The cross section of expected stock returns Jonathan Lewellen Dartmouth College and NBER This version: March 2013 First draft: October 2010 Tel: 603-646-8650; email: jon.lewellen@dartmouth.edu. I am grateful to Eugene Fama, Ken French, Bob Resutek, Jay Shanken, and workshop participants at Columbia Business School, Dimensional Fund Advisors, McGill University, Rice University, and the University of Washington for helpful comments and suggestions.
The cross section of expected stock returns Abstract This paper studies the cross-sectional properties of return forecasts derived from Fama-MacBeth regressions. These forecasts mimic how an investor could, in real time, combine many firm characteristics to get a composite estimate of a stock s expected return. Empirically, the forecasts vary substantially across stocks and have strong predictive power for actual returns. For example, using ten-year rolling estimates of Fama- MacBeth slopes and a cross-sectional model with 15 firm characteristics (all based on low-frequency data), the expected-return estimates have a cross-sectional standard deviation of 0.90% monthly and a predictive slope for future monthly returns of 0.77, with a standard error of 0.08.
1. Introduction The asset-pricing literature finds significant cross-sectional predictability in stock returns. Firm characteristics such as size, book-to-market (B/M), past returns, accruals, and investment seem to predict a firm s subsequent returns, effects that show up both in the performance of characteristic-sorted portfolios and in slopes from Fama-MacBeth (FM) cross-sectional regressions (see Fama and French, 2008, for a recent review). Many of the documented patterns are highly significant and seem almost certainly to be real, i.e., they are unlikely to be due to random chance or data-snooping biases. This paper provides new evidence on the cross-sectional properties of expected stock returns, focusing on two closely related questions that, to date, do not have clear answers in the literature: (1) How much crosssectional variation in expected returns can we actually predict?, and (2) How reliable are estimates of expected returns from FM regressions? These questions are not answered either by the portfolio sorts common in the literature which consider one or two pre-selected characteristics at a time or by the results from standard cross-sectional regressions. As an alternative, I study the cross-sectional dispersion and out-of-sample predictive ability of return forecasts derived from FM regressions (based on slopes estimated in prior years). The primary question I consider is whether these forecasts line up with true expected returns, i.e., do they predict subsequent realized returns with a slope of one, as they should if they are truly good estimates of expected returns? My results contribute to the literature in a least four ways: First, the literature shows that many firm characteristics are correlated with subsequent stock returns, but we do not have much evidence on whether the characteristics can actually be used, individually or in combination, to estimate expected stock returns in real time. For example, even though we know that B/M and accruals are significantly related to subsequent returns, we do not know whether forecasts derived from those variables line up well with true expected returns. Second, the out-of-sample performance of aggregate predictive regressions has received considerable attention, 1
but the out-of-sample performance of FM regressions has not. If historical cross-sectional slopes are poor estimates of the true slopes going forward, either because of noise in the estimates or because of time-variation in the true parameters, the out-of-sample predictive power of FM regressions could be poor even if firm characteristics have historically been significant predictors of returns. Third, we know that trading strategies (i.e., portfolio sorts) based on one or two firm characteristics taken at a time have performed quite well historically, but there has been much less work on how an investor could combine many characteristics into a composite trading strategy, based only on information available at the time (i.e., without knowing how strong the predictive power of each characteristic would turn out to be). Outof-sample forecasts from FM regressions provide a simple, yet surprisingly effective, way to form a composite trading strategy going long high-expected-return stocks and short low-expected-return stocks again using only slope estimates available in real time. My tests consider regressions with up to 15 firm characteristics, many of which turn out not to be significant predictors of stock returns, in order to capture the idea that an investor may not have known ex ante which variables were best. Fourth, there has been much work in recent years attempting to infer a firm s expected stock return (i.e., cost of equity capital) from its observed stock price and forecasts of its dividends and earnings, but there has not been a similar effort to estimate expected returns from known predictors of stock returns. My results suggest that cross-sectional regressions provide quite reliable estimates of expected returns indeed, the estimates appear to be much more reliable than prior work has found for the implied cost of capital, though a direct comparison is beyond the scope of the paper. My tests focus on the period 1964 2009, either pooling all stocks together or looking at just those larger than the NYSE 20th percentile ( all-but-tiny stocks) or the NYSE median ( large stocks). I consider three specifications of FM regressions based on progressively larger sets of predictor variables. The first model includes size, B/M, and past 12-month returns; the second model adds past stock issuance, accruals, profitability, and asset growth; and the third model includes a host of additional characteristics that an investor might have thought it turns out erroneously could help to predict returns, such as dividend yield, beta, and market 2
