Suppose that a market efficiency supporter was trying to explain the high stock market returns
between the start of 2009 and 2020 (over 15% per annum, annualized). He argued that the stock
market was not irrationally overvalued in 2021, but rather merely that investors had (rationally)
realized that the stock market is not particularly risky, so that required returns on the stock
market had fallen.
a. Using the present value framework, explain this argument.
b. Does this argument explain the high returns over the period?
c. What would the argument predict going forward? Suppose that there is a large decline in the
stock market in 2022. Would this vindicate the argument or not?
d. Your friend Bob is not particularly bright. He says "what do you mean, returns have gone
down. For the past eight years, returns have gone up. If you’re estimating expected returns using
historical returns, you should raise your estimate of future expected returns, not lower it."
Respond.