“Asset prices should equal expected discounted cash flows. Forty years ago, Eugene Fama (1970) argued that the expected part, “testing for market efficiency,” provided the framework for organizing the research of asset prices at that time.I argue that the “discounted” part best organizes our research today.
“I start with the facts: how discount rates vary over time and across assets. Moving on to the theory: Because 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 time-varying expected returns. As David DeRosa writes in Bursting the bubble: rationality in a seemingly irrational marketCochrane “aims to explain long-term trailing returns on common stocks with current dividend yields.”
In times of depressed returns or high valuation ratios, it’s worth reviewing Cochrane’s full address.
So what is their underlying thesis?
Cochrane posits a pattern of predictability in all markets — that a return or valuation ratio translates directly into expected excess returns all asset classes and includes both a strong common element and a strong business cycle component.
Although his presentation is titled “Discount Rates,” he notes that “discount rate,” “risk premium,” and “expected return” are really the same thing. Cochrane claims 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.
It analyzes annual data as well as five-year retention periods, and while the R2 of the regression is not particularly robust, the regression coefficient is actually quite large. This indicates that returns vary considerably with the dividend yield. Cochrane asks the question, “How do expected returns vary over time?”
In addition, the R2 rise with time Because? Cochrane explains that “High prices, relative to dividends, have reliably preceded many years of poor returns. Low prices have preceded high performances.”
According to their analysis, this predictable pattern holds across all markets. A yield or valuation ratio transforms one-for-one into the expected excess return for stocks, bonds, credit markets, currencies, sovereign debt and housing. Cochrane describes it as follows:
- With housing, higher price/rent ratios do not predict perpetually higher prices or rents, but simply lower yields.
“There is a strong common element and a strong business cycle association to all these forecasts,” explains Cochrane. “Low prices and high expected returns persist in ‘bad times,’ when consumption, production, and investment are low, unemployment is high, and firms are failing, and vice versa.”
What’s the big lesson investors can take from these findings? My answer is that the Cochrane research on time-varying expected returns is essential. In practice, we can incorporate Cochrane’s insights into our applied asset pricing 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 represent variation in the discount rate that we don’t understand.”
For more on Cochrane’s scholarship, among other 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 marketfrom 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, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Sebastian Petric, CFA
