On the Stability of the Cross‐Section of Expected Stock Returns in the Cross‐Section: Understanding the Curious Role of Share Turnover

In this paper, we shed further light on cross‐sectional predictors of stock return performance. Specifically, we explore whether the cross‐section of expected stock returns is robust within stock groups sorted by past monthly return. We find that the book/market and momentum effects are remarkably robust to sorting on past returns. However, share turnover is negatively related to future returns for stocks with abnormally low stock price performance in the recent past, but postively related to returns for well‐performing stocks. This casts doubt on the use of turnover as a liquidity proxy, but is consistent with turnover being a proxy for momentum trading which pushes prices in the direction of past price movements. Our results are robust to both NYSE/AMEX and Nasdaq stocks, and also robust to stratifying the sample by time period.     

Stock Market Comovements and Industrial Structure

We use monthly stock indices for 58 countries to construct pairwise correlations of returns and explain these correlations with risk‐adjusted differences in industrial structure across countries. We find that countries with similar industries exhibit higher stock market comovements. The results are robust to the inclusion of other regressors such as differences in income per capita, stock market capitalizations, measures of institutions, as well as various fixed time, country, and country‐pair effects. Our results are consistent with models where the impact of each industry‐specific shock is proportional to the share of this industry in the overall industrial output of the country.     

An Analysis of Closed-end Fund Seasoned Equity Offerings

We examine the stock price reaction to seasoned equity offerings (SEOs) of closed‐end funds and the determinants of the issuance decision. We find that sample funds have negative and significant average announcement‐day returns that are less than the returns associated with industrial firm SEOs, most likely because funds have fewer information asymmetries. Issuing funds have higher pre‐issue returns, higher premiums, lower betas, and lower three‐year, post‐issue returns than nonissuing funds. The results of the study are consistent with the argument that fund managers time issues to take advantage of mean reversion in fund returns.     

Bear beta

We test whether bear market risk, time variation in the probability of future bear market states, is priced. We construct an Arrow–Debreu security that pays off in bear market states (AD Bear) from traded Standard & Poor’s (S&P) 500 index options and use its returns to measure bear market risk. We find that bear beta (exposure to bear market risk) has a strong relation with expected stock returns that is robust, persistent, and remains strong among liquid and large stocks. Historical bear beta also predicts future bear market risk exposure. We conclude that bear market risk is priced in the cross section of stock returns.     

Fast profits: Investor sentiment and stock returns during Ramadan

Observed by more than 1.5 billion Muslims, Ramadan is one of the most celebrated religious traditions in the world. We investigate stock returns during Ramadan for 14 predominantly Muslim countries over the years 1989-2007. The results show that stock returns during Ramadan are significantly higher and less volatile than during the rest of the year. No discernible declines in market liquidity are recorded. We find these results consistent with a notion that Ramadan positively affects investor psychology, as it promotes feelings of solidarity and social identity among Muslims world-wide, leading to optimistic beliefs that extend to investment decisions.     

Bank Capital: Lessons from the Financial Crisis

Using a multicountry panel of banks, we study whether better capitalized banks experienced higher stock returns during the financial crisis. We differentiate among various types of capital ratios: the Basel risk‐adjusted ratio, the leverage ratio, the Tier 1 and Tier 2 ratios, and the tangible equity ratio. We find several results: (i) before the crisis, differences in capital did not have much impact on stock returns; (ii) during the crisis, a stronger capital position was associated with better stock market performance, most markedly for larger banks; (iii) the relationship between stock returns and capital is stronger when capital is measured by the leverage ratio rather than the risk‐adjusted capital ratio; (iv) higher quality forms of capital, such as Tier 1 capital and tangible common equity, were more relevant.     

Stock‐Split Post‐Announcement Returns: Underreaction or Market Friction?

We explore the relationship between stock splits and subsequent long‐term returns during the period from 1950 to 2000. We find that, contrary to much previous research, firms do not exhibit positive long‐term post‐split returns. Instead, we find that significant positive returns after the announcement date do not persist after the actual date of the stock split. We also observe that abnormal returns are correlated with the price‐delay or market friction. We conclude that the stock‐split post‐announcement “drift” is only of short duration, and it is attributable to trading frictions rather than behavioral biases.     

