The efficient market hypothesis asserts that financial markets are “informationally efficient”; that is, investors shouldn’t expect to consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. However, we know that the market isn’t perfectly efficient. In fact, as I explained in my Seeking Alpha series on…
A June 2012 study by Robert Novy-Marx, “The Other Side of Value: The Gross Profitability Premium,” provides investors with new insights into the cross section of stock returns. Among the important findings were: Profitability, as measured by gross profits-to-assets—gross profits being sales minus cost of goods sold—has roughly the same power as book-to-market (a value…
Modern financial theory now includes the existence of many anomalies that shouldn’t exist if investors were perfectly rational and markets were perfectly efficient. Perhaps the most important anomaly is the persistent and pervasive momentum premium. Among the others are the low-volatility anomaly (low-volatility stocks have outperformed high-volatility stocks) and the poor performance of extreme small…
Today concludes our two-part series on the research aimed to provide explanations for risk. We’ll pick up with more research on the topic. We looked at three different papers in Part I as we sought to assess the value premium through the lens of risk, and today we turn to a fourth paper: The 2005 study “Understanding…
Modern financial theory now includes the existence of many anomalies that shouldn’t exist if investors were perfectly rational and markets were perfectly efficient. Perhaps the most important anomaly is the persistent and pervasive momentum premium. Among the others are the low-volatility anomaly (low-volatility stocks have outperformed high-volatility stocks) and the poor performance of extreme small…
Today concludes our two-part series on the research aimed to provide explanations for risk. We’ll pick up with more research on the topic. We looked at three different papers in Part I as we sought to assess the value premium through the lens of risk, and today we turn to a fourth paper: The 2005 study “Understanding…
William Sharpe and John Lintner are typically given most of the credit for introducing the first formal asset pricing model, the capital asset pricing model (CAPM). CAPM provided the first precise definition of risk and how it drives expected returns. The CAPM looks at returns through a “one-factor” lens, meaning the risk and return of…
My last post showed that the quality (or profitability) premium provided valuable insights into not only U.S. stock returns, but international developed markets as well. Today I’ll look at the question of whether this quality factor applies to emerging markets. The simple answer is yes. To review, the profitability/quality factor tells us that more profitable firms outperform…
Today’s post will begin a two-part series that explores the research examining risk-based explanations for the value premium, which, unlike the risk-based explanations of the size premium, have been a bit controversial. In June 1992, the paper “The Cross-Section of Expected Stock Returns” was published in the Journal of Finance. The authors, Professors Eugene F….
When estimating returns, we know that current valuations provide valuable information. The earnings yield derived from the Shiller CAPE 10—the cyclically adjusted price-to-earnings ratio—is considered by many to be at least as good, if not better, than other metrics. It uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in…
Market-timing strategies attempt to outperform a buy-and-hold strategy by anticipating the future direction of a market. They can work, but mostly they don’t. First, such strategies are based on the belief that future security prices are predictable, typically through the use of technical indicators, such as trend following or momentum, that are computed from the…
There’s a growing body of evidence that beta is actually a two-sided, not a one-sided, “coin,” and those two faces are separated by perceptions of risk. Being risk averse, most investors care more than just about the standard deviation of returns (volatility), assigning more weight to downside deviations from the mean than to upside deviations….
In 1993, the Fama-French three-factor (beta, size and value) model replaced the single-factor capital asset pricing model (CAPM) and became the standard model in finance, explaining more than 90 percent of the variation of returns of diversified portfolios. While the model was a big improvement over the CAPM, it couldn’t explain some major anomalies. In…
Since the publication of the study “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency” in 1993, the momentum anomaly—buying past winners and selling past losers, generates abnormal returns in the short run—has received a lot of attention. This anomaly presents perhaps the greatest challenge to market efficiency, because it could not be explained by…
What’s known as the carry trade is one of the more popular strategies of hedge funds, and it’s also becoming popular for investors seeking alternative fixed-income strategies that can provide higher yields in today’s environment of low rates. The strategy involves borrowing (going short) a currency with a relatively low interest rate and using the…