Dr. P.V. Viswanath
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Taking Stock: Financial economists wonder what is left of their favourite models
Jun 5th 2003
SINCE the stockmarket bubble burst more than three years ago, investors have had ample time to ponder where to put the remains of their money. Economists and analysts too have been revisiting old ideas. None has been dearer to them than the capital asset pricing model (CAPM), a formula linking movements in a single share price to those of the market as a whole. The key statistic is “beta”: the proportion of a given change in the market that, on average, is reflected in the price of the share.
Beta has taken a beating along with investors' wallets. A recent study by André Annema and Marc Goedhart of McKinsey, a consultancy, argues that the bubble in technology, media and telecoms shares has had a long-lasting effect. Because the prices of these shares rose, and then fell, by more than the market as a whole, their betas increased during the bubble and its aftermath. And because beta for the whole market must be equal to one, betas for other, old-economy shares fell. The study concludes that investors should strip out the effects of the bubble. That implies some large adjustments to betas.
In any case, many investors and managers have already given up on beta. Although it is useful for compiling share portfolios—in particular, for working out their overall correlation with the market—it tells you little about share-price performance in absolute terms. In fact, the CAPM's obituary was already being written more than a decade ago when a paper by Eugene Fama and Kenneth French, then both at the University of Chicago, showed that the shares of small companies and “value stocks” (shares with low price-earnings ratios) do much better over time than their betas would predict. However, pointing out this problem raises another one: why should small size or low market value make a company a better bet than any other?
Another new paper, by John Campbell and Tuomo Vuolteenaho of Harvard University, tries to resuscitate beta by splitting it into two. The authors start from first principles. In essence, the value of a company depends on two things: its expected profits and the interest rate used to discount these profits. Changes in share prices therefore stem from changes in one of these factors.
From this observation, they propose two types of beta: one to gauge shares' responses to changes in profits; the other to pick up the effects of changes in the discount rate. This helps them explain the performance of small and value companies. Shares of such companies are more sensitive than the average to news about profits, in part because they are bets on future growth. Shares with high price-earnings ratios vary more with the discount rate. In all cases, above-average returns compensate investors for above-average risks.
History says that shareholders have a lot to be optimistic about. Over the past 100 years, investors in American shares have enjoyed a premium, relative to Treasury bonds, of around seven percentage points. Similar effects have been seen in other countries. Some studies have reached less optimistic conclusions, suggesting a premium of four or five points. But even this makes shares far more attractive, in the long run, than bonds.
Even so, economists these days are still hard pressed to offer convincing explanations of why investors have enjoyed better returns from equities, or of why they should expect a premium in the future. The usual argument is that shares carry more risk than government bonds: as the residual owners of a company, shareholders stand to lose their entire investment in the event of bankruptcy. Yet Rajnish Mehra of the University of California, Santa Barbara, argues that it is hard to see why this should give rise to a premium of much more than a percentage point.
Many answers have been put forward to explain the premium. One is that workers cannot hedge against many risks, such as losing their jobs, which tend to hit at the same time as stockmarket crashes; this means that buying shares would increase the volatility of their income, not reduce it, so that investors require a premium to be persuaded to hold them. Another is that shares, especially in small companies, are much less liquid than government debt. It is also sometimes argued that in extreme times—in depression or war, or after bubbles—equities fare much worse than bonds, so that equity investors demand higher returns to compensate them for the risk of catastrophe.
Mr Mehra finds all this unconvincing. It turns out, for example, that bonds often do as poorly as equities in times of great distress. In France in the 1920s their prices fell by around 90%. Holders of Mexican bonds suffered huge losses in the 1980s. Other investors in emerging-market bonds have also been clobbered at various times.
All of which implies a somewhat unsatisfactory conclusion. Yes, over long periods equities have done better than bonds. But there is no equity “premium”—in the sense of a fairly predictable excess over bond returns on which investors can rely. There is a large element of mean reversion in share-price swings: shares look overvalued at the end of a bull run, when premiums may even turn negative, as they have done recently; after a long bear market, they are almost certain to bounce back. Searching for a consistent, God-given premium is a fool's errand.