Pessimism and the Risk Premium

The Dividend Guy has posted an article discussing market rebounds after downturns. This effect could be explained statistically by reversion to the mean, but this doesn't give any insights to the causes of the phenomenon, which I think is quite easily explained.

An investment with higher risk must, if fairly priced, give a higher expected return. This phenomenon is referred to as the risk premium. Now, in an efficient market, when some bad news comes to light, investors adjust their expectations for future earnings, and stock prices drop to maintain a fair P/E ratio. However, investors also conclude that risk has increased, causing them to demand a higher return, which implies a lower P/E ratio, so prices drop further.

When the bad news ends and good news starts to roll in, prices will initially grow along with higher expected future earnings; and then the perception of risk drops, causing the P/E ratio to grow again.

So, for example, suppose we learn that company ABC's expected earnings will be half what they were thought to be. For a fixed P/E ratio, this means that the stock price should be half what it was. However, this bad news also leads to increased perception of risk, so the P/E ratio drops, and the stock price can end up much lower than half of what it was.

Conversely, when the bad news ends and the expected earnings double, the stock price would merely double if not for the risk premium; but when the risk premium disappears, the P/E ratio increases, and the stock price can end up much higher than it was.

Without the risk premium, P/E ratios would remain fixed. Thanks to the risk premium, P/E ratios fluctuate with the market mood. This is a good thing for those with longer investment horizons: they are less risk-averse, and can pick up some good bargains during times of pessimism.

Lower P/E ratios during times of pessimism explain why returns would be higher during those times, causing overall stock performance to revert to the mean. This explains one small part of why Warren Buffet has had so much success being greedy when others are fearful.