leverage (15 variables in total). All of the variables are relatively slow-moving, representing either level variables (like size and B/M) or flow variables measured over at least an annual horizon (like accruals, asset growth, and dividend yield). My primary tests focus on monthly return forecasts derived from 10-year rolling averages of FM slopes. These forecasts have a cross-sectional standard deviation around 0.85% for all stocks, 0.60% for all-but-tiny stocks, and 0.50% for large stocks using all three sets of predictor variables, increasing only slightly as the set of characteristics expands (forecasts from the three models are highly correlated with each other). The estimates suggest considerable dispersion in expected returns, compared, for example, with average returns of just over 1.00% per month. More importantly, the expected-return estimates appear to line up well with true expected returns: In out-ofsample FM regressions, I find slopes of 0.77 0.85 for all stocks, slopes of 0.60 0.77 for all-but-tiny stocks, and slopes of 0.50 0.78 for large stocks when subsequent returns are regressed on the three sets of expectedreturn forecasts (these estimates are all highly significant, with t-statistics of 4.03 10.22). Results are similar when cumulative average slopes starting in 1964 are used instead, and even just the prior 1-, 3-, or 5-years of FM slopes are useful in estimating expected returns. For additional perspective, I sort stocks into deciles based on the various expected-return forecasts. Focusing again on estimates derived from 10-year rolling FM slopes, the spread between the predicted monthly returns of the top and bottom deciles is 2.82% using the small set of predictors (size, B/M, and momentum) and 3.20% using the full set of 15 characteristics. The actual spread in their subsequent realized returns is almost as large, 2.43% monthly in the first case and 2.49% monthly in the second (with t-statistics greater than ten). On a value-weighted basis, the spread in realized returns is 1.29% in the first case and 1.55% in the second (tstatistic of 3.60 and 4.51, respectively). Forecasts based on all three sets of predictor variables line up well with average returns, and the incremental predictive power of accruals, asset growth, and the other characteristics included in the more complete models is surprisingly modest. 3
For the subset of stocks bigger than the NYSE median, the spread between the predicted monthly returns of the top and bottom deciles is 1.64% using the small set of predictors and 1.97% using the full set of 15 variables. The spread between their subsequent realized returns is smaller but highly significant, ranging from 0.92% to 1.19%. Thus, FM-based estimates of expected returns appear to be somewhat more accurate for smaller stocks reflecting, in part, the substantial cross-sectional variation in their true expected returns but are also informative about true expected returns even among larger stocks. My final tests explore whether the results carry over to longer horizons. Forecasts of 6- and 12-month returns seem to be noisier than their monthly counterparts yet still have strong predictive power for returns. For example, in out-of-sample FM regressions, I find statistically strong slopes of 0.71 0.92 for all stocks, 0.47 0.64 for all-but-tiny stocks, and 0.46 0.71 for large stocks when annual returns are regressed on predicted returns (the slopes vary depending on how the forecasts are constructed, i.e., which set of predictors is used and how many years of past data are averaged to get the FM slopes). Forecasts based on longer histories of FM slopes work best and, statistically, are quite strongly related to subsequent annual returns. My tests are most closely related to those of Haugen and Baker (1996) and Hanna and Ready (2005), who also study the usefulness of past FM regressions. However, those papers differ from mine in key ways: (1) They focus on the profitability of high-turnover trading strategies, driven largely by short-lived predictors such as a stock s prior 1-month return, and do not study either the cross-sectional properties or accuracy of FM expected-return forecasts; (2) they focus on 1-year rolling averages of FM slopes, which seem to provide (in my tests) very noisy estimates of expected returns and to pick up short-term patterns in the data. In addition, my paper provides new evidence on predictability among larger stocks, on the predictability of longer horizon returns, and on the incremental role of characteristics such as accruals, asset growth, and stock issuance that have received significant attention in recent years. The remainder of the paper is organized as follows: Section 2 describes the data; Section 3 studies monthly return forecasts and tests how well they line up with subsequent realized returns; Section 4 extends the tests to semiannual and annual returns; and Section 5 concludes. 4
2. Data My tests use all common stocks on the Center for Research in Security Prices (CRSP) monthly files, merged with accounting data from Compustat (thereby restricting the tests to 1964 2009). I also consider two subsamples of larger firms: all-but-tiny stocks are those larger than the NYSE 20th percentile and large stocks are those larger than the NYSE median based on equity value at the beginning of the month. These groups are suggested by Fama and French (2008) as a simple way to check whether predictability is driven by micro-cap stocks or also exists among the economically more important population of large stocks. At the end of 2009, the NYSE 20th percentile is $416 million and the NYSE median is $1,652 million. Those breakpoints roughly partition the sample into the popular definitions of micro-cap vs. small-cap vs. mid- and large-cap stocks (see, e.g., Investopedia.com). Return forecasts are derived from regressions of monthly returns on lagged firm characteristics. I consider three regression models that encompass a progressively larger set of predictors. The first two models focus on characteristics that prior research has found to be significant predictors of returns: Model 1 includes size, B/M, and past 12-month stock returns, while Model 2 adds prior three-year stock issuance and one-year accruals, profitability, and asset growth. Model 3 includes eight additional characteristics that have a weaker relation, historically, to subsequent returns, including beta, dividend yield, one-year stock issuance, three-year returns, 12-month volatility, 12-month turnover, market leverage, and the sales-to-price ratio. The logic of the three specifications is that the first two models are most relevant if we believe an investor identified the best predictors early in the sample perhaps based on theory rather than empirical evidence while the third model is most relevant if an investor considered a larger number of predictors, even those we now know did not add significant explanatory power to the model. The variables are defined below. Stock prices, returns, shares outstanding, dividends, and trading volume come from CRSP and sales, earnings, assets, and accruals come from the Compustat annual file. Market data are assumed to be known immediately; accounting data are assumed to be known four months after the end of the fiscal year (thus, sales, earnings, etc. are assumed to be observable by the end of April for a firm whose fiscal year ends in the prior December). 5
