Estimating Earnings Trend Using Unobserved Components Framework

Similar documents
A Note on Missing Data Effects on the Hausman (1978) Simultaneity Test:

On the Impact of Inflation and Exchange Rate on Conditional Stock Market Volatility: A Re-Assessment

This specification describes the models that are used to forecast

The relation between U.S. money growth and inflation: evidence from a band pass filter. Abstract

FORECASTING WITH A LINEX LOSS: A MONTE CARLO STUDY

Final Exam Answers Exchange Rate Economics

UCLA Department of Economics Fall PhD. Qualifying Exam in Macroeconomic Theory

1 Purpose of the paper

Asymmetry and Leverage in Stochastic Volatility Models: An Exposition

VOLATILITY CLUSTERING, NEW HEAVY-TAILED DISTRIBUTION AND THE STOCK MARKET RETURNS IN SOUTH KOREA

R e. Y R, X R, u e, and. Use the attached excel spreadsheets to

CENTRO DE ESTUDIOS MONETARIOS Y FINANCIEROS T. J. KEHOE MACROECONOMICS I WINTER 2011 PROBLEM SET #6

Predictive Ability of Three Different Estimates of Cay to Excess Stock Returns A Comparative Study for South Africa and USA

Macroeconomics II A dynamic approach to short run economic fluctuations. The DAD/DAS model.

Empirical analysis on China money multiplier

Volume 31, Issue 1. Pitfall of simple permanent income hypothesis model

4452 Mathematical Modeling Lecture 17: Modeling of Data: Linear Regression

On the Relationship between Time-Varying Price dynamics of the Underlying. Stocks: Deregulation Effect on the Issuance of Third-Party Put Warrant

Finance Solutions to Problem Set #6: Demand Estimation and Forecasting

Erratic Price, Smooth Dividend. Variance Bounds. Present Value. Ex Post Rational Price. Standard and Poor s Composite Stock-Price Index

Unemployment and Phillips curve

Subdivided Research on the Inflation-hedging Ability of Residential Property: A Case of Hong Kong

Stock Market Behaviour Around Profit Warning Announcements

Financial Markets And Empirical Regularities An Introduction to Financial Econometrics

FADS VERSUS FUNDAMENTALS IN FARMLAND PRICES

Cyclical versus Secular: Decomposing the Recent Decline in U.S. Labor Force Participation

Ch. 10 Measuring FX Exposure. Is Exchange Rate Risk Relevant? MNCs Take on FX Risk

Non-Stationary Processes: Part IV. ARCH(m) (Autoregressive Conditional Heteroskedasticity) Models

Hedging Performance of Indonesia Exchange Rate

Watch out for the impact of Scottish independence opinion polls on UK s borrowing costs

Comparison of back-testing results for various VaR estimation methods. Aleš Kresta, ICSP 2013, Bergamo 8 th July, 2013

A NOTE ON BUSINESS CYCLE NON-LINEARITY IN U.S. CONSUMPTION 247

FINAL EXAM EC26102: MONEY, BANKING AND FINANCIAL MARKETS MAY 11, 2004

The Relationship between Money Demand and Interest Rates: An Empirical Investigation in Sri Lanka

Industry Profitability Dispersion and Market-to-book Ratio

Return-Volume Dynamics of Individual Stocks: Evidence from an Emerging Market

The Death of the Phillips Curve?

The Impact of Interest Rate Liberalization Announcement in China on the Market Value of Hong Kong Listed Chinese Commercial Banks

Linkages and Performance Comparison among Eastern Europe Stock Markets

GARCH Model With Fat-Tailed Distributions and Bitcoin Exchange Rate Returns

Midterm Exam. Use the end of month price data for the S&P 500 index in the table below to answer the following questions.

Advanced Forecasting Techniques and Models: Time-Series Forecasts

International Review of Business Research Papers Vol. 4 No.3 June 2008 Pp Understanding Cross-Sectional Stock Returns: What Really Matters?

