Value Matters

Value Matters:
Predictability of Stock Index Returns

Giacomo Bormetti?
?
QUANTLab, Scuola Normale Superiore, Pisa & List Group Joint Laboratory, Italy
In collaboration with N. Angelini, F. Nardini and S. Marmi
Dipartimento di Matematica - Universita di Bologna, February 15 2013

Giacomo Bormetti
Goals
The aim of this work is twofold
give empirical support to Shillers test of the appropriateness of prices in the stock market
based on the Cyclically Adjusted Price Earnings (CAPE) ratio
provide a theoretical framework to support it
Dipartimento di Matematica - Universita di Bologna, February 15 2013 1

Giacomo Bormetti
Intro
A question that has been asked with a certain regularity since the establishment of the first
stock index is the following: is it possible to calculate the Intrinsic Value of the Dow ?
Or, more generally: what is the intrinsic value of Wall Street?
A first commonsense answer is that this value may be calculated by summing the intrinsic
value of each quoted company.
The latter depends on the expected future earnings and on the balance sheet; therefore,
aggregating all expectations for all companies quoted in the market provides the desired
answer.
However, this approach soon appears to be a challenging task.

Giacomo Bormetti
Intro
Between the Fifties and the Sixties the researchers attitude towards the problem changed
radically. Modern portfolio theory and the statistical evidence (nowadays largely falsified)
that stock prices follow random walks, see Mandelbrot (1965), Fama (1965), has led to the
Efficient Market Hypothesis, see Samuelson (1965), Fama (1970).
Informational efficiency of financial markets: one can not achieve returns in excess of
average market returns on a risk-adjusted basis, given the information available at the time
the investment is made.
If this were the case, the intrinsic value of a stock would be its market price.

Giacomo Bormetti
Intro
If this were the case, bubble bursts as in 1987 and exceptional price booms as in the late
90 would never happen.
At the very beginning of 2000 Robert Shiller wrote
we do not know whether the market level makes any sense, or whether they are indeed
the result of some human tendency that might be called irrational exuberance
Robert J. Shiller. Irrational Exuberance. Princeton University Press, 2000.

Giacomo Bormetti
Intro
Shillers skeptical attitude was anticipated in one of the most famous books ever written on the
stock market: in 1934, Graham and Dodd strongly advocated the fundamental approach to
investment valuation and recommended to shift(s) the original point of departure, or basis
of computation, from the current earnings to the average earnings, which should cover a
period of not less than five years, and preferably seven to ten years. Since 1988 Campbell
and Shiller have been focusing their attention on average earnings as predictor of future
dividends and future stock prices.
Shiller (2000) proposed an innovative test of the appropriateness of prices in the stock market:
the Cyclically Adjusted Price Earning ratio

Giacomo Bormetti
CAPE Ratio
10
xt = ln heit ln Pt
All nominal series are in local currencies and have been deflated using
Consumer Price Indexes available at the Federal Reserve Economic Data repository
http://research.stlouisfed.org/fred2/.
The second component refers to a moving average of real earnings over a time window of ten
years.

Giacomo Bormetti
Log Gross Returns
Ht = ln (Pt+1 + Dt) ln Pt
The realized log gross return on the index, held from the beginning of time t and the beginning
of time t + 1

Giacomo Bormetti
Yields
The gross yield can be written
h1 h1
1X 1X Dt+i

yt,h = (Xt+i+1 Xt+i) + log 1+
h i=0 h i=0 Pt+1+i
where Xt = ln Pt.

