Market Anomalies and Multifactor

Models

by
Nai-fu Chen
University of California, Irvine

- P/E and Size Effect
- Multifactor Models
- Value Stocks, Contrarian Strategies, Open
Market Repurchases, Fama-French Three
Factor Model
- Momentum: price, earnings, credit risk
- Volatility and Skewness as predictors of
future returns

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6 . Without such assumption. investors facing multiperiod investment decisions would want to use current investment opportunities to hedge against multiperiod risks.Intuition leading up to multifactor models A critical assumption for CAPM (i) One period model or (ii) Investors cannot hedge against multiperiod risks.

Intertemperal Capital Asset Pricing Model (ICAPM) [Robert Merton (1973)] Assumption : In Continuous time... β JK are asset specific risk measures (they depend on J) and λ1 ...+ λ Kβ JK where β J1 ... The solution of the resultant differential equation (from dynamic programming and Ito’s process) yields: E( rJ ) = rF + λ1β J1 + λ 2β J 2 +. λ 2 .. asset prices follow geometric brownian motions : dp = μ(X)dt + σ(X)dz P where X is a vector of state variables..... λ K are economy wide risk premiums (they do not depend on J) -7- ....

t=1. .. Example : Investment J is a portfolio of government bonds β J1 would be slightly positive (if bonds and stock prices tend to move together) β J2 would be negative (since if inflation goes up...An Example : K=2 risk 1 is the market risk 2 is inflation risk rJt = a J + β J1rmt + β J 2 Ι t + ε Jt To estimate β J1 and β J2 . bond prices fall) Example : Investment J is a portfolio of real-estate stocks β J1 would be positive β J2 would be positive -8- . T. run a time series regression of rJt on rmt and Ι t ... interest rates go up.

2 and β J2 = 0. λ1 = 8%.2 and β J2 = 0 : E (rJ ) = 5% + 8% × 1.e.8 = 13. a positive β J2 ). If most investors prefer an investment with the characteristics that its return is positively related to inflation (i. Numerical Example : Let λ 0 = 5%.8% (Portfolio A) which is lower than the expected return of a portfolio with β J1 = 1...8 has an expected return of E( rJ ) = 5% + 8% × 1. J = 1. then λ 2 is negative.. one way is to run a cross-sectional regression of rJ on β J1 and βJ2 : ∧ ∧ ∧ rJ = λ 0 + λ1 β J1 + λ 2 β J 2 + e J . λ 2 = −1% A real-estate stock portfolio with β J1 = 1.. N In this case.2 − 1% × 0 = 14. λ 2 reflects the aggregate taste and preferences of investors in regard to inflation risk.To estimate λ1 and λ 2 .2 − 1% × 0.6% -9- (Portfolio B) .

8 × (unexpected inflation) + noise If unexpected market return = 0 unexpected inflation = 3% noise = 0 then.8% + 1.2 × 0% + 0. the realized return Portfolio A is high.8% + 1. λ < 0 If the risk characteristic is undesirable.2 × 0% + 0 × 3% = 14 .2 × (unexpected market return) +0. the investment provides a hedge against inflation. For λ : If the risk characteristic is desirable.6% + 1.8 × 3% = 16. In this sense.2% (Portfolio A) rJ = 14 .6% (Portfolio B) So when inflation rate is high. the realized return : rJ = E( rJ ) + unexpected return = 13.10 - .Notice the difference between realized return and expected return: For the real-estate stock portfolio. λ > 0 . rJ = 13.

.Arbitrage Pricing Theory (APT) [Ross (1976)] If rJ = E (rJ ) + β J1δ1 + . E(rJ) = rF + λ1βJ1 + … + λKβJK Factor 1 Stock 1 • Stock 2 Factor 2 • • • Factor 3 • Stock N .. in the absence of arbitrage. then.11 - . + β JK δ K + ε J .

Connor (1984) Roll and Ross (1980). Chen (1983) . Dybvig (1982).E rf λ λ b1 λ b2 Intuitive Proof E x C x B x A b1 References : Chen and Ingersoll (1983). Grinblatt and Titman (1983).12 - .

ln(IPt +1 / IPt ) [+] Changes in short term interest rates TB t +1 − TB t [−] Unexpected inflation I t − TB t [−] Changes in the slope of the term structure LTGB t − TB t [−] Changes in Investor confidence Low Grade Bond Return t − LTGB t [+] Hamao (1988) .Chen.13 - . Roll and Ross (1986) Stock Returns Common Stock Factors Factor Analysis Common Stock Factors Macroeconomic Variables Macroeconomic Factors Affecting Stock Returns : Production Growth (Long and Short Term) ln(IPt +12 / IPt ).

Multifactor Explanation of the Size Effect Chan. Chen and Hsieh (1985) Chan and Chen (1991) .14 - .

15 - . Chen and Hsieh (1985): Size Effect .Chan.

