18], we looked at investment grade corporate bond, so the safest of corporate bond. Their price dropped nearly 20%. That's unprecedented because stock prices are extremely volatile. But bonds, we expect them to be safe and safe bonds are really safe. That almost never happened before in such extreme, extreme movements. That [inaudible 0:47:35]. You have to imagine, this is a big lockdown, and we're back in hotels, we're locked at home, and we look at the news every day, the financial news every day, and we see this happening. We have done a lot of work before our financial institutions can create crises. We have done a lot of work around certain crises and so on. But it looks like nothing we had seen before, so we wanted to dig into this some more.

Cameron Passmore: How did the response in the bond market differ from the credit default swap market?

Valentin Haddad: A simple way to think about bond prices [inaudible 0:48:03] prices. Well, the price is going to be down, the company is likely to default. That will be the natural explanation, at least at first glance for this price. So, well, we're going to have a big recession due to COVID, many firms are going to go bankrupt, so that's why we see the price go down. But there's another place where you can get that information, that's the credit default swap market. So, the contracts where investors buy and sell insurance against default. Insurance is expensive. That means that, likely, the company is likely to leave.

We didn't see the price of the insurance go up during that period for that segment. Price went up a little, I shouldn't say we didn't see it go up, by a small amount. To give you a concrete example, and that's kind of my favorite example of disparities, is to look at Google. Google is an extremely sad company. Before even I tell you any price number, there was no reason to believe COVID-19 was going to do harm to Google. If anything, we all spend more time on computers, this was good news for Google. If you look at the CDS, or the credit default swap for Google, the price didn't move. I think maybe because of a few basis points between [inaudible 0:49:01]. Something like 50 basis points. It went up a little bit. But if I show you the plot, it looks pretty flat.

The price of a five-year Google bond went down to pretty much 80 cents on the dollar. That looks like it's pricing a massive risk of default for Google. Once you look at everything else, you don't see this risk of default. We like credit default swaps, because it's also a price, it's also in the market, and you didn't see this price move. You just see the price of the bond itself go down. That's something that told us that something wrong was going on in markets, more so than with the way markets worked, more so than Google itself.

Ben Felix: Man, that's interesting. You see the bond prices tank; you think it's the price of risk is increasing. But then you look at another place where you can see the price of risk and it hasn't actually changed that much. What was causing the crash and bonds then?

Valentin Haddad: Natural gas. People don't want to buy bonds. Most of the people want to sell bonds, but it's not because the bonds themselves are risky. It is because people want to offer positions. That's why you got a massive fire sale going on in this market. So then, we tried to ask ourselves, well, where are the investors setting and how come this has such a big effect? There are a few dimensions you can point to. The biggest one, and even off topic, well, people have done most studies. I think that's the one that's the most important, is that bond mutual funds sold a lot of positions. So, a lot of bond mutual fund expands very large outflows. While a lot of them did not even form specialized bond, safe bonds, but a lot of mutual funds would sell that sector bonds first. You have to manually try to make some investment grade high yield bond, you get a big outflow. It turns out, the funds chose to sell the more liquid bonds first. Usually, more liquid bond first.

All those funds went to like a simple rule of thumb. That is, by the way, a good rule of thumb 99% of the time. That is, if you have to liquidate, sell liquid assets. But it is so much so that then the liquid data you're rated are done in those markets. That's one big aspect. That's unprecedented because until 2008, we didn't have very big bond mutual funds in the US. There are some big ones, as we know, PIMCO was actually going to fund all this stuff. Most mutual bonds were held to insurance companies, to much more stable institutions. After 2008, we saw this big raise of bond mutual funds, and that is completely kicking back the economy because we do outflows that are just massive sales.

Cameron Passmore: Why weren't market participants stepping in to buy the bonds as these prices fell?

Valentin Haddad: So, you have to ask yourself, "Well, who can step in?" One category that historically plays a role [inaudible 0:51:32] are dealers. The bond dealers, so you think about like large investment banks. Historically, they intermediate a lot of the trading in this market, and so they will say, "With an active crisis, we're going to buy those bonds, keep them on our balance sheet for today, until we pull down, and we put it back."

In this case, there are two concerns I think that prevents this from happening. One is, the false reality cannot intermediate as much as they used to, we just have much more regulation in the market preventing that. The other one is that this crisis and the pandemic, and it did last quite a long time. So, there was a sense that even though it's very acute, it can be a long-lasting problem. What we'll need is investor that can weight it out. That kind of kicked out the dealers, even when the dealers didn't want to take on assets for a long time. There was a lack of this long-term absorption capacity.

