Extra Slides on Return Predictability

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11/24/11

1

Empirics of Financial Markets

Patrick J. Kelly, Ph.D.

(Rational) Return Predictability

© 2010 Patrick J. Kelly 2

The debate

• The orthodoxy

– Stock returns are close to unpredictable

• Past price and volume information (Technical analysis) is useless

• Apparent predictability is a statistical artifact

– Bond returns are nearly unpredictable

• Term structure rises because future short rates are expected to rise, notbecause long term bonds earn higher return than a series of short termbonds.

– Foreign exchange rate movements are not predictable

• If a country has higher interest rates than available another for the same risk,the high interest rate country currency will depreciate – you will make thesame money saving domestically or internationally

– Active managers do no better than luck on a risk adjusted basis .


Data Mining


R2 = 0.44


Term Structure of Interest Rates

• Relationship between yields to maturity and maturity (term)

• Yield curve - a graph of the yields on bonds relative to thenumber of years to maturity

– Usually Treasury Bonds

– Have to be similar risk or other factors would be influencing yields


Yield Curves

§ http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve

Normal Yield Curve:

Short-term rates lower.

Long-term higher ascompensation for longer

duration and risk.

Steep Yield Curve: Short-

term rates lower either

high demand for liquidityOR Long-term a lot higher

due to expectations of higher rates (strong future

economy)

Inverted Yield Curve:

Long-term are lower than

short term.

Recession is forthcoming

and investors are lockingin higher long term rates



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Theories of Term Structure

• Expectations

• Liquidity Preference

– Upward bias over expectations


Yield Curves

§ http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve

Normal Yield Curve:Short-term rates lower.

Long-term higher ascompensation for longer

duration and risk.

Steep Yield Curve: Short-term rates lower either

high demand for liquidityOR Long-term a lot higher

due to expectations of

higher rates (strong future

economy)

Inverted Yield Curve:Long-term are lower than

short term.

Recession is forthcoming

and investors are lockingin higher long term rates

Yield Curve Today (November, 2011)


back


Mutual Fund Manager Performance

1970s & 80s


Are Markets Efficient? – Yes?

Pure luck? – Some managers do seem to have a great track record(Warren Buffet, George Soros) – skill or luck?

• 1024 managers flip coins (pick one of two stocks)

• After 1 round, 512 managers, on average, flip heads

• After 2 rounds, 256 managers, on average, flipped 2 heads

• After 10 rounds, only 1 manager will have flipped heads 10times

– They are crowned the head-flipping king and will giveseminars on how to flip the coin the right way!

back

The more recent evidence

• There are assets, portfolios, funds and strategies that earn

returns that cannot be explained by market betas.

• Returns are predictable

– Long term stock returns can be predicted by dividend yields and

the term premium

• Short term (daily, weekly, monthly still largely unpredictable)

• Technical strategies are still largely useless

– Bond return are predictable.

• Steeply sloping yield curve means long-term bonds earn a higher rate of return

– Exchange rates are predictable

• Carry trades are profitable

– Some fund managers do appear a little more skilled, but not toomuch after controlling for other factors (HML, SMB and WML)




11/24/11

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Long Term Stock Return Predictability

• Stock returns follow a random walk – returns are NOT

predictable – Fama (1965, 1970)

But then…

• Short rates (US Treasuries) predicts returns

– Fama and Schwert (1977), Fama (1981), Geske and Roll (1983)

• Dividend yields predict returns

– Rozef (1984), Shiller (1981), Fama and French (1988)

• Term structure (long – short rates) predicts

– Campbell (1987), Fama (1984), Keim and Stambaugh (1986),Harvey (1988)

• Default premium (high – low risk bonds) predicts

– Chen, Roll, Ross (1986), Keim and Stambaugh (1986)© 2010 Patrick J. Kelly 13

Maybe not…

• Evidence for predictability is weak – Goetzman and Jorion (1983), Hodrick (1992), Kim and Nelson

(1993), Richardson and Stock (1989)

• Predictability has all but disappeared

– Ang and Bekeart (2007), Cochrane (2008), Goyal and Welch (2003,

2008), Valkanov (2003)

• Henkel, Martin and Nardari (2011) resolves these differences

– Predictability is greater in recessions

– Predictability is weak in expansions


Market Risk Premia in Recessions and Expansions

Henkel, Martin, and Nardari (2011)


Do Fundementals Forecast Future Returns?

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C u m u l a t i v e p r o p o r t i o n o f r e c e s s i o n d a t a i n C R S P S a m p l e

Random walk

Fama (1965, 1970)

Short rate predicts

Fama and Schwert (1977)

Fama (1981)

Geske and Roll (1983)

Dividend yield predicts

Rozeff (1984), Shiller (1981)

Term premium predicts

Campbell (1987), Fama (1984)

Keim and Stambaugh (1986)

Harvey (1988)

Default premium predicts

Chen, Roll and Ross (1986)

Keim and Stambaugh (1986)

Predictability debatable

Goetzmann and Jorion (1993)

Hodrick (1992)

Kim and Nelson (1993)

Richardson and Stock (1989)

Predictability illusory?

