Return predictability and time-varying risk premium for 2014 workshop at UESTC

1. Return predictability and time-varying risk premiumfor 2014 workshop at UESTC

2. The Short of It: Investor Sentiment and Anomalies by Stambaugh, Yu, and Yuan (2012,JFE) • This study explores the role of investor sentiment • in abroad set of anomalies in cross-sectional stock returns. • 11 asset-pricing anomalies, including • Financial distress, • Net stock issues, • Total accruals, • momentum, • Gross profit-to-assets, • Asset growth, • return-on-assets (ROA), and • investment-to-assets.

3. The investor sentiment index

4. Sentiment and short-sale constraints • They consider a setting with • the presence of market-wide sentiment and • overpricing should be more prevalent than underpricing, • due to short-sale impediments. • Long-short strategies that exploit the anomalies exhibit profits consistent with this setting.

5. Main findings • First, each anomaly is stronger (its long-short strategy is more profitable) following high levels of sentiment. • Second, the short leg of each strategy is more profitable following high sentiment. • Finally, sentiment exhibits no relation to returns on the long legs of the strategies.

6. Liquidity Shocks and Stock Market Reactionsby Bali, Peng, Shen, and Tang (RFS, forthcoming) • Liquidity is time-varying, and • subject to shocks that have persistent effects • (that is, negative liquidity shocks predict lower future liquidity). • Studying market reactions to liquidity shocks can generate important insights • on how the market processes information about liquidity shocks and • on the information efficiency of financial markets.

7. In theory • Given the positive relation between stock-level illiquidity and expected returns, • a persistent negative shock to a security’s liquidity should, • as pointed out by Acharya and Pedersen (2005), • result in low contemporaneous returns and • high future returns, and vice versa. • This prediction may not hold • in a market with frictions.

8. two potential market frictions • There are two potential market frictions that • prevent public information from being incorporated in security prices: • limited investor attention • (small stocks, stocks with low analyst coverage and institutional ownership) and • illiquidity. • investor inattention can lead to underreaction to information.

9. Liquidity shocks • This paper focuses on liquidity shocks, • which can be viewed as a type of public information on liquidity. • Compared with the direct and well defined information events, • liquidity shocks are not well defined and • their pricing implications are harder to interpret by average investors. • As a result, the stock market can underreact to liquidity shocks.

10. Three measures of liquidity shocks • 1. the negative difference between Amihud’s (2002) illiquidity measure and its past 12-month average. • 2. liquidity shocks using an ARMA(1,1) specification for Amihud illiquidity. • 3. the changes in bid-ask spreads.

11. Main findings • Decile portfolios • long in stocks with positive liquidity shocks and short in stocks with negative liquidity shocks • generate one-month-ahead raw and risk-adjusted returns of • 0.75% to 1.23% per month for equal-weighted portfolios, and 0.67% to 1.17% for value-weighted portfolios. • The predictive power of liquidity shocks on future returns • remains economically and statistically significant for up to six months. • This evidence suggests that • the market underreacts to stock-level liquidity shocks.

12. the underlying mechanisms • the positive link • between liquidity shocks and future stock returns is indeed stronger • for stocks that receive less attention • (small stocks, stocks with low analyst coverage and institutional ownership), • as well as for less liquid stocks. • Both investor inattention and illiquidity can • drive stock market underreactions to liquidity shocks, • but investor attention is a more dominant factor than illiquidity.

13. Controlling for liquidity risk and … • The results remain significant after controlling for • the level of illiquidity, • exposures to systematic liquidity risks, and • the volatility of liquidity. • The results hold as well after controlling for other risk factors…

14. Contributions • Provide the first piece of evidence of • Stock market underreaction to stock-level liquidity shocks. • Provide evidence that • the theory of investor inattention is important • in understanding stock market underreactions to liquidity shocks. • The results suggest that • liquidity shocks and • how the stock market reacts • are important in predicting the cross-section of future stock returns.

15. Share issuance and cross-sectional returnsPontiff and Woodgate (2008, JF) • Share issuance occurs as a firm purchases or sells its own stock. • Some participants in the long-run return debate argue that • post-SEO and post-stock merger long-run returns are abnormally low, and that • post-share repurchase long-run returns are abnormally high. • This debate motivates them to examine • whether share issuance can be used to forecast stock returns in the cross-section.

16. three hypotheses • Combining market-wide sentiment with Miller’s argument about the effect of short-sale impediments leads to three hypotheses. • The first hypothesis is that • the anomalies should be stronger following periods of high investor sentiment.

