Conditional Persistence of Earnings Components and Accounting Anomalies

We suggest that the failure of investors to distinguish between an earnings component's autocorrelation coefficient (unconditional persistence) and the marginal contribution of that component's persistence to the persistence of earnings (conditional persistence) provides a partial explanation of post‐earnings‐announcement drift, post‐revenue‐announcement drift, and the accrual anomaly. When the conditional persistence of revenue surprises is high (low) relative to its unconditional persistence, both the post‐earnings‐announcement drift and the post‐revenue‐announcement drift are high (low), because investors’ under‐reaction to revenues and earnings is stronger when the persistence of revenue surprises is more strongly associated with the persistence of earnings surprises. Also, the mispricing of accruals decreases substantially when the conditional persistence of accruals is high relative to its unconditional persistence, because investors’ over‐reaction to accruals is mitigated when the persistence of accruals is indeed more strongly associated with the persistence of earnings. Our findings also suggest that financial analysts’ failure to distinguish between unconditional and conditional persistence of revenues and accruals results in more biased revenue and earnings predictions.     

The option market’s anticipation of information content in earnings announcements

We exploit information in option prices in order to study whether the ex post responsiveness of stock prices to earnings information is reflected from an ex ante, firm- and quarter-specific perspective. Specifically, we develop a measure of anticipated information content (AIC) that isolates the forecasted magnitude of the stock market’s reaction to earnings information. We find that the AIC positively correlates with the ex post magnitude of the stock market sensitivity to unexpected earnings, increases with earnings persistence, firm growth prospects, the richness of firms’ information environments and the presence of (and changes in) sophisticated ownership, and decreases with discount rates. Our paper sheds light on the role that earnings information plays in shaping option-market behavior and offers researchers an option-market approach to studying the responsiveness of stock prices to earnings information.     

Performance persistence of closed-end funds

Studies of performance persistence of closed-end funds (CEFs) use two measures of persistence; autocorrelation and rank correlation of performance. The autocorrelation measure offers limited information because it cannot separate persistence relative to the market and to the industry. The rank correlation measure is generally applied to two periods, disregarding multi-period persistence. We investigate performance persistence of CEFs in terms of both market price return and net asset value return using contingency tables and multiple regression models. Jensen’s alpha and the Sharpe ratio are used as measures of risk-adjusted performance. We test three hypotheses: (i) CEFs performing better than the industry median will do so persistently, (ii) CEFs outperform the market persistently; and (iii) performance persistence can be partly explained by dividend yield. The findings are fivefold. First, the number of persistent years varies with the models used to calculate risk-adjusted performance. Second, with 4-index unconditional beta fixed variance model, CEFs persistently beat their industry for six out of 10 years in terms of both market price return and net asset value return. Third, with a 4-index unconditional beta fixed variance model, we find performance persistence relative to market for 6 and 7 years, out of the 10 years considered, in terms of market price return and net asset value return, respectively. Fourth, the disaggregate sample tests show that performance of municipal bond funds is more persistent than equity funds and taxable bond funds. Fifth, dividend patterns can partially explain persistence with liquidity as control.     

A Cross-Sectional Empirical Test of a Dual-State Multi-Factor Pricing Model

During empirical testing of the Capital Asset Pricing Model an assumption is typically made that risk is intertemporally constant. However, prior research finds that risk changes over time. We empirically test a conditional dual-state cross-sectional model allowing risk to change through prior identification of different market and economic states. We examine relationships between returns and conditional market and economic-factor betas, size, book-to-market equity, and earnings-price ratios. We find that relationships shift across regimes, suggesting the importance of a conditional, as opposed to unconditional, model. Relationships also change in January.     

