Lower share prices mean high expected returns. This has long been one of the cornerstones of conventional financial economics. New research, though, shows that it is not true.
Yale University’s Stefano Giglio and colleagues surveyed American clients of Vanguard in February, when the S&P 500 was near a record high, and again in mid-March after it had fallen 20 per cent. They found that, after the fall, investors thought shares had become riskier: the probability they attached to shares falling more than 30 per cent in the following 12 months almost doubled from 4.5 to 8 per cent. Conventional financial economics says such greater risk should have been accompanied by higher expected returns. But it wasn’t. In fact, the opposite. In February, investors expected a 6 per cent return on the S&P 500 in the following 12 months, but in March they expected less than 2 per cent.
Lower prices and greater risk, then, led to lower expected returns – a flat contradiction of orthodox economics, and indeed common sense. Yes, shares have soared back since then; higher risk has led to higher returns. But lots of investors weren’t expecting this.
Of course, this is just one survey. But it is consistent with other new evidence, gathered by Harvard University’s Andrei Shleifer and colleagues. They show that equity analysts’ forecasts of longer-term earnings growth overreact to news about companies’ current trading conditions. Analysts overextrapolate good times and bad, which tends to drive share prices up too much in good times and push them down too much in bad.
This too contradicts conventional economic theory, which predicts that expectations are formed rationally. But it is consistent with a big fact – that the dividend yield on the aggregate market does a much better job of predicting share prices than it does dividend growth. This is what we’d expect to see if prices rise and fall too much relative to current dividends.
What this tells us is that equity analysts make the same mistake as retail investors. They extrapolate too much from current conditions, causing share prices to move too much. The idea that professionals are more rational than us is wrong – perhaps because professional investors sometimes have incentives to stick with the herd: nobody wants to hear from a bear in good times.
But why is overextrapolation so common? One explanation is that people are prone to a recency bias. They think that the recent environment will continue into the future. In the run-up to the 2008 crisis, for example, banks took on too much risk because they thought the “Great Moderation” would continue.
Some innovative research by Todd Feldman at San Francisco State University has confirmed that this can be an expensive mistake. He programmed computerised traders to commit different particular systemic errors of judgment, and he found that the recency bias was the one that cost traders the most money.
But there’s something else. As Yale University’s Robert Shiller showed in his recent book, Narrative Economics, our beliefs are shaped by those around us. In good times we hear lots of optimistic talk and in bad times lots of pessimism. In this way, optimism and pessimism spread pro-cyclically just as a virus does. And this pushes prices up too far in good times and down too much in bad.
Is all this true right now? The fact that the dividend yield on the All-Share index, at 4.7 per cent, is well above its long-term average suggests that equities might have overreacted on the downside, despite their recent recovery.
On the other hand, though, there are good reasons to be concerned about medium-term growth even if we see a temporary surge in demand and profits as the lockdown is relaxed. We might not fully return to our old habits; government might tighten fiscal policy too much and too fast; boardrooms might be scarred by the recession into becoming more cautious about capital spending plans; and if the economy is “built back better” incumbent firms (especially if they are big carbon-emitters) might lose out to newer ones.
We know that in the past we have tended to overweight pessimistic arguments when prices are low because of the recency bias and peer pressure. This is why the dividend has predicted returns so well. What we do not know, though – and indeed cannot know – is whether the past is still a guide to the future.