Working
Papers
Purifying the Equity Premium
(with Tuomo Vuolteenaho), London School of Economics working paper, November
2025
ABSTRACT: The
equity premium has conventionally been defined as the return on stocks minus
the return on bills. We decompose this conventional definition into two
components: the pure equity premium, defined as stocks minus duration-matched
inflation-indexed bonds, and the real term premium, defined as duration-matched
inflation-indexed bonds minus bills. Empirically, we find that the pure equity
premium has no “puzzling” features, as it not only has a relatively low Sharpe
ratio, but it also has high correlation with measured consumption growth.
However, challenges remain: The real term premium is much more volatile than
stock returns, and realizations of the pure equity premium and real term
premium are very negatively correlated.
Equity Valuation without DCF (with Thummim Cho and Robert Rogers), London
School of Economics working paper, October 2025.
ABSTRACT:
We introduce discounted alpha—a novel framework
for equity valuation. By correcting market prices rather than discounting
long-duration cash flows, our approach avoids the discount-rate sensitivity
that undermines DCF and uncovers fundamental variation missed by leading
methods. Applying our estimates, we find that private equity funds appear to
capture substantial CAPM misvaluation, both initially
at buyout and subsequently at exit, and that fundamental buy-and-hold funds
tilt toward characteristics that predict underpricing but not short-term
alphas. Furthermore, biased beliefs embedded in analyst estimates appear to be
an important driver of model-implied price distortions. However, despite these
pockets of misvaluation, firm equity values are
“almost efficient” by Black’s (1986) definition.
What Drives Booms and Busts in Value? (with John Campbell and Stefano Giglio), London
School of Economics working paper, May 2025. Revise-and-resubmit The Journal of Financial Economics
Internet Appendix to
“What Drives Booms and Busts in Value?”
ABSTRACT:
Value investing delivers volatile returns, with large drawdowns during both
market booms and busts. This paper interprets these returns through an
intertemporal CAPM, which predicts that aggregate cash flow, discount rate, and
volatility news all move value returns. We document that indeed these shocks
explain a large fraction of quarterly value returns over the last 60 years. We
also distinguish between the intra-industry and inter-industry components of
value, showing that the ICAPM explains the former better. Finally, we develop a
novel methodology to perform this decomposition at the daily
frequency, using it to interpret value returns during the Covid-19 pandemic.
The Day Destroys
the Night, Night Extends the Day: A Clientele Perspective on Equity Premium
Variation (with Dong Lou and Spyros Skouras), London School of
Economics working paper, July 2024. Revise-and-resubmit The Journal of Finance
ABSTRACT:
We provide a powerful new predictor of the equity premium by showing that
smoothed overnight market returns strongly negatively forecast subsequent
close-to-close quarterly market returns (R2=16%). While our signal
also negatively forecasts intraday market returns, we find that lagged smoothed intraday returns positively forecast the overnight
component. Since both aspects of past market returns drive the
price-to-earnings ratio (PE), this partially-offsetting
effect explains PE's relatively poor forecasting ability (R2=2%). We
interpret these patterns through a clientele
perspective: Individual investor expectations and consumption growth strongly
positively forecast overnight returns, while intermediary risk tolerance
strongly negatively forecasts intraday returns.
Long-Horizon Investing in a Non-CAPM World (with Dimitri Vayanos and Paul Woolley), London School of Economics working
paper, October 2022.
Revise-and-resubmit The
Journal of Finance
ABSTRACT:
We study dynamic portfolio choice in a calibrated equilibrium model where value
and momentum anomalies arise because capital slowly moves from under- to
over-performing market segments. Over short horizons, momentum’s Sharpe ratio
exceeds value’s, the value-momentum correlation is negative, and the conditional
value-momentum correlation positively predicts Sharpe ratios of value and
momentum. In contrast, over long horizons, value’s Sharpe ratio can exceed
momentum’s, the value-momentum correlation turns positive, and the value spread
becomes a better predictor of Sharpe ratios. Momentum’s optimal portfolio
weight relative to value’s declines significantly as horizon increases. We
provide novel empirical evidence supporting our model’s predictions.