Giacomo Bormetti
Shiller US time series

0.05
(a) 2 Years (b) 4 Years
1921
1971 1991
1891 1951
1901 1961 1981
0 1881 1911
1941
2001 1931
0.05
0.05
(c) 6 Years (d) 8 Years
0.05
0.05
(e) 10 Years (f) 12 Years
+Dt+i
Pt+i
log Pt+i+1
0
1
i=0
Ph
h
1
0.05
0.05
(g) 14 Years (h) 16 Years
0.05
6 5 4 6 5 4
loghei10
t log Pt loghei10
t log Pt
Figure 3: Regression of yield (1) on the explanatory log earning - price ratio.
Figure 1: S&P500 time series
Points, freely available
lines, labels, and color from
scale as http://www.econ.yale.edu/~shiller/
in figure 1. for the entire
period January 1871 - March 2011.
13
Giacomo Bormetti
Shiller US time series: 2 years
0.05
(a) 2 Years
1921
1971 1991
1891 1951
1901 1961 1981
0 1881 1911
1941
2001 1931
0.05
0.05
(c) 6 Years
Figure 2: S&P500 time series freely available from http://www.econ.yale.edu/~shiller/ for the entire
0
Giacomo Bormetti
Shiller US time series: 16 years
5 4 6 5 4
loghei10
t log Pt loghei10
t log Pt
Figure 3: S&P500 time series freely available from http://www.econ.yale.edu/~shiller/ for the entire
yield (1) on the explanatory log earning - price ratio.
d color scale as in figure 1.

Giacomo Bormetti
Standard&Poor Composite, 1871 - 2010

10 hei10
h 1 log Pt+h vs log heit yt,h vs log t
h Pt Pt Pt
R2 R2
Pr(>F ) Pr(>F ) Pr(>F ) Pr(>F )
24 371 36 69 7 6.1% 518 34 90 7 10.8%
0.023 0.029 0.001 0.003
48 313 24 57 6 9.5% 448 22 76 4 17.6%
0.006 0.009
120 270 14 49 3 18.9% 379 12 63 2 33.9%

144 289 13 53 3 23.4% 385 11 65 2 38.9%

168 301 12 55 2 28.6% 379 10 63 2 43.5%

192 308 11 57 2 35.3% 371 9 62 2 49.1%

Table 1: All values for , , and associated errors are expressed in 104 units; p-values of order or smaller
than 104 have been left blank.

Giacomo Bormetti
Statistical Signatures
the ability of the logarithmic averaged earning over price ratio to predict returns of the index;
this evidence increases switching from returns to gross returns;
data dispersion measured by the yield variance scales as one over the time horizon.

Giacomo Bormetti
Dynamical Modeling
What we require of our model is similar to what Chiarella (1992) argued for Firstly we
require that the model generate a significant transitory component around the equilibrium
which reflects the rationally expected value of the asset. Secondly the model must allow for
the incorporation of chartists, a group which bases its market actions on an analysis of
past trends.
We choose, however, a different approach and we work at an aggregate level instead of

explicitly modeling two different types of agents.

Giacomo Bormetti
Assumptions
The return growth depends on three components
a. a momentum component, naturally justified in terms of agents expectation that expected

returns are higher in bullish markets than in bearish ones;
b. a fundamental component (VALUE), proportional to a function of the level of the

logarithmic averaged earnings over price ratio at time zero; the initial time value of log EP
ratio determines the reference growth level;
c. a noise component ensuring the diffusive behavior of stock prices.

Giacomo Bormetti
Linear Stochastic Difference System

Xt+1
= Xt + t + t

= t + loghei10

t+1 t Xt + H + gF t + W t (1)
t+1 X
= t + 1 X Wt

The set of the eigenvalues includes 1, independently of and , and two ones more
+1 1q
+ = + (1 )2 4 ,
2 2
+1 1q
= (1 )2 4 .
2 2
In order to ensure |+| < 1 and || < 1, we need to impose the following restrictions
(1 )2
0 < < 1, and 0 < .
4

Giacomo Bormetti
64
Stable Node
3 Multi-Dimensional, First-Order, Linear Systems: Characterization
y2t
y1t
Fig. 3.1. Stable Node

