Research Review | 17 November 2023 | Return Expectations

Causes of Deviations from a Real Earnings Yield Model of the Equity Premium
Austin Murphy and Zeina N. Alsalman (Oakland University)
October 2023
A market-based forecast of inflation added to equity earnings yields explains much of the variation in stock market returns over multi-year horizons. Return deviations from the prediction are found to be negatively related to the current inflation rate (output gap) over annual (all) horizons. Existing inflation is discovered to be positively (negatively) associated with future higher interest rates (real money supply and long-term profit growth). However, long-term inflationary expectations are positively correlated with long-term real future profit growth and stock returns. These results support the hypothesis of equity returns being positively (negatively) related to inflation (countercyclical anti-inflationary policies).

The Size Premium in a Granular Economy
Logan P. Emery and Joren Koëter (Erasmus University)
October 2023
The distribution of market capitalization in the U.S. is highly concentrated. We investigate how this phenomenon impacts the difference in returns between small and large firms (i.e., the size premium). If the stock market is sufficiently concentrated (i.e., granular), large firms may carry a risk premium because their idiosyncratic risk is not diversified in the market portfolio. At the same time, prior work has shown that small firms may be allocated too little capital in concentrated stock markets, which could increase their expected returns. We find that the expected size premium increases by 13.33 percentage points per annum during periods of higher concentration, indicating that the capital allocation effect dominates. Evidence from a variety of tests on investor attention, equity financing, fundamental volatility, and capital intensity support this conclusion. Nonetheless, we also find evidence of an active granular diversification effect, as the size premium weakens following idiosyncratic increases in granularity.

Forward Return Expectations
Mihir Gandhi, Niels Joachim Gormsen (U. of Chicago), et al.
September 2023
We measure investors’ short- and long-term stock-return expectations using both options and survey data. These expectations at different horizons reveal what investors think their own short-term expectations will be in the future, or forward return expectations. While contemporaneous short-term expectations are not countercyclical across all data sources, we find that forward expectations are consistently countercyclical, and excessively so: in bad times, forward expectations are higher than justified by investors’ own subsequent short-term return expectations. This excess volatility in forward expectations helps account for excess volatility in prices, inelastic demand for equities, and stylized facts about the equity term structure.

Subjective Return Expectations and Stock Market Risk Premia
Pascal Büsing and Hannes Mohrschladt (University of Muenster)
May 2023
We examine the time-series and cross-section of stock market risk premia from the perspective of financial analysts. Our novel approach is based on the notion that analysts’ stock recommendations reflect both their subjective return expectations and their perceived stock risk. Thus, we can empirically infer presumed risk premia from recommendations and target price implied expected returns. We show that analysts’ presumed risk premia are strongly countercyclical and predict future stock market returns. In the cross-section, the presumed risk premia are comparably large for high-beta, small, and value stocks lending support to a risk-based interpretation of these characteristics.

Inflation Expectations and Stock Returns
Manav Chaudhary and Benjamin Marrow (University of Chicago)
September 2023
Do stocks protect against rising inflation expectations? We directly measure investors’ expectations using traded inflation-indexed contracts and show that, post-2000, stocks offer positive returns in response to higher expected inflation: unconditionally, a 10 basis point increase in 10-year breakeven inflation is associated with a 1.1% increase in the value-weighted stock index. Using high-frequency identification around scheduled CPI releases, we show this relationship is likely causal. We provide evidence that the price increase is driven by lowering future expected excess returns rather than changing risk-free rates or cashflows; VAR decompositions of returns as well as mediation regressions that directly control for alternate channels attribute nearly all the changes to expected excess returns. Finally, we show inflation expectations predict future output and reduced volatility, suggesting that investors use information about high future inflation as a signal for economic growth, lowering risk premia.

Business Condition Expectations and Stock Return Predictability: International Evidence
Fuwei Jiang (Central University of Finance and Economics), et al.
September 2023
We construct a one-month-ahead conditional expectation measure of global business conditions relying on lagged OECD composite leading indices, and demonstrate that this index is a powerful predictor for aggregate stock returns around the globe, both in- and out-of-sample. We indicate that leading economic variables are valuable in capturing one-month-ahead conditional expectations when their lead time over actual economic activity is known. Moreover, the predictive power of the index at one-month return horizon stems from capturing business condition expectations for the future one-month. The predictability weakens as the forecast horizon for business condition expectations deviates further from the future one-month. Furthermore, we show that the index affects stock returns through the cash flow channel, and provides incremental forecasting information beyond local idiosyncratic business conditions and other economic and financial forces.

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  1. Pingback: Quantocracy's Daily Wrap for 11/20/2023 - Quantocracy

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