AlphaLetters Selected Journal Paper Reviews

Nothing to do this weekend? (I’m grasping the last days of Summer BBQ’ing all weekend.) Here is a boatload of academic papers to put you to sleep. (PS Here is a great BBQ sauce site. My favorite hot sauce is my hometown Texas Pete, and for breakfast the Costa Rican Lizano is hard to beat.)

From the guys at AlphaLetters, here is a sampling of quantitative journal papers, including an update to the “magazine cover indicator’:

1. Value
Category: Dividend Yield, and Book-to-Market Ratio
Title: Stock Returns, Dividend Yield, and Book-to-Market Ratio
Author: Xiaoquan Jiang, Bong-Soo Lee
Source: Journal of Banking & Finance, Vol. 31, No. 2: (February 2007)455-475
Link: http://linkinghub.elsevier.com/retrieve/pii/S0378426606002238

Abstract:
A dividend yield model has been widely used in previous research that relates stock market valuations to cash flow fundamentals. Given controversies about using dividends as a proxy for cash flows, a loglinear book-to-market model has recently been proposed. However, these models rely on the assumption that dividend yield and book-to-market ratio are both stationary, and empirical evidence for this is, at best, mixed. We develop a new model, the loglinear cointegration model, that explains future profitability and excess stock returns in terms of a linear combination of log book-to-market ratio and log dividend yield. The loglinear cointegration model performs better than the log dividend yield model and the log book-to-market model in terms of cross-equation restriction tests and forecasting performance comparisons. The superior performance of the loglinear cointegration model suggests that the linear combination may be a better indicator of intrinsic fundamentals than the dividend yield or the book-to-market ratio separately.

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Category: Market P/E Ratio
Title: The Market P/E Ratio, Earnings Trends, and Stock Return Forecasts
Author: Robert A. Weigand; Robert Irons
Source: The Journal Of Portfolio Management, Summer 2007
Link: http://www.iijournals.com/JPM/default.asp?Page=2&ISS=24026&SID=690610

Abstract:
This is an analysis of periods characterized by high price/equity ratios, using measures of the market P/E based on both one-year trailing earnings and ten-year smoothed earnings. High P/E periods are preceded by accelerating equity returns and declines in both nominal interest rates and stock market volatility. Stock returns following a high P/E period are marginally higher when earnings growth remains strong and interest rates continue falling. Even when these mitigating factors are in place, however, real returns are appreciably lower for decades following high levels of the market P/E ratio. The worst case scenario for future equity returns occurs when P/E ratios expand during periods of strong earnings growth. Once earnings growth slows, equities are left profoundly overvalued, which leads to prolonged periods of low and sometimes negative real returns. The findings suggest that U.S. equities are currently priced to deliver real returns that are positive, but well below their historical average.

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Category: Expected profitability, investment rate
Title: Profitability, Investment and Average Returns
Author: Eugene F. Fama, Kenneth R. French
Source: Journal of Financial Economics, Vol. 82, No. 3: (December 2006)491-518
Link: http://linkinghub.elsevier.com/retrieve/pii/S0304405X06001164
Earlier version: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=570343

Abstract:
Valuation theory says that expected stock returns are related to three variables: the book-to-market equity ratio (Bt/Mt), expected profitability, and expected investment. Given Bt/Mt and expected profitability, higher rates of investment imply lower expected returns. But controlling for the other two variables, more profitable firms have higher expected returns, as do firms with higher Bt/Mt. These predictions are confirmed in our tests. Our results are qualitatively similar to earlier evidence, but in quantitative (economic) terms, there are some interesting surprises.

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2. Momentum
Category: Momentum, Earnings
Title: Interaction of Stock Return Momentum with Earnings Measures
Author: Ilya Figelman
Source: Financial Analysts Journal, May/June 2007, Vol. 63, No. 3: 71-78
Link: http://www.cfapubs.org/doi/ref/10.2469/faj.v63.n 3.4692
Earlier version: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=992224

Abstract:
Examination of the interaction of stock return momentum with various earnings measures finds that large capitalization companies with poor past returns and high return on equity (ROE) significantly underperform the market and companies with poor past returns and low ROE. Thus, the profitability of high-ROE companies with poor past returns may have peaked. In addition, companies with poor past returns and poor earnings quality (as measured by accruals) significantly underperform the market and companies with poor past returns and good earnings quality. Therefore, the market may not fully recognize manipulation of earnings. The findings are consistent with the explanation that momentum is driven by slow reaction to news.

