Equity Yield Research Articles

Short-Term Market Timing Using the Bond-Equity Yield Ratio

The Bond-Equity Yield Ratio (BEYR) has recently become a popular relative pricing tool favored by market practitioners. In this paper we compare the short-term profitability of a naive strategy based on the extreme values of the BEYR to the short-term profitability of a more sophisticated strategy relying on regime switches. Although the latter seems to perform better than the former, there is no overwhelming international evidence that these dynamic strategies deliver significantly higher risk-adjusted returns than the buy-and-hold portfolios. In addition, the profitability of these active strategies does not appear to be significantly different when the equity yield, instead of the BEYR, is used as criterion to time the market.

Overconfidence, Short-Sale Constraints, and Stock Valuation

There is a recent renaissance in the research of investor differences of opinion and short-sale constraints. This literature usually assumes that investor opinion is generated from an exogenous distribution and hence does not link opinion divergence and stock valuation to stock fundamentals. In addition, most theories simply model short-sale constraints as short-sale prohibition. This paper develops a stock market model based on investor overconfidence and short-sale constraints, in which overconfidence generates differences of opinion and the degree of short-sale constraints is variable. In the model, after receiving private signals, overconfident investors and rational investors exchange one risky asset with which there is a restriction in maximum number of shortable shares. In equilibrium, conditional on private signals, stocks can be overvalued or undervalued. How stocks are mispriced depends on whether private signals are favorable or adverse and, accordingly, what investors are bound by short-sale constraints. However, due to the asymmetry in under- and overvaluation introduced by short-sale constraints, on average, stocks are overvalued. The model produces a distribution of investor differences of opinion that is correlated with stock fundamentals, which explains the cross-sectional differences in opinion divergence. The models also examines the effects of investor overconfidence and short-sale constraints on opinion divergence, trading volume, and short interest. It shows that a variation in overconfidence induces a negative correlation between subsequent stock returns and opinion divergence, trading volume, or short interest. In contrast, a variation in short-sale constraints generates a positive correlation between subsequent stock returns and trading volume or short interest but has no effects on opinion divergence. These relationships provide an explanation for a number of stylized facts in the cross-section. After we further incorporate multiple assets whose payoffs share a common factor, the model gives many implications for the time-series behavior of aggregate returns. It explains the ability of cross-sectional averages of firm valuation measures (such as book-to-market equity and dividend yield) to forecast market returns and returns of various portfolios. It also provides an explanation for the stronger predictability of equal-weight market returns than value-weight market returns. Finally, we suggest a number of new predictors of aggregate returns, including cross-sectional averages of opinion divergence, of trading volume, and of short interest, and cross-sectional dispersions of firm misvaluation and of opinion divergence.

Implied Equity Duration: A New Measure of Equity Security Risk

We derive a measure of implied equity duration as a natural extension of the traditional measure of bond duration and develop an algorithm for the empirical estimation of implied equity duration. We show that the standard empirical predictions and results for bond duration hold for our measure of implied equity duration and that implied equity duration represents an important common factor in stock returns. We also show that the book-to-market factor advocated by Fama and French (1993) acts as a noisy proxy for an underlying duration factor. Finally, we provide evidence that the long-run equity yield curve is downward sloping for durations up to 20 years. Our results suggest that existing empirical tests of asset pricing models using short holding period equity returns are misspecified.

Dynamic Asset Allocation Between Stocks and Bonds Using the Bond-Equity Yield Ratio

We put forward the Bond-Equity Yield Ratio (BEYR) as a criterium to dynamically allocate capital between equities and bonds on a short-term basis. Relying upon 30 years of monthly data for a large collection of countries, we use the cointegration, regimeswitching and ARMA-GARCH type methodologies to model and forecast the BEYR. While no model systematically beats the random walk from a statistical point of view, the out-of-sample forecasts show that the regime-switching model based on the forecasted probability generates the best and most consistent trading performance. A strategy based on the distribution percentiles is also consistent in its ability to outperform the buy-andhold strategies. All in all, the BEYR is a remarkable relative market pricing tool in the US as it delivers higher risk-adjusted returns than the equity yield on a short-term basis.

The trading profitability of forecasts of the gilt–equity yield ratio

Research has highlighted the usefulness of the Gilt–Equity Yield Ratio (GEYR) as a predictor of UK stock returns. This paper extends recent studies by endogenising the threshold at which the GEYR switches from being low to being high or vice versa, thus improving the arbitrary nature of the determination of the threshold employed in the extant literature. It is observed that a decision rule for investing in equities or bonds, based on the forecasts from a regime switching model, yields higher average returns with lower variability than a static portfolio containing any combinations of equities and bonds. A closer inspection of the results reveals that the model has power to forecast when investors should steer clear of equities, although the trading profits generated are insufficient to outweigh the associated transaction costs.

The Information Content of the Gilt–equity Yield Ratio

In principle the gilt–equity yield ratio (GEYR) can be used as a decision criterion for choosing between equity and bonds because it is sensitive to mispricing. However, the GEYR is also influenced by other variables. Consequently, observed movement in the GEYR cannot be confidently attributed to mispricing without controlling for the other variables which might cause the GEYR to vary. This paper demonstrates that the GEYR can be used as a signal to switch profitably between equity and bonds provided that the GEYR threshold value indicating a profitable switch is adjusted to incorporate changes in variables such as expected inflation and the equity risk premium. Simple empirical experiments are carried out aimed at evaluating how well the GEYR performs as a trading rule.

