Knowledge that Transforms

Abstract We show that the repurchaser–issuer return spread is stronger among stocks with high return volatility. Rational and behavioral theories predict that this finding is the product of risk volatility and sentiment volatility, respectively. However, our results are inconsistent with these theories as they currently stand. Loadings on standard risk factors do not follow the dynamics that would explain the return predictability related to issuance decisions. If we sort on a stock's beta with respect to the aggregate sentiment index of Baker and Wurgler (2006, J. Finance, 61, 1645–1680), which proxies for sentiment volatility, the results are weaker—economically and statistically—than when sorting on return volatility.

Abstract Using holdings data on a representative sample of all Shanghai Stock Exchange investors, we show that increases in ownership breadth (the fraction of market participants who own a stock) predict low returns: highest change quintile stocks underperform lowest quintile stocks by 23% per year. Small retail investors drive this result. Retail ownership breadth increases appear to be correlated with overpricing. Among institutional investors, however, the opposite holds: stocks in the top decile of wealth-weighted institutional breadth change outperform the bottom decile by 8% per year, consistent with prior work that interprets breadth as a measure of short-sales constraints.

Abstract This paper develops a model in which performance evaluation causes runs by fund managers and results in asset fire sales. Performance evaluation nonetheless is efficient as it disciplines managers. Optimal performance evaluation combines absolute and relative components in order to make runs less likely. When runs induce large price discounts, this requires a high degree of absolute performance evaluation and a low degree of relative performance evaluation. The overall costs of using performance evaluation are shown to be decreasing in asset liquidity, implying that more developed financial markets should have more delegation. However, such markets are not less prone to runs.

Abstract The focus of this article is on the predictive role of the stock-bond yield gap—the difference between the stock market earnings (dividend) yield and the 10-year Treasury bond yield—also known as the “Fed model”. The results show that the yield gap forecasts positive excess market returns, both at short and long forecasting horizons, and for both value- and equal-weighted stock indexes, and it also outperforms competing predictors commonly used in the literature. These findings go in line with the predictions from a present-value decomposition. The absence of predictive power for dividend growth, dividend payout ratios, earnings growth, and future one-period interest rates, actually strengthens the return predictability associated with the yield gap at very long horizons. By performing an out-of-sample analysis, the results show that the yield gap has reasonable out-of-sample predictability for the equity premium when the comparison is made against a simple historical average, especially when one imposes a restriction of positive equity premia. Furthermore, the yield gap proxies generally show greater out-of-sample forecasting power than the alternative state variables. An investment strategy based on the forecasting ability of the yield gap produces significant gains in Sharpe ratios.

Abstract Close to 30% of the US population experiences at least one mental or substance abuse disorder each year. Given the prevalence of mental health issues, this paper analyzes the role of mental health and cognitive functioning in household portfolio choice decisions. Generally, we find that households affected by mental health issues decrease investments in risky instruments. Various mental health issues can reduce the probability of holding risky assets by up to 19%. Moreover, single women diagnosed with psychological disorders increase investments in safe assets. We also find that cognitive functioning issues are associated with an increase in financial assets devoted to retirement accounts.

Abstract Do public equity markets serve an unique role that is not easily served by other forms of financing in emerging economies? We analyze this question using the collapse of India’s equity market in 1997, which provides an exogenous shock to firms’ ability to issue equity. We find that both public and private firms exhibit higher bankruptcy rates and lower growth after 1997. The decline in growth is greater among firms with more external finance needs and fewer tangible assets. Overall, the evidence suggests that public equity markets are an important, not easily replaced, source of finance in emerging economies.

Abstract Traditional theories of capital structure do not explain the puzzling phenomena of zero-leverage firms and negative net debt ratios. We develop a theory where firms adopt a net debt target that acts as a balancing variable between equityholders and managers. Negative (positive) net debt occurs in human (physical) capital intensive industries. Negative net debt arises because tradeable claims cannot be issued against transferable human capital. Heterogeneity in capital structure occurs when firms have debt that is not fully collateralized. Physical capital intensive firms take on high leverage but may underlever to avoid bankruptcy costs. This creates excess rents for managers (even if the supply of human capital is competitive) because wealth constraints prevent managers from coinvesting.

Abstract This article empirically relates the internal organization of a firm with decision making quality and corporate performance. We call “independent from the CEO” a top executive who joined the firm before the current CEO was appointed. In a very robust way, firms with a smaller fraction of independent executives exhibit (1) a lower level of profitability and (2) lower shareholder returns following large acquisitions. These results are unaffected when we control for traditional governance measures such as board independence or other well-studied shareholder friendly provisions. One interpretation is that “independently minded” top ranking executives act as a counter-power imposing strong discipline on their CEO, even though they are formally under his authority.

Abstract We provide evidence on the causal link between financing constraints and the risk of corporate cash flows and returns. For identification, we compare public US firms in the same industry, location, and size quintile, but whose access to bank credit was differentially affected by WorldCom’s demise in 2002. A credit shortage induces a permanent increase in the volatility and skewness of operating cash flows and an increase in the correlation between firm stock and market returns. We document how firms’ cash, payout, and investment policies respond endogenously to mitigate the impact of constraints on risk.

Abstract We provide a new perspective on option and stock price behavior around 52-week highs and lows. We analyze whether option-implied volatilities (IVs) change when stock prices approach or break through their 52-week high or low. We also study the effects of highs and lows on a stock’s beta and return volatility. We find that IVs and stock betas decrease when approaching a high or low, and that volatilities increase after breakthroughs. The effects are economically large and significant. The approach results can be explained by the anchoring theory. The breakthrough results are consistent with anchoring and the investor attention hypothesis.