Publicly traded versus privately held: implications for conditional conservatism in bank accounting

Compared with privately held banks, publicly traded banks face greater agency costs because of greater separation of ownership and control but enjoy greater benefits from access to the equity capital market. Differences in control and capital market access influence public versus private banks’ accounting. We predict and find that public banks exhibit greater degrees of conditional conservatism (asymmetric timeliness of the recognition of losses versus gains in accounting income) than private banks. We predict and find that public banks recognize more timely earnings declines, less timely earnings increases, and larger and more timely loan losses. Although public ownership gives managers greater ability and incentive to exercise income-increasing accounting, our findings show that the demand for conservatism dominates within public banks and that the demand for conservatism is greater among public banks than private banks. Our results provide insights for accounting and finance academics, bank managers, auditors, and regulators concerning the effects of ownership structure on conditional conservatism in banks’ financial reporting.

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.     

Variance Spillover and Skewness in Financial Asset Returns

Bond and stock returns have been observed in the literature to exhibit unconditional skewness and temporal persistence in conditional skewness. We demonstrate that observed persistence in conditional third central moments can be due to the spillover of conditional variance dynamics. The confounding of true skewness and a variance spillover effect is problematic for financial modeling. Using market data, we empirically demonstrate that a simple standardization approach removes the variance‐induced skewness persistence. An important implication is that more parsimonious return and asset pricing models result if skewness persistence need not be modeled.     

Underwriting relationships: Information production costs, underwriting fees, and first mover advantage

We study underwriting relationships in the floating rate debt market, where many issuers have a large number of offerings. We find that frequent issuers maintain close relationship with only three to five underwriters and pay significantly less underwriting fees than infrequent issuers. The findings are consistent with the notion that starting an underwriting relationship requires expenses for information production. We also find that an issuer’s first underwriter has a cost advantage over later-comers in competing for the issuer’s business. As a result, the first underwriter wins a larger share of the issuer’s business. JEL Classification G21 · G24     

Does It Pay to Bet Against Beta? On the Conditional Performance of the Beta Anomaly

Prior studies find that a strategy that buys high‐beta stocks and sells low‐beta stocks has a significantly negative unconditional capital asset pricing model (CAPM) alpha, such that it appears to pay to “bet against beta.” We show, however, that the conditional beta for the high‐minus‐low beta portfolio covaries negatively with the equity premium and positively with market volatility. As a result, the unconditional alpha is a downward‐biased estimate of the true alpha. We model the conditional market risk for beta‐sorted portfolios using instrumental variables methods and find that the conditional CAPM resolves the beta anomaly.     

Never judge a book by its cover: what security analysts have to say beyond recommendations

Our study analyzes market reaction to the entire content of a large sample of analysts’ reports from the period 2002 to 2004 for the German market. In particular, we explore whether the three summary measures in the reports, i.e., recommendation revisions, earnings forecast revisions, and target price forecast revisions are acknowledged by the market. Additionally, we investigate if stated justifications in the written text of analysts’ reports contain information value beyond the three summary measures. We find that earnings forecast revisions and target price forecast revisions contain valuable information, both unconditionally and conditional on the rest of the information in the report. Our findings also reveal that justifications made by analysts are of high salience to market participants. These justifications provide valuable information, both unconditionally and conditional on all other types of information in a report. Our findings also suggest that business ties between banks and the analyzed companies do not affect market reaction to dissemination of an analysts’ report.

Conservatism in residual income models: theory and supporting evidence

In this paper, we develop a framework for evaluating the impact of conservative accounting on the structure of residual income models of equity valuation. We explore specific examples of both unconditional and conditional conservatism and observe a common mathematical structure. We proceed to generalise our model and identify the joint dependency of conservatism and the persistence of abnormal earnings on the weights attached to book values, earnings and dividends. We are able to show theoretically the likely numerical impact of conservatism on price-earnings ratios and under-valuations produced by residual income models. We investigate empirically the interaction between conservatism and persistence and find they accord well with the theory developed. We briefly discuss the implications of testing the effect of conservatism on valuation and linear information dynamics.     

