ABSTRACT: We study dynamic portfolio choice in a calibrated equilibrium model where value and momentum anomalies arise because capital moves slowly 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 predicts positively Sharpe ratios of value and momentum. Over long horizons instead, 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 empirical evidence supporting our model’s predictions.
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, April 2022.
ABSTRACT: We decompose market returns into their overnight and intraday components, which dramatically improves equity premium forecasts. Past smoothed overnight market returns strongly negatively forecast subsequent close-to-close returns (quarterly R2 of over 14%), primarily through intraday mean reversion. In contrast, past smoothed intraday market returns strongly positively forecast subsequent overnight returns; this partially-offsetting effect explains PE's relatively poor forecasting ability (R2 only 3%). Our decomposition also resurrects the conditional CAPM: If we allow market betas to vary with past smoothed overnight returns, the unconditional alpha of the four Fama-French non-market factors decreases by 91%. We interpret these return patterns through a clientele perspective. First, individual investor expectations and consumption growth strongly positively forecast overnight market returns; intermediary risk tolerance and household equity share strongly negatively forecast intraday market returns. Second, aggregate discount-rate news associated with revisions in future expected overnight (intraday) returns is positively (negatively) correlated with aggregate cash-flow news. Finally, while the Tech boom and Covid crash/rebound were primarily driven by overnight returns, the Global Financial Crisis was mostly an intraday phenomenon.
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.
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.
· 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 instead 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 stark contrast, when activity is high, prices overshoot as short-run abnormal returns are much larger and then revert in the long run. We document a novel positive-feedback channel operating through firm-level leverage that facilitates these boom-and-bust cycles.
· previously circulated as Asset Pricing with Price Levels
ABSTRACT: We propose a novel way to study asset prices based on price distortions rather than abnormal returns. We derive the correct identity linking current mispricing to subsequent returns, generating a price-level analogue to the fundamental asset pricing equation, E[MRe] = 0, used to study returns. Our empirical test reveals that the CAPM describes the cross-section of prices better than it describes expected short-horizon returns. Despite the improvement, significant mispricing remains. An interaction of book-to-market and quality provides a parsimonious model of CAPM mispricing that both long-term buy-and-hold investors and researchers disciplining models from the price perspective should prioritize.
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.
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.
15. Ripples into Waves: Trade Networks, Economic Activity, and Asset Prices (with Jinfan Chang, Huancheng Du, and Dong Lou), forthcoming, The Journal of Financial Economics
· 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.
14. Comomentum: Inferring Arbitrage Activity from Return Correlations (with Dong Lou), forthcoming, The Review of Financial Studies.
· 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.
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.
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.
· Lead article
· 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.
· 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.
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.
· 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.
· 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.
· 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.
· previously circulated as New forecasts of the equity premium
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  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.
· 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.
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.
What The Financial Crisis Can Teach Us About Investing, 2014, New Statesman, September 12-18.
· Invited summary of the 2013 Nobel Prize in Economics.
Last Revised: May 3, 2022