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Abstract:
Many market observers point to the very high fraction of earnings retained (or low dividend payout ratio) among companies today as a sign that future earnings growth will be well above historical norms. This view is sometimes interpreted as an extension of the work of Miller and Modigliani. They proved that, given certain assumptions about market efficiency, dividend policy should not matter to the value of a firm. Extending this concept intertemporally, and to the market as a whole, as many do, whenever market-wide dividend payout ratios are low, higher reinvestment of earnings should lead to faster future aggregate growth.

However, in the real world, many complications exist that could confound the expected inverse relationship between current payouts and future earnings growth. For instance, dividends might signals managers' private information about future earnings prospects, with low payout ratios indicating fear that the current earnings may not be sustainable. Alternatively, earnings might be retained for the purpose of "empire-building," which itself can negatively impact future earnings growth.

We test whether dividend policy, as we observe in the payout ratio of the market portfolio, forecasts future aggregate earnings growth. This is, in a sense, one test of whether dividend policy "matters." The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors such as simple mean reversion in earnings. Our evidence contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is fully consistent with anecdotal tales about managers signaling their earnings expectations through dividends, or engaging in inefficient empire building, at times; either of these phenomena will conform with a positive link between payout ratios and subsequent earnings growth.

Our findings offer a challenge to optimistic market observers who see recent low dividend payouts as a sign of high future earnings growth to come. These observers may prove to be correct, but history provides scant support for their thesis. This challenge is potentially all the more serious, as recent stock prices, relative to earnings, dividends and book values, rely heavily upon this expectation of superior future real earnings growth.

Abstract:
The goal of this article is an estimate of the objective forward-looking equity risk premium relative to bonds through history - specifically, since 1802. For correct evaluation, such a complex topic requires several careful steps: To gauge the risk premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. 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. We demonstrate that the long-term forward-looking risk premium is nowhere near the level of the past; today, it may well be near zero, perhaps even negative.

Abstract:
We are in an industry that thrives on the expedient of forecasting the future by extrapolating the past. As a consequence, investors have grown accustomed to the idea that stocks "normally" produce an 8% real return and a 5% risk premium over bonds, compounded annually over many decades. Why? Because long-term historical returns have been in this range, with impressive consistency. Because investors see these same long-term historical numbers, year after year, these expectations are now embedded into the collective psyche of the investment community.

Both figures are unrealistic from current market levels. Few have acknowledged that an important part of the lofty real returns of the past has stemmed from rising valuation levels and from high dividend yields which have since diminished. As this article will demonstrate, the long-term forward-looking risk premium is nowhere near the 5% of the past; indeed, it may well be near-zero today, perhaps even negative. Credible studies, in the US and overseas, are now challenging this flawed conventional view, in well-researched studies by Claus and Thomas [2001] and Fama and French [2000, Working Paper], to name just two. Similarly, the long-term forward-looking real return from stocks is nowhere near history's 8%. Our argument will show that, barring unprecedented economic growth or unprecedented growth in earnings as a percentage of the economy, real stock returns will probably be roughly 2-4%, similar to bonds. Indeed, even this low real return figure assumes that current near-record valuation levels are "fair," and likely to remain this high in the years ahead. "Reversion to the mean" would push future real returns lower still.

Furthermore, if we examine the historical record, neither the 8% real return nor the 5% risk premium for stocks relative to government bonds has ever been a realistic expectation (except from major market bottoms or at times of crisis, such as wartime). Should investors require an 8% real return, or should a 5% risk premium be necessary to induce an investor to bear stock market risk? These returns and risk premiums are so grand that investors should perhaps have bid them away a long time ago - indeed, they may have done so in the immense bull market of 1982-1999.

Intuition suggests that investors should not require such outsize returns, and the historical evidence supports this view. This is a topic meriting careful exploration. After all, according to the Ibbotson data, investors earned 8% real returns over the past 75 years, and stocks have outpaced bonds by nearly 5% over the past 75 years. So, why shouldn't investors have expected these returns in the past and why shouldn't they continue to do so? Expressed in a slightly different way, we examine two questions. First, can we derive an objective estimate of what investors should have had good reasons to have expected in the past? And, why should we expect less in the future than we've earned in the past?