The Reliability of Output Gap Estimates in Canada

Reconciling Gross Output TFP Growth with Value Added TFP Growth

A Screen for Fraudulent Return Smoothing in the Hedge Fund Industry

Computer Lab 6. Minitab Project Report. Time Series Plot of x. Year

Stock Index Volatility: the case of IPSA

Wealth Effects (Plural) and U.S. Consumer Spending *

CHAPTER CHAPTER18. Openness in Goods. and Financial Markets. Openness in Goods, and Financial Markets. Openness in Goods,

Forecasting Cross-Section Stock Returns using The Present Value Model. April 2007

Volatility Spillovers between U.S. Home Price Tiers. Tiers during the Housing Bubble

Financial Econometrics (FinMetrics02) Returns, Yields, Compounding, and Horizon

MODELLING THE US SWAP SPREAD

Stock Returns and Changes in the Business Cycle

International transmission of shocks:

DYNAMIC ECONOMETRIC MODELS Vol. 7 Nicolaus Copernicus University Toruń Krzysztof Jajuga Wrocław University of Economics

Idiosyncratic Volatility and Cross-section of Stock Returns: Evidences from India

A Method for Estimating the Change in Terminal Value Required to Increase IRR

2. Quantity and price measures in macroeconomic statistics 2.1. Long-run deflation? As typical price indexes, Figure 2-1 depicts the GDP deflator,

MA Advanced Macro, 2016 (Karl Whelan) 1

Pricing formula for power quanto options with each type of payoffs at maturity

Stylized fact: high cyclical correlation of monetary aggregates and output

Asymmetric Stochastic Volatility in Nordic Stock Markets

Volatility in Natural Gas and Oil Markets. by Robert S. Pindyck

Option Valuation of Oil & Gas E&P Projects by Futures Term Structure Approach. Hidetaka (Hugh) Nakaoka

Volatility Spillovers between Stock Market Returns and Exchange Rate Changes: the New Zealand Case

Does Gold Love Bad News? Hedging and Safe Haven of Gold against Stocks and Bonds

Measuring and Forecasting the Daily Variance Based on High-Frequency Intraday and Electronic Data

Asian Journal of Empirical Research

Market Risk and the Concept of Fundamental Volatility:

Macroeconomic Variables Effect on US Market Volatility using MC-GARCH Model

Extreme Risk Value and Dependence Structure of the China Securities Index 300

CAN THE CONSUMPTION-FREE NONEXPECTED UTILITY MODEL SOLVE THE RISK PREMIUM PUZZLE? AN EMPIRICAL STUDY OF THE JAPANESE STOCK MARKET

The Effect of Open Market Repurchase on Company s Value

Financial Econometrics Jeffrey R. Russell Midterm Winter 2011

Importance of the macroeconomic variables for variance. prediction: A GARCH-MIDAS approach

INSTITUTE OF ACTUARIES OF INDIA

Hedging Demands under Incomplete Information

An Exercise in GMM Estimation: The Lucas Model

Uncovered Interest Parity and Monetary Policy Freedom in Countries with the Highest Degree of Financial Openness

What Drives the Housing Markets in China: Rent, Cost of. Capital, or Risk Premium of Owning relative to Renting?

ECONOMIC GROWTH. Student Assessment. Macroeconomics II. Class 1

OPTIMALITY OF MOMENTUM AND REVERSAL

Revisiting the Fama and French Valuation Formula

Output: The Demand for Goods and Services

CHAPTER CHAPTER26. Fiscal Policy: A Summing Up. Prepared by: Fernando Quijano and Yvonn Quijano

Forecasting Financial Time Series

Bank of Japan Review. Performance of Core Indicators of Japan s Consumer Price Index. November Introduction 2015-E-7

Modelling Volatility Using High, Low, Open and Closing Prices: Evidence from Four S&P Indices

Documentation: Philadelphia Fed's Real-Time Data Set for Macroeconomists First-, Second-, and Third-Release Values

Country-Specific Idiosyncratic Risk and Global Equity Index Returns

Capital Strength and Bank Profitability

The Effect of a Discount Rate on Price Change Behavior: An Empirical Analysis. Robert Stretcher 1. and. Hiranya K Nath 2. February 2004 (Preliminary)

Return Predictability and the Implied Intertemporal Hedging Demands for Stocks and Bonds: International Evidence

Systemic Risk Illustrated

Trends in Earnings Volatility, Earnings Quality and Idiosyncratic Return. Volatility: Managerial Opportunism or Economic Activity

On the Intraday Relation between the VIX and its Futures

A Study of Process Capability Analysis on Second-order Autoregressive Processes

Portfolio investments accounted for the largest outflow of SEK 77.5 billion in the financial account, which gave a net outflow of SEK billion.

