“Asset prices should equal expected discounted cashflows. Forty years ago, Eugene Fama (1970) argued that the expected part, ‘testing market efficiency,’ provided the framework for organizing asset-pricing research in that era. I argue that the ‘discounted’ part better organizes our research today.
I start with facts: how discount rates vary over time and across assets. I turn to theory: why discount rates vary.” — John H. Cochrane, Senior Fellow, Hoover Institution, Stanford University
In his 2011 Presidential Address to the American Finance Association, John H. Cochrane explores the concept of time-varying expected returns. As noted in the article by David DeRosa, titled “Bursting the Bubble: Rationality in a Seemingly Irrational Market,” Cochrane seeks to explain the subsequent long-term returns on common stocks using current dividend yields.
During times of depressed yields or high valuation ratios, it is worth revisiting Cochrane’s address to gain insights.
So, what is Cochrane’s underlying thesis?
Cochrane suggests a pattern of predictability in markets — where yield or valuation ratios directly translate to expected excess returns for all asset classes, comprising both a strong common element and a strong business cycle component.
Although Cochrane’s presentation is titled “Discount Rates,” he highlights that “discount rate,” “risk premium,” and “expected return” are essentially the same thing. Cochrane posits that discount rates vary over time and supports his point by modeling common equity returns with current dividend yields in a regression, similar to the Shiller regression.
His analysis includes both annual data and five-year holding periods. While the R-squared value of the regression may not be particularly robust, the regression coefficient is quite large, indicating significant variation in returns based on the dividend yield. Cochrane raises the question, “How much do expected returns vary over time?”
Furthermore, the R-squared value increases with time. Cochrane explains this phenomenon by stating, “High prices, relative to dividends, have reliably preceded many years of poor returns. Low prices have preceded high returns.”
According to Cochrane’s analysis, this predictable pattern holds true across all markets. A yield or valuation ratio transforms one-to-one into expected excess returns for equities, bonds, credit markets, foreign exchange, sovereign debt, and housing. Cochrane elaborates on this concept as follows:
- With housing, higher price/rent ratios do not anticipate perennially higher prices or increasing rents but simply low returns.
“There is a strong common element and a strong business cycle association to all these forecasts,” Cochrane explains. “Low prices and high expected returns hold in ‘bad times,’ when consumption, output, and investment are low, unemployment is high, businesses are failing, and vice versa.”
What is the key lesson that investors can extract from these findings? The answer lies in the importance of Cochrane’s research on time-varying expected returns. In practice, we can incorporate Cochrane’s insights into our applied asset-pricing models.
Moreover, in today’s “seemingly irrational” markets, it is crucial to maintain humility. As Cochrane observes:
“Discount rates vary a lot more than we thought. Most of the puzzles and anomalies that we face amount to discount-rate variation we do not understand.”
For further insights into Cochrane’s scholarship, along with other relevant topics, don’t miss “Cochrane and Coleman: The Fiscal Theory of the Price Level and Inflation Episodes” and “Bursting the Bubble: Rationality in a Seemingly Irrational Market” from the CFA Institute Research Foundation.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice. Additionally, the opinions expressed do not necessarily reflect the views of CFA Institute or the author’s employer.
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