LogSize -1 = Log market value of equity at the end of the prior month, LogB/M -1 = Log book value of equity minus log market value of equity at the end of the prior month, Return -2,-12 = Stock return from month -12 to month -2, LogIssues -1,-36 = Log growth in split-adjusted shares outstanding from month -36 to month -1, Accruals Yr-1 = Change in non-cash net working capital minus depreciation in the prior fiscal year, ROA Yr-1 LogAG Yr-1 DY -1,-12 = Income before extraordinary items divided by average total assets in the prior fiscal year, = Log growth in total assets in the prior fiscal year, = Dividends per share over the prior 12 months divided by price at the end of the prior month, LogReturn -13,-36 = Log stock return from month -36 to month -13, LogIssues -1,-12 = Log growth in split-adjusted shares outstanding from month -12 to month -1, Beta -1,-36 = Market beta estimated from weekly returns from month -36 to month -1, StdDev -1,-12 = Monthly standard deviation, estimated from daily returns from month -12 to month -1, Turnover -1,-12 = Average monthly turnover (shares traded/shares outstanding) from month -12 to month -1, Debt/Price Yr-1 = Short-term plus long-term debt divided by market value at the end of the prior month, Sales/Price Yr-1 = Sales in the prior fiscal year divided by market value at the end of the prior month. A couple of observations might be useful. First, all of the characteristics are highly persistent in monthly data because they either represent level variables that change slowly (like size and B/M) or flow variables measured over at least a year (like earnings and sales). This suggests that any predictability I find in monthly returns is likely to extend to longer horizons. (My final tests with semiannual and annual returns address this issue directly.) Second, many of the characteristics are highly correlated with each other, either because they are mechanically related (like short-term and long-term stock issuance) or capture related features of the firm (like beta and standard deviation, or asset growth and accruals). However, the resulting multicollinearity in the regressions is not a significant concern here because I am primarily interested in the overall predictive power of the model, not the slopes on individual variables. The Appendix provides a brief survey of prior work that uses these or similar variables to predict stock returns. I do not know of any paper that simultaneously considers all of the characteristics, but my goal is not to break new ground in defining the set of predictors. Table 1 reports summary statistics for monthly returns and the 15 characteristics defined above. The numbers 6
Table 1 Descriptive statistics, 1964 2009 The sample includes all common stocks on CRSP with current-month returns (Return, %) and beginning-of-month market value, book-to-market equity, and lagged 12-month returns. All-but-tiny stocks are those larger than the NYSE 20th percentile (based on a firm s market value of equity) and Large stocks are those larger than the NYSE median. Stock prices, returns, shares outstanding, dividends, and turnover come from CRSP and book equity, total assets, debt, sales, earnings, and accruals come from Compustat (annual data). Accounting data are assumed to be known four months after the end of the fiscal year. The numbers represent the time-series averages of the cross-sectional mean ( Avg ), standard deviation ( Std ) and sample size ( N ) for each variable. All stocks All but tiny stocks Large stocks Avg Std N Avg Std N Avg Std N Return (%) 1.24 14.77 3,950 1.08 9.94 1,690 0.99 8.53 866 LogSize -1 4.49 1.92 3,950 6.25 1.18 1,690 7.16 0.89 866 LogB/M -1-0.50 0.84 3,950-0.72 0.73 1,690-0.79 0.70 866 Return -2,-12 0.13 0.48 3,950 0.19 0.41 1,690 0.18 0.36 866 LogIssues -1,-36 0.11 0.25 3,498 0.10 0.22 1,564 0.09 0.21 825 Accruals Yr-1-0.02 0.10 3,636-0.02 0.08 1,491-0.02 0.07 762 ROA Yr-1 0.02 0.13 3,886 0.05 0.08 1,661 0.06 0.06 853 LogAG Yr-1 0.12 0.26 3,890 0.15 0.22 1,661 0.14 0.20 854 DY -1,-12 0.02 0.02 3,928 0.02 0.02 1,686 0.03 0.02 864 LogReturn -13,-36 0.10 0.58 3,392 0.24 0.46 1,536 0.27 0.41 816 LogIssues -1,-12 0.04 0.11 3,948 0.03 0.10 1,690 0.03 0.10 866 Beta -1,-36 0.95 0.55 3,707 1.05 0.50 1,621 1.04 0.46 844 StdDev -1,-12 0.15 0.08 3,950 0.11 0.04 1,690 0.09 0.03 866 Turnover -1,-12 0.07 0.07 3,639 0.08 0.07 1,613 0.08 0.07 846 Debt/Price Yr-1 0.84 1.57 3,899 0.65 1.17 1,658 0.63 1.11 853 Sales/Price Yr-1 2.62 3.68 3,896 1.64 2.01 1,658 1.41 1.56 853 LogSize -1 = Log market value of equity at the end of the prior month LogB/M -1 = Log book equity minus log market value of equity at the end of the prior month Return -2,-12 = Stock return from month -12 to month -2 LogIssues -1,-36 = Log growth in split-adjusted shares outstanding from month -36 to month -1 Accruals Yr-1 = Working capital accruals, à la Sloan (1996), in the prior fiscal year ROA Yr-1 = Income before extraordinary items divided by average total assets in the prior fiscal year LogAG Yr-1 = Log growth in total assets in the prior fiscal year DY -1,-12 = Dividends per share over the prior 12 months divided by price at the end of the prior month LogReturn -13,-36 = Log stock return from month -36 to month -13 LogIssues -1,-12 = Log growth in split-adjusted shares outstanding from month -12 to month -1 Beta -1,-36 = Market beta estimated from weekly returns from month -36 to month -1 StdDev -1,-12 = Monthly standard deviation, estimated from daily returns from month -12 to month -1 Turnover -1,-12 = Average monthly turnover (shares traded/shares outstanding) from month -12 to month -1 Debt/Price Yr-1 = Short-term plus long-term debt divided by market cap at the end of the prior month Sales/Price Yr-1 = Sales in the prior fiscal year divided by market value at the end of the prior month represent time-series averages of the monthly cross-sectional mean, standard deviation, and sample size for each variable. Since the smallest set of predictors I consider includes size, B/M, and 12-month momentum, I restrict the sample to firms with valid data for those three variables. All characteristics, except monthly returns, are winsorized monthly at their 1st and 99th percentiles. 7
