Fun With Discount Rates

Far and away, one of the best reads of the year is the Credit Suisse Global Investment Returns Yearbook – and the 2015 edition is no exception. Click here to download.

The yearbook is hot off the presses, 68 pages and chock full of thought provoking content, so I am not even close to being finished at this point.

One of the articles titled ‘Do Equity Discount Rates Mean Revert?’ fits nicely with a piece that I wrote recently (click here for a refresher). In my article, I recounted one of the bedrock theories of finance, that the value of an asset is equal to the present value of its future cash flows.

The good news is that the model applies to stock and bond investors alike. The bad news for stock investors is that we don’t know what the future cash flows will be or how much we should discount them.

In fact, the only thing we know about the present value of a current asset is the current price, which allows us to infer something about the assets future cash flows or implied discount rate.

The authors of the Credit Suisse article use present values and estimates of cash flow to determine a discount rate, which is interesting because, as financial theory suggests, the discount rate should equal the expected return over time.

While the authors are quite short on how they estimate their future cash flows, so there are some major assumptions baked into their analysis, but it’s still interesting because it shows that discount rates (and, therefore, expected returns) vary over time.

A low discount rate implies a low expected return and the lowest discount rates, according to the authors, occurred in the peak of the tech bubble. At that point, the implied discount rate was two percent. As it turns out, discount rates were the lowest going into the ‘lost decade’ of stock returns.

Discount rates were highest during the 1981 recession, just as market returns were heading into a major bull market. At the trough of the 2008 financial crisis, discount rates were equally high.

All of this coincides with other long-term measures that we have evaluated in the past like the Shiller PE ratio or Tobin’s Q. (Click here for the article)

Additionally, the data from the Credit Suisse authors, like the Shiller PE ratio and Tobin’s Q, all suggest that the market is overvalued. We first made this observation back in February 2014, so it should be obvious that these kinds of signals are not useful for short-term predictions.

Investors who read my article last year and sold out (not my recommendation!) would have missed a nice 17 percent return since then.

Believing that the market is overvalued may help set expectations about future returns, but they tell you nothing about where markets are headed in the short run, which is still measured in years.

You can’t use this kind of data to tell whether you’re on the precipice of a bear market or whether stocks could rise for several more years without interruption.

Naturally, I’m hoping for the latter, but I want everyone to understand – and be prepared for – the former.