So said J.P. Morgan one day when he was asked for a prediction about the stock market. The cagey banker gave us the only market forecast that’s always right. Prices bounce around a lot. They always do. Sometimes they bounce higher (or fall lower) than usual. When that happens, cries of market inefficiency and irrational investors take flight. The alternative view is that markets are simply repricing assets based on new expectations for risk and return. What’s the evidence that rational pricing prevails? One clue is that the underlying fundamentals of the market change in line with prices.
Showing cause and effect between prices and fundamentals can be tricky, especially for stocks. Professor Robert Shiller made the case in an influential 1981 paper that equity prices “move too much to be justified by subsequent changes in dividends.” But after 30 years of closer inspection, it’s clear that the relation between equity prices, dividends and expected return is more nuanced. A 2008 paper by Professor John Cochrane, for instance, outlines a persuasive case that dividends provide valuable information about expected equity return, which is what you’d expect in well-functioning marketplace. Expected return, in other words, varies, and there’s nothing inefficient about that per se. In a world where everything is changing, no less is required in the equity market. That can be disorienting in the short term, but over time it looks quite reasonable, based on the fluctuations in the economy overall.
Cochrane’s hardly alone in pointing out that current dividend yield for stocks overall offers a pretty good measure of what you’ll earn in the market over, say, the next decade or two. Comparing the current equity yield with subsequent 10-year returns, for instance, shows a moderately tight relationship, as a recent article published on Vox shows.
Why should you expect to earn more from stocks at one point in time vs. another? Perceptions of risk change. It’s surely rational that the expected return for stocks was higher in late-2008/early 2009 than it is today, for instance. The macro risk was higher then compared with now.
Bond prices in relation to fundamental value also dispense clues about what to expect in the long run. We know the current yield at any given point and we also know that if you buy a bond today there’s little mystery about the future return if you hold the security till maturity. With sovereign debt in particular, there’s a high degree of confidence about expected return for buy-and-hold strategies. (Inflation complicates the analysis, but for now we’ll leave that aside.) Today’s current yield is basically the expected return for Treasuries, assuming that you hold the security to its maturity date. A 10-year Treasury Note currently yields a bit more than 2.5%. If you buy a Note today and hold it through maturity, chances are pretty good that you’ll earn a total return in the neighborhood of 2.5%.
But the calculation is more complicated with corporate bonds. The risk of default is higher, much higher, depending on the bond. Default risk, however, isn’t constant; it fluctuates. BCA Research recently posted a chart of the 12-month trailing default rate for corporates here. Not surprisingly, the rate varies, sometimes by wide degrees. During the Great Recession, the default rate surged to around 14%, up from the previous cyclical low of about 2%. It’s been falling recently, dipping to a recent level of under 6%.
Default risk is especially potent for junk bonds. No wonder, then, that bond prices in this corner move around a lot, sometimes dramatically in short periods. In turn, the trailing yield on junk bonds changes in kind. Consider the chart below, which shows the recent history of the yield spread for the high-yield bond sector relative to the 10-year Treasury. The spike in this spread to nearly 20% in late-2008/early 2009 from the previous low of 2.5% in mid-2007 is striking, but it’s hardly irrational. As the crowd came to grips with the threat of economic turmoil in 2008, junk bond prices fell, pushing yields up in the process.
The connection between asset prices and the economic cycle is quite strong. Making assumptions in real time is still precarious, of course, which means that the latest assessment via prices is always debatable in terms of accuracy. The crowd makes mistakes, a factor that’s further complicated by the short-term noise of traders. But over time, there’s quite a bit of economic logic to the fluctuation in prices. It’s not perfect, but it’d be a mistake to dismiss market prices as hopelessly irrational and bereft of useful information.
Ultimately, it’s all about the ebb and flow of the economy. Prices adjust based on the broad cycle. The market typically goes to excess on the upside during good times, followed by excess selling during recessions. Par for the course.
Yes, the future’s always uncertain, which means that the market’s latest attempt at discounting the morrow is always subject to revision. That’s a problem if we have to deploy all of our risk capital today, and put it in just one asset class. But we can manage the risk by owning multiple asset classes and making reasonable assumptions about the medium-to-long-run future based on current prices and valuations. In other words, we can engage in a degree of dynamic asset allocation as tool for managing risk, enhancing return, and perhaps a bit of both.
Is the market perfectly efficient? No, but neither is it perfectly inefficient. Like so much in finance, the truth lies somewhere between the extremes.