The table shows that all-but-tiny stocks make up just under half the sample and large stocks roughly half of those (i.e., just under a quarter of the sample). With two exceptions (dividend yield and turnover), the crosssectional variation of the characteristics is highest in the full sample and lowest among large stocks. That property will be inherited by their expected-return estimates as well. 3. Expected stock returns My primary tests, described in this section, focus on monthly stock returns. I first summarize basic FM crosssectional regressions and then explore the properties and out-of-sample predictive power of return forecasts derived from these regressions. 3.1. FM regressions Table 2 reports average slopes, R 2 s, and sample sizes for 548 monthly cross-sectional regressions, 1964:05 2009:12. The t-statistics are based on the time-series variability of the slope estimates, incorporating a Newey- West correction with four lags to account for possible autocorrelation in the slopes. As explained above, I show results for three groups of firms (all stocks, all-but-tiny stocks, and large stocks) and for three specifications of the regressions. The results are consistent, qualitatively and quantitatively, with prior research. In the first two models, the slopes on B/M, 12-month past returns, and profitability are significantly positive, while the slopes on size, past stock issuance, accruals, and asset growth are significantly negative. In general, the estimates are reasonably similar for the three groups of firms. The predictive ability of size, B/M, and asset growth is somewhat weaker among larger stocks (both the point estimates and t-statistics), while the predictive ability of stock issuance and profitability is somewhat stronger. Adding the remaining characteristics to the regression, in the third model, has a modest effect on the slopes of the seven variables included in Models 1 and 2 (the results just described). Among the new variables, beta is the only one that is at least marginally significant for all three groups of stocks (t-statistics of 1.81 3.09). A firm s prior volatility (standard deviation over the past year) is significantly negative in the all-but-tiny and 8
Table 2 Fama-MacBeth regressions, 1964 2009 This table summarizes Fama-MacBeth cross-sectional regressions (average slopes, R 2 s, and number of stocks) when monthly returns (in %) are regressed on lagged firm characteristics. t-statistics for the slopes are based on the timeseries variability of the estimates, incorporating a Newey-West correction with four lags to account for possible autocorrelation in the estimates. The full sample includes all common stocks on CRSP with the necessary data to estimate the cross-sectional regression in each panel (i.e., the firm must have data for returns and all predictor variables in a given month). All-but-tiny stocks are those larger than the NYSE 20th percentile (based on beginning-of-month market value) and Large stocks are those larger than the NYSE median. Returns, stock prices, shares outstanding, dividends, and turnover come from CRSP and book equity, total assets, debt, sales, earnings, and accruals come from Compustat (annual data). Accounting data are assumed to be known four months after the end of the fiscal year. The variables are defined in Table 1. All stocks All but tiny stocks Large stocks Slope t-stat R 2 Slope t-stat R 2 Slope t-stat R 2 Model 1: Three predictors LogSize -1-0.14-2.74 0.035-0.05-1.20 0.048-0.05-1.07 0.058 LogB/M -1 0.57 6.97 0.37 4.20 0.31 3.70 Return -2,-12 1.09 5.50 1.08 5.10 1.05 4.37 N 3,950 1,690 866 Model 2: Seven predictors LogSize -1-0.14-3.29 0.044-0.09-2.16 0.064-0.09-1.96 0.079 LogB/M -1 0.46 6.13 0.34 3.92 0.32 3.54 Return -2,-12 0.89 5.01 0.95 4.60 0.96 4.19 LogIssues -1,-36-0.37-3.36-0.35-3.01-0.56-3.89 Accruals Yr-1-1.55-5.59-1.84-5.44-1.37-3.46 ROA Yr-1 1.39 2.42 2.82 4.52 2.64 3.80 LogAG Yr-1-0.78-6.01-0.46-2.81-0.39-1.92 N 3,219 1,381 729 Model 3: Fifteen predictors LogSize -1-0.16-4.88 0.078-0.16-4.34 0.118-0.13-3.56 0.150 LogB/M -1 0.38 6.32 0.21 3.06 0.19 2.41 Return -2,-12 0.98 6.58 0.94 5.34 0.91 4.75 LogIssues -1,-36-0.36-3.53-0.22-1.69-0.41-2.82 Accruals Yr-1-1.53-6.00-1.88-5.60-1.45-3.91 ROA Yr-1 1.52 3.63 2.09 4.41 1.96 3.06 LogAG Yr-1-0.55-4.32-0.29-2.04-0.13-0.79 DY -1,-12-0.09-0.05-1.00-0.52 0.98 0.51 LogReturn -13,-36-0.06-0.92-0.08-0.95-0.02-0.21 LogIssues -1,-12 0.04 0.17-0.26-1.08-0.25-0.90 Beta -1,-36 0.35 3.09 0.35 2.62 0.26 1.81 StdDev -1,-12-1.17-1.05-5.91-4.37-6.00-3.62 Turnover -1,-12-4.75-3.59-1.05-0.83-0.31-0.20 Debt/Price Yr-1-0.04-1.27 0.01 0.36 0.02 0.42 Sales/Price Yr-1 0.03 2.15 0.02 1.07 0.02 0.83 N 2,913 1,317 711 9
large-stock samples, but not in the full sample, while past turnover and the sales-to-price ratio are significant only in the full sample. The remaining variables dividend yield, long-term returns, 12-month stock issuance, and market leverage are not significant for any group of stocks, with t-statistics ranging from -1.27 to 0.51 after controlling for the other firm characteristics. Several features of the results are worth highlighting. First, it would be wrong to interpret the FM R 2 as informative about the overall predictive power of the variables. The FM R 2 provides information mostly about the fraction of contemporaneous volatility explained by characteristic-based portfolios, not about the predictive ability of the characteristics. A simple example illustrates why: Suppose all stocks have the same expected return but different betas and a one-factor market model explains all return volatility (stocks have no idiosyncratic residuals). In FM regressions, beta would have perfect explanatory power month-by-month even though it has no predictive power for returns; beta would be perfectly positively related to returns half the time, when the market goes up, and perfectly negatively related to returns half the time, when the market drops, because realized returns always line up exactly with beta. More generally, FM slopes can be interpreted as returns on characteristic-based portfolios (Fama, 1976), and the FM R 2 reflects, in large part, how much ex post return volatility these portfolios explain. 