ASYMMETRIC COVARIANCE,VOLATILITY, AND THE EFFECT OF NEWS

We propose that covariance (rather than beta) asymmetry provides a superior framework for examining issues related to changing risk premiums. Accordingly, we investigate whether the conditional covariance between stock and market returns is asymmetric in response to good and bad news. Our model of conditional covariance accommodates both the sign and magnitude of return innovations, and we find significant covariance asymmetry that can explain, at least in part, the volatility feedback of stock returns. Our findings are consistent across firm size, firm leverage, and temporal and cross‐sectional aggregations.     

The Risk‐Return Relation in International Stock Markets

We investigate the risk‐return relation in international stock markets using realized variance constructed from MSCI (Morgan Stanley Capital International) daily stock price indices. In contrast with the capital asset pricing model, realized variance by itself provides negligible information about future excess stock market returns; however, we uncover a positive and significant risk‐return tradeoff in many countries after controlling for the (U.S.) consumption‐wealth ratio. U.S. realized variance is also significantly related to future international stock market returns; more importantly, it always subsumes the information content of its local counterparts. Our results indicate that stock market variance is an important determinant of the equity premium.     

Cash Flows and Discount Rates,Industry and Country Effects and Co‐Movement in Stock Returns

We apply the Campbell decomposition to industry‐by‐country, national, global industry, and world stock index returns using 1995–2003 data. World, global industry, and country factors are all important for each of the two key components of stock returns: news about future dividends and news about future discount rates. Furthermore, the world component of future discount rates is more important than the idiosyncratic component, while the reverse is true for news about future dividends. Our results are broadly consistent with co‐movement in future discount rates arising from perceptions of common elements of risk in international equity markets.     

IS THE BOOK‐TO‐MARKET RATIO A MEASURE OF RISK?

We develop a leverage‐based alternative to traditional asset pricing models to investigate whether the book‐to‐market ratio acts as a proxy for risk. We argue that the book‐to‐market ratio should act as a proxy because of the expected relations between (1) financial risk and measures of capital structure based on the market value of equity and (2) asset risk and measures of capital structure based on the book value of equity. We find no relation between average stock returns and the book‐to‐market ratio in all‐equity firms after controlling for firm size, and an inverse relation between average stock returns and the book‐to‐market ratio in firms with a negative book value of equity.     

ANALYZING STOCK MARKET VOLATILITY USING EXTREME‐DAY MEASURES

We develop a simple measure of volatility based on extreme‐day returns and apply it to market returns from 1885 to 2002. Because returns are not normally distributed, the extreme‐day measure, which is distribution free, might provide a better measure of stock market risk than the traditional standard deviation. The extreme‐day measure more accurately explains investor behavior relative to standard deviation as shown by equity fund flows, and we find evidence that large negative changes appear to influence investor behavior more than large positive changes.     

Overconfidence among option traders

The investor overconfidence theory predicts a direct relationship between market‐wide turnover and lagged market return. However, previous research has examined this prediction in the equity market, we focus on trading in the options market. Controlling for stock market cross‐sectional volatility, stock idiosyncratic risk, and option market volatility, we find that option trading turnover is positively related to past stock market return. In addition, call option turnover and call to put ratio are also positively associated with the past stock market return. These findings are consistent with the overconfidence theory. We also find that overconfident investors trade more in the options market than in the equity market. We rule out explanations other than investor overconfidence, such as momentum trading and varying risk preferences, for our findings.     

A test of risk arbitrage profitability

We explore the performance of risk arbitrage involving three types of merger offers: cash tender, stock swap, and collar offers for the period between 1990 and 2000. Our result reveals that risk arbitrage for a successful stock offer generates higher returns than a successful cash offer. This finding implies that the profitability of risk arbitrage depends on the level of asymmetric information associated with the payment method. We also find that the beta of typical risk arbitrage positions/portfolios is heavily influenced by the payment method and market conditions.     

