The Inefficient Stock Market What Pays Off and Why (Prentice Hall, 1999) Visit our web-site at HaugenSystems.com

Background:  The evolution of academic finance.

The Evolution of Academic Finance 1930’s40’s50’s60’s70’s80’s90’sbeyond The Old Finance Theme: Analysis of Financial Statements and the Nature of Financial Claims Paradigms:Security Analysis Uses and Rights of Financial Claims (Graham & Dodd) (Dewing) Foundation:Accounting and Law The Old Finance

The Evolution of Academic Finance 1930’s40’s50’s60’s70’s80’s90’sbeyond The Old Finance Modern Finance Bob goes to college Modern Finance Theme:Valuation Based on Rational Economic Behavior Paradigms: Optimization Irrelevance CAPM EMH (Markowitz) ( Modigliani & Miller) (Sharpe, Lintner & Mossen) (Fama) Foundation:Financial Economics

The Evolution of Academic Finance 1930’s40’s50’s60’s70’s80’s90’sbeyond The Old Finance Modern Finance The New Finance Bob goes to college The New Finance Theme:Inefficient Markets Paradigms:Inductive ad hoc Factor Models Behavioral Models Expected Return Risk (Haugen) (Chen, Roll & Ross) (Kahneman & Tversky) Foundation:Statistics, Econometrics, and Psychology

Background:  The evolution of academic finance.  Estimating expected return with the Asset Pricing Models of Modern Finance  CAPM: strong assumption -- strong prediction

Expected Return Risk (Return Variability) Market Index on Efficient Set Market Index A B C Market Beta Expected Return Corresponding Security Market Line x x x x x x x x x x x x x x x x x x x x x x x x

Market Index Expected Return Risk (Return Variability) Market Index Inside Efficient Set Corresponding Security Market Cloud Expected Return Market Beta

Background:  The evolution of academic finance.  Estimating expected return with the Asset Pricing Models of Modern Finance  CAPM: strong assumption -- strong prediction.  APT: weak assumption -- weak prediction.

The Arbitrage Pricing Theory  Estimating the macro-economic betas.

Relationship Between Return to General Electric and Changes in Interest Rates -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% Return to G.E. -10%-5%0%5%10% Percentage Change in Yield on Long-term Govt. Bond Line of Best Fit April, 1987

The Arbitrage Pricing Theory  Estimating the macro-economic betas.  No-arbitrage condition for asset pricing.  If risk-return relationship is non-linear, you can arbitrage.

What Pays Off

Probability Distribution For Returns to a Portfolio Possible Rates of Returns Probability Expected Return Variance of Return

Risk Factor Models  The variance of stock returns can be split into two components:  Variance = systematic risk + diversifiable risk  Systematic risk is computed using the following spreadsheet.

Spreadsheet for Computing Systematic Risk Portfolio Beta (Inflation) (Oil Price) Correlation Between Inflation and Oil Price Portfolio Beta (Inflation) (Oil Price) Correlation Between Inflation and Oil Price

Risk Factor Models  Factor betas are estimated by relating stock returns to (unexpected) percentage changes in the factor over a period where the stock’s character is similar to the present.

Relationship Between Return to General Electric and Changes in Interest Rates -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% Return to G.E. -10%-5%0%5%10% Percentage Change in Yield on Long-term Govt. Bond Line of Best Fit April, 1987

Relationship Between Rate of Inflation and Percentage Change in Price of Oil Monthly Rate of Inflation Monthly Percentage Change in Price of Oil Line of Best Fit

Risk Factor Models  Factor correlations can be estimated over a longer period because they are, presumably, more stable over time. This may increase the predictive accuracy of factor models relative to more naïve historical estimates.

Computing Portfolio Systematic Risk 1.00 Portfolio Beta * Portfolio Beta * 1.00 (Inflation) +Portfolio Beta * Portfolio Beta * Correlation Between (Inflation) (Oil Price) Inflation and Oil Price Portfolio Beta * Portfolio Beta * 1.00 (Oil Price) +Portfolio Beta * Portfolio Beta * Correlation Between (Inflation) (Oil Price) Inflation and Oil Price = Portfolio Systematic Risk

Risk Factor Models  If your factors have truly captured the structure behind the correlations between stock returns, then portfolio diversifiable risk can be estimated by summing the products of (a) the diversifiable risk of each stock and (b) the square of its portfolio weight.