1 Second, the slopes on B/M and 12-month momentum depend somewhat on how B/M is measured. In particular, some studies follow Fama and French (1992) and calculate B/M once a year at the end of June, using book equity for the prior fiscal year and market equity as of the prior December. My measure is based, instead, on the latest observations for both market and book equity (the latter updated four months after the fiscal year). Thus, my variable reflects recent stock-price changes in a more timely way than the Fama and French measure and, consequently, is more negatively correlated with momentum (which is updated monthly in most studies, including this one). This fact strengthens the FM slopes on both B/M and momentum. For 1 A better measure of a model s predictive power is given by the R 2 from a pooled time-series, cross-sectional regression, using returns and characteristics de-meaned relative to their monthly cross-sectional means in order to take out marketwide movement in the variables through time (mimicking what FM regressions do). This pooled R 2 is appropriate because the variance of the fitted values in the numerator reflects a single set of slopes estimated for all months, rather than month-bymonth realizations of FM slopes, while the variance in the denominator reflects the cross-sectional variance of returns (implicitly weighting each month by the number of firms in the sample at the time). For the specifications in Table 2, these R 2 s range from 0.0019 0.0027 for all stocks, 0.0017 0.0029 for all-but-tiny stocks, and 0.0024 0.0046 for large stocks, about 20 40 times smaller than the FM R 2 s. 10
example, in Model 1, the full-sample slope on B/M drops from 0.57 to 0.33 and the slope on momentum drops from 1.09 to 0.74 if I redefine B/M using Fama and French s approach (the slopes remain strongly significant for all three groups of stocks). A related observation concerns the impact of the year 2009 on momentum. Several months in 2009 were disastrous for momentum strategies and have a big impact on the momentum slopes. For example, in the fullsample regressions for Model 1, the slope on 12-month returns drops from 1.27 if the tests end in 2008 to 1.09 using all months. The monthly slope hits a low of -33.18 in April 2009, and the average slope for all of 2009 is -7.13 (losers, but not winners, rebounded strongly in March, April, and May of 2009). Although slopes on other variables are much less sensitive to the inclusion of 2009, the extremely poor predictive performance of momentum in that year tends to reduce the overall out-of-sample performance of expected-return estimates from the regressions, especially among larger stocks. Fig. 1 shows how the slopes on selected characteristics change through time. The figure plots 10-year rolling averages of the slopes from Model 2, which includes the seven characteristics with the strongest predictive power. (All seven characteristics are included in the regressions, but the figure omits the slopes on size and ROA because they have a different magnitude than the others.) Most of the slopes shrink toward zero over time (including those on size and ROA), but the 10-year rolling estimates lie almost entirely on one side of the x-axis or the other, i.e., the magnitudes but not the signs change through time. The relatively steady decline in the slopes suggests that past estimates will tend to overstate the cross-sectional dispersion in true expected returns going forward, exactly the pattern I document below. 3.2. Estimates of expected stock returns Table 3 explores the properties and out-of-sample predictive ability of forecasts (i.e., estimates of expected returns) derived from the FM regressions above. The forecasts are based on a firm s beginning-of-month characteristics and either the prior 10-year rolling average or the cumulative average, starting in 1964, of slopes from the three models in Table 2. (I consider estimates based on alternative rolling windows later.) Again, the goal is to mimic what an investor could have forecast for expected returns, in real time, using only 11
Fig. 1. Ten-year rolling slope estimates, 1974 2009 The figure plots ten-year rolling averages of Fama-MacBeth slopes on selected characteristics (the x-axis indicates the ending date for the ten-year window). Panel A shows estimates using all stocks and Panel B shows estimates using large stocks, defined as those larger than the NYSE median based on market value at the beginning of the month. The estimates come from Model 2: Monthly returns (in %) are regressed on size, B/M, 12-month momentum (Ret12), three-year stock issuance (Issue36), accruals, ROA, and asset growth (LogAG). Market data come from CRSP and accounting data come from Compustat. The variables are defined in Table 1. slopes from prior FM regressions. The left-hand columns in Table 3 summarize the univariate properties of the return forecasts, in particular, the average of their monthly cross-sectional means, standard deviations, and 10th and 90th percentiles. I report the mean mostly for descriptive purposes; the cross-sectional dispersion is more important for understanding how well the estimates capture variation in expected returns across stocks (an analyst could shift all of the estimates up or down to reflect different beliefs about overall market returns). 12
Table 3 Expected stock returns, 1974 2009 This table reports the properties (average, standard deviation, 10th and 90th percentiles) and predictive ability (slope, standard error, t-statistic, R 2 ) of monthly return forecasts derived from a firm s current characteristics and slopes from past FM regressions (10-year rolling estimates or cumulative averages starting in 1964). All point estimates equal time-series averages of monthly cross-sectional parameters. Predictive slopes and R 2 s come from (out-of-sample) FM regressions of monthly returns on the expected-return estimates; standard errors are based on the time-series variability of the estimates, incorporating a Newey-West correction with four lags. The full sample includes all common stocks on CRSP with the necessary data to estimate expected returns. All but tiny stocks are those larger than the NYSE 20th percentile based on market cap and Large stocks are those larger than the NYSE median. Market data come from CRSP and accounting data come from Compustat. Model 1 includes size, B/M, and 12-month momentum; Model 2 adds three-year stock issuance and one-year accruals, profitability, and asset growth; Model 3 adds beta, dividend yield, market leverage, sales/price, three-year returns, and one-year stock issuance, volatility, and turnover. Univariate properties Predictive ability FM estimate Model Avg Std p10 p90 Slope S.E. t-stat R 2 Panel A: All stocks Rolling Model 1 1.26 0.79 0.31 2.19 0.85 