Swedroe: Time Varying Factor Premiums

February 19, 2019

Academic research has found that valuation metrics, such as the earnings yield (E/P) or the CAPE 10 earnings yield, and valuation spreads have information in terms of future returns—the higher the earnings yield, the higher the expected return; and the larger the spread in valuations between growth and value stocks, the larger the future value premium is likely to be. What’s more, this relationship holds across asset classes, not just stocks.

This relationship should be expected, as the cross-sectional book-to-market spread is a proxy for the price of risk. When the price of risk increases, the cross-sectional spread in risk premiums (and consequently, book-to-market) widens, and the expected premiums to factors such as market beta, size and value also increase.

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For example, the June 2018 study “Value Return Predictability Across Asset Classes and Commonalities in Risk Premia,” by Fahiz Baba Yara, Martijn Boons and Andrea Tamoni, found that valuation spreads provide information.

The authors found that “Returns to value strategies in individual equities, commodities, currencies, global government bonds and stock indexes are predictable by the value spread. … In all asset classes, a standard deviation increase in the value spread predicts an increase in expected value return in the same order of magnitude (or more) as the unconditional value premium.”

Jim Davis’ 2007 study “Does Predicting the Value Premium Earn Abnormal Returns?” also found that book-to-market ratio spreads contain information regarding future returns. However, he also found that style-timing rules did not generate high average returns because the signals are “too noisy”—they don’t provide enough information to offer a profitable timing signal.

Thiago de Oliveira Souza provides the latest evidence on time-varying factor premiums with his October 2018 study “Time-Varying Factor Risk and Price of Risk Premiums.” The author investigated whether this variation in the overall market price of risk induces similar variation in the Fama-French factor (market beta, size, value, profitability and investment) risk premiums.

His data series on the factors of size, value, profitability and investment cover the period June 1963 through 2017, and 1926 through 2017 for market beta.

Following is a summary of de Oliveira Souza’s findings:

  • There are common variables that forecast all factor premiums (except the profitability premium) and provide evidence that the individual stock premiums also vary in coordination with the market price of risk.
  • Increases in the cross-sectional book-to-market spreads significantly forecast increases in one-month-ahead premiums for all except the profitability factor.
  • Increases in the investment (profitability) spreads marginally forecast increases in the investment (profitability) premiums.

De Oliveira Souza concluded: “The results that I present support the risk-based explanation of all but the profitability premium, but cannot be taken as strong evidence against the risk-based explanation of the profitability factor.”

For value investors, the above findings are good news, as the relatively poor performance of value stocks in the U.S. over the past decade has led to a widening of the book-to-market spread between value and growth stocks, restoring it to about the same level it was when Eugene Fama and Kenneth French published their famous study, “The Cross-Section of Expected Stock Returns,” in 1992 (they had found a large value premium).

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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