Can Book-to-Market, Size, and Momentum Be Risk Factors That Predict Economic Growth?

Abstract

In this study we examine the extent to which the profitability of the HML, SMB, and WML trading strategies can be linked to macroeconomic risk factors. Using a large cross-section of securities from ten developed markets, we find that the HML and SMB portfolios contain significant information about future GDP growth. The predictive ability of these strategies is to a large degree independent of any information contained in the domestic market factor, which is known to be a leading indicator of economic growth. Even in the presence of popular business cycle variables, HML and SMB retain their ability to predict future economic growth in some of the countries examined. Examination of the portfolio holdings over the life of the trading strategies shows that more than 50% of the securities in the extreme portfolios of HML and SMB remain the same over a period of three years. In most countries, more than 30% of the stocks never exit the extreme portfolios over the whole life of the trading strategy. High book-to-market and small capitalization stocks in these portfolios may be more sensitive to changes in the economic environment because they seem to be entrenched in their respective categories. The vulnerability of high book-to-market and size stocks to changes in the economic environment appears to give rise to the link between the performance of the HML and SMB trading strategies and future economic growth. Little evidence is found to support this hypothesis for the returns of the WML strategy. Finally, industry factors cannot explain the returns of any of these strategies.