DiversifiableRisk Decreases with the Number of Stocks in a Portfolio Diversifiable Risk Decreases with the Number of Stocks in a Portfolio Diversifiable Risk Number of Stocks in Portfolio

Expected Return Factor Models  The factors in an expected return model represent the character of the companies. They might include the history of their stock prices, its size, financial condition, cheapness or dearness of prices in the market, etc.  Factor payoffs are estimated by relating individual stock returns to individual stock characteristics over the cross-section of a stock population (here the largest 3000 U.S. stocks).

Book to Price -100% -50% 0% 50% 100% -1.5 Total Return Relationship Between Total Return and Book to Price Ratio January, 1981 Line of Best Fit

Five Factor Families  Risk  Liquidity  Price level  Growth potential  Price history

The Most Important Factors  The monthly slopes (payoffs) are averages over the period 1979 through mid “T” statistics on the averages are computed, and the stocks are ranked by the absolute values of the “Ts”.

Most Important Factors 1979/01 through 1986/ /07 through 1993/12 FactorMeanConfidenceMeanConfidence One-month excess return-0.97%99%-0.72%99% return Twelve-month excess0.52%99%0.52%99% Trading volume/market cap -0.35%99%-0.20%98% Two-month excess return-0.20%99%-0.11%99% Earnings to price0.27%99%0.26%99% Return on equity0.24%99%0.13%97% Book to price0.35%99%0.39%99% Trading volume trend-0.10%99%-0.09%99% Six-month excess return0.24%99%0.19%99% Cash flow to price0.13%99%0.26%99%

Projecting Expected Return  The components of expected return are obtained by multiplying the projected payoff to each factor (here the average of the past 12) by the stock’s current exposure to the factor. Exposures are measured in standard deviations from the cross-sectional mean.  The individual components are then summed to obtain the aggregate expected return for the next period (here a month)

FactorExposurePayoffComponent Book\Price1.5 S.D.x20 B.P.=30 B.P. Short-Term Reversal1.0 S.D.x-10 B.P.= Estimating Expected Stock Returns Trading Volume-2 S.D.x-20 B.P.=40 B.P. Total Excess Return 80 B.P.

The Model’s Out-of-sample Predictive Power  The 3000 stocks are ranked by expected return and formed into deciles (decile 10 highest).  The performance of the deciles is observed in the next month. Then expected returns are re- estimated, and the deciles are re-ranked.  The process continues through 1993.

Logarithm of Cumulative Decile Performance

Decile -40% -30% -20% -10% 0% 10% 20% 30% 012 Realized Return Realized Return for 1984 by Decile (Y/X = 5.5%) Y X

Extension of Study to Other Periods (Nardin Baker) The same family of factors is used on a similar stock population. Years before and after initial study period are examined to determine slopes and spreads between decile 1 and 10.

1997 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%100% Years 1998 difference slope Slope and Spread

Decile Risk Characteristics The characteristics reflect the character of the deciles over the period

Fama-French Three- Factor Model Monthly decile returns are regressed on monthly differences in the returns to the following: S&P 500 and T bills. The 30% of stocks that are smallest and largest. The 30% of stocks with highest book-to-price and the lowest.

Sensitivities (Betas) to Market Returns 10 Decile Market Beta

Sensitivities (Betas) to Relative Performance of Small and Large Stocks Decile Size Beta

Sensitivities (Betas) to Relative Performance of Value and Growth Stocks Decile Value/Growth Beta

Fundamental Characteristics Averaged over all stocks in each decile and over all months ( )

Risk

Decile Risk Characteristics Debt to Equity Stock Volatility Decile 0% Interest Coverage Market Beta Debt to Equity Volatility Volatility41.42%33.22% 10% 20% 30% 40% 50% Coverage Coverage Beta

Liquidity

Size and Liquidity Characteristics $0 $10 $20 $30 $40 $50 $60 $ Decile Stock Price Trading Volume $400 $500 $600 $700 $800 $900 $1,000 $1,100 Size $14.93 $30.21 Price $470 $1011 Size $42.42$60.89 Trading Volume