0 < 2 < 1 < 1
Focus: 0 < 1 = 2 < 1

The steady-state equilibrium is globally stable. Namely, limt

y1t = 0 and limt y2t = 0, (y10 , y20 ) #2 . As depicted in Fig. 3.3
y1t = 0 and limt y2t = 0, (y10 , y20 ) # . As depicted in Fig. 3.3
convergence to the steady-state equilibrium, (0, 0), is monotonic. The
speed of convergence is the same for each state variable, and the tra-
jectory of the system from any initial condition to the steady-state
equilibrium is linear.
Giacomo Bormetti
Unstable Node
y2t
y1t
Fig. 3.2. A Saddle

0 < 2 < 1 < 1

Giacomo Bormetti
Modeling Dividends
We mainly follow the proposal discussed by Campbell and Shiller, where it is argued that the log
dividend price ratio follows a stationary stochastic process, and the fixed mean of log Dt log Pt,
log G , can be used as an expansion point
d
(dt1 Xt) = (dt1 Xt log G) + dWt ,
with dt = log Dt, d > 0, and {Wtd} for t = 1, . . . , h i.i.d. standard Gaussian variates. At
variance with the proposal of Campbell and Shiller, we also assume that G can possibly depend
on the log EP at time zero, i.e. G = G(loghei10
0 log P0 ).

Giacomo Bormetti
Long Term Convergence
Preposition 1. The expected gross yield is linear in F and G , provided we consider sufficiently
long horizons
1

E0[yt,h] ' g(1 + F ) + G + O .
h
Moreover its variance converges to zero with rate of convergence equal to minus one
2
X 1 G 2d2 1
V ar0 [yt,h] = + + o( ) .
h h (2 ) h
Corollary 2. If F and G are linear in loghei10 0 log P0 , than the stochastic model (1) is able
to reproduce the linear scaling of returns with the initial log EP ratio on the long run.

Giacomo Bormetti
0.05 0.05
(a) 2 Years (b) 4 Years (a) 2 Years (b) 4 Years
1921
1971 1991
1891 1951
1901 1961 1981
0 1881 1911
1941 0
2001 1931
0.05 0.05
0.05 0.05
(c) 6 Years (d) 8 Years (c) 6 Years (d) 8 Years
0 0
0.05 0.05
0.05 0.05
+Dt+i
+Dt+i
Pt+i
Pt+i
log Pt+i+1
log Pt+i+1
0
0
1
i=0
Ph1
i=0
Ph
h
1
h
1
0.05
0.05
0.05
(g) 14 Years (h) 16 Years 0.05
0
0
0.05
0.05
6 5 4 6 5 4
6 5 4 6 5 4
loghei10
t log Pt loghei10
t log Pt
loghei10
t log Pt loghei10
t log Pt
Figure 3: Regression of yield (1) on the explanatory log earning - price ratio.
Points, lines, labels, and color scale as in figure 1.
Giacomo Bormetti
OLS at the time of endogenous persistence

R.F. Stambaugh, J. of Financ. Econom. 54 (1999) p. 375421
In our work we investigate a regression of the form

.
yt = yt1,1 = + xt1 + ut , (2)
and we assume that xt obeys a first-order autoregressive (AR(1)) process
xt = + xt1 + vt , (3)

ut
where are serially independent and identically distributed bivariate normal with
vt
2
u uv
contemporaneus correlation = .
uv v2
An assumption that typically fails to hold which is used to obtain finite-sample results in
the standard setting is that ut has zero expectation conditional on {. . . , xt1, xt, xt+1, . . .},
i.e. E [ut|xt, xt1] 6= 0.

Giacomo Bormetti
OLS with endogenous and persistent regressors

In our case we consider the NULL model where = 0
heit1
ln(Pt + Dt1) ln Pt1 = + ln + ut
Pt1
and
heit heit1
ln = + ln + vt
Pt Pt1
if the price moves up, i.e. Pt > Pt1, then ut is positive.