Now, you could look for other investors. You could say, "Well, maybe insurance companies could step in.” Insurance companies, a lot of them didn't step in. So, they definitely didn't want to step into much. They tend to be much more stable in terms of their inflows, outflows, and bond funds. But they start to worry, because as the price of the bonds drops, if it drops too much, the company will go bankrupt. So, it seemed like they were worried, and not that we are into bad space. Some did positive, I think, I might be quoting the wrong one, but I believe like MetLife, for example, did come into this market a bit during that time. But just not nearly enough to stabilize the market, there was not enough capacity to come in. So, what was needed at this point was to come in on short notice and be able to coordinate this. I'm going to come in, I'm going to hold up throughout the pandemic. It seemed like not many investors were willing to do it. Something interesting.

We even talked to pension funds, large pension funds. I guess I cannot tell you which one. The large pension funds, they asked us to come talk about these results. What was interesting is that, the people managing the fund talking to us, "We knew this. We knew they work with this. We could see those good deals. But it's just, our management was like, 'No, it's the crisis. We're not going to suddenly start to switch our policy.’" So, there was also just a bunch of frictions in a way that make that – a lot of investors cannot move into a market that fast.

Ben Felix: Wow. That's super interesting. Sounds like a job for the Fed. What effect did the Feds intervention have?

Valentin Haddad: The Fed did step in. They said, they might step in, I should say, to be precise. What happened is, the Fed did something that never did before. They stepped into the [inaudible 0:53:48] markets. In 2008, the Fed did QE, so that was one of the first time they will say, "Well, we buy long term treasuries, we buy mortgage-backed securities." But even after that, I think most people saw this was very limited to treasuries or treasury life securities. I think there was always this idea that you shouldn't participate in stock market, you shouldn't participate in corporate bond, you shouldn't start to decide which firms are doing better. But in a pretty unexpected way, they just stepped in and they said, "We're going to create those institutions." Which was the primary market, create facilities in the primary market, create facility. We're going to upsell with those bonds. So, that felt they could buy up to $300 billion of investment-grade corporate bond. Later, we're going to expand it in different dimensions up to $800 billion dollars. So, that's a big step in. The day they announced that, the market recovers. I think about a third of the crash recovers just that morning.

Ben Felix: Is that good for markets?

Valentin Haddad: I tell you briefly about some other people we've done, and that's going to [inaudible 0:54:45] good or bad, that's going to amplify the debate, I think. They said, we can save you up to $300 billion, and later, we can save you up to $800 million. The market did recoil, and you told that the Fed never really stepped in. The Fed reports something like $14 billion of assets. By the fall 2020, the Fed is not owning any corporate bond anymore.

What we think is that, well, that was a possibility that the fire sell could get even worse. What the Fed did really was, say, "Well, I'm willing to do whatever it takes to fix it." It turns out the pandemic was not as bad as people thought it could get. It was extremely bad, just to be clear, but it was not as bad as we thought it could get. So, we did most of the final intervention, it did not happen. It could have happened, but it did not happen. Why does that make things kind of worse or more stressful, is that the positive side is that, well, that's great, they can stabilize market and the expert didn't do much. Then, there's not much cost.

The worrisome part is, well, they might be willing to step in again. Now, they can kind of like open Pandora's box and credit these commitments. Now, that's another form of faith boots that it will always step in when things are risky. We try to look at a bit in that subsequent research, do we see traces on that. We see some traces that suggests a little bit of this. So, if you look since 2020, after the pandemic cooldown, the price of investment breakup. I don't know if anything seems too high. It's hard to tell. But if you took it off casually, to whatever investment grade bond trader, I don't know today. I haven't talked to them recently.

Even a year or two ago, the Fed is in this market somehow. Even though they're not intervening, it has a view that the possibility of the Fed steps in is just propping up the market. That can be worrisome. That creates more [inaudible 0:56:24], that creates issues that the Fed's stepping in too much. At the same time. Markets are not perfect. The crash to south wave is not an efficient market phenomenon that we want to let happen. It makes sense that we want to fix this. The reason they step in so fast is that they don't want 2008 to happen, they don't want this to spill over somewhere else.