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Category: Momentum, International Markets, Business Cycle
Title: Profitability of Momentum Strategies in International Markets: The Role of Business Cycle Variables and Behavioural Biases
Author: Antonios Antoniou, Herbert Y.T. Lam, and Krishna Paudyal
Source: Journal of Banking & Finance, Vol. 31, No. 3: (March 2007)955-972
Link: http://linkinghub.elsevier.com/retrieve/pii/S0378426606002159

Abstract:
The paper investigates whether business cycle variables and behavioral biases can explain the profitability of momentum trading in three major European markets. Unlike previous studies, the paper nests both riskbased and behavioral-based variables in a two-stage model specification in an attempt to explain momentum profits. The findings show that, although momentum profitability in European markets is unexplained by conditional asset pricing models, it is attributable to asset mispricing that systematically varies with global business conditions. In addition, behavioral variables do not appear to matter much. Thus risk factors, which are undetected thus far and are largely attributable to the business cycle, could explain the momentum payoffs in European stock markets.

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3. Analysts forecasts
Category: Earning surprise, analysts forecast
Title: Double Surprise into Higher Future Returns
Author: Alina Lerman, Joshua Livnat, and Richard R. Mendenhall
Source: Financial Analysts Journal, July/August 2007, Vol. 63, No. 4: 63-71
Link: http://www.cfapubs.org/doi/abs/10.2469/faj.v63.n4.4750

Abstract:
Post-earnings-announcement drift is the well-documented ability of earnings surprises to predict future stock returns. Despite nearly four decades of research, little has been written about the importance of how earnings surprise is actually measured. We compare the magnitude of the drift when historical time -series data are used to estimate earnings surprise with the magnitude when analyst forecasts are used. We show that the drift is significantly larger when analyst forecasts are used. Furthermore, we show that using the two models together does a better job of predicting future stock returns than using either model alone.

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Category: PIN, public news surprises, media coverage
Title: Stock Price Reaction to Public and Private Information
Author: Clara Vega
Source: Journal of Financial Economics, Vol. 82, No. 1: (October 2006)103-133
Link: http://www.sciencedirect.com/science/article/B6VBX-4JN2P6M-1/2/fc4b72d50149534b2b17990f0e3c6cba

Abstract:
I empirically measure the effect of public surprises, media coverage and private information on the postannouncement drift. Since private information is not observed by the econometrician, I use transaction level data and Easley and O’Hara’s (1992) microstructure model to calculate the probability of private informationbased trading, PIN, prior to an earnings announcement. Using the PIN measure together with a comprehensive public news database I show that stocks associated with high PIN, public news surprises agents agree on and low media coverage experience low or insignificant drift. The main conclusion is that not all information-acquisition variables have the same effect on the market’s efficiency. Whether information is public or private is irrelevant; what matters is whether information is associated with the arrival rate of noise traders, informed traders, uncertainty or disagreement among traders.

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4. Novel strategies
Category: Industry classification, Strategic Group classification
Title: Firm, Strategic Group, and Industry Influences on Performance
Author: Jeremy C. Short, David J. Ketchen, Jr., Timothy B. Palmer, and G. Tomas M. Hult
Source: Strategic Management Journal, Vol. 28, No. 2: (February 2007)147-167
Link: http://www3.interscience.wiley.com/cgi-bin/abstract/114029267/ABSTRACT?CRETRY=1&SRETRY=0
Earlier version: http://msu.edu/~hult/publications/SMJ07a.pdf

Abstract:
A long-standing debate has focused on the extent to which different levels of analysis shape firm performance. The strategic group level has been largely excluded from this inquiry, despite evidence that group membership matters. In this study, we use hierarchical linear modeling to simultaneously estimate firm-, strategic group-, and industry-level influences on short-term and long-term measures of performance. We assess the three levels’ explanatory power using a sample of 1,165 firms in 12 industries with data from a 7-year period. To enhance comparability to previous research, we also estimate the effects using the variance components and ANOVA methods relied on in past studies. To assess the robustness of strategic group effects, we examine both deductively and inductively defined groups. We found that all three levels are significantly associated with performance. The firm effect is the strongest, while the strategic group effect rivals and for some measures outweighs the industry effect. We also found that the levels have varying effects in relation to different performance measures, suggesting more complex relationships than depicted in previous studies.

