Cross-section Of Stock Returns Research Articles

Non-Myopic Betas

We introduce non-myopic investors into the standard conditional Capital Asset Pricing Model. In equilibrium, the intertemporal hedging demand of non-myopic investors leads to a two-factor CAPM in which risk premiums are determined both by the market (myopic) beta and by the “non-myopic beta,” with respect to the future return on the mean-variance efficient portfolio. We identify this efficient portfolio non-parametrically as a solution to a fixed-point problem, and use it to estimate the non-myopic betas. We show that non-myopic betas are indeed priced in the cross-section of stock returns, and the relationship between expected returns and non-myopic betas is monotone increasing and economically significant. Using U.S. mutual fund data, we find that non-myopic betas of mutual fund returns are negatively related to their long-term Sharpe ratios, in agreement with theoretical predictions. In the presence of funding constraints, our model predicts that a low non-myopic beta is associated with a higher alpha. We confirm this prediction by constructing a “Betting Against Non-Myopic Beta” factor and showing that it generates superior performance over and above a number of factor models.

The Trend in Firm Profitability and the Cross Section of Stock Returns

This study shows that the recent trajectory of a firm’s profits predicts future profitability and stock returns. The predictive information contained in the trend of profitability is not subsumed by the level of profitability, earnings momentum, or other well-known determinants of stock returns. The profit trend also predicts the earnings surprise one quarter later, and analyst forecast errors over the following twelve months, suggesting that sophisticated investors underreact to the information in the profit trend. On the other hand, we find no evidence of investor overreaction, and our results cannot be explained by well-known risk factors

Internet Appendix: Asset Pricing without Garbage

This paper provides an explanation for why garbage implies a much lower relative risk aversion in the consumption-based asset pricing model than National Income and Product Accounts (NIPA) consumption expenditure: unlike garbage, NIPA consumption is filtered to mitigate measurement error. I apply a simple model of the filtering process that allows one to undo the filtering inherent in NIPA consumption. “Unfiltered NIPA consumption” well explains the equity premium and is priced in the cross-section of stock returns. I discuss the likely properties of true consumption (i.e., without measurement error and filtering) and quantify implications for habit and long-run risk models.The paper "Asset Pricing without Garbage" to which these Appendices apply is available at the following URL: http://ssrn.com/abstract=2327055.

Ninety Years of Media Coverage and the Cross-Section of Stock Returns

Using a novel dataset on New York Times coverage of U.S. firms from 1924 to 2013, we re-examine the relation between media coverage and stock returns. The relation between changes in media coverage and returns is consistent with an attention-driven price pressure effect: Top-quintile outperform bottom-quintile coverage change stocks by 10.68% during the formation year. Over the next two years, these stocks underperform their counterparts by 5.04%. In contrast to previous findings, the level of media coverage positively predicts stock returns. Top-quintile outperform bottom-quintile coverage stocks by 2.76% per year (Sharpe Ratio of 0.48, Momentum: 0.49). This is consistent with the media having a positive effect on corporate governance and profitability, which is not adequately priced.

The market price of risk of the variance term structure

Abstract In this paper I examine the market price of risk of the variance term structure. To this end, the S&P 500 option implied variance term structure is used as a proxy for aggregate variance risk. Principal component analysis shows that time variation in the variance term structure over the 1996–2012 period can be explained mainly by two factors which capture changes in the level and slope. The market price of risk of each factor is estimated in the cross-section of stock returns. The slope of the variance term structure is the most significant factor in the cross-section of stocks returns and carries a negative risk premium. The slope factor has also some predictive ability over long horizon equity returns.

Comprehending the Growth Effect: Reexamining the Mispricing of Total Asset Growth

Asset growth has been shown to be negatively associated with future returns. Cooper, Gulen, and Schill (2008. Asset Growth and the Cross-Section of Stock Returns. Journal of Finance) argue that an aggregation of all asset growth components as total asset (TA) growth leads to the strongest association with future negative returns. Based on their study, the literature now employs TA growth as an umbrella proxy for “the growth effect.” I hypothesize that not all types of growth imply negative future returns. Specifically, I show that growth financed by suppliers is positively associated with future performance and returns. Removing this growth component from TA growth makes it evident that the TA growth anomaly is simply a noisy manifestation of the net operating asset (NOA) growth anomaly. Consequently, I suggest caution when using TA growth to control for the growth effect.

