interested in the macro-finance view? Then you definitely need to read the new working paper of John Cochrane on discount rates, variation of risk premia and return forecastibility.
I argue that characterizing discount rate variation over time and across assets has replaced informational efficiency as the central organizing question of asset pricing research. I survey the facts: in the last 40 years we have learned that discount rates vary dramatically. Most views of the world changed 100%, we thought 100% of the variation in market dividend yields was due to variation in expected cashflows; now we know 100% is due to variation in discount rates. We thought 100% of the cross-sectional variation in expected returns came from the CAPM, now we think that’s about zero and a zoo of new factors describes the cross section. I show how time-series, cross-section, regression, and portfolio approaches are really the same, and think about how the empirical project can achieve a needed unification.
- One possible definition of “bubble” is “prices that are high on expectations of subsequent
higher prices; people buy just because they think they can sell to a greater fool.” This is a
“rational bubble,” a violation of the transversality condition. In such a bubble expected returns are always the same, so higher valuations do not make it more likely to see a low return. As we saw above, the data speak strongly against this form of bubble. Higher valuations do correspond to lower returns, and “just enough” to fully “explain” price variation. Once we look at a 15 year horizon, high prices do not correspond to ever-higher prices. To continue sensibly, then, a “bubble” must be defined as a high valuation, which corresponds to a discount rate that is “too low” in some sense. The fact is that high valuations correspond to low long-run returns, period. Now, we have something solid to talk about. Perhaps low risk premium in economic booms correspond to low macroeconomic risk premiums, and high risk premiums in recessions correspond to higher macroeconomic risk premiums. I survey those theories below. Perhaps the same variation in risk premiums corresponds to something “wrong” either in psychology, market frictions, monetary policy, etc. Good. At least we know what we’re talking about. That’s progress. - Bonds/term structure. A rising yield curve signals better one-year return for long-term
bonds, not higher future interest rates. A one percentage point rise in the n year forward
rate over the spot rate signals a one percentage point risk in the expected one year return
on n year bonds. Forward-spot spreads do not forecast one-year changes in spot rates
(Fama and Bliss (1987); Campbell and Shiller (1991)).
Macroeconomists have not digested this lesson. The Federal Reserve looks at long-term
treasuries and the TIPS spread to gauge inflation expectations, and at Federal Funds futures to gauge policy expectations (Piazzesi and Swanson (2008)) . These spreads forecast returns, not the intended objects. - Bonds/credit spreads. Credit spreads are higher than default probabilities, and variation
in credit spreads over time largely signals changes in expected returns, not changes in
probabilities of default. ( Berndt and Duffie (2010).) - Foreign exchange.High foreign interest rates relative to domestic rates signal a higher
return on foreign bonds, not a devaluation—the “carry trade.” (Hansen and Hodrick (1980), Fama (1984).)
