US Stocks

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US Stocks

Post by Barry Barnitz » Wed Feb 28, 2007 11:23 pm

[contributions welcome]

Definitions

Stock
Value Stock
Growth Stock
Price Earnings Ratio
Price to Book Ratio
Risk Premium
Systematic Risk
Unsystematic Risk
Beta
Alpha
R-Squared
Standard Deviation



This series of three posts will begin with a look at historical US Stock returns.

1. A new historical database for the NYSE 1815 to 1925: Performance and predictability: by William N. Goetzmann, Roger G. Ibbotson, Liang Peng
In this paper, we collect individual stock prices for NYSE stocks over the period 1815 to 1925 and individual dividend data over the period 1825 to 1870. We use monthly price and dividend information on more than 600 individual securities over the period to estimate a stock price index and total return series that extends virtually to the beginning of the New York Stock Exchange. We use this data to estimate the power of past returns and dividend yields to forecast future long-horizon returns. We find some evidence of predictability in sub-periods but little predictability over the long term. We estimate the time-varying volatility of the U.S. market over the period 1815 to 1925 and find evidence of a leverage effect on risk. This new database will allow future researchers to test a broad range of hypotheses about the U.S. capital markets in a rich, untouched sample. ( 2001 Elsevier Science B.V. All rights reserved.
2. The Worldwide Equity Premium: A Smaller Puzzle by Dimson, Elroy, Marsh, Paul and Staunton, Mike
We use a new database of long-run stock, bond, bill, inflation, and currency returns to estimate the equity risk premium for 17 countries and a world index over a 106-year interval. Taking U.S. Treasury bills (government bonds) as the risk-free asset, the annualised equity premium for the world index was 4.7% (4.0%). We report the historical equity premium for each market in local currency and US dollars, and decompose the premium into dividend growth, multiple expansion, the dividend yield, and changes in the real exchange rate. We infer that investors expect a premium on the world index of around 3-3 1/2% on a geometric mean basis, or approximately 4 1/2-5% on an arithmetic basis.
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US Stocks: The Equity Risk Premium

Post by Barry Barnitz » Wed Feb 28, 2007 11:46 pm

This second in a series of posts examines the Equity Risk Premium- the reward one should receive for bearing risk.

1. History and the Equity Risk Premium by William N. Goetzmann and Roger G. Ibbotson
We summarize some of our own past findings and place them in the context of the historical development of the idea of the equity risk premium and its empirical measurement by financial economists. In particular, we focus on how the theory of compensation for investment risk developed in the 20th century in tandem with the empirical analysis of historical investment performance. Finally, we update our study of the historical performance of the New York Stock Exchange over the period 1792 to the present, and include a measure of the U.S. equity risk premium over more than two centuries. This last section is based upon indices constructed from individual stock and dividend data collected over a decade of research at the Yale School of Management, and contributions of other scholars.
2. Equity Premium: Historical, Expected, Required, and Implied by Pablo Fernandez (2006)
The equity premium designates four different concepts: Historical Equity Premium (HEP); Expected Equity Premium (EEP); Required Equity Premium (REP); and Implied Equity Premium (IEP).
We highlight the confusing message of the textbooks and academic articles regarding the equity premium and its evolution. The confusion arises from not distinguishing among the four concepts and from not recognizing that although the HEP is equal for all investors, the REP, the EEP and the IEP are different for different investors.
contributed by Adrian Nenu

