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Market Expectations in the Cross Section of Present Values

52 Pages Posted: 2 Feb 2011 Last revised: 11 Sep 2012

Bryan T. Kelly

University of Chicago - Finance; National Bureau of Economic Research (NBER)

Seth Pruitt

Arizona State University (ASU) - Finance Department

Date Written: July 1, 2012

Abstract

Returns and cash flow growth for the aggregate U.S. stock market are highly and robustly predictable. Using a single factor extracted from the cross section of book- to-market ratios, we find an out-of-sample return forecasting R-squared as high as 13% at the annual frequency (0.9% monthly). We document similar out-of-sample predictability for returns on value, size, momentum and industry-sorted portfolios. We present a model linking aggregate market expectations to disaggregated valuation ratios in a dynamic latent factor system. We find that spreads in growth and value portfolios’ exposures to economic shocks are key to identifying predictability and are consistent with duration-based theories of the value premium. Our findings suggest that discount rates are far less persistent, and their shocks far more volatile, than implied by leading asset pricing models.

JEL Classification: G11, G12, G17

Suggested Citation

Kelly, Bryan T. and Pruitt, Seth, Market Expectations in the Cross Section of Present Values (July 1, 2012). Journal of Finance, Forthcoming; Chicago Booth Research Paper No. 11-08; Fama-Miller Working Paper ; AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1752543 or http://dx.doi.org/10.2139/ssrn.1752543

Bryan Kelly (Contact Author)

University of Chicago - Finance ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-8359 (Phone)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Seth Pruitt

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

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