Best Ideas (with Miguel
Anton and Randy Cohen),
London School of Economics working paper, April 2021.
· Internet
Appendix to “Best Ideas”
ABSTRACT: We find that the stocks in which active mutual
fund or hedge fund managers display the most conviction towards ex-ante, their
“Best ideas,” outperform the market, as well as the other stocks in those
managers' portfolios, by approximately 2.8 to 4.5 percent per year, depending
on the benchmark employed. The vast majority of the
other stocks managers hold do not exhibit significant outperformance. Thus, the
organization of the money management industry appears to make it optimal for
managers to introduce stocks into their portfolio that are not outperformers.
We argue that investors would benefit if managers held more concentrated
portfolios.
Stock Prices Under Pressure: How Tax and Interest Rates
Drive Seasonal Variation in Expected Returns (with Johnny Kang, Tapio
Pekkala, and Ruy Ribeiro), London School of Economics working paper, February
2015.
· Internet
Appendix to “Stock Prices Under Pressure”
ABSTRACT:
We show that interest rates drive mispricing at the turn of a tax period as
investors face the trade-off between selling a temporarily-depressed
stock this period and selling next period at fundamental value, but with tax
implications delayed accordingly. We confirm these patterns in US returns,
volume, and individual selling behavior as well as in UK data where tax and
calendar years differ. At quarter-end, the trade-off is only present following
recessions, consistent with the tax code. We then link a significant portion of
the variation in the risks and abnormal returns of size, value, and momentum to
tax-motivated trading.
New in Town: Demographics, Immigration, and the Price of Real Estate (with Dragana Cvijanovic and Jack Favilukis), London School of Economics working paper, April 2010
ABSTRACT: We link cross-sectional
variation in both realized and expected state-level house price appreciation to
cross-sectional variation in demographic changes. In
particular, we extract two components of expected population growth: 1)
a natural component due to predictable demographic changes related to fertility
and mortality rates and 2) a non-natural component due to immigration. Our
analysis shows that only the second component forecasts cross-sectional
variation in state-level house price appreciation. We find that the sensitivity
of both realized and expected returns to these demographic changes is stronger
for states with greater population density, consistent with population growth actually causing the price appreciation rather than merely
being correlated with some other phenomenon. We also document that building
permits anticipate a portion of future population growth and house price
appreciation. However, lagged measures of building activity do not subsume the
ability of our expected immigration proxy to forecast price appreciation. Our
findings are consistent with fundamentals driving an economically important
portion of cross-sectional variation in state-level housing returns. However,
markets appear to significantly underreact to the component of fundamentals
that is arguably more difficult for market participants to anticipate.
Publications
19. Putting
the Price in Asset Pricing (with Thummim Cho), 2024, The Journal of Finance 79
3943-3984.
· Internet
Appendix to “Putting the Price in Asset Pricing”
· previously circulated as Asset Pricing with Price Levels
ABSTRACT: We propose a novel way to estimate a portfolio’s abnormal price, the percentage gap between price and the present value of dividends computed with a chosen asset pricing model. Our method, based on a novel identity, resembles the time-series estimator of abnormal returns, avoids the issues in alternative approaches, and clarifies the role of risk and mispricing in long-horizon returns. We apply our techniques to study the cross-section of price levels relative to the CAPM and find that a single characteristic, adjusted value, provides a parsimonious model of CAPM-implied abnormal price.
18. Scale or Yield? A Present-Value Identity (with Thummim Cho, Lukas Kremens, and
Dongryeol Lee), 2024, The Review of Financial Studies
37, 950-988.
ABSTRACT: We
propose a loglinear present-value identity in which investment (“scale”),
profitability (“yield”), and discount rates determine a firm’s market-to-book
ratio. Our identity reconciles existing influential market-to-book
decompositions and facilitates novel insights from three empirical
applications: (i) Both investment and profitability
are important contributors to the value spread and stock return news variance.