17. Main findings • Post-1970, share issuance exhibits a strong cross-sectional ability to predict stock returns. • This predictive ability is more statistically significant than the individual predictive ability of size, book-to-market, or momentum. • They estimate the issuance relation pre-1970 and find no statistically significant predictive ability for most holding periods.

18. Implication • The post-1970 results are consistent with an opportunistic view of capital structure • whereby decision makers (insiders) repurchase or sell shares • in order to take advantage of variability in expected returns.

19. Share issuance and cross-sectional returns: International evidenceMcLean, Pontiff, and Watanabe (2009, JFE) • Share issuance predicts cross-sectional returns • in a non-U.S. sample of stocks from 41 different countries. • Issuance predictability has greater statistical significance than either size or momentum, and is similar to book-to-market. • As in the U.S., the international issuance effect is robust across both small and large firms. • Unlike the U.S., the effect is driven more • by low returns after share creation • rather than positive returns following share repurchases.

20. Cross-country differences • Issuance return predictability is stronger in countries • with greater issuance activity, • greater stock market development, and • stronger investor protection. • The results suggest that the share issuance effect is related to • the ease with which firms can issue and repurchase their shares. • Market-based economies???

21. World markets for raising new capitalby Henderson, Jegadeesh and Weisbach (2006, JFE) • The financial markets are increasingly integrated globally. • Corporations now enjoy • not only a tremendous amount of flexibility in deciding • which type of security to issue to fund their investments, • but also in which location to issue these securities. • For instance, • firms in Europe can raise capital by issuing bonds, convertible bonds, or stocks in the U.S. or Japan.

22. Research questions, which would broaden our understanding of corporate finance in a globally integrated environment. • To what extent do firms rely on domestic sources of capital, • and to what extent do they raise capital internationally? • Are some countries more dependent on foreign capital than others? • Do firms find it easier to raise some form of capital, • such as debt, more easily outside their borders • than other forms of capital, such as equity? • How do financial market conditions, and factors • such as interest rates and equity valuations, • affect the decision of what security to issue, and where to issue that security?

23. MM theorem • In perfectly frictionless markets, MM (1958) theorem implies • just as the type of securities a firm issues is irrelevant, • the location in which these securities are issued is also irrelevant. • In reality, however, • market frictions, imperfectly integrated capital markets, and taxes • render the choice of marketplace an important consideration for practitioners. • This paper addresses a number of questions about • when and where firms raise capital and • what kinds of securities they issue to raise capital.

24. reasons for raising capital internationally • 1. Expanding a shareholder base internationally • improves risk sharing and thereby lowers the cost of capital. • 2. Firms may raise capital and list their securities abroad • if transaction costs are lower in foreign markets than in domestic markets. • 3. When firms issue stock in countries with more stringent • capital market regulations and reporting standards than in their home countries, • they commit to abide by these higher standards. • Such a commitment can facilitate capital-raising throughout the world.

25. reasons for raising capital internationally • 4. an important advantage of foreign debt is the potential • to hedge exchange rate risk. • For example, firms that realize significant revenues in foreign currencies can hedge their exchange rate risk by issuing debt in those currencies. • 5. from a tax perspective, the process for ‘‘allocating’’ • the interest deduction depends on where the bond is issued cross-country. • companies that derive significant foreign income • are likely to issue debt in the countries that generate the income. • 6. market timing: searching for cheaper capital anywhere

26. Graham and Harvey’s (2001) survey of CFOs • Among these factors, a survey of chief financial officers • by Graham and Harvey (2001) • lists the hedging consideration as the most important factor for issuing foreign debt, • followed by tax considerations and interest rate timing.

27. Findings_1 • During the 1990–2001 period, • firms raised about $25.3 trillion of new capital, • including $4.9 trillion from abroad, • Suggesting that cross-border security issues were a large part of corporate capital raising activity. • International debt issuances are substantially more common • than equity issuances, • with debt (equity) issues accounting for 87% (9%) of all securities issued internationally, and • about 20% (12%) of all public debt issuances.

28. Findings_2 • A number of cross-country patterns are evident. • First, companies are drawn to liquid markets: • the U.S. and the U.K. are by far the most popular sources for new cross-border equity. • Firms from countries with illiquid equity markets issue a larger fraction of new equity outside their countries • than do firms from countries with relatively well-developed equity markets. • Moreover, proximity seems important: • firms are more likely to issue securities in countries that are geographically close to them.

29. Findings_3 • European debt markets are more attractive to foreign issuers • than are European equity markets. • Finally, firms in the U.S. and Canada are by far • the largest issuers of nonconvertible preferred stock, • while convertible bonds are popular in Europe. • Large fractions of both preferred stock and convertibles are issued internationally, • although the total value of these securities is relatively small • compared to common equity and nonconvertible debt.