Skewness, Lottery-Like Features, and the Cross-Section of Stock Returns

We propose a novel perspective on testing the negative relation between skewness/lottery-like features and stock returns in the cross-section. This perspective is deeply rooted in individual investor trading behavior. We construct a composite index to capture individual investor preference on stocks and find a monotonically increasing return predictability of skewness/lottery-like features with the index. Our findings suggest that it is individual investors who pay a price in exchange for a small probability of winning a large payoff, thus leading to the negative relation between skewness and return. Our results are robust to various skewness and MAX measures.

The information content of the sentiment index

The widely-used Baker and Wurgler (2006) sentiment index is strongly correlated with business cycle variables, especially the short interest rate and Lee (2011) liquidity risk factor. The power of the sentiment index to predict cross-sectional stock returns is mainly driven by its information content related to these business cycle variables. About 63% percent of the total variation in the investor sentiment index can be explained by well-known, contemporaneous risk/business cycle variables. We decompose the widely used investor sentiment index into two components: one related to standard risk/business cycle variables and the other unrelated to those variables. We show that the power of the sentiment index to predict cross-sectional stock returns is mainly driven by the risk/business cycle component, while the residual component has little significance in predicting cross-sectional stock returns.

Macro Disagreement and the Cross-Section of Stock Returns

This paper examines the effects of macro-level disagreement on the cross-section of stock returns. Using forecast dispersion measures from the Survey of Professional Forecasters database as proxies for macro disagreement, I find that high macro beta stocks earn lower future returns relative to low macro beta stocks following high macro disagreement states. This negative relation between returns for macro factors and macro disagreement is robust and exists for a large set of macroeconomic factors, suggesting that high macro beta stocks are overvalued compared with low macro beta stocks due to their greater sensitivity to aggregate disagreement.

Financing Constraints and the Substitutability of Labor: Implications for the Cross-Section of Stock Returns

We examine the cross-sectional relation between log growth in physical capital to log growth in labor and subsequent stock returns. The ratio is a strong predictor of negative future returns. This relation strengthens with measures of financing constraint while remaining robust to previously provided determinants of returns. A ratio-based 2-factor model outperforms common models explaining various asset pricing anomalies, indicating that anomalies reflect cross-sectional variation in this ratio. We interpret the findings as outcomes reflecting displacements on the production isoquant, in turn, affecting operating flexibility and risk premia. Other empirical results support this interpretation.

Market-Wide Investor Sentiment, Growth Forecasts, and Cross-Sectional Stock Returns

I analyze whether or not market-wide investor sentiment induces stock mispricing, by affecting the boldness of predictions of firms’ long-term earnings growth. I predict that bullish market-wide sentiment induces investors to aggressively separate firms with high growth futures from others, and that this excessive boldness results in a high level of mispricing. Consistent with my prediction, I observe an excessively large dispersion in consensus growth forecasts when proxies for investor sentiment are high at the beginning of the period. Furthermore, stocks with higher-predicted growth experience more negative forecast revisions and lower subsequent stock returns, especially following periods of high investor sentiment.

Does Crime Pay? Asset Pricing with Revealed Utility of Heterogeneous Consumers

I propose violent crime growth as a measure of revealed marginal utility growth of heterogeneous consumers in incomplete markets. Consumer heterogeneity is measured using the cross-sectional average and cross-sectional variance of crime growth exploiting a monthly panel of reported crime incidents from over 10,000 law enforcement agencies across the United States from 1975-2012. Consistent with heterogeneous consumer models such as Mankiw (1986), I find that the cross-sectional average and variance of violent crime growth can explain the cross-section of stock returns. Specifically, investors pay a premium for assets that have higher betas to the violent crime growth moments.

Information uncertainties and asset pricing puzzles: risk or mispricing?

Purpose – Prior research has documented the role of information uncertainty in the cross-sectional variation in stock returns. Miller (1977) hypothesizes that if information uncertainty is caused by differences of opinion, prices will reflect only the positive beliefs due to short-sale constraints. These anomalous stock price behaviors may result from mispricing. In contrast, Merton (1974) asserts that default risk is a function of the uncertainty in the asset value process. Information uncertainty may be subsumed by credit or default risk. The paper aims to discuss these issues. Design/methodology/approach – The authors employ various sorting techniques and Fama-MacBeth Regressions to test the hypotheses. Findings – The authors provide empirical evidence consistent with Merton’s (1974) default risk hypothesis and inconsistent with Miller’s (1977) mispricing hypothesis. Research limitations/implications – Risk aversion and not misplacing is the primary factor driving information-related anomalies in equities markets. Practical implications – It would be quite difficult to find arbitrage opportunities in equities markets because there appears to be little, if any, mis-pricing due to information uncertainties. Originality/value – This study provides important information about the primary underlying information-related source of certain empirical anomalies in the cross-section of stock returns.