3. What Risk Premium is 'Normal'? by Arnott, Robert D. and Bernstein, Peter L.
To gauge the expected real stock return, we need both stock dividend yields and an estimate of expected real dividend growth. Accordingly, we go through each of these steps, in reverse order, to form the building blocks for the final goal: an estimate of the objective, forward-looking equity risk premium, relative to bonds, through history.
4. The Equity Premium by Fama, Eugene F. and French, Kenneth R.
We estimate the equity premium using dividend and earnings growth rates to measure the expected rate of capital gain. Our estimates for 1951-2000, 2.55% and 4.32%, are much lower than the equity premium produced by the average stock return, 7.43%. Our evidence suggests that the high average return for 1951-2000 is due to a decline in discount rates that produces large unexpected capital gains. Our main conclusion is that the stock return of the last half-century is a lot higher than expected.
5 . Long-Run Stock Returns: Participating in the Real Economy by Roger G. Ibbotson and Peng Chen
In the study reported here, we estimated the forward-looking long-term equity risk premium by extrapolating the way it has participated in the real economy. We decomposed the 1926?2000 historical equity returns into supply factors?inflation, earnings, dividends, the P/E, the dividend payout ratio, book value, return on equity, and GDP per capita. Key findings are the following. First, the growth in corporate productivity
measured by earnings is in line with the growth of overall economic productivity. Second, P/E increases account for only a small portion of the total return of equity. The bulk of the return is attributable to dividend payments and nominal earnings growth (including inflation and real earnings growth). Third, the increase in the equity market relative to economic productivity can be more than fully attributed to the increase in the P/E. Fourth, a secular decline has occurred in the dividend yield and payout ratio, rendering dividend growth alone a poor measure of corporate profitability and future growth. Our forecast of the equity risk premium is only slightly lower than the pure historical return estimate. We estimate the expected long-term equity risk premium (relative to the long-term government bond yield) to be about 6 percentage points arithmetically and 4 percentage points geometrically.
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US Stocks: Factors

Post by Barry Barnitz » Thu Mar 01, 2007 12:02 am

The third in a series of posts examines the role of factors-- market, size, and value-- in the composition of US stock returns

Larry Swedroe has offered the following explanation of these three factors:
Effective Diversification in a Three-Factor World
Prior to the publication of the study by Professors Eugene F. Fama and Kenneth R. French the conventional wisdom was that we lived in a one-factor world—the risk and return of a portfolio is determined by its beta. Beta is a measure of equity-type risk (or market risk) of a stock, mutual fund, or portfolio, relative to the risk of the overall (U.S.) stock market. An asset with a beta above one has more equity-type risk than the overall market, while an asset with a beta below one has less equity-type risk than the overall market.

Fama and French hypothesized that we actually lived in a three-factor world—the risk and return of a portfolio is explained by not only beta, but also by its exposure to two other risk factors. Those risk factors are the risk of size (small companies) and price (value stocks). Fama and French found that while small and value stocks have higher beta (they have more equity-type risk), they also have additional risk unrelated to beta. Thus small and value stocks are riskier than large and growth stocks and thus they have higher expected returns. Studies have confirmed that the three-factor model explains well over 90 percent of the returns of diversified portfolios.

For the period the 1927–2005, the average annual returns to these three risks factors was:
·Market Factor (The return of the all equity universe minus the return on one-month Treasury bills): 8.08 percent.
·Size Factor (The return of small stocks minus the return of large stocks): 3.17 percent.
·Price Factor (The return of high book-to-market [value] stocks minus the return of low book-to-market [growth] stocks: 5.03 percent.

Independent Risk Factors
It is important to understand that size and price are independent (unique) risk factors in that they provide investors with exposure to different risks than does exposure to market risks. We can see evidence of their independence when we examine the historical correlations of the size and price factors to the market factor. If the correlations are high, the risk factors will be relatively good substitutes for each other. If that is the case then while investors can increase the expected return (and, of course, risk) of the portfolio by increasing their exposure to these risk factors, there is no real diversification benefit. On the other hand, if the correlations are low, not only will investors increase expected returns, but they will also gain a diversification benefit.

For the period 1927–2005, the correlation of the market risk factor to the size risk factor was just 0.408, and its correlation to the price risk factor was 0.091. And the correlation of the size risk factor to the price risk factor was almost zero (.026). In other words, we can effectively diversify equity risks by diversifying across the three independent risk factors. And each of the three risk factors has the potential for increasing investment returns. The following are two recent examples demonstrating that size and price are independent risk factors.

