A skeptical appraisal of asset-pricing tests

with Stefan Nagel and Jay Shanken

The finance literature has proposed a wide variety of new asset-pricing models in recent years, motivated by evidence that small, high-B/M stocks have positive CAPM-adjusted returns.  Indeed, it is now standard practice to evaluate a model based on how well it explains average returns on the Fama-French 25 size-B/M portfolios, something many models seem to do remarkably well.  In this paper, we provide a skeptical appraisal of the empirical methods used in the literature.  We argue that asset-pricing tests are often highly misleading, in the sense that apparently strong explanatory power (high cross-sectional R²s and small pricing errors) in fact provides exceptionally weak support for a model.  We offer a number of suggestions for improving empirical tests and evidence that several proposed models don’t work as well as originally advertised.

Revised January 2006

Taxes and financing decisions

with Katharina Lewellen

We argue that trade-off theory’s simple distinction between debt and ‘equity’ is fundamentally incomplete because firms have three, not two, distinct sources of funds:  debt, internal equity, and external equity.  Internal equity (retained earnings) is generally less costly than external equity for tax reasons, and may even be cheaper than debt.  It follows that, without any information problems or adjustment costs, optimal leverage is a function of internal cashflows, debt ratios can wander around without a specific target, and a firm’s cost of capital depends on its mix of internal and external finance, not just its mix of debt and equity.  The trade-off between debt, retained earnings, and external equity depends critically on the tax basis of investors’ shares relative to current price.  We estimate how the trade off varies cross-sectionally and through time for a large sample of U.S. firms.

Revised February 2005

Herding, feedback trading, and stock returns: Evidence from Korea

with Joon Chae

We study the trading behavior and profits of individuals, institutions, and foreign investors on the Korean Stock Exchange from 1995 – 2000.  Our data identifies, for individual stocks, the monthly buy and sell activity of each of the three investor groups.  At the firm level and in aggregate data, individuals follow contrarian strategies, buying when stocks decline and in subsequent months.  Institutions and foreigners follow the opposite, positive-feedback, strategy.  All three groups exhibit both herding and persistence in their trading decisions.  Interestingly, foreigners appear to have stock-picking ability even though positive-feedback strategies earn negative profits during our sample.  We discuss the implications of our findings for both rational and irrational asset-pricing theories.

Temporary movements in stock prices

Mean reversion in stock prices is stronger than commonly believed. I show 1-, 3-, and 5-year returns are negatively related to future returns over the subsequent 12 to 18 months. Reversals in 1-year returns are the most reliable, with strong significance in both the full 1926 – 1998 sample and the more recent 1946 – 1998 period. The reversals are also economically significant. The full-sample evidence suggests that 25% to 40% of annual returns are temporary, reversing within 18 months. The percentage drops to between 20% and 30% after 1945. Mean reversion appears strongest in larger stocks and can take several months to show up in prices.

Revised May 2001

The conditional CAPM does not explain asset-pricing anomalies

with Stefan Nagel

Recent studies suggest that the conditional CAPM might hold, period-by-period, and that time-variation in risk and expected returns can explain why the unconditional CAPM fails.  We argue, however, that variation in betas and the equity premium would have to be implausibly large to explain important asset-pricing anomalies like momentum and the value premium.  We also provide a simple new test of the conditional CAPM using direct estimates of conditional alphas and betas from short-window regressions, avoiding the need to specify conditioning information.  The tests show that the conditional CAPM performs nearly as poorly as the unconditional CAPM, consistent with our analytical results.

Forthcoming in Journal of Financial Economics (revised February 2005)

Stock returns, aggregate earnings surprises, and behavioral finance

with S.P. Kothari and Jerold Warner

We study the stock market's reaction to aggregate earnings news.  Prior research shows that, for individual firms, stock prices react positively to earnings news but require several quarters to fully reflect the information in earnings.  We find a substantially different pattern in aggregate data.  First, returns are unrelated to past earnings, suggesting that prices neither underreact nor overreact to aggregate earnings news.  Second, aggregate returns correlate negatively with concurrent earnings; over the last 30 years, for example, stock prices increased 5.7% in quarters with negative earnings growth and only 2.1% otherwise.  This finding suggests that earnings and discount rates move together over time, and provides new evidence that discount-rate shocks explain a significant fraction of aggregate stock returns.