0.09 9.79 0.007 slopes Model 2 1.30 0.83 0.32 2.27 0.84 0.08 10.22 0.007 Model 3 1.17 0.90 0.12 2.22 0.77 0.08 10.17 0.009 Cumulative Model 1 1.14 0.81 0.20 2.09 0.87 0.07 11.76 0.007 slopes Model 2 1.12 0.84 0.16 2.09 0.86 0.07 13.20 0.008 Model 3 0.74 1.03-0.50 1.89 0.66 0.07 9.14 0.012 Panel B: All but tiny stocks Rolling Model 1 1.13 0.55 0.53 1.74 0.77 0.12 6.23 0.015 slopes Model 2 1.14 0.61 0.48 1.79 0.73 0.10 6.97 0.014 Model 3 1.10 0.66 0.35 1.82 0.60 0.10 5.82 0.015 Cumulative Model 1 0.96 0.62 0.30 1.66 0.62 0.12 5.22 0.017 slopes Model 2 0.91 0.67 0.21 1.62 0.69 0.10 6.91 0.016 Model 3 0.70 0.68-0.09 1.43 0.69 0.11 6.43 0.019 Panel C: Large stocks Rolling Model 1 1.07 0.47 0.56 1.60 0.78 0.16 4.73 0.024 slopes Model 2 1.07 0.51 0.52 1.63 0.76 0.13 5.94 0.021 Model 3 1.08 0.55 0.47 1.71 0.50 0.12 4.03 0.021 Cumulative Model 1 0.86 0.52 0.30 1.44 0.62 0.16 3.93 0.025 slopes Model 2 0.80 0.56 0.19 1.41 0.73 0.12 6.03 0.022 Model 3 0.60 0.54-0.03 1.20 0.73 0.13 5.47 0.025 Forecasts from all three models suggest considerable cross-sectional variation in expected returns. For the full sample, the cross-sectional standard deviation ranges from 0.79% using 10-year rolling slope estimates for Model 1 to 1.03% using cumulative slope estimates for Model 3. The 10th percentiles of the distributions are close to zero (positive for Models 1 and 2, zero or negative for Model 3), while the 90th percentiles range from 1.89% to 2.27% monthly. Thus, using the 10th and 90th percentiles as a guide, the estimates imply a spread of roughly 2% monthly between high and low expected returns. 13
Dropping tiny stocks from the sample reduces variability in the expected-return estimates, but the crosssectional standard deviations are still 0.55 0.68% for all-but-tiny stocks and 0.47 0.56% for large stocks. An investor using FM-based estimates of expected return would forecast, on the low end, excess returns that are zero or negative for many large stocks and, on the high end, excess returns greater than 15% annualized (the average monthly Tbill rate during the sample is 0.45%). Dispersion of the forecasts is higher when more variables are included in the model but the differences are surprisingly modest for all three samples. For example, using 10-year windows and all stocks, the crosssectional standard deviation increases from 0.79% for Model 1 to 0.83% for Model 2 to 0.90% for Model 3. These numbers suggest that the characteristics added to Models 2 and 3 contribute only a small amount to the cross-sectional volatility of expected returns, surprising given the strong statistical significance of some of the variables in FM regressions. I discuss this result further below. The right-hand columns in Table 3 explore the critical question of whether the estimates actually pick up crosssectional variation in true expected returns. An estimate that provides an unbiased forecast of returns should predict subsequent realized returns with a slope of one (better forecasts may or may not have greater statistical significance, due to the confounding effects of cross-sectional correlation in returns). The tests in Table 3 are based on out-of-sample FM regressions, again with t-statistics based on the time-series variability of the monthly slopes. The return forecasts do a good job of capturing variation in expected returns, especially in the full sample of stocks. In particular, in the full sample, the predictive slopes for the six specifications range from 0.66 to 0.87 and the t-statistics range from 9.14 to 13.20. The point estimate is highest (0.87) for return forecasts based on cumulative FM estimates of Model 1, and the t-statistic is highest (13.20) for return forecasts based on cumulative FM estimates of Model 2 (with a slightly lower point estimate of 0.86). The slopes are reliably less than one in untabulated tests, the minimum t-statistic testing that hypothesis is 1.76 but the results suggests that the vast majority of variation in the expected-return estimates does, in fact, reflect differences in stocks true expected returns. 14
The same conclusions carry over to the all-but-tiny and large-stock samples but the predictive slopes tend to be lower. The slopes range from 0.60 to 0.77 for all-but-tiny stocks and from 0.50 to 0.78 for large stocks (tstatistics of 3.93 6.97). For these groups, rolling FM estimates from Models 1 and 2 seem to capture variation in true expected returns the best (slope estimates of 0.73 0.78), but cumulative FM estimates for Model 3 follow close behind (slope estimates of 0.69 0.73). Again, the slopes are statistically less than one in all but one case, the exception being expected-return estimates for large stocks based on 10-year rolling slopes for Model 1 (with an untabulated t-statistic of 1.37). The evidence in Table 3 has several implications. At the most basic level, the tests show that FM-based expected-return estimates have strong predictive power for subsequent stock returns. Stocks estimated to have high expected returns based on prior FM regressions do, in fact, have significantly higher returns going forward. The predictive ability of the estimates is stronger than the predictive ability of any of the individual characteristics in the various models (see Table 2). At the same time, however, the expected-return estimates vary more than the true expected returns they forecast. The cross-sectional dispersion of the estimates needs to be shrunk by about 15 30% (i.e., by one minus the slopes in Table 3) in order to get a sense of how much true expected returns, as forecast by the estimates, actually vary across stocks. An additional implication of the results is that FM regressions are stable enough and estimated precisely enough to have strong out-of-sample predictive ability. Unlike time-series predictive regressions, prior FM regressions provide a reliable way to forecast subsequent returns. Put differently, FM regressions provide an effective way to combine many firm characteristics, in real time, into a composite forecast of a stock s expected return recognizing that the estimate should be shrunk a bit toward the cross-sectional mean to account for apparent noise in the estimate. 3.3. Comparing the models As observed above, the three regression models capture similar variation in expected returns, despite the fact 15