Ang and Bekaert (2007)

Cochrane (2008)

Goyal and Welch (2003, 2008)

Valkanov (2003)

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Henkel, Martin and Nardari (2011)

• Predictive explanatory power in good and bad times

– Using : Short Rates, Dividend Yield, Term Premia


The argument for predictability (Fama and French, 1989)

• Expected returns vary over the business cycle

• At the bottom of a recession, high expected returns areneeded to entice investors to hold risky assets

– E[r] é => Pê

– We see low prices followed by higher returns, because this iscompensation for the extra risk that exists during down turns.

• Rational return predictability is about predicting changes inrisk, not return per se.

– Variables that measure relative price movements work well topredict returns

• Price/dividend ratio, earnings to price, book value to price,

• earnings dividend ratio, term spread, default spread, investment to capital,consumption/wealth ratio (cay – Lettau and Ludvigson, 2001)




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Return Predictability: dividend yields at different horizons

Table 20.1. OLS regressions of percent excess returns (value weighted NYSE − treasury bill rate) and real dividend growth on the percent VW

dividend/price ratio

R t →t +k = a + b ( D t /P t ) D t +k / D t = a + b ( D t /P t )Horizon k (years) b σ (b ) R 2 b σ (b ) R 2

1 5.3 (2.0) 0.15 2.0 (1.1) 0.06

2 10 (3.1) 0.23 2.5 (2.1) 0.063 15 (4.0) 0.37 2.4 (2.1) 0.06

5 33 (5.8) 0.60 4.7 (2.4) 0.12

R t →t +k indicates the k -year return. Standard errors in parentheses use GMM to correct

for heteroskedasticity and serial correlation. Sample 1947–1996.


Predictability with cay and dividend and earnings to price


-

Horizon (years) cay d − p d − e rrel R 2

1 6.7 0.181 0.14 0.08 0.041 −4.5 0.101 5.4 0.07 −0.05 −3.8 0.23

6 12.4 0.166 0.95 0.68 0.396 −5.10 0.036 5.9 0.89 0.65 1.36 0.42

The return variable is log excess returns on the S&P composite index. cay is

Lettau and Ludvigson’s consumption to wealth ratio. d − p is the log dividend

yield and d − e is the log earnings yield. rrel is a detrended short-term interest

rate. Sample 1952:4–1998:3.

Source: Lettau and Ludvigson (2001b, Table 6).

Dividend Yield and Following 7-year Return (proxy for E[r])


Basic Question

• Do dividend yields (D/P) change because dividend growthchanges?

• Or does D/P change because expected returns change?

– Or do investors expect prices to rise forever?

1) Past thinking: K is relatively constant so all D/P changes are afunction of changes in dividends/cashflows – NOT true!

2) Changes in dividend yields are almost 100% about changes inexpected return

3) Implication of #2 –

• Decreases in D/P forecast low returns

• Increases in D/P forecast high returns

4) This relation (#2) is prevalent all over the place


Dividend Yield and Following 7-year Return (proxy for E[r])


Classic view

• The classic view is that all price-dividend volatility is a

function of changes in dividend-growth expectations.

• What Cochrane shows is that

– All price-dividend volatility comes from variation in E[r]

– None from variation in expected dividend growth

– None from “rational bubbles”

• When prices are just on the expectation of future higher prices

– That is – high expected returns, because prices will be higher in future, not high

expected returns because prices drop now.




11/24/11

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Classic vs. Current View


Classic view:Prices dropping

must mean futuredividends will drop

Cochrane’s view:Prices dropping

must mean futureprices will rise

NOTE

• Important

• This does NOT mean that only changes in discount rates

cause changes in returns. BOTH changes in discount ratesand changes in dividend growth affect prices and returns.

– Just both don’t affect D/P

• Only changes in discount rates cause changes in D/P


The Effect is Pervasive!

• Stocks: High D/P→High Returns

• US Treasuries: Rising Yield Curve →High 1-year Returnsfor long-term bonds, not rising interest rates

– US FED long rates to gauge inflation… problem

• Bonds/Credit Spreads: High Yields →High Returns, notdefault

• Foreign Exchange: High foreign rates to domestic rates

signal higher return on foreign bonds (the carry trade) notdevaluation of currency

• Sovereign Debt: High levels of soverign/foreign debt doesnot signal government or trade surpluses. Low E[r] on debt

• Houses: High Rent/Price→High Returns, not higher rents© 2010 Patrick J. Kelly 27

Rent to Price


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