Is Now the Time to Buy Stocks? - WSJ.com

In class just the other day we talked about Efficient Markets and concluded that while markets are exceedingly difficult to beat on a risk adjusted basis, it does appear that as we learn more perfect efficiency in the sense of a random walk, is not really the case. So it is a great coincidence that in the Wall Street Journal there is the following by the University of Chicago's John Cochrane.

Is Now the Time to Buy Stocks? - WSJ.com:

"The correlation is obvious: When prices are low relative to dividends, subsequent seven-year returns are likely to be high. Stocks do not follow a "random walk." More deeply, price declines above and beyond declines in dividends over the following year have entirely rebounded. This finding is confirmed by 30 years of research, ranging from "behaviorists" such as Robert Shiller and Richard Thaler to "efficient marketers" such as Eugene Fama and Ken French, to "economists" such as John Campbell and myself. The same pattern also appears in price/earnings, book/market and other ratios, and in many other markets.

The interpretation is pretty clear too. In a recession, or following losses, many investors become more averse to holding risks. They want to sell. But we can't all sell -- a fact routinely ignored in much financial advice and commentary. Instead, prices must fall and prospective returns rise until some investors are willing to buy. Unsurprisingly, upward spikes in the dividend yield came in bad economic times.

Which means that there is some predictability in stock prices due to changing risk aversion levels that correlate with economic conditions. That is not to say that tons of people are correctly predicting these changes in aversion (and price levels) and does not change my view that largely passive investing (index funds or in some cases ETFs) are the way to go, but does help explain the long held view that stock returns tend to be too volatile relative to firms' dividends.

By the way the article also gives an always well placed warning:

"History is not a guarantee -- this time could be different."