Transcription:

Esimaing Earnings Trend Using Unobserved Componens Framework Arabinda Basisha and Alexander Kurov College of Business and Economics, Wes Virginia Universiy December 008 Absrac Regressions using valuaion raios for predicing long erm sock reurns ofen use a en-year moving average of earnings as a proxy for unobserved fuure earnings. This paper shows ha he earnings rend can be direcly esimaed using bivariae unobserved componens models. The resuls show ha he valuaion raios based on he esimaed rends improve he fi of sock reurn predicive regressions. However, he 90 percen confidence inervals around he esimaed rends are large and end o include he moving average rend. JEL Classificaion: C, C51, G1. Keywords: Valuaion Raios, Unobserved Componens Model Corresponding auhor. Dep. of Economics, PO Box 605, College of Business and Economics, Wes Virginia Universiy, Morganown, WV - 6506. Tel: 304-93-7854, E-Mail: arbasisha@mail.wvu.edu. Dep. of Finance, PO Box 605, College of Business and Economics, Wes Virginia Universiy, Morganown, WV - 6506. Tel: 304-93-789, E-Mail: alkurov@mail.wvu.edu.

Inroducion Empirical sudies by Campbell and Shiller (1998, 001) show ha valuaion raios can be used for predicing long erm real sock reurns. In paricular, hey use he price-smoohed earnings raio compued by assuming a en-year moving average of real earnings as earnings rend, i.e., he componen ha capures long erm fuure earnings. 1 Compuing a muli-year moving average reduces he effec of cyclical flucuaions on corporae earnings. Averaging pas earnings in valuaion analysis is a common approach firs recommended by Graham and Dodd (1934), bu i may no be he bes way o model he earnings rend. This paper relaxes he assumpion of he moving average rend by leing he daa speak. We direcly esimae he earnings rend using unobserved componens models. Our models use boh he real earnings daa and long-erm real sock reurns daa. The unobserved componens framework also allows us o compare he performance of differen saisical assumpions by using he Schwarz Informaion Crierion. The heoreically and saisically appealing moivaion for esimaing he earnings rend is derived from he Beveridge-Nelson (1981) decomposiion of a ime series ino is rend and cycle componens. The rend can be inerpreed as a long erm condiional forecas of he ime series. Morley (00) and Morley, Nelson and Zivo (003) show ha he Beveridge-Nelson decomposiion can be usefully cas ino an unobserved componens framework which allows he rend and he cycle shocks o be correlaed. Furher sudies by Ord e al. (1998) and Anderson e al. (006) show ha he perfec correlaion beween he shocks, as in he Beveridge-Nelson decomposiion, can be modeled as a single source shock. Laubach (001) argues in a differen conex of esimaing NAIRUs ha bivariae modeling can also help o reduce he uncerainy around he esimaed unobserved componens. 1 Many oher empirical sudies also use he price-smoohed earnings raio for predicing sock reurns. These sudies are no menioned due o space consideraions. 1