But in this case, since hei is slowly fluctuating, vt is negative
vice versa if the price goes down
is empirically measured very close to one, i.e. the process is almost integrated, therefore ut
and vt are almost perfectly anti-correlated.
As a result, if we regress the yield on the cyclically adjusted ratio, we introduce a non-negligible
bias.

Giacomo Bormetti
A Monte Carlo experiment
The vector (ut vt) is assumed to be normally distributed, independently across t, with mean zero
and covariance matrix 2
u uv uv
=
v2
Realistic values from Shillers time series
u = 0.18, v = 0.19
uv = 0.96
= 0.06
= 0.31
= 0.88
NMC = 1000

Giacomo Bormetti
0.3
True Beta
MC median
MC 90% Confidence Interval
0.25
0.2
0.15
0.1
0.05
-0.05
-0.1
0.99 0.995 1 1.005 1.01
Figure 4: is given by the Ordinary Least Squares estimator

Giacomo Bormetti
Reducing the bias

Y. Amihud and C. M. Hurvich, J. of Financ. Quant. Anal. 39 (2004) p. 813841
It is worthwhile to construct a proxy vtC for the errors, on the basis of the available data {xt}nt=0
C C C
vt = xt ( + xt1)
where C and C are estimators of and .

Define the bias-corrected estimator C to be the coefficient of xt1 in the augmented regression
C C C
yt = + xt1 + vt + et
Theorem 2. The bias of the estimator C is given by E[ C ] = C E[C ].

The literature on reduced-bias estimator of the lag-1 autocorrelation parameter of AR(1) models
is of direct relevance to the construction of C .
Kendalls estimator C,K = + (1 + 3)/n, AHs estimator C = C,K + 3(1 + 3)/n2

C C Pn
= (1 ) t=0 xt/n

Giacomo Bormetti
A second Monte Carlo experiment

0.25
True Beta
MC median
MC 90% Confidence Interval
0.2
0.15
0.1
0.05
-0.05
-0.1
-0.15
0.99 0.995 1 1.005 1.01
Figure 5: is given by the Ordinary Least Squares estimator but for the augmented regression

Giacomo Bormetti
Hjalmarssons long run estimator for local-to-unity AR(1) processes

E. Hjalmarsson, J. of Financ. Quant. Anal., Forthcoming
Hjalmarsson defines the proxy vtC for the errors on the basis of the available data {xt}nt=0 as
C

C
vt = x t + 1 + xt1
n
where the AR(1) coefficient is modelled as local-to-unit 1 + C

n . Preliminary, he treats C as a
known parameter. Then he aggregates

C C
yt+K1 + . . . + yt = K + K xt1 + K vt + . . . + vt+K1 + et,K
Assumption 2. Let wt = (ut vt)0 and Ft = {ws|s t} be the filtration generated by wt.
1. E[wt|Ft1] = 0
2. E[wtwt0 ] = [(11 12), (21 22)]
3. supt E[u4t ] < and supt E[||vt||4] <

Giacomo Bormetti
Theorem 2. Suppose the data is generated by equations (2) and (3), and that Assumption
2 holds.

1. Under the null hypothesis = 0, as K, T , such that K/ T 0
1 1 1 1
T
Z Z Z
0 1 0 0
K dB1JC 1222 dB2JC JC JC
K 0 0 0

2. Under the alternative hypothesis 6= 0, as K, T , such that K/ T 0
1 1 1
2T Z Z
+ 0 0
K K dB2JC JC JC
K2 0 0
PK1 R1 Rt
+
where K = i=0 (1 + C i
n) , JC = JC 0
JC , and JC (t) = 0
e(ts)C dB2(s).

Giacomo Bormetti
Hjalmarssons long run estimator for local-to-unity AR(1) processes

E. Hjalmarsson, J. of Financ. Quant. Anal., Forthcoming
However, C is not known, and it is even not possible to consistently estimate it, please refer to P.
Phillips, H. R. Moon, and Z. Xiao. How to estimate autoregressive roots near unity, Econometric
Theory, 17 (2001), pp. 2969 for a detailed discussion.
As discussed in J. Y. Campbell and M. Yogo. Efficient tests of stock return predictability, Journal
of Financial Economics, 81 (2006) pp. 2760 a confidence interval for C can be obtained and
a range of possible estimates and values of the test-statistic are obtained.
A drawback of this method is that no clear-cut point estimate is produced, but rather a range
of estimates.