(ii) Any cross-sectional return predictability has a mirror image in cash-flow
fundamentals, providing asset-pricing theories with additional moments to
match. (iii) The investment spread significantly improves the predictability of
time-series variation in the value premium and justifies the poor performance
of value in recent years.
17. The Booms and
Busts of Beta Arbitrage (with Shiyang Huang, Xin Liu, and Dong Lou), 2024, Management Science 70,
4953-5625.
· Internet Appendix to “The Booms
and Busts of Beta Arbitrage”
· 2013 IdR
QUANTVALLEY / FdR Quantitative Management Initiative
Research Award
· 2013 Europlace
Institute of Finance Research Grant
ABSTRACT:
Low-beta stocks deliver high average returns and low risk relative to high-beta
stocks, an opportunity for professional investors to “arbitrage” away. We argue
that beta-arbitrage activity generates booms and busts in the strategy’s
abnormal trading profits. In times of low arbitrage activity, the
beta-arbitrage strategy exhibits delayed correction, taking up to three years
for abnormal returns to be realized. In contrast, when arbitrage activity is
high, prices overshoot and then revert in the long run. We document a novel
positive feedback channel operating through firm leverage that facilitates
these boom-and-bust cycles.
16. Ripples
into Waves: Trade Networks, Economic Activity, and Asset Prices (with
Jinfan Chang, Huancheng Du, and Dong Lou), 2022, The Journal of
Financial Economics 145, 217-238.
· Internet Appendix to “Ripples Into Waves: Trade Networks, Economic Activity, and Asset
Prices”
· previously circulated as Trade Networks and Asset Prices: Evidence
from the SCDS Market
ABSTRACT: We
exploit information in sovereign CDS yields and the international trade network
to provide causal evidence of the propagation of global economic shocks. We
first show that trade links are an important source of shock transmission using
the natural experiments of the Japanese tsunami and the Covid-driven Wuhan
lockdown. We then confirm more general and gradual information flows along the
trade network by showing extensive country-level credit/equity cross-sectional
return predictability. News about country fundamentals flows primarily from
importers to exporters, depends on both direct and indirect links in the trade
network, and is magnified by the exporting country’s financial vulnerability.
15. Comomentum: Inferring Arbitrage Activity from Return
Correlations (with Dong Lou),
2022, The Review of Financial
Studies 35, 3372-3302.
· Internet
Appendix to “Comomentum: Inferring Arbitrage Activity
from Return Correlations”
· Finalist for the 2014
AQR Insight Award
· 2012
Q Group Research Award
· 2012
Inquire Europe Research Award
ABSTRACT: We propose a novel measure of arbitrage activity to examine whether arbitrageurs can have a destabilizing effect in the stock market. We focus on stock price momentum, a classic example of a positive-feedback strategy that our theory predicts can be destabilizing. Our measure, dubbed comomentum, is the high-frequency abnormal return correlation among stocks on which a typical momentum strategy would speculate. When comomentum is low, momentum strategies are stabilizing, reflecting an underreaction phenomenon that arbitrageurs correct. When comomentum is high, the returns on momentum stocks strongly revert, reflecting prior overreaction from crowded momentum trading which pushes prices away from fundamentals.
14.
Time-series Variation in Factor Premia: The
Influence of the Business Cycle (with Mo Haghbin and Alessio de Longis),
2020 Journal of Investment Management 18,
69-89.
ABSTRACT:
Factor cyclicality can be understood in the context of factor sensitivity to
aggregate cash-flow news. Factors exhibit different sensitivities to
macroeconomic risk, and this heterogeneity can be exploited to motivate dynamic
rotation strategies among established factors: size, value, quality, low
volatility and momentum. A timely and realistic identification of business
cycle regimes, using leading economic indicators and global risk appetite, can
be used to construct long-only factor rotation strategies with information
ratios nearly 70% higher than static multifactor strategies. Results are
statistically and economically significant across regions and market segments,
also after accounting for transaction costs, capacity and turnover.
