A Fundamental Factor Model

Abstract

This paper constructs a fundamental pricing factor based on observed accounting information. In contrast to standard models where accounting data often enter via data dredging, the factor is founded on consumption-based asset pricing theory and accounting principles that connect accounting numbers to consumption at risk. The factor performs well relative to standard factors in explaining cross-sectional returns. Further, it delivers out-of-sample expected returns that forecast the actual returns that investors receive, a feature on which extant asset pricing models perform poorly. The factor return has little correlation with the market portfolio, and exhibits the property of protecting payoffs in bad states when consumption is low. This prompts a two-factor representation that combines the market portfolio and a zero-beta portfolio with a hedge against loss to consumption.