“Asset prices should correspond to expected discounted cash flows. Forty years ago, Eugene Fama (1970) argued that the expected part, “testing market efficiency,” provided the framework for organizing asset pricing research during this era. I argue that the “discounted” part higher organizes our research today.
“I’ll start with the facts: discount rates vary over time and depending on the investment. I turn to theory: discount rates vary.” — John H. CochraneSenior Fellow, Hoover Institution, Stanford University
In his 2011 Presidential Address to the American Finance AssociationJohn H. Cochrane studies time-varying expected returns. As David DeRosa writes in, Cochrane “attempts to explain the subsequent long-term returns of common stocks in terms of current dividend yields.”
In times of low returns or high valuation ratios, it’s value re-reading Cochrane’s full address.
So what’s his underlying thesis?
Cochrane posits a pattern of predictability across markets — that a return or valuation ratio translates directly into expected excess returns for asset classes and has each a powerful common element and a powerful business cycle component.
Although his presentation is titled “Discount Rates,” he notes that “discount rate,” “risk premium,” and “expected return” are literally all the identical thing. Cochrane argues that discount rates vary over time, and supports his point by modeling common equity returns with current dividend yields in a regression, much like the Shiller regression.
He analyzes the annual data in addition to the five-year holding periods and through 2 Although the regression is just not particularly robust, the regression coefficient is definitely quite large. This suggests that the return depends significantly on the dividend yield. Cochrane asks, “How much do expected returns vary over time?”
Furthermore, the 2 increases over time. Why? Cochrane explains that “s.”
According to his evaluation, this predictable pattern applies to all markets. A yield or valuation ratio converts one-to-one into expected excess returns for stocks, bonds, credit markets, foreign exchange, government bonds and houses. Cochrane describes this as follows:
- In the case of residential real estate, higher price-to-rent ratios don’t mean permanently higher prices or rising rents, but simply low returns.
“All of these forecasts have a strong common element and a strong connection to the business cycle,” explains Cochrane. “Low prices and high return expectations also apply in “bad times” When consumption, production and investment are low, unemployment is high and businesses fail and vice versa.”
What’s the large lesson investors can take from these findings? My answer is that Cochrane’s research on time-varying expected returns is important. In practice, we are able to integrate Cochrane’s findings into our applied asset pricing models.
And in today’s “seemingly irrational” markets, we may maintain a way of humility. As Cochrane notes:
“The discount rates vary much more than we thought. Most of the mysteries and anomalies we face are due to discount rate fluctuations that we do not understand.”
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Photo credit: ©Getty Images / Anthony Harvie