Price History

Technical History Decile -20% -10% 0% 10% 20% 30% Excess Return 2 months -1.80% 1.21% 12 months %30.01% 3 months -6.89% 8.83% 6 months %16.60% 1 mon th 0.09%-0.14%

Profitability

Current Profitability Asset Turnover 115% Return on Equity 15.39% Profit Margin 7.86% Return on Assets 6.50% 90% 100% 110% 120% Asset Turnover Decile 80%-10% 0% 10% 20% 1 Profit Margin Return on Assets Return on Equity Earnings Growth 0.95%

Trends in Profitability

Decile 5 Year Trailing Growth -1.5% -1.0% -0.5% 0.0% Profitability Trends (Growth In) Asset Turnover -0.13% Profit Margin -0.95% Return on Assets -1.11% Return on Equity -1.18%

Cheapness in Stock Price

Price Level Sales-to-Price 214% 207% Cash Flow-to-Price 6% 17% Earnings-to-Price-1.55% 10% Dividend-to-Price 2.19%3.69% 50% 100% 150% 200% Sales-to-Price Book-to-Price Decile 0%-10% 0% 10% 20% 12 Cash Flow-to-Price Earnings-to-Price Dividend-to-Price Book-to-Price81%80%

Simulation of Investment Performance Efficient portfolios are constructed quarterly, assuming 2% round-trip transactions costs within the Russell 1000 population. –Turnover controlled to 20% to 40% per annum. –Maximum stock weight: 5%. –No more that 3X S&P 500 cap. weight in any stock. –Industry weight to within 3% of S&P 500. –Turnover controlled to within 20% to 40%.

10% 11% 12% 13% 14% 15% 18% 17% 16% 20% 19% 12% Annualized total return 17%18%13%14%15%16% Annualized volatility of return 1000 Index G I H L Optimized Portfolios in the Russell 1000 Population:

Possible Sources of Bias Survival bias: excluding firms that go inactive during test period. Look-ahead bias: using data that was unavailable when you trade. Bid-asked bounce: if this month’s close is a bid, there is 1 chance in 4 that next and last month’s close will be at an asked, showing reversals. Data snooping: using the results of prior studies as a guide and then testing with their data. Data mining: spinning the computer.

Actual Performance

Performance of 413 Mutual Funds 10/96 - 9/98 “T” stat. on mean monthly out- performance to S&P 500 Large funds with highest correlation with S&P with a 36 month history

Three Year Out-(Under)-Performance T-Distribution 0% 5% 10% 15% 20%25% to to to to to to to to to -1.0 to to to to to to to T-statistics for mean out-(under) performance Percent of sample

Why

The Topography of the Stock Market

TrueAbnormal Profit True Abnormal Profit F Best estimate (using all relevant information and state-of-the-art analysis) of the risk adjusted, present value of a firms future abnormal profits.

Priced Abnormal Profit F Risk adjusted, present value of future abnormal profits reflected in the stock price.

True Abnormal Profit Priced Abnormal Profit Growth Stocks Value Stocks Efficient Market Line under- priced stock The Position of Portfolios in Abnormal Profit Space

willproduceexcessreturn True Abnormal Profit Priced Abnormal Profit Efficient Market Line over- priced stock The Position of Portfolios in Abnormal Profit Space Growth Stocks Value Stocks

willproduceexcessreturn True Abnormal Profit Priced Abnormal Profit Efficient Market Line willproduce deficient return The Position of Portfolios in Abnormal Profit Space Growth Stocks Value Stocks

Imprecision Imprecision

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line Priced Abnormal Profit True Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets IMPRECISION: Different prices for stocks with the same TRUE Abnormal Profit The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

Available assets IMPRECISION: Stocks with the same price have different TRUE abnormal profit The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Bias Bias

The Market Over-reacts to Success and Failure

Mean-reversion in Relative Profitability How Fast? Fuller Huberts & Levinson ( )

