MODELS OF STOCK MARKET PREDICTABILITY

I briefly review the success of past studies purporting to explain equity valuations and predict future equity returns. The Campbell‐Shiller mean reversion models are contrasted with an expanded version of the so‐called Federal Reserve model. At least from 1970 to 2003, Federal Reserve–type models did somewhat better at predicting long‐horizon returns than did a mean reversion model based on dividend yields and price‐earnings multiples. However, timing investment strategies based on any of these prediction models do no better than a buy‐and‐hold strategy. Although some predictability of returns exists, there is no evidence of any systematic inefficiency that would enable investors to earn excess returns.     

The relationship between asset growth and the cross-section of stock returns

There is a large body of literature examining the association between stock characteristics and the cross-section of stock returns in international markets. Recently, Cooper et al. (2008) reported a strong association between total asset growth and stock returns in the US. In this paper, we show that an asset-growth effect also exists in the Australian equity market. Of particular interest, it is present amongst the largest Australian stocks. Over the 1983-2007 period, an equally-weighted portfolio of low-growth Big stocks outperforms a portfolio of high-growth Big stocks by an average 1% per month, equating to nearly 13% per annum. At an individual stock level of analysis, the asset-growth effect remains even after controlling for other variables whose association with the cross-section of returns is well known. Finally, we explicitly test whether asset growth is a priced risk factor using the common two-stage cross-sectional regression methodology. We find no evidence to support a risk-based explanation, thereby lending credence to Cooper et al.’s (2008) suggestion that the asset-growth effect is attributable to mispricing.     

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.     

MACROECONOMIC NEWS AND STOCK MARKET CALENDAR AND WEATHER ANOMALIES

An analysis of six stock market calendar and weather anomalies from 1980 to 2003 shows that (1) returns on trading days in which macroeconomic announcements were made generate the anomalies and (2) five of the six anomalies are not present at all on the trading days in which such announcements were not made (more than 60% of the sample). The results suggest that the market response to macroeconomic news, not psychological or institutional factors, is the main source of calendar and weather anomalies.     

The second moment matters! Cross-sectional dispersion of firm valuations and expected returns

Behavioral theories predict that firm valuation dispersion in the cross-section (“dispersion”) measures aggregate overpricing caused by investor overconfidence and should be negatively related to expected aggregate returns. This paper develops and tests these hypotheses. Consistent with the model predictions, I find that measures of dispersion are positively related to aggregate valuations, trading volume, idiosyncratic volatility, past market returns, and current and future investor sentiment indexes. Dispersion is a strong negative predictor of subsequent short- and long-term market excess returns. Market beta is positively related to stock returns when the beginning-of-period dispersion is low and this relationship reverses when initial dispersion is high. A simple forecast model based on dispersion significantly outperforms a naive model based on historical equity premium in out-of-sample tests and the predictability is stronger in economic downturns.     

Do Demand Curves for Small Stocks Slope Down?

Stocks added to the S&P 500 generally experience positive abnormal returns following the announcement. Several competing explanations exist for this reaction, but small sample sizes and other issues make it difficult to distinguish among them. We examine this subject using the small‐cap Russell 2000 index, which has several advantages over the S&P 500 in this context. Our primary finding is that stocks added to or deleted from the Russell 2000 experience significant changes in stock price and trading volume, but the effect is transitory. The results support the price pressure hypothesis.     

The divergence of liquidity commonality in the cross-section of stocks

This paper demonstrates that the cross-sectional variation of liquidity commonality has increased over the period 1963–2005. The divergence of systematic liquidity can be explained by patterns in institutional ownership over the sample period. We document that our findings are associated with similar patterns in systematic risk. Our analysis also indicates that the ability to diversify systematic risk and aggregate liquidity shocks by holding large-cap stocks has declined. The evidence suggests that the fragility of the US equity market to unanticipated events has increased over the past few decades.     

A liquidity-augmented capital asset pricing model

Using a new measure of liquidity, this paper documents a significant liquidity premium robust to the CAPM and the Fama–French three-factor model and shows that liquidity is an important source of priced risk. A two-factor (market and liquidity) model well explains the cross-section of stock returns, describing the liquidity premium, subsuming documented anomalies associated with size, long-term contrarian investment, and fundamental (cashflow, earnings, and dividend) to price ratios. In particular, the two-factor model accounts for the book-to-market effect, which the Fama–French three-factor model fails to explain.     

Options, short-sale constraints and market efficiency: A new perspective

This paper undertakes a new investigation of the potential for options to mitigate short-sale constraints. I find that option introduction alleviates 79% of the price adjustment efficiency disparity between short-sale constrained and unconstrained stocks in relation to negative news. No significant improvement in adjustment efficiency is found in response to positive information. These results are robust to controls for endogeneity biases associated with the option introduction selection process. Further, I find evidence that post-option improvement in efficiency is similar in relation to private and public information. This suggests that short-sale constraint effects stem, at least in part, from an irrational, optimism bias or another behavioral source as suggested theoretically by Miller (1977). Collectively, these results suggest that options act as an effective substitute to short-sales, significantly contributing to the informational efficiency of the market.     

Why is PIN priced?

