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Investing Research Articles

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

Abnormal Returns from Small Stocks with Good Prospects

In their December 2005 paper entitled “Information and Prospects: Investment Opportunities and Market Efficiency in the Small-Cap Segment”, German Espinosa and Robert Veszteg examine the value of analysts as guides for selecting stocks that amplify the small firm effect. Is it better to search independently for “hidden gems” or to focus instead on small stocks followed by analysts? Are those analysts one step ahead in the relatively slow diffusion process for new information about small firms? The authors test the hypothesis that small firms with unusually large analyst followings tend to be those with the best prospects. Using monthly data on financial analyst coverage and returns for the stocks of U.S. and Canadian markets between June 1996 and June 2004, they find that: Keep Reading

Challenging the Value Premium

Current research on the value premium, the outperformance of value stocks in comparison with other (growth) stocks, mostly involves explaining it through either behavioral or efficient-market mechanisms. However, in their November 2005 paper entitled “Does the Value Premium Really Exist in the UK Equity Market?”, Panagiotis Andrikopoulos, Arief Daynes, David Latimer and Paraskevas Pagas challenge its existence. Their study focuses on eliminating any possible effects of survivorship bias, look-ahead bias and the method of calculating returns in comparing the performance of value and growth stocks of United Kingdom firms. They classify value versus growth via four selection factors (low for value, high for growth): book-to-market value, earnings-to-price ratio, dividend yield and weighted average sales growth. Using a new database of 2006 UK equity issues fully listed at any time during 1987-1996, they find that: Keep Reading

Trading Signals from Retail Investor Behavior

What can small-trade volume tell us about the behavior and success of retail investors? Two December 2005 papers tackle this question. In a paper entitled “Small Trades and the Cross-section of Stock Returns”, Soeren Hvidkjaer investigates the effect of retail investor trading behavior on stock returns by studying intermediate-term and long-term returns for stocks with small-trade buying or selling pressures. In a paper entitled “Do Noise Traders Move Markets?”, Brad Barber, Terrance Odean and Ning Zhu offer a similar study, adding an analysis of the short-term returns for stocks with small-trade buying or selling pressures. Their joint findings are: Keep Reading

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