Why yields are the best guide to future stock market returns

Stock Market Investing
In 2011 John Cochrane, a professor at the University of Chicago’s Booth School of Business, gave a presidential address on “Discount Rates” to the American Finance Association. It was published in 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.

Yield predict returns
The old school views regarding stock were that when yields are low, cash flows are expected to grow quickly. But according to the new school view, it is the discount rate that explains the asset price. Thus, this entails the investors’ acceptance to lower returns. They seem to be a much better guide to get expected returns. Thus, people are preferring earning the yields. Not all companies, earnings are distributed to shareholders but they are distributed to shareholders in dividends. Some are also used to generate future income growth. And growth is considered part of expected returns.

Yields are seen as more user-friendly steer.
Yields have many pieces of evidence to steer unexpected returns. 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.

Yields have a predictive power
The future cash flowing from the 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. The predictive power of yields holds for bonds and stocks, but also for other assets, such as housing. And valuations based on aggregate earnings or book value predict stock returns just as well as the dividend yield.

If yields predict return, 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 what stocks will return in the short run, but how much more they will return over safe bonds in the long run. This extra reward is the equity risk premium—and to Mr Cochrane’s way of thinking the discount rate, the risk premium and the expected return on equities “are all the same thing”. One forward-looking measure of the equity risk premium shows a wide variation over time (see chart). Investors with a long-term horizon might profitably use such variations to decide on the mix of risky stocks and safe bonds to hold in a portfolio. The higher the risk of premium on stocks, the more the odds favour the investors to tilt their portfolio away from bonds.

Conclusion
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, until the next bear market makes them rethink of memories of the previous market crash, people get more comfortable owning equities. In his address, Mr Cochrane argued that in a market slump a typical investor is inclined to ignore the high premiums offered by stocks because he fears for his job. The correlation between employment income and stock prices is to be blamed. Future returns are remarkably hard to predict. Yields may only be a weak guide to them, but they are the best we have.
Why yields are the best guide to future stock market returns Why yields are the best guide to future stock market returns Reviewed by Newzpot on 21:24:00 Rating: 5

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