This paper uses he above developmens in he unobserved componens modeling o esimae he earnings rend under hree differen assumpions abou correlaion of shocks. The resuls indicae a fairly volaile earnings rend in all hree cases. The fi of he long-run sock reurns predicive regression is higher in all he cases relaive o he moving average rend. However, he 90 percen confidence inervals of he esimaed rends end o include he moving average rend. The unobserved componens model and he esimaes The following unobserved componens model is used for esimaing he earnings rend. The firs measuremen equaion uses log real earnings, e, o be decomposed ino wo unobserved componens: is permanen (or sochasic rend) par p and he cyclical par c. e = p + c (1) The permanen par is assumed o follow a random walk wih a consan drif μ in equaion (). The cyclical par c is assumed o follow an auoregressive process in equaion (3). Following Morley (001) and Morley e al. (003), we use an auoregressive process of order wo. p = + p 1 μ + ε () φ ( L) = ω (3) c The second measuremen equaion, equaion (4), is he fuure sock reurns equaion. The sock reurn over he nex en years, 10 r +1, depends on a consan, he valuaion raio shown by log real sock price s ) minus he permanen par of log real earnings p ) and a serially correlaed ( unobserved componen o accoun for oher omied facors. The componen is assumed ( f +1 f + 1

o ake a moving average form based on comparison of SICs (no repored) in equaion (5). We use en lags in he moving average process. r 10 = + β ( s p ) + f + 1 + 1 α (4) f θ (5) = ( L) v + 1 + 1 We use hree specificaions of he correlaions beween he hree shocksε, ω and ν. In he firs specificaion, hey are assumed o be uncorrelaed as in Clark (1987). In he second and hird specificaions, following Anderson e al. (006) which uses he Beveridge-Nelson resul of perfecly negaive correlaion of he shocks, ε and ω are assumed o be perfecly correlaed and modeled as a single source shock using ω = γε. The shock ε is assumed o be uncorrelaed o ν + 1 in he second specificaion and we allow for ha correlaion o be esimaed in he hird specificaion. We use annual average daa ranging from 1871 o 007 obained from Rober Shiller s web sie. The en-year sock reurn is compued from 1871 o 1997 where he 1997 sock reurn denoes he sock reurn from 1997 o 007. Therefore, based on he daa availabiliy, we are able o esimae he earnings rend from 1871 o 1996. We esimae he parameers of he model using maximum likelihood and hen use he Kalman filer o obain he esimaes of he rend. The sandard errors of he esimaed rends are compued using Hamilon s (1986) procedure and are based on 1000 Mone Carlo replicaions. The resuls are repored in Table 1 and he esimaed rends are shown in Figure 1. Panel A of Table 1 shows ha he valuaion raio based on he en-year moving average of earnings predics fuure long erm sock reurns wih a fi of 19 percen. The upper-lef panel of Figure 1 shows he moving average rend. Panel B of Table 1 shows he parameer esimaes from he 3

bivariae unobserved componens model wih uncorrelaed shocks. The esimae of μ shows ha real earning grew a an average annual rae of 1.4 percen. The sandard deviaions of all shocks are moderae and fairly precisely esimaed. The esimaed earnings rend is shown in he upperrigh of Figure 1 along wih is 90 percen confidence inerval and he moving average rend. One can observe ha alhough he esimaed earnings rend appears o be fairly differen han he moving average rend, he 90 percen confidence inerval does include he moving average rend almos all of he ime. The regression of he long-erm fuure sock reurns on he esimaed earnings rend has a fi of abou 9 percen, which is 10 percen higher han he moving average rend is used. Panel C of Table 1 repors he parameer esimaes using a single source of shock beween he rend and cycle of real earnings bu uncorrelaed wih shocks o fuure real sock reurns ν + 1. The esimaes are largely similar o hose in Panel B, alhough he poin esimae of he sandard deviaion of he shock o he earnings rend is higher, implying a more volaile rend. The lower-lef panel of Figure 1 shows he esimaed rend, which appears o be more volaile han he rend in he uncorrelaed case. The fi of he sock reurns regression on he valuaion raio based on he esimaed rend is sill abou 9 percen. Panel D of Table 1 repors he parameer esimaes using a single source of shock beween he rend and cycle of real earnings and correlaed wih shocks o fuure real sock reurns ν + 1. The esimaes are largely similar o hose in Panel C. The poin esimae of he sandard deviaion of he shock o earnings rend is higher han ha repored in Panel B, implying a more volaile rend. The correlaion beween he rend shock and he fuure sock reurns shock is esimaed o be -0.3, low bu precisely esimaed. The lower-righ panel of Figure 1 shows he esimaed rend which appears o be more volaile han he rend in he 4