To me, I view it more as like as a cost-benefit trade-off. At least in my mind, we are past the world says, the Fed should never intervene in markets. We should always respect market. When I look at this episode, everything screams that something wrong is going on in the organization of markets, that there are frictions, and it makes sense for a policymaker to enter. The problem is that once you come in once, you build commitments to come in again, and those commitments might be costly, and that we know anytime when it does.

Ben Felix: It's a great answer to the question, but it highlights how messy this system is.

Valentin Haddad: Extremely messy, yes.

Ben Felix: Crazy. What do you think the implications of this research are for the safety of bonds in a crisis?

Valentin Haddad: What we learned I think from this episode is the corporate bond market is much less stable maybe that it used to, and that we thought it was. It's been a big debate, actually, before even that crisis. Even before the crisis, that was a big debate. But if you look at everything about the corporate bond market, it looked much better than before. It was much more liquid, bid ask spreads was small. It's because, bond mutual funds, ETFs, also like that, the way we have big rolls of bond ETF, so everybody's trading bonds. The market looks like it's better. What we learn is that, this liquidity is very fragile in a way, that is kind of this big outflows. We can destroy everything on their way.

That's one lesson, the lesson of how to fix it. To us, we keep going back to this thing that what we need is not just better intermediation. So, a lot of the lessons from 2008 was intermediation is really important. We need to have good trading system, we need to be able to move those bonds around fast. In that case, to another question of moving the bonds around. It was that, we need debits to hold those bonds. People often use this analogy, the types of finance matter a lot. In my mind, that's not the problem. The problem is not the type. We need like one whole tanks. We need a whole tank to hold the assets for a long time. Now, we're like three years out, we've made big progress in adding those. So, I will still be quite concerned for the stability of those markets. Well, we do have a lot of the negative shock. The shock was not starting in corporate bonds, it was just a broader economic negative shock, and it just propagated in this market.

Ben Felix: What do you think is a safe asset in a crisis?

Valentin Haddad: So far, treasuries have done okay. Even treasuries, there was some notion that there's a safety premium on treasuries, typically, that this premium was getting even negative that people just needed cash. COVID was special in some sense. This episode really highlighted some projects in the corporate bond market. It's not that many crises will look COVID prices of cash, really. There was always a sense but at that point in time, that a big consequence is, that businesses are going to be closed for a while. This is why we have to shut down for a while and open later so that you need cash. That's the only thing you need. You need to like survive for a few months. The only safe asset was cash. That is from the point of view of investors.

This all happened much faster in the horizon that we need the cash, but that's what I think everybody was looking for. Which instead of, it will never happen again. But this is very specific as to this type of crisis. In many other recessions, even last recession, last crisis don't look like that. So, I think, safer assets can hold their safety in those times.

Cameron Passmore: Our final question for you, Valentin. How do you define success in your life?

Valentin Haddad: I think, I don't think about success that much. I think about happiness. I might have you – right now, am I setting myself up to be happy? I don't really have a very final goal. I feel like when you talk about success, it's like a final goal. I'm trying to enjoy the journey. A lot of this happiness is at home. I have a wife that I love and a daughter that I love, and we spend a lot of time spending together. In my work is kind of the same. I enjoy the journey a lot. These are very important question. I hope I can contribute to the world and to do the conversation, but I also enjoy the process of working through those questions. That's my two cents to those questions.

Ben Felix: It's a great answer.

Cameron Passmore: It's a great answer, for sure. Great to have you, Valentin. This has been an incredible conversation. Thanks for your knowledge.

Valentin Haddad: Oh, thank you for having me. This was really fun.

Ben Felix: Awesome. Thanks, Valentin.

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Participate in our Community Discussion about this Episode:

https://community.rationalreminder.ca/t/episode-314-professor-valentin-haddad-how-competitive-is-the-stock-market-episode-discussion/31035

Papers From Today’s Episode:

‘How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing’ — https://dx.doi.org/10.2139/ssrn.3821263

‘Concentrated Ownership and Equilibrium Asset Prices’ — https://www.stern.nyu.edu/sites/default/files/assets/documents/Princeton- Haddad - Concentrated ownership.pdf

‘Bubbles and the Value of Innovation’ — https://drive.google.com/file/d/1tnvZ5L_zUcehn5hR720Nl1vtsTv4VgK0/view

‘When selling becomes viral: Disruptions in debt markets in the COVID-19 crisis and the Fed’s response’ — https://doi.org/10.1093/rfs/hhaa145

‘How Speculation Affects the Market and Outcome-Based Values of Innovation’ — https://ideas.repec.org/a/fip/fedreb/94686.html