Essays on the value effect in the time series and cross section of stock returns

Abstract

This thesis consists of three essays. The commonality of the essays lies their investigation of the value effect, in either the time series or cross section of stock returns. Specifically, the first essay examines the predictive power of the aggregate book-to-market ratio for aggregate stock returns in the U.S. stock market, after aggregate profitability and asset investment have been controlled for. The second essay studies the crash risks of the size (SMB), value (HML), and momentum (UMD) factors in the G7 countries, and whether such risks can be internationally diversified. The third essay looks at how the Fama-French three-factor model performs in the Chinese stock market, after the special features of the market have been accounted for. In the first essay, we find that both aggregate profitability and asset investment have significant predictive power for aggregate stock returns. While previous studies that use the book-to-market ratio (B/M) to predict aggregate stock returns emphasize the need to control for expected profitability, we show that it is important to control for expected investment as well. Just knowing expected future profits is not enough—it is also important to control for how much additional investment is needed to generate those profits. On the other side, at both the aggregate-market and 48-industry levels, profitability and investment are positively correlated with each other yet predict future returns in opposite directions; B/M and profitability are negatively correlated with each other yet predict future returns in the same direction. This correlation structure also calls on a simultaneous control for all three variables when predicting aggregate stock returns in order to extract the most forecast power out of them. Using aggregate B/M, profitability, and asset investment as predictors produces statistically and economically significant improvement in out-of-sample R2s and certainty equivalent return (CER) gains in equity premium forecasts. A decomposition of total assets into its components shows that cash and short-term asset growth predicts one-year-ahead (but not two-year-ahead) stock returns, while the growth rate of longer-term assets predicts two-year-ahead stock returns only. Since total asset growth consists of both the short- and long-term components of investment, its predictive power for future stock returns is robust across different time horizons. In the second essay, we find that the crash risks of momentum tend to be higher than those of size and value. International diversification lowers the crash risks of size and value, but not momentum. By examining the conditional correlations and return coexceedances of style portfolios across countries, we conclude that this difference in the effect of diversification is due to the left (right) tails of momentum (size and value) portfolios being more correlated than their right (left) tails across countries. The third essay explores to what extent the Fama-French three factors explain the variation in Chinese stock returns. We document empirical evidence on this issue and identify some pitfalls that arise in the application of the three-factor model to Chinese stock returns. We find that several special features in China affect the three factors considerably and also influence the explanatory power of the three-factor model.