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Category: Risk–Return Relationship, volatility, risk premium
Title: The Emp irical Risk–Return Relation: A Factor Analysis Approach
Author: Sydney C. Ludvigson, Serena Ng
Source: Journal of Financial Economics, January 2007, Vol. 83, No. 1: 171-222.
Link: http://dx.doi.org/10.1016/j.jfineco.2005.12.002
Earlier version: http://www.nber.org/papers/w11477.pdf

Abstract:
A key criticism of the existing empirical literature on the risk-return relation relates to the relatively small amount of conditioning information used to model the conditional mean and conditional volatility of excess stock market returns. To the extent that financial market participants have information not reflected in the chosen conditioning variables, measures of conditional mean and conditional volatility–and ultimately the risk-return relation itself–will be misspecified and possibly highly misleading. We consider one remedy to these problems using the methodology of dynamic factor analysis for large datasets, whereby a large amount of economic information can be summarized by a few estimated factors. We find that three new factors, a “volatility,” “risk premium,” and “real” factor, contain important information about one-quarter ahead excess returns and volatility that is not contained in commonly used predictor variables. Moreover, the factor-augmented specifications we examine predict an unusual 16-20 percent of the one-quarter ahead variation in excess stock market returns, and exhibit remarkably stable and strongly statistically significant out-of-sample forecasting power. Finally, in contrast to several pre-existing studies that rely on a small number of conditioning variables, we find a positive conditional correlation between risk and return that is strongly statistically significant, whereas the unconditional correlation is weakly negative and statistically insignificant.

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Category: Investor Sentiment
Title: Measuring Investor Sentiment in Equity Markets
Author: Arindam Bandopadhyaya and Anne Leah Jones
Source: Journal of Asset Management, Vol. 7, No. 3–4: (September/November 2006)208-215
Link: http://www.palgrave-journals.com/jam/journal/v7/n3/abs/2240214a.html
Earlier version: http://www.financialforum.umb.edu/documents/Bando%20and%20Anne%20Working%20Paper%201007.pdf

Abstract:
Recently, investor sentiment has become the focus of many studies on asset pricing. Research has demonstrated that changes in investor sentiment may trigger changes in asset prices, and that investor sentiment may be an important component of the market pricing process. Some authors suggest that shifts in investor sentiment may in some instances better explain short-term movement in asset prices than any other set of fundamental factors. In this paper we develop an Equity Market Sentiment Index from publicly available data, and we then demonstrate how this measure can be used in a stock market setting by studying the price movements of a group of firms which represent a stock market index. News events that affect the underlying market studied are quickly captured by changes in this measure of investor sentiment, and the sentiment measure is capable of explaining a significant proportion of the changes in the stock market index.

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Category: 130/30 strategies
Title: Active Extensions: Alpha Hunting at the Fund Level
Author: Martin Leibowitz and Anthony Bova
Source: Journal Of Investment Management
Link: https://www.joim.com/abstract.asp?ArtID=248

Abstract:
Active equity strategies that are highly benchmark-centric will generally have a minimal impact on fund level volatility. Since most US institutional portfolios are overwhelmingly dominated by their equity exposure, any incremental tracking error will be submerged by the beta effect. Positive alpha opportunities from tightly beta-targeted strategies can therefore be particularly valuable because they can significantly increase the fund’s total return with only minor increases in the overall volatility or other ‘beyond-model’ forms of risk. Active extensions strategies such as ‘130/30’ portfolios are intrinsically benchmark-centric and can potentially lead to higher levels of active alpha. The expanded footings open the door to a fresh set of actively chosen underweight positions and provide a wider range of alpha-seeking opportunities for both traditional and quantitative management. Active extension strategies can be designed to fit within a sponsor’s existing allocation space for active US equity. With proper risk control, an active extension may entail tracking error that is only moderately greater than that of a comparable long-only fund. A carefully implemented short extension can expand relationships with existing managers. A sponsor may wish to draw upon those active managers that have already been vetted in terms of their alpha-seeking skills, organization infrastructure, and risk-control procedures The preconditions for realizing any of these benefits are a credible basis for producing positive alphas in both long and short portfolios, a high level of risk discipline, an ability to minimize and/or offset unproductive correlations, and an organizational ability to pursue short extensions in a benchmark-centric, cost-efficient fashion.

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5. Trading cost
Category: Trading cost, optimal execution
Title: Execution Risk
Author: Robert Engle and Robert Ferstenberg
Source: The Journal Of Trading, Spring 2007
Link: http://www.iijournals.com/JOT/DEFAULT.ASP?Page=2&ISS=23701&SID=682136
Earlier Version: http://www.nber.org/papers/w12165.pdf

Abstract:
Transaction costs in trading involve both risk and return. Risk is a result of price movements and price impacts over a gradual trading period. Return is associated with the cost of immediate execution. The tradeoff between risk and return in optimal execution reflects the same risk preferences as in ordinary investment. Models of the joint optimization of positions and trades show conditions under which optimal execution does not depend on the other holdings in the portfolio. Optimal execution, however, may call for trades in assets other than those listed in the trading order; these can hedge the trading risks. The execution risk model for trading with reversals and continuations implies a natural measure of liquidity risk.