30. Market timing • Does market timing play a role in firms’ decisions to issue debt or equity, both locally and internationally? • If firms time the market, • then aggregate domestic equity issues • should be negatively correlated with future market returns. • They also examine • whether, at the aggregate level, market timing considerations • affect firms’ decisions to raise equity abroad. • whether firms time their long-term debt issues, both • domestically and internationally, prior to increases in interest rates.

31. Fig. 2. Average annual equity returns following above/below median equity issues.

32. Fig. 3. Foreign timing of U.S. and U.K. equity markets.

33. main results on market timing • First, firms are more likely to issue equity • when the stock market appears to be overvalued. • i.e., stock market returns are abnormally low following periods of high equity issues. • Second, international equity issues predict • future market returns in the countries in which firms issue equity. • Finally, firms time their long-term debt issues • prior to future increases in interest rates. • Thus, market timing considerations appear to be important in security issuance decisions in most countries.

34. Reconciling the Return Predictability EvidenceLettau and Nieuwerburgh (2008, RFS) • The question of whether stock returns are predictable • has received an enormous amount of attention. • This is not surprising because the existence of return predictability • is not only of interest to practitioners but also • has important implications for financial models of risk and return. • Classic predictive variables are financial ratios, such as • the dividend-price ratio, • the earnings price ratio, and • the book-to-market ratio

35. variations in expected returns • Growth rates of fundamentals, such as dividends or earnings, • are much less forecastable than returns, • suggesting that most of the variation of financial ratios is • due to variations in expected returns.

36. Present value model Campbell and Shiller (1988)

37. problems • Correct inference is problematic • because financial ratios are extremely persistent; • in fact, standard tests leave the possibility of unit roots open. • the statistical evidence of forecastability is weaker • once tests are adjusted for high persistence. • Financial ratios have poor out-of-sample forecasting power. • The forecasting relationship of returns and financial ratios exhibits significant instability over time. • in rolling 30-year regressions of annual log CRSP value-weighted returns on lagged log dividend-price ratios, • the OLS regression coefficient varies between zero and 0.5 and • the associated R2 ranges from close to zero to 30%, depending on the subsample.

38. problems • In summary, the return predictability literature has yet to provide convincing answers to the following four questions: • What is the source of parameter instability? • Why is the out-of-sample evidence so much weaker than the in-sample evidence? • Why has even the in-sample evidence disappeared in the late 1990s? • Why are price ratios extremely persistent?

39. A simple solution • The puzzling empirical patterns can be explained • if the steady-state mean of financial ratios has changed over the course of the sample period. • Such changes could be due to • changes in the steady-state growth rate of economic fundamentals resulting from • permanent technological innovations and/or • changes in the expected return of equity caused by, for example, improved risk sharing, • changes in stock market participation, • changes in the tax code, or • lower macroeconomic volatility.

41. Implications • The implications for forecasting regressions with the dividend-price ratio are immediate. • First, in the presence of steady-state shifts, • a nonstationary dividend-price ratio is not a well-defined predictor and • this nonstationarity could cause problems. • Second, the dividend-price ratio must be adjusted to remove the • nonstationary component to render a stationary process.

42. adjusted dividend-price series

46. in-sample results • “adjusted” price ratios have favorable properties • compared to unadjusted price ratios. • In the full sample, the slope coefficient in regressions of • annual log returns on the lagged log dividend-price ratio • increases from 0.094 for the unadjusted ratio • to 0.235 and 0.455 for the adjusted ratio with one and two steady-state shifts, respectively. • the regression coefficients using adjusted price ratios as regressors • are more stable and significant over time. • similar differences exist for other price ratios, • such as the earnings-price ratio and the book-to-market ratio.

47. Inferences • Taking changes in the long-run mean of the dividend-price ratio into account is crucial for forecasts of stock returns. • Forecasting with the unadjusted dividend-price ratio series • results in coefficient instability in the forecasting regression and • unreliable inference • (insignificance in small samples, and results depending on the subsample). • These disconcerting properties are due to a nonstationary component that shifts the mean of the dividend-price ratio.

50. other financial ratios • the other financial ratios indicate a predictability pattern • similar to that of the dividend-price ratio. • Without an adjustment for the change in their long-run mean, • the relationship between 1-year ahead returns and financial ratios is unstable over time. • However, once we filter out the nonstationary component, • we find a stable forecasting relationship and a large predictability coefficient.