Forthcoming in Journal of Financial Economics (revised May 2005)

Predicting returns with financial ratios

This article studies whether financial ratios like dividend yield can predict aggregate stock returns.  Predictive regressions are subject to small-sample biases, but the correction by previous studies can substantially understate forecasting power.  I show that dividend yield predicts market returns from 1946 – 2000, as well as in various subsamples.  Book-to-market and the earnings-price ratio predict returns during the shorter sample 1963 – 2000.  The evidence remains strong despite the unusual price run-up in recent years.

Journal of Financial Economics 74 (November 2004), 209-235.

Discussion of 'The Internet downturn: Finding valuation factors in Spring 2000'

This article reviews ‘The Internet downturn: Finding valuation factors in Spring 2000’ by Elizabeth Keating, Thomas Lys, and Robert Magee (KLM).  Their paper contributes to a growing literature on the valuation of Internet firms, finding a number of strong relations among market prices, financial ratios, and assorted ‘new economy’ measures of performance.  I argue that their results tell us more about investors’ (mis-) perceptions in Spring 2000 than about the underlying economics of Internet firms.  Moreover, the valuations seem unlikely to repeat.  KLM’s findings may not generalize to other firms or time periods.

Journal of Accounting and Economics 34 (January 2003), 237-247

Learning, asset-pricing tests, and market efficiency

with Jay Shanken

This paper studies the asset-pricing implications of parameter uncertainty.  We show that, when investors must learn about expected cash flows, empirical tests can find patterns in the data that differ from those perceived by rational investors.  Returns might appear predictable to an econometrician, or appear to deviate from the CAPM, but investors can neither perceive nor exploit this predictability.  Returns may also appear excessively volatile even though prices react efficiently to cash flow news.  We conclude that parameter uncertainty can be important for characterizing and testing market efficiency.

Journal of Finance 57 (June 2002), 1113-1145

Momentum and autocorrelation in stock returns

This paper studies momentum in stock returns, focusing on the role of industry, size, and book-to-market (B/M) factors.  Size and B/M portfolios exhibit momentum as strong as that in individual stocks and industries.  The size and B/M portfolios are well diversified, so momentum cannot be attributed to firm- or industry-specific returns.  Further, industry, size, and B/M portfolios are negatively autocorrelated and cross-serially correlated over intermediate horizons.  The evidence suggests that stocks covary ‘too strongly’ with each other.  I argue that excess covariance, not underreaction, explains momentum in the portfolios.

Review of Financial Studies 15 (Special 2002), 533-563.

The time-series relations among expected return, risk, and book-to-market

This paper examines the time-series relations among expected return, risk, and book-to-market (B/M) at the portfolio level.  I find that B/M predicts economically and statistically significant time-variation in expected stock returns.  Further, B/M is strongly associated with changes in risk, as measured by the Fama and French (1993) three-factor model.  After controlling for risk, B/M provides no incremental information about expected returns.  The evidence suggests that the three-factor model explains time-varying expected returns better than a characteristics-based model.

Journal of Financial Economics 54 (October 1999), 5-43

On the Predictability of Stock Returns: Theory and Evidence

Empirical studies show that stock returns are predictable both cross-sectionally and over time. Broadly speaking, this dissertation investigates whether the empirical patterns are consistent with market efficiency. The paper consists of two essays. In the first essay, I investigate the ability of firms’ book-to-market ratios to predict returns, which has been documented extensively in cross-sectional tests. To help understand the source of this predictability, I examine the time-series relations among expected return, risk, and book-to-market. I show that book-to-market captures significant time-variation in risk, but provides no incremental information about expected returns. In the second essay, I explore the effects of estimation risk, or investor uncertainty about the parameters of the cashflow process, on the behavior of prices and returns. I show that, with estimation risk, the observable properties of prices and returns can differ significantly from the properties perceived by rational investors. Estimation risk can generate return predictability in ways that resemble irrational pricing.

Dissertation (Simon Graduate School of Business Administration, University of Rochester), 2000.