uncorrelaed case. The fi of he sock reurns regression on he valuaion raio based on he esimaed rend is marginally lower a abou 8 percen bu sill higher he 19 percen fi repored in Panel A. This model also shows he lowes SIC of he hree unobserved componens models, implying ha i provides he bes descripion for he daa. The s p ) ( erm in equaion (4) can be viewed (up o a consan) as a deviaion of he aggregae sock prices from he earnings rend, or as a proxy for marke mispricing. Brown and Cliff (005) find ha sock marke valuaion errors are posiively correlaed wih invesor senimen. We examined he relaion beween our mispricing proxy and he invesor senimen index from Baker and Wurgler (006). The senimen index is esimaed as he firs principal componen of he closed-end fund discoun, equiy share in new securiy issues, and lagged NYSE urnover. The coefficien of he senimen index in a linear regression using he 1934-1996 period was posiive and significan a he 10 percen level. Conclusion The main conribuion of his paper is o show ha he earnings rend can be esimaed by using a bivariae unobserved componens framework under differen assumpions abou he correlaions of he shocks. All hree esimaed rends show a beer fi of he regression equaion using he price-earnings raio o predic long erm sock reurns han he radiional specificaion using he moving average earnings rend. The drawback of he esimaed rends is ha heir 90 percen confidence inerval almos always includes he moving average rend. However, his drawback will become less of an issue wih availabiliy of more daa, making he unobserved componens models an asympoically aracive choice. These resuls are no abulaed o save space, bu are available upon reques. 5

References Anderson, H. M., Low, C. N. and R. Snyder (006); Single source of error sae space approach o he Beveridge Nelson decomposiion, Economics Leers, 91, 104-109. Baker, M. and J. Wurgler (006); Invesor Senimen and he Cross-Secion of Sock Reurns, Journal of Finance, 61, 1645-1680. Beveridge, S. and C. Nelson (1981); A New Approach o he Decomposiion of Economic Time Series ino Permanen and Transiory Componens wih Paricular Aenion o he Measuremen of he Business Cycle, Journal of Moneary Economics, 7, 151-174. Brown, G. W. and M. T. Cliff (005); Invesor Senimen and Asse Valuaion, Journal of Business, 78, 405-440. Campbell, J. Y. and R. J. Shiller (1998); Valuaion Raios and he Long-Run Sock Marke Oulook, Journal of Porfolio Managemen, 4, 11-6. Campbell, J. Y. and R. J. Shiller (001); Valuaion Raios and he Long-Run Sock Marke Oulook: An Updae, NBER Working Paper Series, no. 81. Clark, P. K. (1987); The Cyclical Componen of US Economic Aciviy, Quarerly Journal of Economics, 10, 797-814. Graham, B. and D. L. Dodd (1934); Securiy Analysis, Firs Ediion. New York: McGraw Hill. Hamilon, J. (1986), A Sandard Error for he Esimaed Sae Vecor of a Sae Space Model, Journal of Economerics, 33, 387-397. Laubach, T. (001); Measuring he NAIRU: Evidence from Seven Economies, The Review of Economics and Saisics, 83, 18-31. Morley, J. (00); A sae-space approach o calculaing he Beveridge-Nelson decomposiion, Economics Leers, 75, 13-17. Morley, J., Nelson, C. and E. Zivo (003); Why Are Beveridge-Nelson and Unobserved- Componen Decomposiions of GDP So Differen?, Review of Economics and Saisics, 85, 35-43. Ord, J. K., Koehler, A. B. and R. Snyder (1997); Esimaion and Predicion for a class of dynamic nonlinear saisical models, Journal of American Saisical Associaion, 9, 161-169. 6

