EFF/KRF: The market has declined sharply in response to rough times and forecasts of future rough times. The decline in market prices combines two effects: (i) lower current and expected future profits, and (ii) higher discount rates for the expected future profits. The discount rate, in turn, has increased because uncertainty about future profits (in other words, risk) has increased and, apparently, because investors have become more risk averse. Higher discount rates for expected profits translate into higher expected stock returns.In short, the two of us believe that the expected return on stocks is currently high. But beware: the high expected return is compensation for the risks associated with different possible outcomes. If the quite pessimistic assessments of future economic performance built into current market prices turn out to be right (which is our best single guess), realized returns will be high. In other words, we will get the currently high expected return if the market's pessimistic expectations of future economic performance are realized. On the positive side, there is a substantial chance that the current assessments of future economic performance built into market prices turn out to be too pessimistic. If so, realized returns will be even higher than expected. But there is also a substantial chance that the current quite pessimistic assessments of economic performance built into market prices turn out to be too optimistic. In that case realized returns will be low, perhaps quite low. This is always the general nature of the risks in stock market investing. The story is more poignant at the moment because risk is so high.
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