“Asset prices should equal expected discounted cash flows. Forty years ago, Eugene Fama (1970) argued that the expected part, “testing the efficiency of the market”, provided the framework for organizing research on asset valuation at that time. I argue that the “updated” part better organizes our research today.
“I start with facts: how discount rates vary over time and across assets. I pass to the theory: Why discount rates vary. — John H. CochraneSenior Fellow, Hoover Institution, Stanford University
In his 2011 Presidential Address to the American Finance Association, John H. Cochrane explores time-varying expected returns. As David DeRosa writes in Bursting the bubble: rationality in a seemingly irrational marketCochrane “seeks to explain subsequent long-term common stock returns with current dividend yields”.
In times of depressed returns or high valuation ratios, Cochrane’s full address is worth revisiting.
So what is its underlying thesis?
Cochrane postulates a pattern of predictability in markets — that a return or valuation ratio translates directly into expected excess returns for all asset classes and has both a strong common element and a strong economic cycle component.
Although his presentation is titled “Discount Rate”, he observes that “discount rate”, “risk premium” and “expected return” are actually the same thing. Cochrane claims that discount rates vary over time and supports his argument by modeling common stock returns with current dividend yields in a regression, similar to Shiller’s regression.
It analyzes annual data as well as five-year holding periods, and while R2 of the regression is not particularly robust, the regression coefficient is actually quite large. This indicates that yields vary significantly with the dividend yield. Cochrane asks the question: “How much do expected returns vary over time?”
Moreover, the R2 increases over time. For what? Cochrane explains that “High prices, relative to dividends, surely preceded many years of low returns. Low prices preceded high returnss.”
This predictable trend applies to all markets, according to his analysis. A yield or valuation ratio transforms one for one into expected excess returns for stocks, bonds, credit markets, currencies, sovereign debt and homes. Cochrane describes this as follows:
- In the case of housing, higher price-to-rent ratios do not anticipate permanent prices or rising rents, but simply low returns.
“There is a strong common element and a strong business cycle association to all of these forecasts,” says Cochrane. “Low prices and high expected returns continue in “bad times”, when consumption, production and investment are low, unemployment is high and businesses fail, and vice versa.
What is the big lesson that investors can learn from these discoveries? My response is that the Cochrane research on time-varying expected returns is essential. In practice, we can incorporate Cochrane insights into our applied asset valuation models.
And in today’s “seemingly irrational” markets, we can also maintain a sense of humility. As Cochrane observes:
“Discount rates vary a lot more than we thought. Most of the puzzles and anomalies we face correspond to variations in discount rates that we don’t understand. »
For more information on the Cochrane Fellowship, among other topics, don’t miss »Cochrane and Coleman: The Fiscal Theory of Price Level and Inflation Episodes” And Bursting the bubble: rationality in a seemingly irrational marketof CFA Institute Research Foundation.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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