The Cross Section of Expected Holding Period Returns and Their Dynamics: A Present Value Approach
Matthew R. Lyle
Northwestern University - Kellogg School of Management
Charles C. Y. Wang
Harvard Business School
June 19, 2014
Journal of Financial Economics (JFE), Forthcoming
Harvard Business School Accounting & Management Unit Working Paper No. 13-050
Rotman School of Management Working Paper No. 2182628
We provide a tractable model of firm-level expected holding period returns using two firm fundamentals ― book-to-market ratio and ROE ― and study the cross-sectional properties of the model-implied expected returns. We find that: 1) firm level expected returns and expected profitability are time-varying, but highly persistent; 2) forecasts of holding period returns strongly predict the cross section of future returns up to three years ahead. We document a highly significant predictive pooled regression slope for future quarterly returns of 0.86, whereas the popular factor-based expected return models have either an insignificant or a significantly negative association with future returns. In supplemental analyses, we show that these forecasts are also informative of the time-series variation in aggregate conditions: 1) for a representative firm, the slope of the conditional expected return curve is more positive in good times, when expected short-run returns are relatively low; 2) the model-implied forecaster of aggregate returns exhibits modest predictive ability. Collectively, we provide a simple, theoretically-motivated, and practically useful approach to estimating multi-period ahead expected returns.
Number of Pages in PDF File: 57
Keywords: Expected returns, discount rates, holding period returns, fundamental valuation, present value
JEL Classification: G12, G17, G10
Date posted: December 2, 2012 ; Last revised: June 20, 2014
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