13. A Tug of War:
Overnight vs. Intraday Expected Returns (with Dong Lou and Spyros Skouras), 2019,
The
Journal of Financial Economics 134, 192-213.
· Internet Appendix to “A Tug of War:
Overnight vs. Intraday Expected Returns”
ABSTRACT:
We link investor heterogeneity to the persistence of the overnight and intraday
components of returns. We document strong overnight and intraday firm-level
return continuation along with an offsetting cross-period reversal effect, all
of which lasts for years. We look for a similar tug of war in the returns of 14
trading strategies, finding in all cases that profits are either earned
entirely overnight (for reversal and a variety of momentum strategies) or
entirely intraday, typically with profits of opposite signs across these
components. We argue that this tug of war should reduce the effectiveness of
clienteles pursuing the strategy. Indeed, the smoothed spread between the
overnight and intraday return components of a strategy generally forecasts time
variation in that strategy’s close-to-close performance in a manner consistent
with that interpretation. Finally, we link cross-sectional and time-series
variation in the decomposition of momentum profits to a specific institutional
tug of war.
12. An Intertemporal CAPM with
Stochastic Volatility (with John
Campbell, Stefano
Giglio, and Robert Turley), 2018, The
Journal of Financial Economics 128, 207-233.
· Lead article
· Internet Appendix to "An
Intertemporal CAPM with Stochastic Volatility".
· Cited
in “Understanding Asset Prices”,
scientific background provided for the 2013 Nobel Prize in Economic Sciences
· 2018 Fama-DFA prize for best capital
markets and asset pricing paper in The
Journal of Financial Economics
· spreadsheet
containing the aggregate and portfolio-level data used in the paper
ABSTRACT: This paper studies
the pricing of volatility risk using the first-order conditions of a long-term
equity investor who is content to hold the aggregate equity market rather than
overweighting value stocks and other equity portfolios that are attractive to
short-term investors. We show that a conservative long-term investor will avoid
such overweights in order to
hedge against two types of deterioration in investment opportunities: declining
expected stock returns and increasing volatility. Empirically, we present novel
evidence that low-frequency movements in equity volatility, tied to the default
spread, are priced in the cross-section of stock returns.
11. Connected
Stocks (with Miguel Anton), 2014 The Journal of Finance 69,
1099-1127.
· Internet Appendix to "Connected
Stocks "
· Slides
· Smith-Breeden
prize nominee for best capital
markets and asset pricing paper in The Journal of Finance.
ABSTRACT: We connect stocks through the active mutual fund owners they have in common. We show that the degree of shared ownership forecasts cross-sectional variation in return correlation, controlling for exposure to systematic return factors, style and sector similarity, and many other pair characteristics. We argue that shared ownership causes this excess comovement based on evidence from a natural experiment—the 2003 mutual fund trading scandal. These results motivate a novel cross-stock reversal trading strategy exploiting information in ownership connections. We show that long/short hedge fund index returns covary negatively with this strategy, suggesting these funds may exacerbate this excess comovement.
10.
Hard Times (with John Campbell and Stefano Giglio), 2013 The Review of Asset Pricing Studies
3, 95-132.
· Internet Appendix to "Hard
Times"
ABSTRACT:
We show that the stock market downturns of 2000-2002 and 2007-2009 have very
different proximate causes. The early 2000's saw a large increase in the
discount rates applied to profits by rational investors, while the late 2000's
saw a decrease in rational expectations of future profits. We reach these
conclusions by using a VAR model of aggregate stock returns and valuations,
estimated both without restrictions and imposing the cross-sectional
restrictions of the ICAPM. Our findings imply that the 2007-2009 downturn was
particularly serious for rational long-term investors, whose losses were not
offset by improving stock return forecasts as in the previous recession.
9.