Small firm returns are nonlinearly related to market returns (like an out-of-the money option) R st − R lt = a s + b s ( R mt − μ m ) + C s ( R mt − μ m )| R mt − μ m |+ e st Cs is reliably positive . We can measure changes in business conditions by the business cycle indicator : Net Business Formation 3. Chen and Hsieh (1985) Conclusions : 1. Small firms are more sensitive to the changes in business conditions as measured by investor confidence 2.Chan.16 - .

17 - .Chan and Chen (1991): Structural Characteristics of Small and Large Firms .

Chan and Chen .18 - .

Chan and Chen (1991) Conclusions : • There are the differences in structural characteristics of small and large firms that induce different responses to the same set of economic factors. Return-to-Asset. Leverage. Size effect can be captured by APT . Interest Expense Coverage. Size is not a perfect indicator (sufficient statistics) [NASDAQ firms] 4. Distress (dividend cuts) [size-matched portfolios] 3.19 - . 1. Small firms are more likely to be “ fallen angels” (not newly listed firms) 2.

2000) Chen and Zhang (1998) Fama and French (1996. Shleifer and Vishny (1994) Ikenberry.Contrarian Strategies. Hamao and Lakonishok (1991) Lakonishok. Lakonishok and Vermaelen (1995.20 - . Value Stocks and Open Market Repurchases Chan. 1998) .

Chan. Book-to-Market and Cash Yield are important indicators of stock returns. Hamao and Lakonishok (1991): E/P. Size. .21 - .

Chan. Hamao and Lakonishok .22 - .

Lakonishok.23 - . . Shleifer and Vishny (1994): Contrarian Investment Strategies.

24 - .Lakonishok. Shleifer and Vishny .

Lakonishok. Shleifer and Vishny .25 - .

Lakonishok. Shleifer and Vishny .26 - .

E/P or GS (average past growth rate of sales).Contrarian Value Investment Strategies Conclusions : Superior investment performance can be obtained by investing in value stocks. . Such performance can be further improved by using a twodimensional classification. C/P. where value is measured by B/M.27 - .

28 - . Josef Lakonishok and Theo Vermaelen (1995): Market Underreaction to Open Market Share Repurchases .David Ikenberry.

Josef Lakonishok and Theo Vermaelen (1995): Market Underreaction to Open Market Share Repurchases .David Ikenberry.29 - .

] .30 - . [See also Ikenberry. Lakonishok and Vermaelen (2000) for Canadian evidence and Peyer and Vermaelen (2007) for the nature and persistence of buyback anomalies.Open market repurchases and value stocks: • Inside information − managers believe that stocks are undervalued • Out-of-Favor stocks − as measured by B/M Extra returns can be gained by buying those value stocks that have announcements for open market repurchases.

Chen and Zhang (1998): Risk and Return of Value Stocks-International Evidence .31 - .

Chen and Zhang .32 - .

Chen and Zhang .33 - .

cash flow to price) produce persistent higher returns in the U.. • Value stocks (size.low return to asset.S. more sensitive to business conditions. price-to-earnings. Hong Kong and Malaysia. past growth in sales. with high financial leverage and face higher uncertainty in future earnings. book-to market. Value stocks do not produce high returns in the fast growing markets of Taiwan and Thailand .34 - . and higher but less persistent returns in Japan.Chen and Zhang (1998) • Value stocks are riskier in terms of earnings . low return to book. They are likely to be firms in distress (dividend cut).

35 - .Fama and French (1998): Value Versus Growth: The International Evidence .

Fama and French (1998): Value Versus Growth: The International Evidence .36 - .

37 - .Fama and French (1998): Value Versus Growth: The International Evidence .

Fama and French (1998): Value Versus Growth: The International Evidence .38 - .

39 - .Fama and French (1998): Value Versus Growth: The International Evidence .

40 - .Fama and French (1996): Multifactor Explanation of Asset Pricing Anomalies .

Fama and French .41 - .

42 - .Fama and French .

43 - .Fama and French .

Bernard and Thomas (1989) Jegadeesh and Titman (1993.44 - . Momentum and Post-announcement drifts Latane and Jones (1979). Jegadeesh and Lakonishok (1996) Lee and Swaminathan (2000) Rouwenhorst (1998) Chordia and Shivakumar (2006) Avramov.Relative Strength. Chordia. Jostova and Philipov (2006) . 2000) Chan.

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46 - .Jegadeesh and Titman .

Jegadeesh and Titman .47 - .

2 • APRIL 2001 Narasimhan Jegadeesh and Sheridan Titman : Profitability of Momentum Strategies : An Evaluation of Alternative Explanations .THE JOURNAL OF FINANCE • VOL LI. No.48 - .

THE JOURNAL OF FINANCE • VOL LI.49 - . No. 2 • APRIL 2001 Narasimhan Jegadeesh and Sheridan Titman : Profitability of Momentum Strategies .

50 - . C.Louis K. Narasimhan Jegadeesh. and Josef Lakonishok (1996): Momentum Strategies . Chan.