On the determinants of stock returns

Objective Present recent empirical evidence on the determinants of stock returns

Outline A review of determinants of stock returns Empirical evidence

Common sense determinants of stock returns Risk factors Liquidity factors Measures of cheapness Measures of profitability Technical factors Sector-related factors

Risk factors Market beta (trailing 60-montth)  APT betas  Volatility of total return (trailing 60-month)  Residual variance (firm-specific risk over trailing 60-month)  Debt-to-equity ratio  NOI/Interest charges

Liquidity factors Market capitalization  Market price per share  Trading volume-to-market capitalization (trailing 12-month)

Measures of cheapness P/E ratios  Market-to-book ratio  Dividend yield  OCF-to-price  Sales-to-price

Measures of profitability Profit margin Total sales/total assets ROA ROE Earnings growth (trailing 5-year)  Earnings surprise

Technical factors Excess return (relative to the S&P 500) in the previous 1 month  Excess return (relative to the S&P 500) in the previous 2 months  Excess return (relative to the S&P 500) in the previous 6 months  Excess return (relative to the S&P 500) in the previous 12 months  Excess return (relative to the S&P 500) in the previous 24 months Excess return (relative to the S&P 500) in the previous 60 months

Sector-related factors Durable goods  Utilities  Energy  Constructions  Manufacturing  etc

Reality check: Empirical evidence Use stocks from the Russell 3000 Stock Index from 1979 to 1993 Run regression: R = a +b 1 Det 1 + b 2 Det 2 + ……+ e

Top ten stock return determinants in the decreasing order of statistical significance: Excess return (relative to the S&P 500) in the previous 1 month (-) Excess return (relative to the S&P 500) in the previous 12 months (+) Trading volume-to-market capitalization (trailing 12-month) (-) Excess return (relative to the S&P 500) in the previous 2 months (-) P/E ratios (-) ROE (+) Market-to-book ratio (-) Excess return (relative to the S&P 500) in the previous 6 months (+) Trading volume trend (-) OCF-to-price (+)

Interpretation Short-term reversal Medium-term momentum Long-term reversal Investors overestimate the mean-reversion period and/or growth rates (cheap stocks earn higher returns) Liquid stocks have lower expected returns

More questions What is the relationship between risk and return? Why do cheaper stocks have higher returns?