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September 16, 2006

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james

Eugene Fama and Ken French say value stocks - those on low price-book ratios - have out-performed the market around the world:

#this out-performance is probably due to their greater exposure to recession risk

#there's evidence here that distress risk does not produce higher returns.

More on distress risk, Chris.

chris

Think of it this way. If a stock has a dividend yield of 10%, then this year's dividends account for 10% of its price. A recession that hits all firms with equal probability will therefore hurt this stock more than a stock with a yield of say 5%.
And recessions often see long-term interest rates fall. But this - as a matter of mathematics - benefits stocks whose cashflows come in the more distant future, so higher-yielding stock benefits less.
Or think of it this way. Why, if investors are rational, would one stock yield 10% and another 5%? It can only be that either the stock's long-term growth prospects are worse, or it carries more risk. One of those risks would be greater exposure to recession.
Common sense, then, says higher-yielding stocks - "value" stocks - should be more vulnerable to recession. Common sense also says investors should be paid to take this risk.
This is what makes Campbell's paper so curious - it suggests that the risk of bankruptcy isn't associated with higher returns. This is just weird.

james

And so, to take it one step further - one should not thus invest?

chris

It's not the job of the economist to tell you what to choose. It's the job of the economist to give you the menu and the prices.
If you're not bothered by the risk of recession - say because you're retired and so aren't worried by losing yor job or business - it might be worth buying value stocks, as you're being paid to take a risk that doesn't bother you. If on the other hand you might lose your job in a recession, value investing would merely compound your risks.
It also depends on your appetite for risk, of course.

james C


I don't think your comments on stock picking and Anthony Bolton are well thought out.

All you have done is find a regression that does not fit very well.

The regression equation does not represent anything meaningful as it is not possible to construct a fund based on it.

Hence your conclusion that Bolton is unskillful is false.

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