Discussion of “The Role of Expectations in Explaining the Cross-Section of Stock Returns”

This paper discusses Copeland et al. (2004), which empirically investigates the role of changes in expectations in explaining contemporaneous cross-sectional stock returns. Because the main results in this study are largely confirmatory of results reported in prior literature, my discussion emphasizes conceptual issues in the econometric specification of earnings–return relations. I derive three versions of return specifications from popular valuation models based on residual earnings, free cash flows, or earnings growth, and contrast them with that adopted by Copeland et al. (2004). This analysis suggests that firmer grounding in theory would help the paper in empirical specifications as well as interpretations of results.     

Expectations and the Cross-Section of Stock Returns

Previous research has shown that stocks with low prices relative to book value, cash flow, earnings, or dividends (that is, value stocks) earn high returns. Value stocks may earn high returns because they are more risky. Alternatively, systematic errors in expectations may explain the high returns earned by value stocks. I test for the existence of systematic errors using survey data on forecasts by stock market analysts. I show that investment strategies that seek to exploit errors in analysts' forecasts earn superior returns because expectations about future growth in earnings are too extreme.     

The Cross-Section of Expected Stock Returns

Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market β, size, leverage, book-to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in β that is unrelated to size, the relation between market β and average return is flat, even when β is the only explanatory variable.     

The Usefulness of Book-to-Market and ROE Expectations for Explaining UK Stock Returns

Abstract:  The fundamental valuation perspective on stock returns suggests that book-to-market will be positively related to returns if market value of equity equals future expected cash flows discounted at the expected return and book value proxies for future cash flows. Building on this perspective, we develop a log linear model which includes expectations of future BM and ROE in addition to current BM as explanatory variables for future stock returns. We show that these three variables explain a significant part of UK cross-sectional stock returns and that they remain highly statistically significant after including additional risk proxy variables. This supports relevance of fundamental valuation based firm characteristics for explaining stock returns and indicates their potential usefulness for predicting future stock returns.     

The Role of Beta and Size in the Cross-Section of European Stock Returns

This paper examines the ability of beta and size to explain cross-sectional variation in average returns in 12 European countries. We find that average stock returns are positively related to beta and negatively related to firm size. The beta premium is in part due to the fact that high beta countries outperform low beta countries. Within countries high beta stocks outperform low beta stocks only in January, not in other months. We reject the hypothesis that differences in average returns on size- and beta-sorted portfolios can be explained by market risk and exposure to the excess return of small over large stocks (SMB). Consistent with recent US evidence, we find that after controlling for size, there is no association between average returns and exposure to SMB.     

The Cross-Section of Stock Returns on The Shanghai Stock Exchange

This study explores the cross-sectional stock return behavior on the A-share market of the Shanghai Stock Exchange (SSE), which is segmented from world's other equity markets. We estimate the effects of beta, firm size, book-to-market equity ratio and a variable unique to the Chinese stock markets, the proportion of firm's floating (tradable) equity over total equity on SSE stocks over the period 1993–2002. We find that smaller firms and value stocks perform better. Systematic risk is negatively significant in down markets. The proportion of floating equity has no direct effect on stock returns. JEL Classification: G14, G15     

Diagnostic Expectations and Stock Returns

We revisit La Porta's finding that returns on stocks with the most optimistic analyst long‐term earnings growth forecasts are lower than those on stocks with the most pessimistic forecasts. We document the joint dynamics of fundamentals, expectations, and returns of these portfolios, and explain the facts using a model of belief formation based on the representativeness heuristic. Analysts forecast fundamentals from observed earnings growth, but overreact to news by exaggerating the probability of states that have become more likely. We find support for the model's predictions. A quantitative estimation of the model accounts for the key patterns in the data.     