Giacomo Bormetti
Test of Hjalmarssons long run estimator on Shillers data series

Yearly Sampling
0.18
Beta 90% Bonferroni
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
-0.02
-0.04
0 2 4 6 8 10 12 14 16

Giacomo Bormetti
A tentative extension of Amihud-Hurvich

We define the proxy vtC for the errors on the basis of the available data {xt}nt=0 as

C C
vt = xt + xt1
with the bias-corrected AR(1) coefficient. Then we aggregate

C C
yt+K1 + . . . + yt = K + K xt1 + K vt + . . . + vt+K1 + et,K .

Giacomo Bormetti
Long-run Monte Carlo experiments: = 0

0.25
True Beta
Bootstrap median
Bootstrap 90% Confidence Interval
0.2
0.15
0.1
0.05
-0.05
-0.1
-0.15
0 2 4 6 8 10 12 14 16

Giacomo Bormetti
Long-run Monte Carlo experiments: = 0.1

0.35
True Beta
Bootstrap median
Bootstrap 90% Confidence Interval
0.3
0.25
0.2
0.15
0.1
0.05
-0.05
0 2 4 6 8 10 12 14 16

Giacomo Bormetti
Bootstrap approach, steps 1 - 4

We start from
yt = + xt1 + ut
where
xt = + xt1 + vt
We estimate the bias-corrected C , C , C , and C .

We then estimate , , , and via OLS, and save them with (ut, vt) for t = 1, . . . , T
We sample b = 1, . . . , 104 bi-variate time series (ubt vtb) with t = sb1, . . . , sbT . The time
indices sb1, . . . , sbT are created sampling random with re-introduction from the original time
series t = 1, . . . , T .
For each b, we compute
b b
yt = + ut
b b b
xt = + xt1 + vt
where the former equation has been obtained imposing the null hypothesis = 0.

Giacomo Bormetti
Bootstrap approach, steps 5 - 7

We correct the AR(1) coefficient for the small sample bias, and compute the proxy for the
error vtC,b
C,b b C,b C,b b
vt = xt + xt1
K = 1: we regress the following model via OLS
b b b b b C,b
yt = 1 + 1 xt1 + 1 vt + et
b 104
Eventually we obtain 1 b=1
K > 1: aggregate and regress

b b b b b b C,b C,b
yt+K1 + ... + yt = K + K xt1 + K vt + . . . + vt+K1 + et,K
b 104
Eventually we obtain K b=1, for each K > 1

Giacomo Bormetti
Long-run bootstrap experiments under the null vs Shiller

0.4
OLS Beta
Bootstrap median
0.35 Bootstrap 90% Confidence Interval
0.3
0.25
0.2
0.15
0.1
0.05
-0.05
-0.1
-0.15
0 2 4 6 8 10 12 14 16
Figure 8: is given by the Ordinary Least Squares estimator

Giacomo Bormetti
Long-run bootstrap experiments under the null vs Shiller

0.35
AUGMENTED OLS Beta
Bootstrap median
0.3 Bootstrap 90% Confidence Interval
0.25
0.2
0.15
0.1
0.05
-0.05
-0.1
-0.15
0 2 4 6 8 10 12 14 16

Giacomo Bormetti
List of references
a. Carl Chiarella. The dynamics of speculative behaviour. Annals of Operations Research,

37:101-123, 1992.
b. Eugene F. Fama. The behavior of stock-market prices. The Journal of Business, 38:34-105,
1965.
c. Eugene F. Fama. Efficient capital markets: A review of theory and empirical work. Journal
of Finance, 25:383-417, 1970.
d. Benoit Mandelbrot. The variation of certain speculative prices. The Journal of Business,
36:394-419, 1965.
e. Paul Samuelson. Proof that properly anticipated prices fluctuate randomly. Industrial
Management Review, 6:41-49, 1965.
f. Robert J. Shiller. Irrational Exuberance. Princeton University Press, 2000.

