You Say Bubble, I Say Fluctuating Risk Premia

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by: James Picerno

David Stockman says that “we have bubbles everywhere" in markets, including stocks, junk bonds and housing. But one man’s bubble is another man’s time-varying risk premium that reflects a fluctuating expected return that’s linked in no small degree with the business cycle. Whew! Yes, one's easier to say and the other's a mouthful. Yet these two narratives are essentially telling us the same thing. But if you’re looking to drum up media exposure, you’re better off talking about bubbles instead of fluctuating risk premia. Bubbles offer more dramatic opportunity for interesting TV conversations. As a practical matter for managing money, however, looking at the markets through a framework of fluctuating risk premia has far more appeal.

Bubble talk in its modern form arguably begins with Professor Robert Shiller’s famous 1981 paper (and its key chart, republished below) that investigates the habit of the stock market to bounce around far more than can be accounted for with dividends ("Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?"). The initial reaction to this influential research, and one that still animates a lot of the discussion in the 21st century, is that the market is irrational and inefficient. But after several decades of analysis on multiple fronts by dozens of economists, there are alternative explanations for the seemingly excessive level of price volatility.


(Click to enlarge)

One of the explanations comes by way of Professor John Cochrane, who’s penned a number of studies in this corner of finance. He recently boiled down the basic issue in a blog post:

You might think that high prices relative to current dividends mean that markets expect dividends to be higher in the future. Sometimes, you'd be right. But on average, times of high prices relative to current dividends (earnings, book value, etc.) are not followed by higher future dividends. On average, such times are followed by lower subsequent long-run returns.

Shiller's graph we now understand as such a regression: price-dividend ratios do not forecast dividend growth. Fortunately, they do not forecast the third term, long-term price-dividend ratios, either -- there is no evidence for "rational bubbles." They do forecast long-run returns. And the return forecasts are enough to exactly account for price-dividend ratio volatility!

Finally, the debate over "bubbles" can start to make some sense. When Shiller says "bubble," in light of the facts, he can only mean "time-variation in the expected return on stocks, less bonds, which he believes is disconnected from rational variation in the risk premium needed to attract investors." When Fama says no "bubble," he means that the case has not been proven, and it seems pretty likely the variation in stock expected returns does correspond to rational, business-cycle related risk premiums.

Market volatility and its connection to expected return and the business cycle is far from resolved. But the growing body of empirical work that attempts to explain how and why prices vary in terms of fluctuating expected return is far more helpful for managing money than running around and screaming bubbles, bubbles are everywhere.

Yes, the markets are volatile, and prices at times seem to disconnect from fundamental values. That’s certainly true in the short term, or so it appears. But when you step back and consider why prices might vary in a longer-run context, the notion of bubbles loses quite a lot of its appeal as an organizing principle for money management.

Imagine a world where price volatility isn’t related to expected return. In that case, a soaring or crashing stock market isn’t connected to a change in expected risk premia. Such a world would truly be irrational. But that’s not the world we live in, at least not according to the historical record.

On the other hand, if it’s entertaining financial chatter that you seek, bubble talk will provide a more satisfying narrative.