Growth or Glamour? Fundamentals and Systematic Risk in Stock
Returns (with John Campbell
and Tuomo Vuolteenaho), 2010, The
Review of Financial Studies 23, 305-344.
· Online
Appendix to Growth or Glamour
· Cited
in “Understanding Asset Prices”,
scientific background provided for the 2013 Nobel Prize in Economic Sciences.
· spreadsheet
containing the aggregate and portfolio-level data used in the paper
ABSTRACT:
The cash flows of growth stocks are particularly sensitive to temporary
movements in aggregate stock prices (driven by movements in the equity risk
premium), while the cash flows of value stocks are particularly sensitive to
permanent movements in aggregate stock prices (driven by market-wide shocks to
cash flows.) Thus the high betas of growth stocks with
the market's discount-rate shocks, and of value stocks
with the market's cash-flow shocks, are determined by the cash-flow
fundamentals of growth and value companies. Growth stocks are not merely
glamour stocks whose systematic risks are purely driven by investor sentiment.
More generally, accounting measures of firm-level risk have predictive power
for firms' betas with market-wide cash flows, and this predictive power arises
from the behavior of firms' cash flows. The systematic risks of stocks with
similar accounting characteristics are primarily driven by the systematic risks
of their fundamentals.
8. The price is
(almost) right (with Randy Cohen
and Tuomo Vuolteenaho), 2009, The
Journal of Finance, 64, 2739-2782.
· previously circulated as Does risk or mispricing explain the
cross-section of stock prices?
ABSTRACT:
Most previous research tests market efficiency using average abnormal trading
profits on dynamic trading strategies, and typically
rejects the joint hypothesis of market efficiency and an asset-pricing model.
In contrast, we adopt the perspective of a buy-and-hold investor and examine
stock price levels. For such an investor, the level of price is more relevant
than the short-horizon expected return, and betas of cash-flow fundamentals are
more important than high-frequency stock return betas. Our cross-sectional
tests suggest that there exist specifications in which differences in relative
price levels of individual stocks can be largely explained by their fundamental
betas.
7. The stock market
and corporate investment: a test of catering theory (with Paola
Sapienza), 2009, The
Review of Financial Studies, 22, 187-217.
· previously circulated as The real effects of investor sentiment
ABSTRACT:
We test a catering theory describing how stock market mispricing might
influence individual firms' investment decisions. We use discretionary accruals
as our proxy for mispricing. We find a positive relation between abnormal
investment and discretionary accruals; that abnormal investment is more
sensitive to discretionary accruals for firms with higher R&D intensity
(opaque firms) or share turnover (firms with shorter shareholder horizons);
that firms with relatively high abnormal investment subsequently have
relatively low (high) stock returns; and that the larger the relative price
premium, the stronger the abnormal return predictability. We show that patterns
in abnormal returns are stronger for firms with higher R&D intensity or
higher share turnover.
6. Cross-sectional
forecasts of the equity premium (with Sam Thompson and Tuomo Vuolteenaho),
2006, The Journal of Financial Economics 81,
101-141.
· previously circulated as New forecasts of the equity premium
· Matlab function
implementing our conditional tests, Matlab program testing this function, and instructions
ABSTRACT:
If investors are myopic mean-variance optimizers, a stock's expected return is
linearly related to its beta in the cross section. The slope of the relation is
the cross-sectional price of risk, which should equal the expected equity
premium. We use this simple observation to forecast the equity-premium time
series with the cross-sectional price of risk. We also introduce novel
statistical methods for testing stock-return predictability based on endogenous
variables whose shocks are potentially correlated with return shocks. Our
empirical tests show that the cross-sectional price of risk (1) is strongly correlated with the market's yield measures
and (2) predicts equity-premium realizations, especially in the first half of
our 1927-2002 sample.
5. Money
illusion in the stock market: The Modigliani-Cohn hypothesis, (with Randy Cohen
and Tuomo Vuolteenaho), 2005, Quarterly
Journal of Economics, CXX, 639-668.