Manager Sentiment and Stock Returns

In this paper, we construct a manager sentiment index based on the aggregated textual tone of conference calls and financial statements. We find that manager sentiment is a strong negative predictor of future aggregate stock market returns, with monthly in-sample and out-of-sample R-square of 9.75% and 8.38%, respectively, which is far greater than the predictive power of other previously studied macroeconomic variables. Its predictive power is also stronger than and is complimentary to the popular investor sentiment indexes. Moreover, manager sentiment also negatively predicts future aggregate earnings and cross-sectional stock returns, particularly for those firms that are either hard to value or difficult to arbitrage.

Default Option and the Cross-Section of Stock Returns

We argue that default option is important for equity valuation and construct a model that explicitly prices the option to default or abandon the firm. An investment strategy that buys stocks that are classified as undervalued by our model and shorts overvalued stocks generates an annual 4-factor alpha of about 11% for U.S. stocks. The model’s performance is stronger for stocks with higher value of default option, such as distressed or highly volatile stocks. We construct a similar strategy in a sample of nine most highly capitalized developed markets and find consistent results. Our findings suggest that investors do not properly incorporate the value of default options in stock prices.

Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns

Accruals are the non-cash component of earnings. They represent adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash. Prior research uncovers two anomalies: expected returns increase in profitability and decrease in accruals. We show that cash-based operating profitability (a measure that excludes accruals) outperforms measures of profitability that include accruals. Further, cash-based operating profitability subsumes accruals in predicting the cross section of average returns. An investor can increase a strategy's Sharpe ratio more by adding just a cash-based operating profitability factor to the investment opportunity set than by adding both an accruals factor and a profitability factor that includes accruals.

The Cross Section of Stock Expected Returns by Chen-Zhang Three-Characteristic Model

The stock expected returns are positively related to operation performances and negatively related to investment and financing activities, we check the three indicators with significant predictive power in the cross-section of stock returns, across large, medium and small cap stock groups: Net Cash Flow from Operation, Accumulative Depreciation, and Change in Common Stock Capital. Stock portfolios with high or low scores in the three indicators demonstrate significant alphas relative to the market portfolio. The long-short portfolios contructed by the scores in the three indicators in large cap and medium cap stock groups demonstrate to enhance the ex-post Sharpe ratio for the market portfolio in back-testing from July 1972 to June 2010.

As told by the supplier: Trade credit and the cross section of stock returns

Abstract With superior information about their customers’ prospects, suppliers extend trade credit to capture future profitable business. We show that this information advantage generates significant return predictability. After controlling for major firm characteristics, firms that rely more on trade credit relative to debt financing have higher subsequent stock returns. The return predictability by trade credit is stronger among firms with lower borrowing capacity or profitability, and is more significant for firms with a higher degree of information asymmetry. Our findings suggest that trade credit extension reveals suppliers’ information that diffuses gradually across the investing public.

Individual Investor Sentiment and Stock Returns: Evidence from the Korean Stock Market

ABSTRACTWe investigate the dynamic relationship between individual investor sentiment and stock returns in the Korean stock market. The evidence indicates that individual investor sentiment has no significant explanatory power for cross-sectional stock returns. However, individual investors’ trades can move stock prices in certain stocks by their contrarian behavior, which leads them to implicitly provide liquidity to other market participants. In addition, individual investors earn a small market-adjusted excess return in the short-horizon future as compensation for liquidity provision. Our findings show that short-horizon return predictability of individual investors does not come from their private information.

The idiosyncratic volatility anomaly: Corporate investment or investor mispricing?

Most of the literature on the idiosyncratic volatility anomaly has focused on plausible explanations for it based on investor preferences, investor irrationality or market characteristics. Surprisingly, the role of asset-pricing models and firm characteristics in the estimation of idiosyncratic risk measures has been largely neglected. Our results suggest that investment and profitability, presumably driven by managers and therefore linked to idiosyncratic risk, are able to account for the anomaly in a cross-section of stock returns. Moreover, we show that this effect is independent and complementary to the effects related to investor preference for skewness.