Knowledge that Transforms

Abstract A long tradition in macro-finance studies the dynamics of aggregate stock returns and dividends using vector autoregressions, imposing the restrictions implied by the Campbell-Shiller (CS) identity to sharpen inference. We develop Bayesian methods that encode a priori skepticism about return predictability while imposing the restrictions. We highlight that persistence in dividend growth induces “dividend momentum,” a previously overlooked channel for return predictability. By combining Bayesian shrinkage and the CS restrictions, we obtain more plausible degrees of return predictability, superior out-of-sample forecasts, and Sharpe ratios, which cannot be obtained by using either shrinkage or the CS restrictions on their own.

Abstract We examine whether politicians affect local firms’ industrial pollution, and whether such effects are transmitted through plant-level networks to affect pollution in other regions. We first document that close Democrat wins in U.S. congressional races are associated with lower emissions and higher abatement at the plant level, especially when politicians have strong pro-environmental preferences. We also find evidence of reallocation: firms shift emissions away from areas represented by Democrats. However, reallocation is imperfect: firm-level costs are higher and market-to-book ratios lower if firms’ representation is more Democratic. Lower pollution-related illnesses around plants in Democratic districts suggest pass-through effects on local communities.

Abstract This paper studies whether the interplay of social comparisons in housing and rising income inequality contributed to the household debt boom in the United States between 1980 and 2007. We develop a tractable macroeconomic model with general social comparisons in housing to show that changes in the distribution of income affect aggregate housing demand, aggregate debt, and house prices if (and only if) social comparisons are asymmetric. In the empirically relevant case of upward-looking comparisons, rising inequality can rationalize a substantial share of the observed housing and debt boom.

Abstract Mergers and acquisitions are often motivated by an intention to create value from intangible assets. We develop a word list of intangibles and apply it to takeover announcements. One standard deviation more in intangible-related language (“intangibles talk”) lowers announcement returns for the acquirer by 0.53 percentage points and predicts worse operating performance. Bidder managers appear to believe in the deals nonetheless, as evidenced by insider trades, payment choices, and completion probabilities and speed. Overall, takeover announcement texts reveal important information about hard-to-measure aspects of deal quality.

Abstract Some bank regulators require that performance bonuses for risk managers (RMs) and for employees in front offices (FOs) be linked to distinct performance metrics, as correlated pay incentives could lead RMs to rubber-stamp risky investments. We theoretically show that a positive correlation between FOs and RMs is optimal for banks, but can be socially excessive in leveraged institutions. Using data from German bank employees, we show empirically that incentive pay is indeed positively correlated between RMs and FOs. Consistent with our predictions, bonus correlations are higher in banks with higher leverage and weaker performance during the Great Financial Crisis.

Abstract During the U.S. housing credit boom, publicly traded banks increased mortgage lending activity and relaxed standards much more than privately held banks. The increase in risk had real effects for a variety of county-level aggregates including employment and consumption. Cross-sectional evidence and a quasi-experiment indicate that the increase in risk stemmed from the institutional ownership and the equity compensation of publicly traded banks, in turn leading banks to place greater weight on short-term equity performance. These results are consistent with the view that a focus on short-term earnings and stock prices amplifies boom–bust credit cycles, in turn leading to real cycles for the aggregate economy.

Abstract During the 2020–2021 “AAPI Hate,” mutual funds led by female managers perceived as East Asian underperformed relative to other female managers. This effect is stronger in states with higher anti-Asian animus, among more actively managed funds, and when these managers hold sole or senior roles. Factors concurrent with COVID-19, including childcare challenges, concerns for overseas families, marketplace and workplace discrimination, and exposure to the Chinese economy, cannot explain the effect. Underperformance is traceable to poor stock picking due to impairments in generating private information. Racial-ethnic animosity, even outside workplace or marketplace, hinders productivity and decision-making in high-skill professions.

Abstract To understand the dynamics of investors’ asset demands, we develop a general-equilibrium model driven by a single latent variable: heterogeneity in investors’ confidence about mean endowment growth. The model predicts persistent heterogeneity in asset demands and concentrated portfolios. Consistent with the data, limited confidence reduces investors’ demand elasticities and makes stock prices excessively volatile—driven by latent demand rather than observable characteristics. The underlying economic mechanisms are driven primarily by investors’ desire to hedge changes in future beliefs instead of current disagreement. Finally, consistent with survey data, investors’ expectations correlate positively with past returns and negatively with future returns.

Abstract Numerous trading strategies examined in options research exhibit remarkably high mean returns and Sharpe ratios. We show some of these seemingly “good deals” are due to look-ahead biases. These biases stem from using information unavailable at the portfolio formation time to filter out observations suspected of being noisy or erroneous. Our results suggest that elevated Sharpe ratios may serve as potential indicators of such look-ahead biases. Furthermore, deviating from previous literature findings, we show that illiquidity is not strongly priced in stock options and that only a small set of stock characteristics are in fact associated with option expected returns. (JEL G12, G14, G17)

Abstract We examine how portfolio regulations affect risk sharing between financial institutions with market power. Unconstrained access to complete markets permits flexible exploitation of market power and induces inefficient risk sharing. Appropriate portfolio restrictions counteract this, improving liquidity and risk sharing by bundling securities with offsetting strategic incentives. However, excessive regulation can be counterproductive, destroying gains from trade. An application of our theory shows that cross-asset spillovers are critical for policy evaluation: in general equilibrium, risk sharing can improve even if certain asset-specific liquidity measures deteriorate. We also discuss the effects of asymmetric regulation for different institutions.