· previously circulated as How inflation illusion killed the CAPM
ABSTRACT:
Modigliani and Cohn [1979] hypothesize that the stock market suffers from money
illusion, discounting real cash flows at nominal discount rates. While previous
research has focused on the pricing of the aggregate stock market relative to
Treasury bills, the money-illusion hypothesis also has implications for the
pricing of risky stocks relative to safe stocks. Simultaneously examining the
pricing of Treasury bills, safe stocks, and risky stocks allows us to
distinguish money illusion from any change in the attitudes of investors
towards risk. Our empirical results support the hypothesis that the stock
market suffers from money illusion.
4. The value
spread (with Randy Cohen
and Tuomo Vuolteenaho), 2003, The
Journal of Finance, 58, 609-641.
· Smith-Breeden
prize nominee for best capital
markets and asset pricing paper in The Journal of Finance
ABSTRACT:
We decompose the cross-sectional variance of firms’ book-to-market ratios using
both a long U.S. panel and a shorter international panel. In contrast to
typical aggregate time-series results, transitory cross-sectional variation in
expected 15-year stock returns causes only a relatively small fraction (20-25
percent) of the total cross-sectional variance. The remaining dispersion can be
explained by expected 15-year profitability and persistence of valuation
levels. Furthermore, this fraction appears stable across time and across types
of stocks. We also show that the expected return on value-minus-growth
strategies is atypically high at times when the value spread (the difference
between the book-to-market ratio of a typical value stock and a typical growth
stock) is wide.
3. Does
diversification destroy value?: Evidence from industry
shocks, (with Owen Lamont), 2002, The
Journal of Financial Economics, 63, 51-77.
· 2002 Jensen prize for best corporate
finance paper in The Journal of
Financial Economics
ABSTRACT:
Does corporate diversification reduce shareholder value? Since firms
endogenously choose to diversify, exogenous variation in diversification is
necessary in order to draw inferences about the causal
effect. We examine changes in the within-firm dispersion of characteristics, or
"diversity." Following the inefficient internal capital markets
hypothesis, we examine investment diversity. We find that exogenous changes in
diversity, due to changes in industry investment, are negatively related to changes
in firm value. Thus diversification destroys value.
This finding is not caused by measurement error. We also find that exogenous
changes in industry cash flow diversity are negatively
related to changes in firm value.
2. The
diversification discount: cash flows vs. returns (with Owen Lamont), 2001, The Journal of Finance 56,
1693-1721.
· Brattle Prize finalist for best
corporate finance paper in The
Journal of Finance.
ABSTRACT:
Diversified firms have different values than comparable portfolios of
single-segment firms. These value differences must be due to differences in
either future cash flows or future returns. Expected security returns on
diversified firms vary systematically with relative value. Discount firms have
significantly higher subsequent returns than premium firms. Slightly more than
half of the cross-sectional variation in excess values is attributable to
variation in expected future cash flows, with the remainder attributable to
variation in expected future returns and to covariation between cash flows and
returns.
1. Financial
constraints and stock returns, (with Owen Lamont and Jesus Saa-Requejo),
2001, The Review of Financial
Studies, 14, 529-554.
ABSTRACT:
We test whether the impact of financial constraints on firm value is observable
in stock returns. We form portfolios of firms based on observable
characteristics related to financial constraints, and test for common variation
in stock returns. Financially constrained firms stock returns move together
over time, suggesting that constrained firms are subject to common shocks.
Constrained firms have low average stock returns in our 1968-1997 sample of
growing manufacturing firms. We find no evidence that the relative performance
of constrained firms reflects monetary policy, credit conditions, or business
cycles.
Other
What The Financial Crisis Can Teach Us
About Investing, 2014, New
Statesman, September 12-18.
Efficiency and Volatility, 2013, Nature 505, 97.
· Invited summary of the 2013 Nobel
Prize in Economics.
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Last
Revised: November
18, 2025