Table 4 Model comparison, 1974 2009 This table compares return forecasts from the three models considered in Tables 2 and 3, referred to as Forecasts 1, 2, and 3 (forecasts are based on 10-year rolling windows of FM regressions). The first three columns summarize the correlation, slope, and residual standard deviation (in %) for Forecast 2 regressed on Forecast 1, Forecast 3 regressed on Forecast 1, and Forecast 3 regressed on Forecast 2. The last three columns report the slope, standard error, and t-statistic when residuals from those regressions are used to predict monthly stock returns. All point estimates equal time-series averages of monthly cross-sectional parameters. The full sample includes all common stocks with market data on CRSP and accounting data on Compustat. All-but-tiny stocks are those larger than the NYSE 20th percentile based on market cap and Large stocks are those larger than the NYSE median. Model 1 includes size, B/M, and 12-month momentum; Model 2 adds three-year stock issuance and one-year accruals, profitability, and asset growth; Model 3 adds beta, dividend yield, market leverage, sales/price, three-year returns, and one-year stock issuance, volatility, and turnover. Predict returns w/ residual Correlation Slope Res. std. Slope S.E. t-stat Panel A: All stocks Forecast 2 regressed on Forecast 1 0.87 0.92 0.39 0.81 0.14 5.82 Forecast 3 regressed on Forecast 1 0.74 0.84 0.58 0.65 0.14 4.71 Forecast 3 regressed on Forecast 2 0.86 0.94 0.43 0.53 0.18 2.87 Panel B: All but tiny stocks Forecast 2 regressed on Forecast 1 0.80 0.91 0.34 0.79 0.13 5.91 Forecast 3 regressed on Forecast 1 0.69 0.86 0.43 0.51 0.12 4.27 Forecast 3 regressed on Forecast 2 0.86 0.95 0.31 0.24 0.24 1.01 Panel C: Large stocks Forecast 2 regressed on Forecast 1 0.79 0.88 0.27 0.77 0.15 5.24 Forecast 3 regressed on Forecast 1 0.66 0.83 0.36 0.34 0.13 2.66 Forecast 3 regressed on Forecast 2 0.81 0.90 0.28 0.08 0.19 0.42 that several of the characteristics added to Models 2 and 3 have strong predictive power in standard FM regressions. Table 4 explores the relation between the models in greater detail, focusing on forecasts derived from 10-year rolling windows of past FM regressions. Much of the predicted variation in expected returns is common to all three models, with pairwise correlations in their forecasts of 0.74 0.87 for all stocks, 0.69 0.86 for all-but-tiny stocks, and 0.66 0.81 for large stocks. The incremental component of Model 2 s forecasts relative to Model 1 (the residual when Model 2 s forecast is regressed on Model 1 s forecast) has a cross-sectional standard deviation of 0.27 0.39% monthly. This is economically important but substantially less than the variation captured by Model 1 (see Table 3). The incremental component of Model 3 relative to Model 2 has a similar standard deviation (0.28 0.43%), whereas the incremental component of Model 3 relative to Model 1 is higher (0.36 0.58%). 16
The last three columns in Table 4 show that the incremental forecast from Model 2 relative to Model 1 has strong out-of-sample predictive power for returns, with slopes of 0.77 0.81 and t-statistics of 5.24 5.91 for the different samples. The incremental component of Model 3 is less informative, with strong significance relative to Model 1 but inconsistent significance relative to Model 2. Overall, the extra characteristics in Models 2 and 3 capture significant variation in expected returns beyond the information contained in size, B/M, and 12- month past returns (the variables in Model 1), but the incremental predictive power seems modest compared to their significance in FM regressions. 3.4. Alternative windows Table 5 tests whether return forecasts based on shorter but more timely rolling windows also provide good estimates of expected returns. The layout is the same as Table 3, with univariate statistics on the left and the predictive performance of the estimates on the right. I show results for forecasts based on 1-, 3-, 5-, and 7-year rolling averages of past FM slopes. The data are the same for all windows except that the tests start in May 1965 for the 1-year window (the 13 month of the sample), May 1967 for the 3-year window (the 37th month of the sample), and so forth. The general pattern of the results suggests that forecasts based on longer windows of past FM slopes are more accurate: The cross-sectional dispersion of the forecasts declines monotonically in all panels as the window grows from one to seven years, consistent with a drop in estimation error. In addition, the predictive slope is lowest for the 1-year rolling estimate in all but one of the panels (the exception is Model 1 for all-but-tiny stocks), again suggesting that the 1-year estimates contain the most noise. At the same time, the forecasting ability of the estimates is surprisingly strong even for those based on just 12 months of past FM regressions. Across all windows and groups of stocks, the slopes range from 0.39 to 0.84. More than half of the slopes (21/36) are above 0.60 and a third (11/36) are above 0.70. The t-statistics are greater than four with only three exceptions, and all t-statistics for the full sample are greater than six (most for large stocks are greater than five). As in Table 3, nearly all of the slopes are significantly smaller than one, so the expected-return estimates vary more than the true expected returns they forecast, but the estimates do a 17
Table 5 Estimates based on alternative rolling windows, 1965 2009 This table replicates Table 3 using return forecasts derived from alternative rolling averages of past Fama-MacBeth slopes (1-, 3-, 5-, or 7-year windows of monthly regressions). Statistics are based on the longest time period available (starting in 1965 for the 1-year rolling estimates, 1967 for the 3-year rolling estimates, etc.). Table 3 provides additional information about the sample and tests. Univariate properties Predictive ability Model FM estimate Avg Std p10 p90 Slope S.E. t-stat R 2 Panel A: All stocks Model 1 1-yr rolling 1.10 1.11-0.28 2.44 0.67 0.10 6.49 0.016 3-yr rolling 1.21 0.87 0.14 2.24 0.73 0.11 6.59 0.012 5-yr rolling 1.20 0.80 0.22 2.15 0.72 0.11 6.66 0.010 7-yr rolling 1.23 0.79 0.28 2.17 0.84 0.10 8.10 0.008 Model 2 1-yr rolling 1.19 1.21-0.27 2.61 0.67 0.07 9.36 0.017 3-yr rolling 1.27 0.93 0.14 2.36 0.69 0.09 7.96 0.012 5-yr rolling 1.27 0.85 0.24 2.26 0.68 0.10 7.03 0.010 7-yr rolling 1.29 0.83 0.30 2.26 0.83 0.09 8.87 0.008 Model 3 1-yr rolling 1.13 1.46-0.61 2.88 0.58 0.06 9.70 0.023 3-yr rolling 1.17 1.08-0.09 2.43 0.63 0.07 8.45 0.015 5-yr rolling 1.17 0.96 0.05 2.30 0.66 0.08 8.21 0.013 7-yr rolling 1.20 0.90 0.13 2.26 0.70 0.08 9.08 0.010 Panel B: All but tiny stocks Model 1 1-yr rolling 0.99 0.90-0.06 2.06 