The Intrinsic Value of the Dow: This Time with Feeling! P Dunne, J Forker, A Zholos Seminar: Trinity College Dublin – Nov 2009

Motivation The stock market and sentiment? – Asset pricing theory weak on sentiment… – Fundamental valuation...Lee et al.(1999) ignores sentiment and ambiguity – Irrational exuberance….Shiller (1981, 1990, 2005) Excess volatility puzzle – Bubbles spill-over…… Prado & Qin (2009)

Mon-policy / asset price debate Bernanke & Gertler (2001), concluded that; Central Banks should set interest rates in response to forecast inflation and the output gap, but that they should not react directly to movements in asset prices. Other views:The Cecchetti report states that; – (i) Central Banks can achieve superior performance by adjusting policy instruments in response to asset prices with the caveat that an understanding as to why asset prices have changed is required – (ii) “asset price misalignments may be difficult to measure, but this is no reason to ignore them.”

Can fundamental analysis help? Can we use fundamental analysis along with measures of sentiment and risk to explain “why asset prices have changed”? Disagreement exists about how to do fundamental analysis and even about capital asset pricing

Capital Asset Pricing CAPM assumes a single risk factor But alternatives in favour today – APT – Fama-French 3 Factor model – Campbell “Good Beta, Bad Beta” It would be good if CAPM worked – Advantage of ‘Single factor’ and ‘single risky portfolio’ for investment – Fewer unknown parameters so easier to use it for fundamental analysis

Sentiment – Can we separate sentiment effects from fundamentals? – Can Sentiment be represented – A risk Factor? – A control variable? – An ECM term? – An instrument for risk aversion?

What we do! Propose and test a method to obtain a risk premium that is clean of sentiment (or uncertainty effects). To do this we must appeal to; – a reinstatement of the CAPM, – the idea of ‘Bellwether stocks’, – various ex-ante variables that are seldom used in fundamental analysis.

Estimates of risk premium E = Monthly IBES analysts core earnings expectations  = Forward Looking betas for each firm each period from Options see. Christensen et al. rf = Risk free rate If we assume earnings follow random walk Plus drift g

Estimates of risk premium rf *= Risk free rate adjusted for expected dividend yield Market beta=1

Estimates of risk premium rf *= Risk free rate adjusted for expected dividend yield Market beta=1 Solve for premium given other info And assuming a random walk Earnings

Backed-out premium for the market: Jan 1996 – Mar 2004

This premium is not right! It becomes negative? It is too variable It has the wrong relationship with systematic volatility VIX is a measure of risk implied by option on the S&P index It should be a good indicator of the amount of systematic risk in existence

Backed-out premium for the market: Jan 1996 – Mar 2004 VIX Decline in implied risk premium could simply reflect an over-valued market

1/ Inverse of the VIX index against the implied risk-premium from market index

So the risk-premium associated with market index is probably missing control variables or the market is contaminated by sentiment/uncertainty/ambiguity/bubble Using Market premium will miss-value most stocks It is also difficult to get a reliable ex-ante beta for most stocks Most stocks are not well described by the simple CAPM – Could this just be reflecting the contamination from sentiment?

Support for alternative… Option-implied beta is source of accurate ex-ante beta for stocks immune to sentiment… » Lemmon & Ni (2008) In certain regimes the simple CAPM works….. » Chung & Yeh (2009) Perhaps there exists an “easy-to-value” assets with insignificant sensitivity to other factors/sentiment » Baker & Wurgler (2007) + Epstein & Schneider(2006) The stock we found to be best source of a reliable risk premium is a well known ‘bellwether’ stock ‘CAT’

Conditions required for sentiment free implied premium “Easy-to-value” asset…..‘Bellwether’ Unaffected by market sentiment & other factors For which a CAPM single-factor model fits One for which an accurate ex-ante, forward looking beta can be estimated from options One for which the permanent-transitory decomposition of earnings is reliable

“Asset-specific” implied premium Solve, given Earnings Forecast

“Asset-specific” implied premium We have monthly IBES ‘core’ earnings forecasts (2 year ahead)

“Asset-specific” implied premium We obtained ‘option implied’ betas for the stocks in the DJ 30 Index Source: Christoffersen et al., (2008)

Option implied betas Chang, Chrisstoffersen, Jacob & Vainberg (2009) These may suffer from slight bias due to the fact that they are derived under the assumption of risk-neutrality….

