From the Chicago Booth Review:
Why do highly valued stock markets often fail to deliver adequate returns? Likewise, why do depressed stock markets sometimes bounce back, delivering big gains to investors?....MORE
Economists have long struggled to explain the countercyclical nature of the equity premium, the excess return that investors earn for risking money in the stock market rather than putting their money in safe government bonds, but Chicago Booth’s Stefan Nagel and University of Michigan PhD candidate Zhengyang Xu suggest an explanation. “When people form expectations about the long run, they tend to rely on a relatively limited memory of what they have seen in their own lifetimes,” Nagel says. “Their expectations are tilted toward more recent data.”
Research has advanced a number of explanations for time variation in the equity premium, one being that at certain times, investors aren’t particularly risk averse. According to this theory, sometimes investors may pile into the stock market and drive up stock valuations, knowing full well that future returns may be low. At these points in time, valuations would be high, even though equity premiums would be low.
But this argument doesn’t explain why equity premiums increased during the 2008–09 financial crisis. According to the risk-aversion theory, investors were afraid to take risks, and therefore dampened stock valuations by avoiding the market even though they expected a high rate of return. The problem is that some survey data do not show that investors expected a high rate of return at the time.
The real reason investors were reluctant to pay high prices for stocks is that they were pessimistic about future stock market fundamentals, Nagel and Xu argue. And that’s because, according to the researchers’ theory, investors’ expectations of future fundamentals are informed by relatively recent experiences of growth. Nagel and Xu constructed a data series of dividend growth for the overall US stock market going back to the 19th century. They then tested whether the weighted average of dividend growth rates in earlier years accurately predicted future stock market returns....