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Category: Commission Costs, liquidity
Title: Is Illiquidity a Risk Factor? A Critical Look at Commission Costs
Author: Jinliang Li, CFA, Robert Mooradian, and Wei David Zhang
Source: Financial Analysts Journal, July/August 2007, Vol. 63, No. 4: 28-39
Link: http://www.cfapubs.org/doi/abs/10.2469/faj.v63.n4.4747

Abstract:
A quarterly time series of the aggregate commission rate for NYSE trading over 1980–2003 allowed an investigation of the information conveyed by this liquidity risk metric and analysis of its critical role in the generation of stock returns. The aggregate commission rate was found to be highly correlated with other illiquidity metrics, such as the bid–ask spread. The rate is significantly and positively related to the excess returns of the stock market portfolio and has significant explanatory power for the cross-sectional variation in stock returns. An analysis of size-based portfolios indicates that returns become more sensitive to the aggregate commission rate with declining market capitalization.

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6. Misc topics
Category: Expected return, median return,
Title: The Misuse of Expected Returns
Author: Eric Hughson, Michael Stutzer, and Chris Yung
Source: Financial Analysts Journal
Link: http://www.cfapubs.org/doi/abs/10.2469/faj.v62.n6.4356
Earlier Version: http://leeds.colorado.edu/uploadedFiles/Faculty_an d_Research/Research_Centers/Burridge_Center_for_Securities_Analysis_and_Valuation/Working_Papers/Working_Paper_Contents/MisuseOfExpectedReturnsFinal.pdf

Abstract:
Much textbook emphasis is placed on the mathematical notion of expected return and its historical estimate via an arithmetic average of past returns. But those wanting to forecast a typical future cumulative return should be more interested in estimating the median future cumulative return than in estimating the mathematical expected cumulative return. For that purpose, continuous compounding of the mathematical expected log gross return is more relevant than ordinary compounding of the mathematical expected gross return.

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Category: Performance Manipulation-Proof Performance Measures
Title: Portfolio Performance Manipulation and Manipulation-Proof Performance Measures
Author: William Goetzmann, Jonathan Ingersoll, Matthew Spiegel and Ivo Welch
Source: Review of Financial Studies, May 2007
Link: http://rfs.oxfordjournals.org/cgi/content/abstract/hhm025v1
Earlier version: http://www.isb.unizh.ch/studium/courses06/pdf/0305_sharpening_the_sharpe_ratio.pdf

Abstract:
Numerous measures have been proposed to gauge the performance of active management. Unfortunately, these measures can be gamed. Our paper shows that gaming can have a substantial impact on popular measures even in the presence of high transactions costs. Our paper shows there are conditions under which a manipulation-proof measure exists and fully characterizes it. This measure looks like the average of a power utility function, calculated over the return history. The case for using our alternative ranking metric is particularly compelling for hedge funds whose use of derivatives is unconstrained and whose managers’ compensation itself induces a non-linear payoff.

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Category: S&P SmallCap 600 Index Change
Title: Market Reaction to Changes in the S&P SmallCap 600 Index
Author: S. Gowri Shankar and James M. Miller
Source: Financial Review, Vol. 41, No. 3: (2006)339-360
Link: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1540-6288.2006.00146.x

Abstract:
Firms added to (deleted from) the S&P 600 index experience a significant price increase (decrease) at announcement. Firms that newly enter (exit) the S&P universe experience a larger price increase (decrease) than firms that move between S&P indexes. Trading volumes are higher after the announcement and institutional ownership increases (decreases) following index additions (deletions). However, the price and volume effects are temporary and are fully reversed within 60 days, in contrast to the permanent effects reported for S&P 500 changes. Our results support the temporary price-pressure hypothesis and are similar to results reported for Russell 2000 index changes

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Category: Cover story
Title: Are Cover Stories Effective Contrarian Indicators?
Author: Tom Arnold, CFA, John H. Earl, Jr., CFA, and David S. North
Source: Financial Analysts Journal March/April 2007, Vol. 63, No. 2: 70-75
Link: http://www.cfapubs.org/doi/pdf/10.2469/faj.v63.n2.4520

Abstract:
Headlines from featured stories in Business Week, Fortune, and Forbes were collected for a 20-year period to determine whether positive stories are associated with superior future performance and negative stories are associated with inferior future performance for the featured company. “Superior” and “inferior” were determined in comparison with an index or another company in the same industry and of the same size. Statistical testing implied that positive stories generally indicate the end of superior performance and negative news generally indicates the end of poor performance.