·In 2001, small stocks returned 18 percent and small value stocks returned 40.6 percent while the S&P 500 produced a negative return of 11.9 percent.
·In 1998, while the S&P rose 28.6 percent while small stocks fell 2.3 percent and small value stocks fell 10 percent.

Diversifying Risk
In the one-factor world there were only two ways to increase returns—either increase the allocation to stocks or buy higher beta stocks. In either case you were taking more of the exact same type of risk you were already taking. The work by Fama and French showed investors that there are other ways to increase the expected return of a portfolio. Instead of adding more of the same type of risk, you could add different types of risk. By adding different types of risk you achieve more effective diversification (not all of your eggs are in one risk basket). The following simplified example (it ignores the diversification return) will illustrate the point.

Let’s assume that in the future we expected equities to provide an annualized return of 7 percent. And we have current bond yields of about 5 percent. Now let’s consider an investor with a portfolio that is currently 50 percent bonds and 50 percent stocks. This allocation results in an expected portfolio return of 6 percent. While developing a financial plan our investor determines that in order to achieve his objective he must achieve a return of return of 6.5 percent, greater than the 6 percent expected return of his portfolio. One way to increase the expected return to 6.5 percent is to increase his allocation to stocks from 50 percent to 75 percent.
(75% x 7%) + (25% x 5%) = 6.5%

Let’s now consider an alternative strategy; one that diversifies risk to other risk factors. For the period 1927–2005, small value stocks achieved an annualized return that was 5.4 percent above the market’s annualized return (15.5 percent versus 10.1 percent). Let’s assume that same relationship will continue in the future. (Note that since size and price are risk factors we do not know that this relationship will continue.) Thus if we are forecasting returns to the market of 7 percent, we would also forecast that small value stocks would return 12.4 percent. Using this information we can look at the expected returns for a few different portfolio allocations.

Let’s first consider a portfolio that takes one-half of the equities and allocates to small value stocks. The expected return would now be:
(25% x 7%) + (25% x 12.4%) + (50% x 5%) = 7.35%

By increasing the allocation to riskier stocks we increased the expected return. We did, however, also increase the risk of the portfolio. The result might be more risk than the investor has the ability, willingness, or need to take. So let’s consider another alternative. This time while we will shift some of the equity allocation to small value stocks (increasing risk), we will also lower the overall equity allocation to just 32 percent (lowering risk). The new allocations are 16 percent total market index, 16 percent small value stocks, and 68 percent bonds. The expected return would now be:
(16% x 7%) + (16% x 12.4%) + (68% x 5%) = 6.5%

We now have a portfolio with a 32 percent allocation to stocks that has virtually the same expected return as the portfolio that had a 75 percent allocation to stocks. Consider, however, that in this case, instead of increasing the expected return by taking more of the same type of risk (market risk), we increased returns by adding different types of risk—the risks of small and value stocks. Thus we diversified our equity risks across these two independent factors. We believe that this a more effective form of diversification. Again, it doesn’t place all of our eggs in one risk-factor basket—while the expected returns of the two portfolios are the same, their risks are, in fact, different.

Risk Aversion
There is another consideration that is especially important to risk averse investors (and most investors are risk averse). Since bonds are safer investments than stocks, if we were to experience a severe bear market, the maximum loss the portfolio could experience is far lower with a 32 percent equity allocation than it is with a 75 percent equity allocation. Thus while the expected returns of the two portfolios are the same, the downside risk is much less with the portfolio with the lower equity allocation. Of course, the upside potential is correspondingly lower as well. For an investor for whom the pain of a loss is greater than the benefit of an equal-sized gain, reducing downside risk as the price of reducing upside potential is a good trade-off.

If you have only 20% equity then assume market drops even to zero, you can only lose 20% of total portfolio---and likely bonds will rise in value significantly so might even make net profit. But if had 60% equity allocation then you would suffer large loss.

On other hand, if market had big rise, the 60% equity allocation would far outperform in all likelihood. Reason is I only have about 20% exposure to beta vs 60%. And beta is the big driver.

I have looked at the historical data on this and it is quite impressive IMO.
Example. An all equity portfolio from 70-06.