Investor Sentiment and the Cross-Section of Stock Returns

We study how investor sentiment affects the cross‐section of stock returns. We predict that a wave of investor sentiment has larger effects on securities whose valuations are highly subjective and difficult to arbitrage. Consistent with this prediction, we find that when beginning‐of‐period proxies for sentiment are low, subsequent returns are relatively high for small stocks, young stocks, high volatility stocks, unprofitable stocks, non‐dividend‐paying stocks, extreme growth stocks, and distressed stocks. When sentiment is high, on the other hand, these categories of stock earn relatively low subsequent returns.     

Asset Growth and the Cross-Section of Stock Returns

We test for firm-level asset investment effects in returns by examining the cross-sectional relation between firm asset growth and subsequent stock returns. Asset growth rates are strong predictors of future abnormal returns. Asset growth retains its forecasting ability even on large capitalization stocks. When we compare asset growth rates with the previously documented determinants of the cross-section of returns (i.e., book-to-market ratios, firm capitalization, lagged returns, accruals, and other growth measures), we find that a firm's annual asset growth rate emerges as an economically and statistically significant predictor of the cross-section of U.S. stock returns.     

The Cross-Section of Realized Stock Returns: The Pre-COMPUSTAT Evidence

Using a database that is free of survivorship bias, this article finds that book-to-market equity, earnings yield, and cash flow yield have significant explanatory power with respect to the cross-section of realized stock returns during the period from July 1940 through June 1963. There is a strong January seasonal in the explanatory power of these variables, even though small stocks are, by construction, excluded from the sample.     

The Errors in the Variables Problem in the Cross-Section of Expected Stock Returns

Recent research has documented the failure of market beta to capture the cross-section of expected returns within the context of a two-pass estimation methodology. However, the two-pass methodology suffers from the errors-in-variables (EIV) problem that could attenuate the apparent significance of market beta. This article provides a new correction for the EIV problem that is robust to conditional heteroscedasticity. After the correction, I find more support for the role of market beta and less support for the role of firm size in explaining the cross-section of expected returns. While the EIV correction leads to a diminished role of firm size, the size variable remains a significant force in explaining the cross-section of expected returns.     

Monetary Policy and the Cross-Section of Expected Stock Returns

Ample evidence shows that size and book-to-market equity explain significant cross-sectional variation in stock returns, whereas beta explains little or none of the variation. Recent studies also demonstrate that proxies for monetary stringency increase the explained variation in stock returns. We reexamine a three-factor model that includes beta, size, and book-to-market equity, while allowing monetary conditions to influence the relations between these risk factors and average stock returns. We find that ex-ante proxies for monetary stringency significantly influence the relations between stock returns and all three risk factors. Additionally, all three variables are found to contribute significantly to explaining cross-sectional returns in a three-factor model that includes the monetary sector.     

The Cross-Section of Expected Stock Returns: New Evidence from an Emerging Market

Over 300 factors have been found to explain the cross-section of expected stock returns. Empirical studies also show that findings from multifactor asset-pricing models have not been consistent in an emerging market. Using DuPont analysis and a residual income valuation model for 284 nonfinancial companies on Ho Chi Minh Stock Exchange during the period 2008–2014, findings suggest that the return on equity and its change are informative for stock returns in Vietnam. In addition, the level of capital turnover, financial cost ratio (FCR), and changes in capital and in the FCR contain incremental explanatory power for stock returns.     

Lazy Investors, Discretionary Consumption, and the Cross-Section of Stock Returns

When consumption betas of stocks are computed using year‐over‐year consumption growth based upon the fourth quarter, the consumption‐based asset pricing model (CCAPM) explains the cross‐section of stock returns as well as the Fama and French (1993) three‐factor model. The CCAPM's performance deteriorates substantially when consumption growth is measured based upon other quarters. For the CCAPM to hold at any given point in time, investors must make their consumption and investment decisions simultaneously at that point in time. We suspect that this is more likely to happen during the fourth quarter, given investors' tax year ends in December.     