The answers to both questions lie in the difference between the observed excess return and the prospective risk premium, two fundamentally different concepts that unfortunately carry the same label, "risk premium." If we distinguish between past excess returns and future expected risk premiums, it is not at all unreasonable that the future risk premiums should be different from past excess returns.

This is a complex topic, requiring several careful steps to evaluate correctly. To gauge the risk premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. 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.

Abstract:
A trillion-dollar industry is based on investing in or benchmarking to capitalization-weighted indexes, even though the finance literature rejects the mean-variance efficiency of such indexes. This study investigates whether stock market indexes based on an array of cap-indifferent measures of company size are more mean-variance efficient than those based on market cap. These Fundamental indexes were found to deliver consistent, significant benefits relative to standard cap-weighted indexes. The true importance of the difference may have been best noted by Benjamin Graham: In the short run, the market is a voting machine, but in the long run, it is a weighing machine.

Investment Theory, Portfolio Theory, Portfolio Management, Equity Strategies, Performance Measurement and Evaluation, Performance Measurement, Equity Investments, Fundamental Analysis and Valuation Models

Abstract:
The insights from the celebrated Capital Asset Pricing Model have led many to champion capitalization-weighted equity market portfolios as mean-variance optimal. Armed with these insights, investment managers and consultants have created a trillion dollar industry, based on investing in passive capitalization-weighted indexes, such as the S&P 500 and other indexes constructed by Russell, MSCI, The Financial Times, Wilshire, Forbes and Fortune to name a few. Trillions more in actively managed equity portfolios are benchmarked against these same capitalization-weighted indexes. But, the CAPM literature already rejects the mean-variance efficiency of capitalization-weighted equity market indexes. This suggests that it should be possible to construct stock market indexes that are more mean-variance efficient than those based on market capitalization.

In this paper, we examine a series of equity market indexes weighted by fundamental metrics of size, rather than market capitalization. We find that these indexes deliver consistent and significant benefits relative to standard capitalization-weighted market indexes. These indexes exhibit similar beta, liquidity and capacity compared to capitalization-weighted equity market indexes and have very low turnover. They show annual returns that are on average 213 basis points higher than equivalent capitalization-weighted indexes over the 42 years of the study. They contain most of the same stocks found in the traditional equity market indexes, but the weights of the stocks in these new indexes differ materially from their weights in capitalization-weighted indexes. Selection of companies and their weights in the indexes are based on simple measures of firm size such as book value, income, gross dividends, revenues, sales, and total company employment.

While price inefficiency could lead to the observed alpha, as capitalization weighting assuredly overweights the overvalued stocks and underweights undervalued stocks, the superior performance may also be attributable to superior mean-variance portfolio construction or to hidden risk factors (in an APT or Fama-French framework), none of which violates the assumption of price efficiency. Regardless of the exact reason, these Fundamental Indexation indexes appear to provide long-term performance superior to that of comparable capitalization-weighted equity indexes. We offer them not as substitutes for capitalization-weighted indexes, but as simple alternatives, that may offer superior return and risk characteristics.

Indexation, Fundamental Indexing, Non-cap based indexing, Mean-Variance Efficiency, Portfolio Construction, Value Premium, Return Predicability

Abstract:
Black (1986) and Summers (1986) suggest that there is noise in stock prices in a sense that the price of a stock can be randomly different from its intrinsic value. Such noise can arise from economic models (e.g., Grossman and Stiglitz (1980) and De Long, Shleifer, Summers, and and Robert J.Waldmann (1990)), market microstructure (e.g., Stambaugh 1983) and Roll (1983)), among other sources.

In this paper, we show that when there is noise in the price of a stock, its expected return conditional on the price or the price-dividend ratio decreases with the price or the price dividend-ratio. These higher expected returns associated with lower price or price-dividend ratios are not compensation for risk, but are generated because a stock with a low price or a price-ratio is more likely to have a negative price noise thus to be undervalued.