Relative Subsequent Growth in Highest, High, Low and Lowest Quintiles of E/P Ratio Low and Lowest Quintiles of E/P Ratio -10%-8%-6%-4%-2%0%2%4%6%8%10% Growth in Earnings per Share Relative to Middle Quintile Lowest E/P(Growth) Low E/P High E/P Highest E/P (Value) 1 Year ahead 2 Years ahead 3 Years ahead 4 Years ahead 5 Years ahead 6 Years ahead 7 Years ahead 8 Years ahead Number of Years After Ranking

Is the Market Surprised by the Speed of Mean- reversion? La Porta Lakonishok Shleifer & Vishny ( )

-1.0%-0.5%0.0%0.5%1.0%1.5%2.0% Three day rate of return -2.0%-1.5% Value Growth First year following ranking Second year following ranking Third year following ranking Fourth year following ranking Fifth year following ranking Returns of Growth and Value Stocks Around Earnings Announcement Dates Around Earnings Announcement Dates

Implications for Market’s Topography

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space BIAS: Overreaction to Abnormal Profit True Priced over- priced Efficient Market Line under- priced Priced Abnormal Profit True Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Available assets Value investors head West GrowthinvestorsheadNorth Priced Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Available assets Priced Abnormal Profit PureGrowth willunderperform GARP willoutperformmarket

The Relative Positions of Positions of the Deciles the Deciles

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Super Stocks Stupid Stocks Priced Abnormal Profit

What’s Behind the Payoff to Profitability? Imprecision

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

What’s Behind the Payoff to Cheapness? Imprecision & Bias

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

Efficient Market Line True Abnormal Profit Priced Abnormal Profit

What’s Behind the Negative Payoff to Risk?

I. Over-valued and Risky Growth Stocks Expensive growth stocks tend to produce low future returns They also tend to be more risky (Fama/French 1992 Table II.)

II. Agency Problems of Financial Analysts (cf., Sias, Financial Analysts’ Journal, 1996)

Thus, There May be Two Causes for the Inversion in the Relationship Between Risk and Expected Return The market’s tendency to over-price the more volatile, growth stocks. The attraction of institutional investors to the more newsworthy, volatile stocks.

What’s Behind the Technical Payoffs to Price History? Short-term reversals Intermediate momentum Long-term reversals

Short-term Reversals Price pressure Reversals of over-reactions

Intermediate Momentum and Long-term Reversals Repetition of earnings surprises of the same sign (Bernard & Thomas). Over-estimating the length of the short- run.

A Test of Relative Predictive Power ( ) Model employing factors exploiting the market’s tendencies to over- and under-react vs. Models employing risk factors only

The Ad Hoc Expected Return Factor Model Risk Liquidity Profitability Price level Price history Earnings revision and surprise

Decile Returns for the Ad Hoc Factor Model Decile 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 1AverageAnnualized Return

The Capital Asset Pricing Model Market beta (Measured over the trailing 5-year periods)

Decile Returns for CAPM Model Decile 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 12AverageAnnualized Return

The Arbitrage Pricing Theory Macroeconomic Factors Monthly T-bill returns Long-term T-bond returns less short-term T-bond returns less low-grade Monthly inflation Monthly change in industrial production Beta Estimation Betas re-estimated monthly by regressing stock returns on economic factors over trailing 3-5 years Payoff Projection Next month’s payoff is average of trailing 12 months

Average Returns for APT Model Annualized Decile 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 1AverageReturn

Overall Results Ad Hoc Expected Return Factor Model –Average Annualized Spread Between Deciles 1 & % –Years with Negative Spreads 0 years Models Based on MODERN FINANCE –CAPM Average Annualized Spread Between Deciles 1 & % Years with Negative Spreads13 years –APT Average Annualized Spread Between Deciles 1 & % Years with Negative Spreads 6 years

Getting to Heaven and Hell in the Stock Market

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Super Stocks Stupid Stocks Priced Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit InvestmentHeaven Stupid Stocks Priced Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit InvestmentHeaven InvestmentHell Priced Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit InvestmentHeaven InvestmentHell Priced Abnormal Profit Can’t get to heaven by going around the corner You must go directly to heaven

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit InvestmentHeaven InvestmentHell Can’t get to hell by going around the corner You must go directly to hell