The Cross-Section of Volatility and Expected Returns

We examine the pricing of aggregate volatility risk in the cross‐section of stock returns. Consistent with theory, we find that stocks with high sensitivities to innovations in aggregate volatility have low average returns. Stocks with high idiosyncratic volatility relative to the Fama and French (1993, Journal of Financial Economics 25, 2349) model have abysmally low average returns. This phenomenon cannot be explained by exposure to aggregate volatility risk. Size, book‐to‐market, momentum, and liquidity effects cannot account for either the low average returns earned by stocks with high exposure to systematic volatility risk or for the low average returns of stocks with high idiosyncratic volatility.     

Predictable Stock Returns: The Role of Small Sample Bias

Predictive regressions are subject to two small sample biases: the coefficient estimate is biased if the predictor is endogenous, and asymptotic standard errors in the case of overlapping periods are biased downward. Both biases work in the direction of making t-ratios too large so that standard inference may indicate predictability even if none is present. Using annual returns since 1872 and monthly returns since 1927 we estimate empirical distributions by randomizing residuals in the VAR representation of the variables. The estimated biases are large enough to affect inference in practice, and should be accounted for when studying predictability.     

The Relative Importance of Stock, Bond and Real Estate Factors in Explaining REIT Returns

This paper examines the link between REIT, financial asset and real estate returns, and tests whether it changed subsequent to the “REIT boom” of the early 1990s. The main focus is on answering the question do REIT returns now better reflect the performance of underlying direct (unsecuritized) real estate? We develop and implement a variance decomposition for REIT returns that separates REIT return variability into components directly related to major stock, bond, and real estate-related return indices, as well as idiosyncratic or sector-specific effects. This is applied to aggregate REIT sector (NAREIT) returns as well as returns to size and property-type based REIT portfolios. Our results show that the REIT market went from being driven largely by the same economic factors that drive large cap stocks through the 1970s and 1980s to being more strongly related to both small cap stock and real estate-related factors in the 1990s. There is also a steady increase over time in the proportion of volatility not accounted for by stock, bond or real estate related factors. We also find that small cap REITs are “more like real estate” compared to larger cap REITs, at least over the 1993–1998 period. We argue that this could be a result of the institutionalization of the ownership of larger cap REITs that took place in the 1990s.     

The Conditional Beta and the Cross-Section of Expected Returns

We examine the cross-sectional relation between conditional betas and expected stock returns for a sample period of July 1963 to December 2004. Our portfolio-level analyses and the firm-level cross-sectional regressions indicate a positive, significant relation between conditional betas and the cross-section of expected returns. The average return difference between high- and low-beta portfolios ranges between 0.89% and 1.01% per month, depending on the time-varying specification of conditional beta. After controlling for size, book-to-market, liquidity, and momentum, the positive relation between market beta and expected returns remains economically and statistically significant.     

The Conditional CAPM and the Cross-Section of Expected Returns

Most empirical studies of the static CAPM assume that betas remain constant over time and that the return on the value-weighted portfolio of all stocks is a proxy for the return on aggregate wealth. The general consensus is that the static CAPM is unable to explain satisfactorily the cross-section of average returns on stocks. We assume that the CAPM holds in a conditional sense, i.e., betas and the market risk premium vary over time. We include the return on human capital when measuring the return on aggregate wealth. Our specification performs well in explaining the cross-section of average returns.     

Macro Liquidity Risk,Money Growth,and the Cross-Section of Stock Returns: The Case of Korea

According to the homogeneity of money holding purpose, we decompose the broad money M2 into an underlying and a non-underlying part and propose innovations in future non-underlying M2 growth as a proxy for macro liquidity. In both the cross-sectional regression tests and the GMM tests, we find that risk related to innovations in future non-underlying M2 growth is strongly significantly priced in Korea, after controlling for the well-known risk factors and other macroeconomic variables. Meanwhile, risk related to innovations in future aggregate or underlying M2 growth is insignificantly priced. These results indicate that non-underlying M2 growth more directly affects macro liquidity than does aggregate or underlying M2 growth.