Fama and French (1992) use the matrix of expected returns conditional on size-value deciles as a demonstration of size and value effects. This matrix can be computed in closed form using our model and, for plausible parameters, is similar to its empirical counterpart (Table V of Fama and French). In our model, small and value stocks have slightly higher betas and positive alphas. Our study suggests that noise creates the size and value effect.

noise, size effect, value effect

Abstract:
We model a continuous time one factor economy where stock prices are noisy proxies of the informationally efficient values. The pricing error process is modeled as a mean-reverting process; this gives us a well defined notion of over-pricing and under-pricing in the market, and stocks fluctuates between being over-priced and under-priced. We show that in this economy, cap-weighting is a sub-optimal portfolio strategy. A non-cap-weighted portfolio outperforms a cap-weighted portfolio with the same factor exposure. This is because, in a cap-weighting scheme, portfolio weights are driven by market prices; as such, more weights are allocated to overvalued stocks and less weight to undervalued stocks. Following the same intuition, we show that in the cross-section, large cap stocks tend to underperform small cap stocks and high price-to-book stocks (growth stocks) tend to underperform low price-to-book stocks (value stocks).

In this economy, if we proxy the hidden risk factor with the market clearing portfolio and regress stock returns against market returns (a CAPM regression), a non-cap-weighted portfolio exhibits significant alpha! However, when we regress the same non-cap-weighted portfolio against market, size and value, the Fama-French style regression exhibits factor loadings on value and size with insignificant alpha. Clearly, value and size are not risk factors in our economy! Value and size shows up in our regressions because the market portfolio is a poorly constructed proxy for the hidden risk factor.

The paper contributes to the anomalies literature by showing that mean-reversion in stock returns and the Fama-French size and value effects are driven by the same market defect - pricing noise! This suggests that models, such as disposition effects and information herding, which can generate stock price over-reaction and therefore mean-reversion in stock prices, can also explain the value and size puzzle.

Mispricing, noise, CAPM, size effect, value effect, excess volatility puzzle, dividend predictability puzzle

Abstract:
We compare the price of a stock at a given point in time with its ex post realized value - defined by the discounted net present value of subsequent actual cash distributions. We refer to this measure as the "Clairvoyant Value" - the value that a clairvoyant investor with perfect foresight would have placed on the company. We use this measure of Clairvoyant Value to tease out some surprising results relating to the extent to which the market has correctly anticipated various future growth rates and the extent to which investors have paid up for future growth expectations. This provides additional historical evidence on market efficiency and the value effect in the U.S. stock market. We find that, although growth stocks (those trading at high multiples) do historically exhibit superior future growth, the market overpays for superior growth expectations with statistical significance.

Clairvoyant Value, Value Effect

Abstract:
For over 40 years, our industry has relied on the Capital Asset Pricing Model (CAPM) beta and the capitalization-weighted market portfolio for asset allocation, for market representation and for our default core equity investments. This elegant world-view is now under siege from various directions.

The “fundamentalists” advocate a portfolio that weights companies in accordance with the recent economic scale of their businesses, thereby resembling the composition of the economy rather than the composition of the stock market. The “minimum variance” crowd points to the value of consistency between investor objectives and portfolio construction. The “egalitarians” advocate equal weighting. Historically, these alternative index strategies have delivered higher return and lower CAPM beta, which can help an investor to target either more return or less risk or a bit of both. Each of these strategies - along with the ever-dominant cap weight indexes - has strengths and weaknesses, some minor and some major.

The cap-weighted standard is also facing a more subtle source of attack as investors reassess their risk budgets. Increasingly, investors are reassessing their risk budgets, usually downward, which can create pressure to move from active into passive strategies and to lower a fund’s exposure to an undiversified single-factor equity risk. But, can we lower our risk profile without abandoning our return goals? Perhaps it is time to consider a bigger tent, allowing for the merits of multiple broad-market indexes and multiple betas.

We explore the comparative merits of four major categories of quasi-passive “index” construction. We do so from a global perspective. And we explore the surprising efficacy of combining multiple index strategies into a diversified beta portfolio.

alternative indexing, beta selection

Abstract:
In historical testing, valuation-indifferent weighting as applied to U.S. and global equities has produced statistically significant and economically large outperformance when compared with traditional capitalization-weighted benchmarks. In this paper, we apply the method to U.S. investment-grade corporate bonds, U.S. high-yield bonds, and hard-currency emerging market bonds. We find that fixed-income portfolios constructed using valuation-indifferent weighting outperform the corresponding cap-weighted benchmarks.

We also find that the outperformance is higher for markets in which we might typically expect more inefficiencies and greater volatilities. Both findings are consistent with the empirical evidence found in the equity applications of valuation-indifferent weighting, as well as the proposed noise-in-price theoretical rationale for these results.

