Explaining Returns with Cash-Flow Proxies

Stock returns are correlated with contemporaneous earnings growth, dividend growth, future real activity, and other cash-flow proxies. The correlation between cash-flow proxies and stock returns may arise from association of cash-flow proxies with one-period expected returns, cash-flow news, and/or expected-return news. We use Campbell's (1991) return decomposition to measure the relative importance of these three effects in regressions of returns on cash-flow proxies. In some of the popular specifications, variables that are motivated as proxies for cash-flow news also track a nontrivial proportion of one-period expected returns and expected-return news. As a result, the R2 from a regression of returns on cash-flow proxies may overstate or understate the importance of cash-flow news as a source of return variance.

Inflation Illusion and Stock Prices

We empirically decompose the S&P 500's dividend yield into (1) a rational forecast of long-run real dividend growth, (2) the subjectively expected risk premium, and (3) residual mispricing attributed to the market's forecast of dividend growth deviating from the rational forecast. Modigliani and Cohn's (1979) hypothesis and the persistent use of the Fed model' by Wall Street suggest that the stock market incorrectly extrapolates past nominal growth rates without taking into account the impact of time-varying inflation. Consistent with the Modigliani-Cohn hypothesis, we find that the level of inflation explains almost 80% of the time-series variation in stock-market mispricing.

Bad Beta, Good Beta

This paper explains the size and value anomalies' in stock returns using an economically motivated two-beta model. We break the CAPM beta of a stock with the market portfolio into two components, one reflecting news about the market's future cash flows and one reflecting news about the market's discount rates. Intertemporal asset pricing theory suggests that the former should have a higher price of risk; thus beta, like cholesterol, comes in bad' and good' varieties. Empirically, we find that value stocks and small stocks have considerably higher cash-flow betas than growth stocks and large stocks, and this can explain their higher average returns. The poor performance of the CAPM since 1963 is explained by the fact that growth stocks and high-past-beta stocks have predominantly good betas with low risk prices.

Bad Beta, Good Beta

This paper explains the size and value “anomalies†in stock returns using an economically motivated two-beta model. We break the beta of a stock with the market portfolio into two components, one reflecting news about the market’s future cash flows and one reflecting news about the market’s discount rates. Intertemporal asset pricing theory suggests that the former should have a higher price of risk; thus beta, like cholesterol, comes in “bad†and “good†varieties. Empirically, we find that value stocks and small stocks have considerably higher cash-flow betas than growth stocks and large stocks, and this can explain their higher average returns. The post- 1963 negative CAPM alphas of growth stocks are explained by the fact that their betas are predominantly of the good variety.

New Forecasts of the Equity Premium

If investors are myopic mean-variance optimizers, a stock's expected return is linearly related to its beta in the cross section. The slope of the relation is the cross-sectional price of risk, which should equal the expected equity premium. We use this simple observation to forecast the equity-premium time series with the cross-sectional price of risk. We also introduce novel statistical methods for testing stock-return predictability based on endogenous variables whose shocks are potentially correlated with return shocks. Our empirical tests show that the cross-sectional price of risk (1) is strongly correlated with the market's yield measures and (2) predicts equity-premium realizations especially in the first half of our 1927-2002 sample.

Caught On Tape: Predicting Institutional Ownership With Order Flow

Many questions about institutional trading behavior can only be answered if one can track institutional equity ownership continuously, yet institutional ownership data are only available on quarterly reporting dates. We infer institutional trading behavior from the “tape”, the Transactions and Quotes database of the New York Stock Exchange, by regressing quarterly changes in reported institutional ownership on quarterly buy and sell volume in different trade size categories. We find that institutions in aggregate demand liquidity, in that total buy (sell) volume predicts increasing (decreasing) institutional ownership. Institutions also tend to trade in large or very small sizes, in that buy (sell) volume at these sizes predicts increasing (decreasing) institutional ownership, while the pattern reverses at intermediate trade sizes that are favored by individuals. Our regression method predicts institutional ownership significantly better than the simple cutoff rules used in previous research.institutions, individuals, trading behavior, execution

The Price is (Almost) Right

Most previous research tests market efficiency and asset pricing models using average abnormal trading profits on dynamic trading strategies, and typically rejects the joint hypothesis. In contrast, we measure the ability of a simple risk model and the efficient-market hypothesis to explain the level of stock prices. First, we find that cash-flow betas (measured by regressing firms' earnings on the market's earnings) explain the prices of value and growth stocks well, with a plausible premium. Second, we use a present-value model to decompose the cross-sectional variance of firms' price-to-book ratios into two components due to risk-adjusted fundamental value and mispricing. When we allow the discount rates to vary with cash-flow betas, the variance share of mispricing is negligible.

Digital urbanisms : Exploring the spectacular, ordinary and contested facets of the media city

Peer reviewe

Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis

Modigliani and Cohn [1979] hypothesize that the stock market suffers from money illusion, discounting real cash flows at nominal discount rates. While previous research has focused on the pricing of the aggregate stock market relative to Treasury bills, the money-illusion hypothesis also has implications for the pricing of risky stocks relative to safe stocks. Simultaneously examining the pricing of Treasury bills, safe stocks, and risky stocks allows us to distinguish money illusion from any change in the attitudes of investors towards risk. Our empirical resuts support the hypothesis that the stock market suffers from money illusion.

The Value Spread

We decompose the cross-sectional variance of firms' book-to-market ratios using both a long U.S. panel and a shorter international panel. In contrast to typical aggregate time-series results, transitory cross-sectional variation in expected 15-year stock returns causes only a relatively small fraction (20%) of the total cross-sectional variance. The remaining dispersion can be explained by expected 15-year profitability and persistence of valuation levels. Furthermore, this fraction appears stable across time and across types of stocks. We also show that the expected return on value-minus-growth strategies is atypically high at times when the value spread (the difference between the book-to-market ratio of a typical value stock and a typical growth stock) is wide.