The Economist UK - 07.09.2019

64 Finance & economics The EconomistSeptember 7th 2019

2

1

will not be sworn into office until Decem-

ber. But his words already have the power

to move markets and shape the economy.

His claim on August 30th that Argentina

was in “virtual default” deepened the mar-

ket sell-off (Standard & Poor’s, a rating

agency, also declared that there had been a

temporary, selective default on some of Ar-

gentina’s obligations). Creditors will not

renegotiate their debts with Mr Macri’s

lame-duck government, fearing that Mr

Fernández might force bigger concessions

later. The same worry may give pause to the

imf. Why should it give billions of addi-

tional dollars to Argentina, when its next

president accuses it of helping to create a

“social catastrophe” of rising prices, unem-

ployment and poverty?

Advisers to Mr Fernández say his cam-

paign rhetoric should not be taken too seri-

ously. “Alberto is acting now as a candida-

te...appealing to the base; he will govern

very differently,” says one of his inner cir-

cle. His chief economic adviser, Guillermo

Nielsen, has published a more moderate

ten-point agenda that leaves some room

for optimism. It recognises the need for a

budget surplus. And it envisages a “social

pact” between the unions and business to

tame inflation by moderating wage-claims

and price increases. A Peronist govern-

ment under Mr Fernández may find it easi-

er to bring the unions into line than today’s

government does. According to Federico

Sturzenegger, the former governor of Ar-

gentina’s central bank, Mr Macri’s adminis-

tration has eschewed that kind of dealmak-

ing because it “did not want to sit the

‘old-politics players’ at the decision table”.

The next government may even consid-

er much-needed reforms of labour laws

and welfare entitlements, according to

Buttonwood Tales of the expected

Premium model

Sources: Federal Reserve;

Standard & Poor’s

*Gap between S&P 500 earnings yield

and real five-year Treasury yields

United States, equity risk premium*

Percentage points

1997 2000 05 10 15 19

-2

0

2

4

6

8

10

I

n 2011 john cochrane, a professor at

the University of Chicago’s Booth

School of Business, gave a presidential

address on “Discount Rates” to the Amer-

ican Finance Association. It was pub-

lished as a paper a few months later. In a

sweeping take, Mr Cochrane set out how

academics’ understanding of the way

asset prices are determined has shifted

over the past half-century. Many papers

are described as “landmark”; this one has

a better claim to the label than most.

His opening line (“Asset prices should

equal expected discounted cash flows”)

indicated that the basic premise has not

changed. But plenty has. In the 1970s the

focus of academic finance was on the

“expected” part of that equation—the

efficiency with which markets priced in

any new information relevant to future

cash flows. The emphasis has shifted.

The “discounted” part, or the risk prefer-

ences of investors, has become the main

organising principle for research, argued

Mr Cochrane.

The old-school view was that when

stock prices are high relative to earnings

or dividends (ie, yields are low), it im-

plies these cash flows are expected to

grow quickly in future. The new school

says it is changes in risk appetite—the

discount rate that investors apply to

future earnings—that explains much of

the variation in asset prices. If prices are

high and yields are low, that implies

investors are willing to accept lower

returns in future. Yields predict returns.

There are practical implications. A

generation ago an investor might have

looked to history for a guide to expected

returns. Now yields are seen as a more

useful steer. This is clearer with govern-

ment bonds. The real annual return on

American Treasury bonds was 1.9%

between 1900 and 2018, according to

Credit Suisse’s Global Investment Returns

Yearbook. But history is bunk. It would not

be wise to expect a 1.9% return when the

yield-to-maturity on inflation-protected

Treasury bonds is zero, as it is now.

The future cash flows from stocks are

not as certain as those from government

bonds. But Mr Cochrane argued that a

similar principle holds with stocks over

the long haul. “High prices, relative to

dividends, have reliably preceded many

years of poor returns. Low prices have

preceded high returns,” he said. The pre-

dictive power of yields holds for bonds and

stocks, but also for other assets, such as

housing. And valuations based on aggre-

gate earnings or book value predict stock

returns just as well as the dividend yield.

A lot of people prefer the earnings

yield. Share buy-backs have become a

more popular way to return capital to

stockholders than paying dividends. The

earnings yield may be a better guide to

expected returns. True, not all company

earnings are distributed to shareholders in

dividends or buy-backs; some are used to

pay for investment to generate future

earnings growth. On the other hand, that

growth should also be considered part of

expected returns.

If yields predict returns, that might

seem to imply that astute investors can

sell stocks when yields (and expected

returns) are low and buy them back when

yields are high. In practice, the signal

from yield is too weak to be relied upon

to catch turning points profitably. But

what matters to a lot of investors is not so

much what stocks will return in the short

run, but how much extra they will return

over safe bonds in the long run. This

extra reward is the equity risk pre-

mium—and to Mr Cochrane’s way of

thinking the discount rate, the risk pre-

mium and the expected return on equi-

ties “are all the same thing”. One forward-

looking measure of the equity risk pre-

mium shows a wide variation over time

(see chart). Investors with a long-term

horizon might profitably use such varia-

tions to decide on the mix of risky stocks

and safe bonds to hold in a portfolio. The

higher the risk premium on stocks, the

more the odds favour investors tilting

their portfolio away from bonds.

A question for academic research is

why exactly expected returns (or, if you

prefer, discount rates) on stocks vary so

much. One explanation is that, as memo-

ries of the previous market crash fade,

people get more comfortable owning

equities—until the next bear market

makes them rethink. In his address Mr

Cochrane argued that in a market slump

a typical investor is inclined to ignore the

high premiums offered by stocks be-

cause he fears for his job. The correlation

between employment income and stock

prices is to blame. Future returns are

remarkably hard to predict. Yields may

only be a weak guide to them; but they

are the best we have.

Why the earnings yield helps explain the mysteries of equity returns