Equity and Growth Revisited: A Supply-Side Approach to Social Development

Does combining several arguments on the relationship between equity and growth yield new insight? Redistribution with growth, prominent in the 1970s, is currently being revisited. East Asian experiences can also be considered with a view to equity. Human development makes a strong case for combining equity and growth along the lines of human capital, but leaves the social dimension unexplored. Studies of welfare states add finesse to equity-growth arguments. Sociology of economics addresses questions of embeddedness, social capital, networks and trust, which are rarely considered in this context. By adding novel elements, this exercise seeks to arrive at a new overall perspective on social development.

THE ROLE OF FINANCIAL SPREADS: EMPIRICAL ANALYSIS OF SPREADS AND REAL ACTIVITY*

The issues of interpretation and estimation of VAR models of output which use financial spreads as indicators are reviewed and new empirical evidence is provided using U.K. data. The principal extensions to the existing U.S. literature are estimation of the role of spreads in the context of a cointegrating model as well as a dynamic VAR, and also use of the reverse yield gap (bond yield less equity yield) as an alternative indicator to traditional spreads such as the yield gap and credit quality spread. The evidence presented suggests financial spreads may have an important indicator function in the U.K., especially in predicting short-run movements in the real economy. Copyright 1994 by Blackwell Publishers Ltd and The Victoria University of Manchester

An Elasticity Approach to Equity Risk Evaluation

This study defines and derives a measure of risk for real estate investment decisions using the concept of elasticity. Specifically, the elasticity of the aftertax equity yield with respect to the ...

A simple model for estimating intrinsic value

ow do we discover the anticipated return 46 (I, s H e ? 8 on corporate equities, when there are no directly observable data? Unlike most other financial assets, equities provide no promised cash flow m c l have no maturity date for redemption at a fixed price. Some analysts assume that bond:; and stocks are perfect substitutes, with the equity yield equal to the bond yield plus a constant risk premium. Yet economic theory provides little support for the idea of constant risk premia. In general, risk premiums depend on asset riskiness, investor preferences, and relative supplies. It would be quite a coincidence if changes in these factors always just balanced each other out. Some analysts instead use the earnings-price ratio as an estimate of equity yields. This figure would be correct if the profit rate on retained earnings is equal to the shareholders’ required yield on equity. While this equality might hold in a theoretical long-run equilibrium, such an equality is far from guaranteed in the short run that we mortals inhabit. Indeed, a desire to estimate the gap between the profit rate and the equity yield is often the very reason why economists want to estimate the equity yield in the first place. This gap is an important gauge of the incentives !for corporations to invest in new plant and equipent . Other analysts estimate the yield on equity as the dividend-price ratio plus a constant, reflecting either an infinite holding period with constcant growth expectations or a one-year holding period with constant capital gains expectations. Such assumptions are

LEVERAGE, DIVIDEND POLICY AND THE COST OF CAPITAL: COMMENT

IN A RECENT COMMENT in this Journal [1] and a recent article [2], Davenport attacks Brigham and Gordon for misspecifying the model the latter developed and tested in [3]. The problem of allowing for expected growth in the earnings of the firm is one of the major difficulties encountered in empirical testing of the MM theory of the effects of leverage on the cost of capital. Davenport criticisms Brigham and Gordon for dealing with this problem in [3] by adopting the familiar infinite horizon growth model [and combining] this equity valuation growth model with MM's equity yield equation based on the assumption of constant future earnings, to derive an entirely invalid regression model.' In their reply [4] Brigham and Gordon disagree and in their opening sentence state We cannot understand the reasoning under which Davenport rejected our model. . This comment aims to clarify the position by showing that, whatever else may be wrong with the Brigham and Gordon study, the major criticism levelled by Davenport is not justified; and that in fact it is Davenport himself who is guilty of the sin of misspecification. To show this we use the discrete form of the perpetual growth model used by Brigham and Gordon and Davenport, i.e.

Evidence on the Importance of Financial Structure

equity in lower ranges of debt to equity to lower the firm's cost of capital. Beyond an ill-defined point, however, due to excessive risk, the securities markets will not react favorably to further increases in the degree of leverage used by the firm, and its cost of capital will rise. Thus, there is an optimum financial structure that minimizes cost of capital. In basic conceptual disagreement are the proponents of the independence hypothesis. Modigliani and Miller [5, 6, 7], in particular, argue that, given certain conditions (i.e., no taxes on corporate income and perfect capital markets), cost of capital is not influenced by a firm's financing mix. The favorable effect upon total market value of substituting nominally low-cost debt for high-cost equity in the firm's financial structure will be offset exactly by a decrease in the price that investors are willing to pay for the firm's common stock. A higher common equity yield is imposed by the market in return for being exposed to greater financial risk. Thus the cost of capital is independent of the financial structure of the firm, and financing decisions are of minimal importance. By strict interpretation, these two theories stand at opposite poles. The principal differences between them disappear, however, in a world where interest exp nse is tax deductible and market imperfections operate to restrict the amount of fixed-income obligations a firm can issue [9, pp. 39-41]. Both schools of thought do in fact subscribe to the optimum financial structure concept under conditions approximating the actual business environment. Accordingly, it is the objective of this article to present evidence on whether the importance of the financial structure of the firm has in practice been confirmed by corporate decision makers. It is hypothesized that, if the financing decision is critical with respect to the valuation of the firm, then decision makers in various industry groups have recognized this fact and developed financial structures suited to their particular business risk. The approach will be to show that an appropriate range of leverage exis s for a particular industry and that firms seek to find this range. In addition, it will be demons rated that inter-industry financial structure differences are persistent over time and are pervasive through ut the industries studied.