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Fama Cross-Section of Expected Stock Returns

Fama Cross-Section of Expected Stock Returns

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American Finance Association
The Cross-Section of Expected Stock ReturnsAuthor(s): Eugene F. Fama and Kenneth R. FrenchSource:
The Journal of Finance,
Vol. 47, No. 2 (Jun., 1992), pp. 427-465Published by: Blackwell Publishing for the American Finance AssociationStable URL:
Accessed: 08/11/2009 16:36
Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available athttp://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unlessyou have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and youmay use content in the JSTOR archive only for your personal, non-commercial use.Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained athttp://www.jstor.org/action/showPublisher?publisherCode=black .Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printedpage of such transmission.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact support@jstor.org.
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THE JOURNAL OF FINANCE*VOL. XLVII, NO. 2*JUNE 1992
The Cross-SectionofExpectedStockReturns
EUGENE F. FAMA and KENNETH R. FRENCH*
ABSTRACT
Twoeasilymeasuredvariables,size and book-to-marketequity,combinetocapturethecross-sectionalvariationinaveragestock returns associated with market3,size, leverage, book-to-market equity, and earnings-price ratios. Moreover, whenthetests allow for variationin3that is unrelated tosize,the relation between market/3and average return is flat, even when3is the only explanatory variable.
THEASSET-PRICINGMODELOF Sharpe (1964),Lintner(1965),and Black(1972)
has long shaped the way academics and practitionersthinkabout averagereturns andrisk. Thecentral predictionof themodelisthat the marketportfolioofinvested wealthismean-varianceefficientinthe sense ofMarkowitz (1959).Theefficiency of the market portfolio implies that (a)expectedreturns on securitiesare a positive linearfunctionoftheir marketO3sthe slopeintheregression of a security'sreturn on the market'sreturn),and(b)marketO3suffice to describe the cross-section ofexpectedreturns.There are several empirical contradictions of the Sharpe-Lintner-Black(SLB)model. The mostprominentis the size effect ofBanz(1981).Hefindsthat marketequity,ME(astock'spricetimes sharesoutstanding),adds totheexplanationofthecross-section ofaveragereturnsprovided by marketOs.Averagereturns on small(low ME)stocks are toohigh giventheirfestimates,andaveragereturnson large stocksaretoo low. Another contradiction of the SLB modelis thepositiverelation betweenleverageandaveragereturndocumentedbyBhandari(1988).It isplausiblethat leverageisassociated with risk and expected return,but inthe SLBmodel, leverageriskshould becaptured bymarketS.Bhandarifinds,how-ever,thatleverage helps explainthecross-section of average stockreturnsintests that includesize(ME)as well asA. Stattman (1980) and Rosenberg, Reid, and Lanstein (1985)findthat aver-agereturns onU.S. stocks arepositivelyrelated to the ratio of afirm'sbookvalueofcommonequity, BE,to itsmarket value,ME.Chan, Hamao, andLakonishok(1991)findthat book-to-market equity, BE/ME, also has a strongroleinexplaining the cross-section of average returns on Japanese stocks.
*
Graduate School ofBusiness, University of Chicago, 1101 East 58th Street, Chicago, IL60637. Weacknowledgethehelpful comments of David Booth, Nai-fu Chen, George Constan-tinides, Wayne Ferson, Edward George, Campbell Harvey, Josef Lakonishok, Rex Sinquefield,Rene Stulz,MarkZmijeweski,andananonymousreferee. This researchissupported bytheNational Science Foundation(Fama) and the Center for ResearchinSecurity Prices (French).
427
 
428The Journalof FinanceFinally, Basu(1983) shows that earnings-price ratios(E/P) help explainthe cross-sectionof average returnson U.S. stocks intests that also includesize and market F. Ball (1978)argues that E/P is a catch-all proxyforunnamed factorsin expected returns;E/P is likely to be higher (pricesarelower relative to earnings) for stockswith higher risksand expected returns,whatever theunnamed sources of risk.Ball's proxyargument for E/Pmight also apply tosize (ME), leverage, andbook-to-marketequity. All thesevariables can be regardedas differentwaysto scale stockprices, to extractthe information inprices about riskandexpected returns(Keim (1988)).Moreover, since E/P, ME, leverage,andBE/MEareallscaled versions ofprice, it is reasonableto expect that some ofthem are redundantfor describing average returns.Our goal is to evaluatethejointrolesofmarket A, size, E/P, leverage,and book-to-market equityinthecross-section ofaveragereturns on NYSE, AMEX,and NASDAQ stocks.Black, Jensen,andScholes (1972)and FamaandMacBeth (1973) findthat,aspredicted bytheSLBmodel, thereis apositivesimple relation betweenaveragestock returns and ,3 during the pre-1969period. Like Reinganum(1981) and Lakonishokand Shapiro(1986), we find thatthe relation between
A3
andaveragereturn disappears duringthemore recent1963-1990period,even when
A
isused alonetoexplain averagereturns.Theappendix showsthatthesimplerelation between
A
and average returnis also weakin the50-year1941-1990 period.Inshort,our tests do notsupportthemost basicprediction of the SLB model, thataverage stock returnsare positivelyrelatedto market /3s.Unlike thesimplerelation between
/3
andaveragereturn,the univariaterelationsbetweenaveragereturn andsize, leverage,E/P,andbook-to-marketequityarestrong.Inmultivariate tests,thenegativerelation betweensizeandaveragereturnisrobust to theinclusion of other variables.Thepositiverelationbetween book-to-marketequityandaveragereturn alsopersistsincompetitionwithothervariables.Moreover,althoughthe size effecthasattracted more attention,book-to-marketequityhas aconsistentlystrongerroleinaveragereturns.Our bottom-lineresults are: (a) :does not seemtohelp explainthe cross-section ofaverage stock returns, and (b)the combina-tion of sizeandbook-to-marketequityseems toabsorb theroles ofleverageandE/Pinaveragestockreturns,atleastduringour1963-1990sampleperiod.Ifassets are priced rationally,ourresultssuggestthat stockrisks aremultidimensional.Onedimensionofriskisproxiedby size,ME. Anotherdimensionofrisk isproxied byBE/ME,theratio of the bookvalue ofcommonequityto its marketvalue.Itispossiblethat the riskcaptured by BE/MEisthe relativedistressfactor of Chan andChen(1991).They postulatethattheearning prospectsoffirmsare associatedwith arisk factorinreturns.Firmsthat the marketjudges tohave poor prospects, signaledherebylow stockpricesandhighratiosofbook-to-marketequity,havehigher expectedstock returns(theyarepenalizedwithhighercosts ofcapital)thanfirmswithstrong prospects.Itis

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