Recent empirical work suggests that a proxy for the probability of informed trading (PIN) is an important determinant of the cross-section of average returns. This paper examines whether PIN is priced because of information asymmetry or because of other liquidity effects that are unrelated to information asymmetry. Our starting point is a model that decomposes PIN into two components, one related to asymmetric information and one related to illiquidity. In a two-pass Fama-MacBeth [1973. Risk, return, and equilibrium: empirical tests. Journal of Political Economy 81, 607–636] regression, we show that the PIN component related to asymmetric information is not priced, while the PIN component related to illiquidity is priced. We conclude, therefore, that liquidity effects unrelated to information asymmetry explain the relation between PIN and the cross-section of expected returns.     

How are shorts informed? : Short sellers,news, and information processing

We find that a substantial portion of short sellers' trading advantage comes from their ability to analyze publicly available information. Using a database of short sales combined with a database of news releases, we show that the well-documented negative relation between short sales and future returns is twice as large on news days and four times as large on days with negative news. Further, we find that the most informed short sales are not from market makers but rather from clients, and we find only weak evidence that short sellers anticipate news events. Overall, the evidence suggests that public news provides valuable trading opportunities for short sellers who are skilled information processors.     

The index premium and its hidden cost for index funds

This paper empirically investigates the index premium and its implications from 1990 to 2005. For additions to the S&P 500 and Russell 2000, we find that the price impact from announcement to effective day has averaged + 8.8% and + 4.7%, respectively, and −15.1% and −4.6% for deletions. The premia have been growing over time, peaking in 2000, and declining since then. The implied price elasticity of demand increases with firm size and decreases with idiosyncratic risk, supporting theoretical predictions. We also introduce a new concept that we label the index turnover cost, which represents a hidden cost borne by index funds (and the indexes themselves) due to the index premium. We illustrate this cost and estimate its lower bound as 21-28 bp annually for the S&P 500 and 38-77 bp annually for the Russell 2000.     

Institutional investors,intangible information,and the book-to-market effect

This paper establishes a robust link between the trading behavior of institutions and the book-to-market effect. Building on work by Daniel and Titman (2006), who argue that the book-to-market effect is driven by the reversal of intangible returns, I find that institutions tend to buy (sell) shares in response to positive (negative) intangible information and that the reversal of the intangible return is most pronounced among stocks for which a large proportion of active institutions trade in the direction of intangible information. Furthermore, the book-to-market effect is large and significant in stocks with intense past institutional trading but nonexistent in stocks with moderate institutional trading. This influence of institutional trading on the book-to-market effect is distinct from that of firm size. These results are consistent with the view that the tendency of institutions to trade in the direction of intangible information exacerbates price overreaction, thereby contributing to the value premium.     

Momentum and post-earnings-announcement drift anomalies: The role of liquidity risk

This paper investigates the components of liquidity risk that are important for understanding asset-pricing anomalies. Firm-level liquidity is decomposed into variable and fixed price effects and estimated using intraday data for the period 1983–2001. Unexpected systematic (market-wide) variations of the variable component rather than the fixed component of liquidity are shown to be priced within the context of momentum and post-earnings-announcement drift (PEAD) portfolio returns. As the variable component is typically associated with private information [e.g., Kyle, 1985. Econometrica 53, 1315–1335], the results suggest that a substantial part of momentum and PEAD returns can be viewed as compensation for the unexpected variations in the aggregate ratio of informed traders to noise traders.     

Seasonality in the cross-section of stock returns

This paper presents a new pattern in the cross-section of expected stock returns. Stocks tend to have relatively high (or low) returns every year in the same calendar month. We recognize the annual cross-sectional autocorrelation pattern documented in Jegadeesh [1990. Evidence of predictable behavior of security returns. Journal of Finance 45, 881–898] at lags of 12, 24, and 36 months as part of a general pattern that lasts up to 20 annual lags, superimposed on the general momentum/reversal patterns. This pattern explains an economically and statistically significant magnitude of the cross-sectional variation in average stock returns. Volume and volatility exhibit similar seasonal patterns but they do not explain the seasonality in returns. The pattern is independent of size, industry, earnings announcements, dividends, and fiscal year. The results are consistent with the existence of a persistent seasonal effect in stock returns.     

Can commodity futures be profitably traded with quantitative market timing strategies?

Quantitative market timing strategies are not consistently profitable when applied to 15 major commodity futures series. We conduct the most comprehensive study of quantitative trading rules in this market setting to date. We consider over 7000 rules, employ two alternative bootstrapping methodologies, account for data-snooping bias, and consider different time periods. We cannot rule out the possibility that trading rules compliment some other trading strategy or that some traders may have success using a specific rule on its own, but we do conclusively show that none of these rules beat the market any more than expected given random data variation.     

Informed trading,information uncertainty,and price momentum

In this paper we investigate the effects of informed trading (PIN) and information uncertainty in determining price momentum. We find that trading strategies based on buying high-uncertainty good-news stocks and shorting high-uncertainty bad-news stocks work well when limited to high-PIN stocks, while stocks with low-PIN do not exhibit price continuations, even when the uncertainty level of those stocks is high. In contrast, momentum returns are always significant for high-PIN stocks, irrespective of information uncertainty. Overall, we show that the informed trading effect is both independent of and stronger than that of information uncertainty in determining price momentum.