Stock Valuation and Learning about Profitability

We develop a simple approach to valuing stocks in the presence of learning about average profitability. The market-to-book ratio (M/B) increases with uncertainty about average profitability, especially for firms that pay no dividends. M/B is predicted to decline over a firm's lifetime due to learning, with steeper decline when the firm is young. These predictions are confirmed empirically. Data also support the predictions that younger stocks and stocks that pay no dividends have more volatile returns. Firm profitability has become more volatile recently, helping explain the puzzling increase in average idiosyncratic return volatility observed over the past few decades.

Technological Revolutions and Stock Prices

We develop a general equilibrium model in which stock prices of innovative firms exhibit "bubbles" during technological revolutions. In the model, the average productivity of a new technology is uncertain and subject to learning. During technological revolutions, the nature of this uncertainty changes from idiosyncratic to systematic. The resulting "bubbles" in stock prices are observable ex post but unpredictable ex ante, and they are most pronounced for technologies characterized by high uncertainty and fast adoption. We find empirical support for the model’s predictions in 1830-1861 and 1992-2005 when the railroad and Internet technologies spread in the United States.

Cash-Flow Risk, Discount Risk, and the Value Premium

A habit persistence, general equilibrium model with multiple assets matches both the time series properties of the market portfolio and the cross-sectional predictability of returns on price sorted portfolios, the value premium. Consistent with empirical evidence, the model shows that (a) value stocks are those with higher cash-flow risk; (b) the size of the value premium is larger in %u201Cbad times,%u201D due to time variation in risk preferences; (c) the unconditional CAPM fails, because of general equilibrium restrictions on the market portfolio. The dynamic nature of the value premium rationalizes why the conditional CAPM and a Fama and French (1993) HML factor outperform the unconditional CAPM.

Conditional Betas

Empirical evidence shows that conditional market betas vary substantially over time. Yet, little is known about the source of this variation, either theoretically or empirically. Within a general equilibrium model with multiple assets and a time varying aggregate equity premium, we show that conditional betas depend on (a) the level of the aggregate premium itself; (b) the level of the firm's expected dividend growth; and (c) the firm's fundamental risk, that is, the one pertaining to the covariation of the firm's cash-flows with the aggregate economy. Especially when fundamental risk (c) is strong, the model predicts that market betas should display a large time variation, that their cross-sectional dispersion should be negatively related to the aggregate premium, and that investments in physical capital should be positively related to changes in betas. These predictions find considerable support in the data.

Labor Income and Predictable Stock Returns

We propose and test a novel economic mechanism that generates stock return predictability on both the time series and the cross section. In our model, investors' income has two sources, wages and dividends, that grow stochastically over time. As a consequence, the fraction of total income produced by wages changes over time de-pending on economic conditions. We show that as this fraction fluctuates, the risk premium that investors require to hold stocks varies as well. We test the main implications of the model and find substantial support for it. A regression of stock returns on lagged values of the labor income to consumption ratio produces statistically significant coefficients and adjusted R2 's that are larger than those generated when using the dividend price ratio. Tests of the cross sectional implication find considerable improvements on the performance of both the conditional CAPM and CCAPM when compared to their unconditional counterparts.

Was There a Nasdaq Bubble in the Late 1990s?

Not necessarily. The fundamental value of a firm increases with uncertainty about average future profitability, and this uncertainty was unusually high in the late 1990s. We calibrate a stock valuation model that includes this uncertainty, and show that the uncertainty needed to match the observed Nasdaq valuations at their peak is high but plausible. The high uncertainty might also explain the unusually high return volatility of Nasdaq stocks in the late 1990s. Uncertainty has the biggest effect on stock prices when the equity premium is low.

Information acquisition in financial markets: a correction

This note provides a proper example for the mechanism of strategic complementarities proposed in our paper. ; Original paper in Review of Economic Studies, January 2000, v. 67, no.1, p. 79–90.Information theory ; Financial markets

Political Uncertainty and Risk Premia

We develop a general equilibrium model of government policy choice in which stock prices respond to political news. The model implies that political uncertainty commands a risk premium whose magnitude is larger in weaker economic conditions. Political uncertainty reduces the value of the implicit put protection that the government provides to the market. It also makes stocks more volatile and more correlated, especially when the economy is weak. We find empirical evidence consistent with these predictions.