Accounting conservatism and the profitability of corporate insiders

We predict that accounting conservatism influences insiders' opportunities to speculate on good and bad news, and thus, insider trading profitability. We find that greater conditional (unconditional) conservatism is associated with lower (higher) insiders' profitability from sales. We find limited evidence that conservatism influences profitability from purchases. These findings are consistent with our hypotheses on the different informational roles of conditional and unconditional conservatism, and on the asymmetric influence of conservatism over the opportunities to speculate on good versus bad news. Our research design takes into consideration the endogenous nature of insiders' trading and conservatism. The results are robust to different measures of conservatism and a number of additional analyses.     

Volatility and cross correlation across major stock markets

Several papers have documented the fact that correlations across major stock markets are higher when markets are more volatile—this is done by comparing unconditional correlations over sub-periods or by using conditional correlations that are time varying. In this paper we examine the relation between correlation and variance in a conditional time and state varying framework. We use a switching ARCH (SWARCH) technique that does two things. One, it enables us to model variance as state varying. Two, a bivariate SWARCH model allows us to go from conditional variance to state varying covariances and correlations and hence test for differences in correlations across variance regimes. We find that the correlations between the U.S. and other world markets are on average 2 to 3.5 times higher when the U.S. market is in a high variance state as compared to a low variance regime. We also find that, compared to a GARCH framework, the portfolio choices resulting from our SWARCH model lead to higher Sharpe ratios.     

Forecasting Japanese Stock Returns with Financial Ratios and Other Variables

This paper extends the previous analyses of the forecastability of Japanese stock market returns in two directions. First, we carefully construct smoothed market price–earnings ratios and examine their predictive ability. We find that the empirical performance of the price–earnings ratio in forecasting stock returns in Japan is generally weaker than both the price–earnings ratio in comparable US studies and the price dividend ratio. Second, we also examine the performance of several other forecasting variables, including lagged stock returns and interest rates. We find that both variables are useful in predicting aggregate stock returns when using Japanese data. However, while we find that the interest rate variable is useful in early subsamples in this regard, it loses its predictive ability in more recent subsamples. This is because of the extremely limited variability in interest rates associated with operation of the Bank of Japan’s zero interest policy since the late 1990s. In contrast, the importance of lagged returns increases in subsamples starting from the 2000s. Overall, a combination of logged price dividend ratios, lagged stock returns, and interest rates yield the most stable performance when forecasting Japanese stock market returns.     

UK stock returns and robust tests of mean variance efficiency

We test both the unconditional and conditional Mean Variance Efficiency of the UK stockmarket, paying particular attention to choosing a suitable set of instruments for the conditional version of the model. By considering more carefully than previous authors the pricing of economic risk within the mean-variance framework we show that certain instruments can enhance the basic model structure. Given the tendency for financial market data to display non-constancy in variance and non-normality we employ the GMM procedure described in Hansen (1982), which requires much weaker distributional assumptions than the more traditional OLS techniques. We discuss forming portfolios of stocks using both size and dividend yield as a criterion to achieve a suitable spread of risk and return, and find that our conclusions are sensitive both to the method of portfolio formation and to the choice of estimator. This is an important finding given the problem of thin trading associated with the size ordering of UK stocks. We find some support for both the unconditional and conditional version of the CAPM, though we are cautious about our conclusions given the instability of the parameter estimates.     

Value-relevance of pension transition adjustments and other comprehensive income components in the adoption year of SFAS No. 158

In the present study, we examine the value-relevance of pension transition adjustments and other comprehensive income (OCI) components in the initial adoption year of Statement of Financial Accounting Standard (SFAS) 158—Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. Using a sample of 697 Standard and Poor (S&P) firms with the fiscal year ending on December 31, 2006, we perform several cross-sectional regression analyses to test the value-relevance of transition adjustments and OCI components in presence of various earnings measures. The results indicate that there is a negative relationship between both the level and change in stock returns and the magnitude of pension transition adjustments. We also find earnings measures and some OCI components are significantly associated with stock returns. When analyzed separately, we find our main results are mostly confined to the sample large S&P 500 firms. We do not find any result for the S&P mid-cap and small-cap firms. The overall results suggest the stock market negatively reacts to the adverse impact of SFAS #158 pension transition adjustments on net worth and future cash flows when the impact is substantial in its magnitude in dollar terms. The study further provides useful insight into the information processing by documenting that the market evaluates accounting information more effectively when such information is recognized in the financial statements rather than disclosed only in the financial footnotes.     