Fundamental Index, Valuation-Indifferent Index, Bond Index

Abstract:
The concept of Clairvoyant Value, introduced in Arnott, Li and Sherrerd (2009), allows us to explore how the market prices in future growth expectations, across securities, and over time. In this paper, we find both concurrent and predictive links between the intertemporal change in the Valuation Dispersion - the relative valuation gap between growth and value stocks - and the observed growth/value “cycle” in the market. On average, that dispersion is twice as wide as subsequent financial results would justify - the market historically has overpaid for growth. Also, historically, a wide dispersion of valuation multiples tends to precede a period of exceptional performance for value stocks relative to growth stocks. Finally, we address the total wealth effect of investing in a Clairvoyant Value portfolio. Clairvoyance on a company’s future business prospects is valuable, but perhaps a bit less so than most investors might surmise.

Clairvoyant Value, Value Effect, Growth/Value Cycle

Abstract:
We model a continuous time one factor economy where stock prices are noisy proxies of the informationally efficient stock values. The pricing error process is modeled as a mean-reverting process, which gives us a well-defined notion of over-pricing (positive pricing error) and under-pricing (negative pricing error) in the market. We show that in this economy, cap-weighting is a sub-optimal portfolio strategy. This is because, in a cap-weighting scheme, portfolio weights are driven by market prices; as such, more weights are allocated to over-valued stocks and less weight to under-valued stocks. More importantly, we show that the CAPM would be rejected in this one factor economy with noise. Regressing portfolio returns against market clearing portfolio returns, non-cap-weighted portfolios exhibit significant alpha on average! Additionally, a value tilted or size tilted portfolio is predicted to outperform(risk-adjusted). By construction, value and size are not risk factors in our one factor economy. However, in the cross-section, large cap stocks and high price-to-book stocks (growth stocks) tend to underperform. This is because higher capitalization stocks and higher price-to books stocks are indeed more likely to be stocks with positive pricing errors. We note that prices are explicitly inefficient in our economy. However, the inefficiency does not lead to arbitrage opportunities. We carefully show conditions which prevent arbitrage in our informationally inefficient economy. The paper contributes to the anomalies literature by showing that mean-reversion in stock returns and the Fama-French size and value effects are driven by the same market defect-pricing noise! This suggests that models, such as disposition effect and information herding, which can generate stock price over-reaction and therefore mean-reversion in stock prices, can also explain the value and size puzzle.

Noise, value effect, size effect, CAPM, non-price-weighted portfolios

Abstract:
Two important concepts played a key role in the bull market of the 1990s. Both represent fundamental flaws in logic. Both are demonstrably untrue. First, many investors believed that earnings could grow faster than the macroeconomy. In fact, earnings must grow slower than GDP because the growth of existing enterprises contributes only part of GDP growth; the role of entrepreneurial capitalism, the creation of new enterprises, is a key driver of GDP growth, and it does not contribute to the growth in earnings and dividends of existing enterprises. During the 20th century, growth in stock prices and dividends was 2 percent less than underlying macroeconomic growth. Second, many investors believed that stock buybacks would permit earnings to grow faster than GDP. The important metric is not the volume of buybacks, however, but net buybacks - stock buybacks less new share issuance, whether in existing enterprises or through IPOs. We demonstrate, using two methodologies, that during the 20th century, new share issuance in many nations almost always exceeded stock buybacks by an average of 2 percent or more a year.

Portfolio Management, asset allocation, Economics, macroeconomics, Investment Industry, future directions and sources of change

Abstract:
We investigate whether dividend policy, as observed in the payout ratio of the U.S. equity market portfolio, forecasts future aggregate earnings growth. The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors, such as simple mean reversion in earnings. Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building. Our findings offer a challenge to market observers who see the low dividend payouts of recent times as a sign of strong future earnings to come.

Portfolio Management: asset allocation; Investment Theory: efficient market theory

Abstract:
A tactical asset allocation process most typically adds value during the volatile periods of the market cycle, when there is substantial divergence in asset class returns. A tactical options program will add value during the trendless periods of the market cycle. Two such programs together are highly complementary, providing a mechanism to add value during the inevitable quiet - hence unprofitable - periods for TAA. The authors discuss simulated results.