Example of “option-implied beta”

“Asset-specific” implied premium But earnings forecasts are not just a random walk!

“Asset-specific” implied premium Assume growth = an estimated drift? And dividend policy matters!

Decomposition of earnings forecast Random walk + noise + measurement error – UC “trend-cycle” model – Method: Kalman Filter The decomposition is important for what comes out as the implied premium! Transitory doesn’t contribute as much to value as permanent High persistence of shocks to transitory will give them greater role

Decomposition of earnings forecast

Decomposition of monthly earnings We apply a Kalman Filter to this unobserved components model The decomposition is sensitive to assumptions about We applied this to a stock that gave promising results using a more simple ARIMA modelling We end-up selecting a UC-ARMA(1,12)

The Earnings Data - Caterpillar

Drift terms

Log “Trend component” and log forecast earnings Persistent transitory deviations from stochastic trend

Valuing the 2 Earnings components The stationary part must be projected forward at each valuation time

The backed-out “CAT” premium

PremCAT Vs PremMKT

PremCAT Vs inverse-VIX R²=0.13

PremCAT on sent-index (various) R²=0.000 Tried various non-linear transformations of sentiment

Recall These are both timely “ex-ante” premia! So they would be sensitive to change in forecasts of fundamentals, changes from option implied betas and changes in the price of the bellwether equity pricing. Variables that can be monitored “real-time”

Back to accounting valuations Using a fundamental valuation approach with 1.Premium based on CATERPILLAR 2.Premium based on MKT 3.What does sentiment variable add? 4.Does it matter if we use other controls? Fama-French?

Simple empirical model Step 1: Cointegration Monthly IBES core FY2 earnings Backed out for CAT FL betas for each firm each period Risk free rate – expected div yield

Simple empirical model Step 1: Cointegration with sentiment

Step 2: ECM Using the ECM terms from step 1 – Assuming that contemporaneous earnings shocks can be included –i.e., weak exogeneity – including dummy for end-year effects – ECM terms are negative and significant – Explanatory power good – Sentiment seems to be another driver of returns in path to equilibrium

ECM

ECM R² Without sentimentWith sentiment AXP HPQ HD IBM MCD MSFT

RIM Present value of discounted income flows in excess of the required return on capital (BV). Lee (1999) considers the cointegration relation between this V and the Stock Market Value. The deviation (V-P) is an ecm term that drives future returns. For individual stocks we can perform analysis of the role of sentiment dissequilibrium

More for the future Earnings-Decomposition approach – Robustness check regarding correlated trend/stationary components How does sentiment disequilibrium relate to future earnings? – Perhaps sentiment predicts long-run fundamentals Proper analysis of causality Characteristics of stocks give “sentiment sensitivity”? Ambiguity/complexity/uncertainty

Other ECM representations… Threshold error-correction-terms? – It could be that sentiment effects are like a trend with occasional breaks – Updating the work of Campbell et al…and of Lee et al. Proper instrumenting for endogeneity of sent

So what? We argue the sentiment component can be identified. The bellwether premium is very stable – Risk-aversion quite stable and close to typical assumed 8% This could be a valuable input into investment decisions – Would help to stabilize or “ground” valuations and make the market less prone to sentiment related bubbles. Could be helpful for policy makers trying to spot when the market is over-valued due to sentiment

Company list AAALCOA INC AXPAMERICAN EXPRESS CO AIGAMERICAN INTL BABOEING CO CATCATERPILLAR JPMJ P MORGAN CCITIGROUP INC KOCOCA COLA CO DISDISNEY WALT CO DDDU PONT XOMEXXON MOBIL GEGENERAL ELEC CO GMGENERAL MTRS CORP HPQHEWLETT PACKARD CO HDHOME DEPOT INC HONHONEYWELL INTCINTEL CORPIBM JNJJOHNSON & JOHNSON MCDMCDONALDS MRKMERCK & CO MSFTMICROSOFT MMM3M CO PFEPFIZER INC MOALTRIA GROUP INC PGPROCTER & GAMBLE SBCSBC COMM INC UTXUNITED TECH VZVERIZON WMTWAL MART