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Where is the Market Going? Uncertain Facts and Novel Theories

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Author Info
John H. Cochrane

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Abstract

Will the stock market provide high returns in the future as it has in the past? The average US stock return in the postwar period has been about 8% above treasury bill rates. But that average is poorly measured: The standard confidence interval extends from 3% to 13%. Furthermore, expected returns are low at times such as the present of high prices. Therefore, the statistical evidence suggests a period of low average returns, followed by a slow reversion to a poorly measured long term average. I turn to a detailed survey of economic theory, to see if models that summarize a vast amount of other information shed light on stock returns. Standard models predict nothing like the historical equity premium. After a decade of effort, a range of drastic modifications to the standard model can account for the historical equity premium. It remains to be seen whether the drastic modifications and a high equity premium, or the standard model and a low equity premium, will triumph in the end. Therefore, economic theory gives one reason to fear that average excess returns will not return to 8% after the period of low returns signaled by today's high prices. I conclude with a warning that low average returns does not imply one should change one's portfolio. Someone has to hold the market portfolio; one should only deviate from that norm if one is different from everyone else.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6207.

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Date of creation: Feb 1998
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Publication status: published as Economic Perspectives XXI: 6 (November/December 1997) Federal Reserve Bankof Chicago.
Handle: RePEc:nbr:nberwo:6207

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G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles

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