Question

Suppose that a market efficiency supporter was trying to explain the high stock market returns between the start of 2009 and 2017 (over 15% per annum, annualized). He argued that the stock market was not irrationally overvalued, but rather merely that investors had (rationally) realized that the stock market is not particularly risky, so that required returns on the stock market had fallen.
a. Using the present value framework, explain this argument.
b. Does this argument explain the high returns over the period?
c. What would the argument predict going forward? Suppose that there is a large decline in the stock market in 2019. Would this vindicate the argument or not?
d. Your friend Bob is not particularly bright. He says “what do you mean, returns have gone down. For the past eight years, returns have gone up. If you’re estimating expected returns using historical returns, you should raise your estimate of future expected returns, not lower it.” Respond.

Answer 1

a. the higher returns over the period are explained by multiple factors. Most important factor is the business cycle. The markets had experienced a huge crash in the previous year- 2008. In 2008, the market returns were -30-50%. In the coming years, the markets regained these levels. As the base year value for this period was very low, the effective returns for this period appear to be very high.

Present value argument to explain this phenomenon is like this- in the period of financial markets crash of 2007-08, the markets were very volatile. The participants perceived a very high risk in the stock markets as large number of defaults were reported. This increased the discount rate of the future cash flows, thereby decreasing the PV of the future cash flows and hence, share prices. In the next decade, the market stabilized and the credit risk decreased as perceived by the market participants. This lowered the discount rate and increased the present value of the future cash flows. This caused higher returns on shares.

b. Present value argument itself cannot explain the high returns in the period on standalone basis. There are of course other factors such as improved business models, regulatory interventions, lower interest rates etc. Improved business practices and regulations lowered the credit risk thereby, lowering the discount rate. the businesses improved their profitability by restructuring the business. Lower interest rate proved to be a stimulus to capital growth. These factors also contributed to the higher returns. There are also technological improvement such as digital integration of financial markets on retail level, block chain development etc.

c. going forward, the movements in share markets or returns will not be explained by present value argument, IF the business cycle remains stable. Currently we are experiencing a stable business cycle without sudden peaks or valleys. If we experience a sudden decline in 2019, it will not be against the present value argument. A sudden drop would be as a result of change in business cycle or more likely a shock the markets. The shock is a negative news that impacts the larger markets. In this scenario, the market participants perceive a larger risk in the market. This increases the discount rate over the perceived period of the shock. Higher discount rate would imply lower present value of the same future cash flows. Hence, this market decline is in line with the present value argument as well.

d. we should explain to Bob the concept of business cycles. It is logical that if the returns in the past have been high and if we are using historical returns to predict the future returns, we should increase the future estimates, considering that the historical returns have been high. However, the choice of historical period makes a lot of difference. The historical period should be chosen carefully and should include at least one full business cycle. In this scenario, if our historical period starts from 2009, we will only see +ve returns. However, if we include 2007-08 period as well, we may see a much lower average return. Similarly, we will see a different result if we include past 20 years in the historical period analysis. A more prudent way would be to understand which phase of business cycle we are currently in and predict the future returns based on historical returns for the same phase of business cycle from the past. The changes in technology will impact the impact the future returns as well and should be accounted for in the analysis as a +ve contributor.