PRESIDENTIAL ELECTION UNCERTAINTY AND COMMON STOCK RETURNS IN THE UNITED STATES

There is substantial evidence on the influence of political outcomes on the business cycle and stock market. We further hypothesize that uncertainty about the outcome of a U.S. presidential election should be reflected in pre‐election common stock returns. Prior research pools returns based on the party of the winning candidate, assuming that the outcome of the election is known a priori. We use candidate preference (i.e., polling) data to construct a measure of election uncertainty. We find that if the election does not have a candidate with a dominant lead, stock market volatility (risk) and average returns rise.     

Do Sovereign Re‐Ratings Destabilize Equity Markets during Financial Crises? New Evidence from Higher Return Moments

This study investigates the effects of S&P's sovereign re‐ratings on the higher moments of equity market returns over recent financial crises. Using a set of intraday stock market index prices and sovereign credit ratings for a sample of 36 countries that experienced sovereign rating changes over the period from 1996 to 2013, we find that the higher moments of stock market returns are significantly more responsive to sovereign re‐ratings during financial crises, but the effects on stock markets are not the same across different financial crises. The effects during crises are, however, magnified for large downgrades and those that are associated with a loss of investment grade status. We find that there are asymmetric effects during financial crises in that downgrades are consistently more significant than upgrades in increasing realized volatility and realized kurtosis. Both upgrades and downgrades affect realized skewness in times of crises in the expected direction.     

Correlation and return dispersion dynamics in Chinese markets

This paper studies the relation between firm-level return dispersions and correlations among Chinese stocks during periods of unusually large upward and downward swings. We analyze individual stock returns across 18 sectors and test if return dispersions and stock correlations show asymmetric patterns for extreme up and down markets. Evidence from studies on U.S. stocks suggests that equity return correlations tend to be much greater on the downside than on the upside and that the degree of comovement gets even stronger during extreme market states. However, in the case of Chinese stock market, we find that higher downside correlations apply to only stocks within the Financial sector. With the exception of Financial stocks, we find that stock correlations are significantly higher during up markets, rather than down markets. Regarding firm-level return dispersions, our findings are consistent with rational asset pricing model predictions. We find that equity return dispersions are significantly higher during periods of large price changes.     

Time‐Varying Risk–Return Trade‐off in the Stock Market

We uncover a strong comovement of the stock market risk–return trade‐off with the consumption–wealth ratio (CAY). The finding reflects time‐varying investment opportunities rather than countercyclical aggregate relative risk aversion. Specifically, the partial risk–return trade‐off is positive and constant when we control for CAY as a proxy for investment opportunities. Moreover, conditional market variance scaled by CAY is negatively priced in the cross‐section of stock returns. Our results are consistent with a limited stock market participation model, in which shareholders require an illiquidity premium that increases with CAY, in addition to the risk premium that is proportional to conditional market variance.     

Do Decomposed Financial Ratios Predict Stock Returns and Fundamentals Better?

We investigate the prediction of excess returns and fundamentals by financial ratios, which include dividend‐price ratios, earnings‐price ratios, and book‐to‐market ratios, by decomposing financial ratios into a cyclical component and a stochastic trend component. We find both components predict excess returns and fundamentals. Cyclical components predict increases in future stock returns, while stochastic trend components predict declines in future stock returns in long horizons. This helps explain previous findings that financial ratios in the absence of decomposition find weak predictive power in short horizons and some predictive power in long horizons. We also find both components predict fundamentals.     

Bank Earnings Management and Tail Risk during the Financial Crisis

We show that a pattern of earnings management in bank financial statements has little bearing on downside risk during quiet periods, but seems to have a big impact during a financial crisis. Banks demonstrating more aggressive earnings management prior to 2007 exhibit substantially higher stock market risk once the financial crisis begins as measured by the incidence of large weekly stock price “crashes” as well as by the pattern of full‐year returns. Stock price crashes also predict future deterioration in operating performance. Bank regulators may therefore interpret them as early warning signs of impending problems.