100% S&P up 11.2 with SD of 16.8. Best year 38% worst -27
But 34% SV and 66 1 Year T bills had same 11.2 and SD of less than half at 7.8. Best year just 25% but worst loss only 5%.
And the first portfolio had 8 negative years and the second had only 4.


Considerations
There are several factors that should be given careful consideration when deciding on the appropriate portfolio mix. The first is that an investor should consider how their intellectual capital (earning power) correlates with the greater economic cycle risks that small and value stocks have as compared to large and growth stocks. Thus a tenured professor or doctor, with a low correlation to those risks, can prudently take greater small and value risks. On the other, it may not be prudent for a construction or automobile worker, with a high correlation to those risks, to increase exposure to those risk factors.

The second consideration is a psychological one. It is risk called tracking error regret. For equities tracking error is the amount by which the performance of a portfolio varies from that of the total market, or other broad market benchmark such as the S&P 500 Index. By diversifying across risk factors you take on tracking error risk. While very few investors care when tracking error is positive (their portfolio beats the benchmark), it seems that most investors care when the tracking error is negative. To have a chance for positive tracking error, you must accept the almost certainty that negative tracking error will appear from time to time (or there would be no risk). And, unfortunately, the emotions that negative tracking error can lead to causes many investors to throw their well-thought-out plans into the trash heap. And losing discipline is a recipe for failure. Thus only those investors that are willing and able to accept tracking error risk should consider diversifying across the other risk factors.

Summary
Fama and French showed us that there were two additional risk factors that we should consider when constructing portfolios. We can either use those risk factors to increase the expected return (and risk) of a portfolio, or we can maintain the expected return of the portfolio by diversifying across these independent risk factors while lowering the equity allocation. For many investors we believe that diversifying across these independent risk factors is a more effective way to diversify portfolio risk.
Larry Swedroe
Papers

1. Factor Rotation by William Bernstein
Over the long haul, the most important "rotation" is in and out of the 3 major market returns factors. And although we can?t predict what they will be over the next decade, it?s a lead-pipe cinch that they won?t look anything like the last 3.
2. Characteristics, Covariances, and Average Returns: 1929-1997 by Davis, James L., Fama, Eugene F. and French, Kenneth R.
The value premium in U.S. stocks returns is robust. The positive relation between average return and book-to-market equity (BE/ME) is as strong for 1929-63 as for the subsequent period studied in previous papers. Like others, we also find a size premium in stock returns. Small stocks have higher average returns than big stocks. The size premium is, however, weaker and less reliable than the value premium. The relations between average return and firm characteristics (size and BE/ME) are better explained by a three-factor risk model than by the behavioral hypothesis that investor overreaction causes characteristics to be compensated irrespective of risk loadings
3. The Anatomy of Value and Growth Stock Returns by Fama, Eugene F. and French, Kenneth R.
We break average returns on value and growth portfolios into dividends and three sources of capital gain, (i) reinvestment of earnings, (ii) convergence in price-to-book ratios (P/B) due to mean reversion in profitability and expected returns, and (iii) upward drift in P/B during 1926-2003. The capital gains of value stocks trace mostly to convergence: P/B rises as some value firms become more profitable and move to lower expected return groups. In contrast, reinvestment, which is trivial to negative for value portfolios, dominates the capital gains of growth stocks. For growth stocks, convergence is negative: P/B falls because growth stocks do not always remain highly profitable with low expected returns.
4. Migration by Fama, Eugene F. and French, Kenneth R.
We study how migration of firms across size and value portfolios contributes to the size and value premiums in average stock returns. The size premium is almost entirely due to the small stocks that earn extreme positive returns and as a result become big stocks. The value premium has three sources: (i) value stocks that improve in type either because they are acquired by other firms or because they earn high returns and so migrate to a neutral or growth portfolio; (ii) growth stocks that earn low returns and as a result move to a neutral or value portfolio; and (iii) slightly higher returns on value stocks that remain in the same portfolio compared to growth stocks that do not migrate.
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