Momentum Profitability and Market Trend: Evidence from REITs

This study investigates Real Estate Investment Trusts’ momentum returns in different market states, and explains the momentum phenomenon with a risk-based dividend growth theory of Johnson (Journal of Finance 57:585–608, 2002). Our results show that momentum returns of REITs are higher during up markets. This study finds that winners’ dividend/price ratios are higher than those of losers, and momentum returns are positively correlated with the difference between winners’ and losers’ dividend/price ratios. We also find that momentum returns are higher after the legislation change of REITs in 1992, and that dividend/price ratios of REITs are also higher after 1992, suggesting that a persistent shock to REIT’s dividend/price ratios in 1992 partly explains REITs’ higher momentum returns after 1992. In sum, results of this study suggest that momentum returns of REITs can be jointly explained by a time-varying factor (market state) and a cross-sectional variance in dividend yields.

The market’s use of supplier earnings information to value customers

In this paper we examine whether the quarterly earnings announcements of supplier firms contain information about their customer’s earnings. Our evidence suggests that they do. Specifically, we find evidence consistent with the market impounding supplier firm earnings information into the stock prices of the firm’s customers. This is consistent with the market using the supplier’s earnings to help assess the customer firm’s future cash flows and/or uncertainty of those cash flows. We also find that the quality of the earnings influences the magnitude of the customer firm’s stock price reaction. The customer’s stock price reaction is increasing in the revenue growth reported by the supplier and the past persistence of the supplier’s earnings. Additional tests reveal that the market reaction is amplified when the customer firm is more dependent on the supplier. Finally, we find that the relative bargaining power of the customer influences the market reaction to supplier earnings. While prior research has documented that the market uses industry peer earnings and customer earnings in pricing a firm’s stock, this is the first study to provide evidence on the market’s use of supplier earnings information.     

Bankruptcy prediction: the case of Japanese listed companies

This paper investigates if bankruptcy of Japanese listed companies can be predicted using data from 1992 to 2005. We find that the traditional measures, such as Altman’s (J Finance 23:589–609, 1968) Z-score, Ohlson’s (J Accounting Res 18:109–131, 1980) O-score and the option pricing theory-based distance-to-default, previously developed for the U.S. market, are also individually useful for the Japanese market. Moreover, the predictive power is substantially enhanced when these measures are combined. Based on the unique Japanese institutional features of main banks and business groups (known as Keiretsu), we construct a new measure that incorporates bank dependence and Keiretsu dependence. The new measure further improves the ability to predict bankruptcy of Japanese listed companies.     

Long-Range Dependence in U.S. Home Price Volatility

The existence of GARCH effects in a financial price series means that the probability of large losses is much higher than standard mean-variance analysis suggests. Accordingly, several recent papers have investigated whether GARCH effects exist in the U.S. housing market, as changes in house prices can have far-ranging impacts on defaults, foreclosures, tax revenues and the values of mortgage-backed securities. Some research in finance indicates that the conditional variance of some assets exhibits far greater persistence, or even “long memory”, than is accounted for in standard GARCH models. If house prices do indeed have this very persistent volatility, properly estimating the conditional variance to allow for such persistence is crucial for optimal portfolio management. We examine a number of U.S. metropolitan areas, and find that, for those with significant GARCH effects, more than half indeed exhibit the very high persistence found in other assets such as equities. We also find that, for those markets exhibiting such persistent volatility, C-GARCH models typically do a better job in forecasting than standard GARCH models. Moreover, there is some tentative evidence that metro areas with the fastest appreciation may be most likely to have such long memory conditional variance. These findings should help in improving risk management, through, for instance the construction of better-specified value-at-risk models.