Table 1: Parameer Esimaes from he Unobserved Componens Models Panel A: The 10 Year Moving Average Regression α β R 1.987 (0.35) -0.671 (0.13) 0.186 Panel B: The UC Model wih Uncorrelaed Shocks μ ε ν ω R SIC 0.014 (0.01) 0.056 (0.0) 0.137 (0.01) 0.13 (0.01) 0.88-1.158 Panel C: The UC Model wih Single Shock for Earnings and Uncorrelaed wih Sock Reurns μ ε ν R SIC 0.014 (0.01) 0.065 (0.0) 0.141 (0.01) 0.87-1.189 Panel D: The UC Model wih Single Shock for Earnings and Correlaed wih Sock Reurns μ ε ν ρ εν R SIC 0.014 (0.01) 0.067 (0.0) 0.135 (0.01) -0.7 (0.09) 0.84-1.193 Noe: The numbers in he parenheses are sandard errors. The R s are compued by regressing he 10 year fuure sock reurns on a consan and he difference of log real sock price and esimaed rend from he given model. The SIC s represen Schwarz Informaion Crierion and are compued for he bivariae UC models only. 7

Figure 1: Esimaes of Earnings Trends from Unobserved Componens Models -1. -1. -1.6-1.6 -.0 -.0 -.4 -.4 -.8 -.8-3. -3. -3.6-3.6-4.0 80 90 00 10 0 30 40 50 60 70 80 90-4.0 80 90 00 10 0 30 40 50 60 70 80 90 Log Real Earnings 10 Moving Average 10 Year Moving Average Earnings Trend, Uncorrelaed Lower Bound Upper Bound -1.0-1.0-1.5-1.5 -.0 -.0 -.5 -.5-3.0-3.0-3.5-3.5-4.0 80 90 00 10 0 30 40 50 60 70 80 90-4.0 80 90 00 10 0 30 40 50 60 70 80 90 10 Year Moving Average Earnings Trend, Single Source Uncorrelaed Lower Bound Upper Bound 10 Year Moving Average Earnings Trend, Single Source Correlaed Lower Bound Upper Bound Noe: The upper-lef panel shows he logarihm of real earnings daa and is 10-year moving average. The upper-righ panel shows he esimaed log real earnings rend and is 90 percen confidence inerval when he shocks are uncorrelaed wih each oher. The lower-lef panel shows he esimaed log real earnings rend and is 90 percen confidence inerval when he permanen shocks o real earnings are perfecly correlaed o is ransiory shocks bu uncorrelaed o fuure sock reurns shock. The lower-righ panel shows he esimaed log real earnings rend and is 90 percen confidence inerval when he permanen shocks o real earnings are perfecly correlaed o is ransiory shocks and correlaed o fuure sock reurns shock. The sandard errors of he rends are based on 1000 Mone Carlo replicaions. 8

No for Publicaion Appendix: Noes for he Referees 1. The univariae Beveridge-Nelson decomposiion of log real earnings yielded an R of abou 9 percen in he sock reurns regression, lower han he valuaion raio using he en-year moving average.. The correlaion beween he rend and he cycle shocks o real earnings was also esimaed following Morley, Nelson and Zivo (003). The esimaes showed a perfecly negaive correlaion as in he Beveridge-Nelson decomposiion. This creaed a problem for geing he sandard error of he esimaed rend following Hamilon (1986), as some parameers were on he border of he parameer space. So we decided o use he model wih a single source of shocks following Anderson e al. (006) ha does he Beveridge-Nelson decomposiion under he assumpion of perfec correlaion. 3. Hamilon s (1986) procedure for compuing he confidence inerval for unobserved componens accouns for boh parameric uncerainy and filering uncerainy. 4. If we limi our sample o he 1871-1987 period, implying he las observaion for he enyear fuure sock reurns covers he period 1987 o 1996, he fi of he regression increases o 0.31, similar o ha of Campbell and Shiller (1998). The fi of he regression based on he esimaed rend from he correlaed model also increases o 0.43. The fi of he regression based on he esimaed rend from he uncorrelaed model increases o 0.45. 5. The following graph compares he esimaed price-earnings raio from correlaed rends model wih he price-earnings raio based on he en-year moving average of earnings. 9

35 30 5 0 15 10 5 80 90 00 10 0 30 40 50 60 70 80 90 Price-Earnings Raio (10 year moving average) Price-Earnings Raio (Correlaed rend) 10