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Value Matters:

Predictability of Stock Index Returns

In collaboration with N. Angelini, F. Nardini and S. Marmi

Dipartimento di Matematica - Universita di Bologna, February 15 2013

The aim of this work is twofold

provide a theoretical framework to support it

Dipartimento di Matematica - Universita di Bologna, February 15 2013 1

However, this approach soon appears to be a challenging task.

Dipartimento di Matematica - Universita di Bologna, February 15 2013 2

Dipartimento di Matematica - Universita di Bologna, February 15 2013 3

At the very beginning of 2000 Robert Shiller wrote

Robert J. Shiller. Irrational Exuberance. Princeton University Press, 2000.

Dipartimento di Matematica - Universita di Bologna, February 15 2013 4

Dipartimento di Matematica - Universita di Bologna, February 15 2013 5

Dipartimento di Matematica - Universita di Bologna, February 15 2013 6

Log Gross Returns

Dipartimento di Matematica - Universita di Bologna, February 15 2013 7

The gross yield can be written

Dipartimento di Matematica - Universita di Bologna, February 15 2013 8

Shiller US time series

Dipartimento di Matematica - Universita di Bologna, February 15 2013 9

Shiller US time series: 2 years

Shiller US time series: 16 years

(g) 14 Years (h) 16 Years

d color scale as in figure 1.

Standard&Poor Composite, 1871 - 2010

Dipartimento di Matematica - Universita di Bologna, February 15 2013 12

this evidence increases switching from returns to gross returns;

Dipartimento di Matematica - Universita di Bologna, February 15 2013 13

We choose, however, a different approach and we work at an aggregate level instead of

Dipartimento di Matematica - Universita di Bologna, February 15 2013 14

The return growth depends on three components

a. a momentum component, naturally justified in terms of agents expectation that expected

b. a fundamental component (VALUE), proportional to a function of the level of the

c. a noise component ensuring the diffusive behavior of stock prices.

Dipartimento di Matematica - Universita di Bologna, February 15 2013 15

Linear Stochastic Difference System

Dipartimento di Matematica - Universita di Bologna, February 15 2013 16

Fig. 3.1. Stable Node

Focus: 0 < 1 = 2 < 1

The steady-state equilibrium is globally stable. Namely, limt

Fig. 3.2. A Saddle

Dipartimento di Matematica - Universita di Bologna, February 15 2013 18

Dipartimento di Matematica - Universita di Bologna, February 15 2013 19

Long Term Convergence

Dipartimento di Matematica - Universita di Bologna, February 15 2013 20

(e) 10 Years (f) 12 Years

OLS at the time of endogenous persistence

In our work we investigate a regression of the form

and we assume that xt obeys a first-order autoregressive (AR(1)) process

Dipartimento di Matematica - Universita di Bologna, February 15 2013 22

OLS with endogenous and persistent regressors

if the price moves up, i.e. Pt > Pt1, then ut is positive.

Dipartimento di Matematica - Universita di Bologna, February 15 2013 23

A Monte Carlo experiment

Dipartimento di Matematica - Universita di Bologna, February 15 2013 24

Figure 4: is given by the Ordinary Least Squares estimator

Dipartimento di Matematica - Universita di Bologna, February 15 2013 25

Reducing the bias

where C and C are estimators of and .

Theorem 2. The bias of the estimator C is given by E[ C ] = C E[C ].

Kendalls estimator C,K = + (1 + 3)/n, AHs estimator C = C,K + 3(1 + 3)/n2

Dipartimento di Matematica - Universita di Bologna, February 15 2013 26