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Investing Research Articles

Should Equity Investors Hope for Good or Bad Economic Forecasts?

Do forecasts for the economy at large predict returns for stock investors? In the September 2005 version of their paper entitled “Stock Returns and Expected Business Conditions: Half a Century of Direct Evidence”, Sean Campbell and Francis Diebold characterize the relationship between expected business conditions (predictions of real growth in GDP six and 12 months ahead) and stock returns. Using half a century (1952-2002) of Livingston Survey expected business conditions results and corresponding measures of expected stock returns, they conclude that: Keep Reading

The Frailty of the Size Effect?

Do long-term investors in small-capitalization firms outperform? Is the size effect simply a manifestation of data snooping or defective statistical methodologies? In his January 2006 paper entitled “Is Size Dead? A Review of the Size Effect in Equity Returns”, Mathijs van Dijk reviews the international evidence for the size effect and synthesizes the debate on its theoretical validity and empirical persistence. He concludes that: Keep Reading

(Not) Capturing the Elusive Value Premium

Do long-term value investors outperform? In their paper entitled “Do Investors Capture the Value Premium?”, Todd Houge and Tim Loughran seek the answer to this question by examining groups of value and growth equity indexes, mutual funds and individual stocks over long periods. They conclude that: Keep Reading

No Reward for Risk?

The market rewards investors for taking risk. Right? High volatility means high risk. Right? High volatility therefore means excess return. Right? In their January 2006 paper entitled “High Idiosyncratic Volatility and Low Returns: International and Further U.S. Evidence”, Andrew Ang, Robert Hodrick, Yuhang Xing and Xiaoyan Zhang test the relationship between past idiosyncratic volatility and future returns for stocks in developed markets around the world. Using data from 23 countries mostly over the period January 1980 through December 2003, they find that: Keep Reading

Last Nail in the Coffin of the Fed Model?

Fed Model proponents argue that there is an equilibrium relationship between the earnings yield of a stock index and the 10-year government bond yield. When the earnings yield is below (above) the 10-year government bond yield, the stock market is overvalued (undervalued). In his January 2006 paper entitled “The Fed Model: The Bad, the Worse, and the Ugly”, Javier Estrada recaps the (lack of) theoretical basis for the Fed Model and tests its empirical support in the markets of 20 countries. Using both actual (trailing) and projected (forward) earnings for total market indices over various periods ending in June 2005, he concludes that: Keep Reading

Classic Research: Mean Reversion in Corporate Profitability

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the February 1999 paper entitled “Forecasting Profitability and Earnings” (download count over 3,600) by Eugene Fama and Kenneth French. Is corporate profitability mean reverting due to competitive forces, as entrepreneurs exit relatively unprofitable industries and enter relatively profitable industries. Are there therefore predictable patterns in corporate earnings? Using a simple return-on-assets model applied to an average of 2304 firms per year over the period 1964-1995, the authors conclude that: Keep Reading

Can Individual Investors Enhance Returns with Options?

In the January 2006 revision of their paper entitled “Is There Money to be Made Investing in Options? A Historical Perspective”, James Doran and Andy Fodor examine the return and risk of a variety of option strategies for a typical investor. Specifically, they assess whether any of 12 S&P 500 index options trading strategies as marginal investments within a larger index portfolio would have enhanced buy-and-hold returns over long periods. They chose the 12 strategies in accordance with the basic strategies outlined by the Chicago Board of Options Exchange. Where historical options price data is unavailable, they estimate plausible reconstructions and transaction costs. Using two long periods (1970-2004 and 1995-2004) and focusing on overall portfolio returns, they find that: Keep Reading

Classic Research: Explaining Large Stock Market Fluctuations

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the August 2003 paper entitled “A Theory of Large Fluctuations in Stock Market Activity” (download count nearly 2,700) by Xavier Gabaix, Parameswaran Gopikrishnan, Vasiliki Plerou and Eugene Stanley. Why do stock prices vary more than company fundamentals? Why do stock markets crash? This paper proposes a theory of large stock market movements based upon a linkage between market activity and the size distribution of large financial institutions. Motivated by empirical findings that stock returns, trading volumes, number of trades, price impacts of trades and sizes of large investors all have power law distributions, the authors propose that: Keep Reading

A Few Notes on Probability Theory, The Logic of Science

Because economics and financial markets lack mature theoretical (deductive) foundations, these fields involve largely empirical (inductive) work. The principal mathematical tools in this pursuit derive from probability and statistics. In his 2003 book Probability Theory, The Logic of Science, E.T. Jaynes presents in textbook form his own evolutionary growth in the understanding of probability theory. His approach is Bayesian, in that he views probabilities as conceptually distinct from frequencies of occurrence and probability theory as synonymous with the process of inductive inquiry. He emphasizes iterative “plausible reasoning” as the kernel of probability theory. He offers a few summarizing points relevant to equity investors/traders, as follows: Keep Reading

A Few Notes on Reinventing The Bazaar, A Natural History of Markets

In his 2002 book, Reinventing The Bazaar, A Natural History of Markets, John McMillan offers an overview of recent research on the workings of markets. His perspective is empirical rather than ideological as he examines economies worldwide to infer when markets work and when they do not. Some summarizing points on critical factors for economic growth are relevant to equity investors considering international diversification, as follows: Keep Reading

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