0.56 0.08 6.56 0.024 3-yr rolling 1.08 0.65 0.33 1.83 0.73 0.12 5.87 0.021 5-yr rolling 1.06 0.57 0.42 1.72 0.45 0.27 1.68 0.019 7-yr rolling 1.10 0.55 0.48 1.72 0.75 0.15 4.99 0.017 Model 2 1-yr rolling 1.03 1.02-0.12 2.21 0.53 0.07 7.96 0.024 3-yr rolling 1.10 0.72 0.28 1.92 0.71 0.09 7.52 0.019 5-yr rolling 1.09 0.64 0.38 1.79 0.60 0.12 5.05 0.017 7-yr rolling 1.12 0.61 0.45 1.79 0.75 0.12 6.45 0.016 Model 3 1-yr rolling 1.02 1.29-0.50 2.51 0.43 0.06 7.05 0.034 3-yr rolling 1.05 0.87 0.05 2.03 0.54 0.08 6.45 0.023 5-yr rolling 1.05 0.74 0.19 1.89 0.53 0.09 5.57 0.020 7-yr rolling 1.08 0.68 0.30 1.84 0.55 0.11 4.96 0.018 Panel C: Large stocks Model 1 1-yr rolling 0.92 0.84-0.03 1.90 0.53 0.10 5.23 0.030 3-yr rolling 1.00 0.58 0.35 1.68 0.78 0.14 5.39 0.027 5-yr rolling 1.00 0.49 0.44 1.57 0.55 0.23 2.42 0.026 7-yr rolling 1.04 0.47 0.51 1.57 0.63 0.24 2.63 0.025 Model 2 1-yr rolling 0.96 0.96-0.11 2.07 0.49 0.07 7.01 0.029 3-yr rolling 1.02 0.65 0.29 1.77 0.69 0.11 6.39 0.026 5-yr rolling 1.03 0.55 0.41 1.65 0.64 0.13 4.90 0.023 7-yr rolling 1.06 0.52 0.48 1.64 0.75 0.13 5.58 0.022 Model 3 1-yr rolling 0.95 1.26-0.48 2.39 0.39 0.06 6.14 0.042 3-yr rolling 0.98 0.80 0.08 1.88 0.52 0.09 5.52 0.030 5-yr rolling 1.02 0.65 0.29 1.75 0.54 0.11 5.07 0.027 7-yr rolling 1.05 0.59 0.39 1.71 0.55 0.13 4.23 0.025 18
reasonable good job of capturing variation in true expected returns. For the shortest windows, the return forecasts reflect some short-term persistence in FM slopes on individual characteristics. For example, in the full sample, FM slopes on 14 of the 15 variables in Model 3 have positive first-order autocorrelations, with an average value of 0.10 across the 15 variables (the average autocorrelation is 0.08 for all-but-tiny stocks and 0.07 for large stocks; the standard error of the autocorrelations is about 1/548 1/2 = 0.04). The persistence essentially vanishes by lag 2, suggesting that it reflects higher-frequency properties of returns rather than long-lasting changes in the slopes. As a robustness check, I have re-run the tests skipping a month between the rolling windows used to estimate FM regressions and the month used to explore the predictive ability of the return forecasts. The predictive ability of the forecasts drops somewhat for short-window estimates but the basic conclusions are quite robust. For example, using 12-month rolling estimates of Model 1, the predictive slopes in Table 5 drop from 0.67 to 0.54 for the full sample (t-statistic of 3.92), 0.56 to 0.45 for all-but-tiny stocks (t-statistic of 4.39), and 0.53 to 0.45 for large stocks (t-statistic of 4.08). The corresponding slopes in Table 3 using 10-year rolling windows drop from 0.85 to 0.84 (t-statistic of 9.90), 0.77 to 0.73 (t-statistic of 5.96), and 0.78 to 0.75 (t-statistic of 4.45) for the three groups of stocks. The results for Models 2 and 3 are similar. 3.5. Portfolios For additional perspective on the predictive power of the return forecasts, Table 6 compares the predicted and actual returns of expected-return-sorted portfolios. To keep the output manageable, I show results only for Model 3, using all 15 firm characteristics as predictors (forecasts are based on 10-year rolling averages of past FM slopes). These results are representative of those from all three models: predicted returns from Models 1 and 2 exhibit a bit less cross-sectional dispersion across portfolios but the actual returns of the portfolios are similar (average returns and t-statistics for the high-minus-low strategies in the table tend to be marginally stronger using Model 2 and marginally weaker using Model 1). The results in Table 6 convey, at a basic level, the same message as my earlier tests: FM-based estimates of 19
Table 6 Expected-return sorted portfolios, 1974 2009 This table reports average predicted excess returns (Pred) and average realized excess returns (Avg) for equal- and value-weighted deciles when stocks are sorted by predicted expected returns. The standard deviation (Std), Newey- West t-statistic (t-stat), and annualized Sharpe ratio (Shp) of realized returns are also reported. Predicted expected returns are derived from a firm s current characteristics and slopes from past Fama-MacBeth regressions (10-year rolling estimates of Model 3, which includes all 15 firm characteristics). The full sample includes all common stocks on CRSP with the data necessary to forecast expected returns. All-but-tiny stocks are those larger than the NYSE 20th percentile based on market cap and Large stocks are those larger than the NYSE median. Market data come from CRSP and accounting data come from Compustat. Equal-weighted Value-weighted Pred Avg Std t-stat Shp Pred Avg Std t-stat Shp Panel A: All stocks Low (L) -0.90-0.32 7.19-0.84-0.15-0.76 0.11 6.01 0.37 0.06 2-0.11 0.40 5.84 1.30 0.24-0.10 0.45 4.77 1.89 0.32 3 0.21 0.60 5.46 2.06 0.38 0.21 0.65 4.65 2.84 0.49 4 0.44 0.78 5.28 2.74 0.51 0.44 0.69 4.67 2.97 0.51 5 0.64 0.81 5.36 2.82 0.52 0.63 0.81 5.01 3.34 0.56 6 0.83 1.04 5.36 3.62 0.67 0.82 0.88 5.22 3.28 0.58 7 1.02 1.12 5.55 3.68 0.70 1.01 1.04 5.67 3.46 0.64 8 1.25 1.31 5.97 4.04 0.76 1.24 1.15 6.03 3.62 0.66 9 1.55 1.66 6.76 4.38 0.85 1.54 1.34 6.68 3.80 0.69 High (H) 2.29 2.17 7.97 4.82 0.94 2.19 1.66 8.28 3.73 0.70 H L 3.20 2.49 5.02 10.00 1.72 2.94 1.55 6.56 4.51 0.82 Panel B: All but tiny stocks Low (L) -0.55-0.02 7.36-0.06-0.01-0.44-0.04 6.48-0.12-0.02 2 0.07 0.51 5.90 1.73 0.30 0.08 0.34 5.02 1.43 0.23 3 0.31 0.64 5.31 2.32 0.42 0.30 0.40 4.69 1.69 0.30 4 0.47 0.74 5.14 2.82 0.50 0.47 0.53 4.61 2.33 0.40 5 0.61 0.78 5.02 3.08 0.54 0.60 0.53 4.74 2.32 0.39 6 0.73 0.91 4.94 3.62 0.64 0.73 0.64 4.79 2.65 0.46 7 0.86 0.88 4.99 3.52 0.61 0.86 0.71 4.90 2.97 0.50 8 1.01 1.05 5.14 4.07 0.70 1.00 0.82 5.16 3.09 0.55 9 1.22 1.15 5.70 4.08 0.70 1.22 0.94 5.78 3.11 0.56 High (H) 1.79 1.37 7.11 3.79 0.67 1.74 1.18 6.92 3.33 0.59 H L 2.34 1.39 5.35 5.34 0.90 2.18 1.22 6.24 3.87 0.67 Panel C: Large stocks Low (L) -0.31 0.15 6.79 0.46 0.08-0.26 0.11 6.36 0.36 0.06 2 0.15 0.62 5.49 2.34 0.39 0.15 0.37 5.06 1.50 0.25 3 0.33 0.52 4.96 2.05 0.36 0.33 0.44 4.65 1.92 0.33 4 0.46 0.65 4.87 2.66 0.46 0.45 0.39 4.52 1.75 0.30 5 0.57 0.72 4.77 2.92 0.52 0.57 0.57 4.61 2.49 0.43 6 0.67 0.71 4.68 3.01 0.52 0.67 0.49 4.53 2.18 0.37 7 0.78 0.80 4.76 3.35 0.58 0.78 0.59 4.70 2.61 0.44 8 0.92 0.82 4.74 3.51 0.60 0.91 0.73 4.97 2.87 0.51 9 1.11 0.83 5.31 3.04 0.54 1.11 0.68 5.44 2.42 0.43 High (H) 1.66 1.28 6.96 3.57 0.64 1.63 1.13 6.88 3.12 0.57 H L 1.97 1.12 5.87 3.86 0.66 1.89 1.01 6.24 3.24 0.56 20