Macroeconomic Fundamentals and the Pricing of Anomaly Portfolios

Abstract

The consensus is that asset pricing models with macroeconomic factors perform poorly, relative to firm-characteristic-based factor models, in explaining the cross-section of stock and bond returns. This is a disconcerting result if the “central task of asset pricing” is to demonstrate the link between macro risk factors and asset returns. I propose a model with a set of factors that mimic underlying fundamental sources of risk in the economy. These factors are extracted using a novel stock-level sort that preserves the relation between stocks and a large set of macroeconomic variables. This model performs at least as well as standard characteristic-based factor models in explaining the cross-section of common benchmark and anomaly portfolio spreads. Taken together, the evidence shows that macroeconomic factors are useful in explaining the cross-section of stock and bond returns.