Time-Varying Risk Premia: Cochrane’s “Discount Rates”
“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 time-varying expected returns. As David DeRosa writes in Bursting the Bubble: Rationality in a Seemingly Irrational Market, Cochrane “seeks to explain subsequent long-term returns on common stocks with current dividend yields.”
In times of depressed yields or high valuation ratios, Cochrane’s full address is well worth revisiting.
So, what is his underlying thesis?
Cochrane posits a pattern of predictability across markets — that a yield or valuation ratio directly transforms to expected excess returns for all asset classes and features both a strong common element and a strong business cycle component.
Though his presentation is titled “Discount Rates,” he observes that “discount rate,” “risk premium,” and “expected return” are all really the same thing. Cochrane asserts 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.
He analyzes the annual data as well as the five-year holding periods, and while the R2 of the regression is not especially robust, the regression coefficient is actually quite large. This indicates that returns vary considerably with the dividend yield. Cochrane asks the question, “How much do expected returns vary over time?”
Moreover, the R2 rises with time. Why? Cochrane explains that “High prices, relative to dividends, have reliably preceded many years of poor returns. Low prices have preceded high returns.”
This predictable pattern holds across all markets, according to his analysis. A yield or valuation ratio transforms one-for-one to expected excess returns for equities, bonds, credit markets, FX, sovereign debt, and houses. Cochrane describes this as follows:
- With equities, dividend yields forecast returns rather than dividend growth.
- For Treasuries, rising yield curves don’t predict higher interest rates in the future but, rather, improved one-year returns for long-term bonds. Likewise, Fed fund futures anticipate returns not funds rate changes.
- In fixed income, high variation in credit spreads across companies and categories over time indicates returns rather than default probabilities.
- In foreign exchange, returns, not depreciation in the exchange rate, are predicted by international interest rate spreads.
- When it comes to sovereign debt, elevated foreign or sovereign debt forecasts reduced returns rather than government or trade surpluses.
- 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, and businesses are failing, and vice versa.”
What’s the big lesson investors can cull from these findings? My answer is that Cochrane’s 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 that we face amount to discount-rate variation we do not understand.”
For more insights 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 Market, from the 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, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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