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Big Ideas

These blog entries offer some big ideas of lasting value relevant for investing and trading.

Trading Frictions Over the Long Run

Careful assessment of the exploitability of premiums or anomalies derived from long-run series such as stock indexes requires consideration of contemporaneous trading frictions. How have frictions changed over time? In the May 2002 version of his paper entitled “A Century of Stock Market Liquidity and Trading Costs”, Charles Jones assembles annual long-run series of three components of aggregate liquidity: (1) proportional bid-ask spreads for large-capitalization NYSE stocks (1900-2000); (2) proportional commissions for NYSE stocks (1925-2000); and, (3) turnover for NYSE stocks (1900-2000). He applies these series to explore the relationship between stock market returns and aggregate liquidity over time. Using a range of sources to calculate bid-ask spreads for the Dow Jones/DJIA stocks and commission, volume and return data for a broader sample of NYSE stocks, he finds that: Keep Reading

Credit Ratings and Stock Return Anomalies

Does designated creditworthiness, closely related to riskiness, drive the performance of many widely acknowledged stock return anomalies? In the April 2010 revision of their paper entitled “Anomalies and Financial Distress”, Doron Avramov, Tarun Chordia, Gergana Jostova and Alexander Philipov use portfolio sorts and regressions to investigate the relationship between financial distress (low credit ratings and downgrades) and profitability for trading strategies based on: stock price momentum, earnings momentum, credit risk, analyst earnings forecast dispersion, idiosyncratic volatility, asset growth, capital investments, accruals and value. Using data for broad samples of U.S. stocks (limited by extensive information requirements) spanning October 1985 through December 2008, they conclude that: Keep Reading

In Search of Super-anomalies

Is there a common factor explaining multiple widely accepted stock return anomalies? In the March 2010 version of their paper entitled “Do Five Asset Pricing Anomalies Share a Common Mispricing Factor?Multifaceted Empirical Analyses of Failure Risk Proxies, External Financing, and Stock Returns” , Joseph Ogden and Julie Fitzpatrick investigate the ability of a single factor, involving operating profit and external financing, to explain five stock return  anomalies: (1) the failure-risk anomaly; (2) earnings momentum; (3) the external financing (stock buybacks/secondary offerings) anomaly; (4) the accruals anomaly; and, (5) the book-to-market anomaly.  Using monthly stock return and firm fundamentals data for a broad sample of U.S. stocks to form 205 portfolios over the period 1974-2008 (60,301 firm-year observations), they find that: Keep Reading

A Long Run Demographic Stock Market Outlook

Does demographic mix of a set of investors affect aggregate demand for yield, and thereby total returns, from equity investments? In the December 2009 version of their paper entitled “Demographic Trends, the Dividend/Price Ratio and the Predictability of Long-Run Stock Market Returns”, Carlo Favero and Arie Gozluklu investigate the relationship between the aggregate stock dividend yield and the ratio of middle-aged (40-49) to young (20-29) populations in the U.S. (M/Y). Using U.S. demographic and aggregate equity dividend and price data spanning 1900-2008, they conclude that: Keep Reading

Beat the Market with Hot-Anomaly Switching?

Can investors beat the market by iteratively finding and exploiting the current hot anomaly? In the September 2009 update of his paper entitled “Real-Time Profitability of Published Anomalies: An Out-of-Sample Test”, Zhijian Huang investigates whether a trader can realize excess returns by repeatedly picking the anomaly with the best return during a rolling historical window from an expanding universe of anomalies as published, with a specific objective of suppressing data snooping bias. The universe includes anomalies that: (1) have been published in at least one of five top-ranked finance journals; (2) relate to the calendar or to cross-sectional predictability; and, (3) can be re-evaluated annually. Using monthly return data associated with 11 anomalies published during 1972-2005 (Monday/weekend effect, January effect and cross-sectional effects related to size, book-to-market ratio, momentum, earnings-price ratio, cash flow-price ratio, dividend yield, debt-equity ratio, sales growth and trading volume/turnover) as available from 1926 through 2008, he concludes that: Keep Reading

Diversifying Across Equity Anomalies

Is diversification across equity anomalies beneficial? In his December 2009 preliminary paper entitled “Diversification Across Characteristics”, Erik Hjalmarsson combines long-short portfolios formed on seven stock anomalies:

  1. Short-term (one-month) reversal (ST-R)
  2. Medium-term (11 months plus skip-month) momentum (Mom)
  3. Long-term (four years plus skip-year) reversal (LT-R)
  4. Book-to-market value (B/M)
  5. Cash flow-to-price ratio (C/P)
  6. Earnings-to-price ratio (E/P)
  7. Market capitalization (Size)

The portfolio for each anomaly is long (short) on an equally weighted basis the tenth of stocks expected to generate the most positive (negative) returns, reformed each month. Using monthly firm characteristics and return data for all NYSE, AMEX and NASDAQ stocks over the period July 1951 through December 2008, he finds that: Keep Reading

Managing Investment Risk by Parsing Uncertainties

How scientific can economics and finance be? In the March 2010 draft of their paper entitled “WARNING: Physics Envy May Be Hazardous To Your Wealth!”, Andrew Lo and Mark Mueller present a framework to help investors, portfolio managers, regulators and policymakers understand the potential effectiveness and inherent limitations of economics and finance. Focusing on levels of uncertainty (fully reducible, partially reducible, and irreducible) to explain some of the key differences between finance and physics and on the role of quantitative models in theory and practice, they conclude that: Keep Reading

Perspectives on Global Equity Diversification

Given the sometimes high correlations in movements among local equity markets, how valuable is international diversification in a global era? In the February 2010 draft of their paper entitled “International Diversification Works (in the Long Run)”, Clifford Asness, Roni Israelov and John Liew examine the argument that global markets are undiversified (correlated) when you need diversification and diversified (uncorrelated) when you don’t. They use an equally weighted 22-country global portfolio for their investigation. Using monthly local currency-denominated total returns, exchange rates and inflation data for Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, UK and U.S. for 1950-2008, they conclude that: Keep Reading

Unfooled by Randomness?

Can people reliably distinguish between actual financial markets time series and randomized data? In the February 2010 draft of their paper entitled “Is It Real, or Is It Randomized?: A Financial Turing Test”, Jasmina Hasanhodzic, Andrew Lo and Emanuele Viola report the results of a web-based experiment designed to test the ability of people to distinguish between time series of returns for eight commonly traded financial assets (including stock indexes, a bond index, currencies and commodities, all given names of animals) and randomized data. Using a sample of 8015 guesses from 78 participants over eight contests conducted during 2009, they conclude that: Keep Reading

Variation in Long-run Stock Market Predictability

Is there a steady, zero or varying supply of stock market return predictability? In their January 2010 paper entitled “Stock Return Predictability and the Adaptive Markets Hypothesis: Evidence from Century Long U.S. Data”, Jae Kim, Kian-Ping Lim and Abul Shamsuddin employ a battery of tests to evaluate the evolution of U.S. stock market return predictability over the last century and determine whether this evolution is consistent with the Adaptive Markets Hypothesis. Using monthly Dow Jones Industrial Average (DJIA) return data, along with various indicators of market conditions and economic fundamentals, for 1900 through 2009, they conclude that: Keep Reading

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