In the field of investments, the underpinnings of modern finance are contained in three basic concepts:
It is possible to build stock portfolios that have the lowest possible risk, given your objective for expected return. Call the technique to build these portfolios The Tool.
What if we assume everyone uses the tool? Then, when we put together all of our portfolios to form a market index like the Standard & Poor's 500 Stock Index, the S&P, itself, will have the lowest possible risk, given its expected return. This idea, based on the universal use of The Tool, goes by the name Capital Asset Pricing Model. We call it The Theory.
What if, somehow, the prices of all stocks reflected everything that was knowable and relevant about them? This notion goes by the name market efficiency. Call it The Fantasy.
There is nothing wrong with The Tool - other than the fact no one uses it.
This, unfortunately, makes The Theory a sham. If no one uses The Tool to squeeze unnecessary risk from their portfolios, the market index won't have the lowest possible risk given its expected return. Better portfolios can be built with the same expected return and lower risk.
Some finance professors still fantasize about a stock market dominated by an army of professional, rational, driven investors, who search in every nook and cranny for clues that might lead them to the discovery of an undervalued stock. When they find a clue, they act - quickly. Their trades push stock prices, making them adjust quickly to reflect the information in the clues.
Never mind about the trades of us little guys who don't have a clue. Never mind that we are driven by greed and fear.
Consider a recent study by two University of California at Los Angeles professors - Narasimhan Jegadeesh and Sheridan Titman - called "Returns to buying winners and selling losers: Implications for stock market efficiency," printed in The Journal of Finance, March 1993.
First, the professors classify stocks as winners or losers, and then measure their subsequent relative performance. Winners are defined as the 10% of the stocks in their sample that had the best returns over the past six months, and losers are defined as the 10% with the worst returns.
The professors then observe the relative performance of the winners and losers over three-day periods within each of the 36 months of the next three years. In each of the 36 months, they measure performance for firms that report earnings in the month, and, for those firms, returns are measured only during the two days preceding and the day of the announcement of quarterly earnings-per-share.
As we see in Figure 1, where we are plotting the monthly differences in the return between the winners and losers, the winners of the past do better in the first month following "now," and also in the seven months that follow.
The winners probably reported good earnings in the trailing six-month period, and the losers, bad. We speak of good and bad relative to market expectations, so these are market "surprises."
The market's surprises in the eight months that follow the trailing six reflect its failure to recognize that good quarterly reports foretell of a few more good ones to follow; and that bad quarterly reports foretell of bad ones to follow. The subsequent good or bad reports catch the market by surprise, and the winners outperform the losers as they are reported.
A rational, efficient market would be aware of this tendency. It would anticipate the good and bad reports and wouldn't have to react upon their arrival.
But look what happens after the eighth month. Now the stocks previously classified as losers are showing superior returns at the earnings announcement dates.
Apparently, the market overreacted to its surprises of the eight months before and the six months before that. The market became convinced that the string of good (or bad) reports of the past 14 months were precursors of many more to follow. They were not.
After the eighth month, the market is being pleasantly surprised at the unexpectedly good reports of the past losers, and unpleasantly surprised by the past winners.
Firms quickly revert to the mean in terms of the growth rates they report in earnings-per-share. The good, as well as the bad, quickly become the average.
How to explain the premium to value investing?
Let The Fantasy speak:
"It seems that value stocks have low current prices and high future returns because they are risky."
Aha! What we've got here is a risk premium. It's not the artifact of corrected overreaction; it's not a surprise.
According to the latest versions of The Fantasy, value stocks are "fallen angels" - stocks of once-successful companies whose fortunes have long since turned against them. They've been so beaten up they now scare the daylights out of us.
But wait a minute. According to Professors Eugene F. Fama and Kenneth R. French, value stocks have lower market risk.*
There is another problem with the risk premium story of The Fantasy.
If it really represents the delivery of risk premium, it should be earned uniformly through time. At least with the same uniformity that investors are exposed and sensitized to risk.
However, we learned from Figure 1 that a big chunk of the value premium comes at the three-day window of time when firms announce their earnings.
Believers in The Fantasy must argue that risk is especially high during these periods and the relatively high returns to value are risk premiums being earned as the risk is experienced. But believers in The Fantasy must come up with believable explanations for the following observations for the earnings announcement dates:
Why does the uncertainty in general go up for the value stocks (which generally produce high returns around earnings announcements) and down for the growth stocks (their returns are low)?
Why does the relative risk switch around (as we see in Figure 1) after the eighth month following rankings of performance over the previous six months? We have argued the inefficient market fails to recognize a good report as a precursor of a few more to follow. When they come, it overreacts, thinking the string will continue unabated for a long period into the future.
And here's a result that should prove even more puzzling to believers in The Fantasy.
Three more professors - Navin Chopra, Josef Lakonishok and Jay Ritter - in "Measuring abnormal performance" in the Journal of Financial Economics, find the rest of the value premium comes at the turn of the year.
The three professors rank the stocks in their study on the basis of the return over the previous five years. They put the 5% of the stocks with the worst trailing five-year records into Group 1, the 5% with the second worst into Group 2, and so on through Group 20, the growth stocks.
The average monthly return to these stocks during the five years after they are ranked is plotted in Figure 2. The monthly average returns in January are shown in the rear, and the average returns of the other months are shown in the front.
Incredible!
The value stocks produce huge January returns, relative to the growth stocks.
Why?
Managers who have done well during the year have an incentive to lock in their performance as they approach the winter months. Bonuses don't increase much when great performance becomes really great, but they shrink dramatically if great becomes mediocre.
So if you've done great, lock in. How? Your performance probably is measured relative to the S&P 500. As you liquidate your profitable aggressive positions, park the proceeds in Blue-Chip stocks that behave like your benchmark.
The process of locking in good performance takes place at different times for different managers during the later part of the year.
Going back, however, is a different story.
On the morning of the first trading day of the year, the starter's gun is raised into the air and fired. The race to beat the market is on for a fresh calendar year. The pros move back.
But they move back selectively, looking to buy the stocks they believe are undervalued. They look for bargains, stocks that have been driven down too far. They also look to avoid or sell short stocks that are overvalued.
Because the pros all move at once, their trades bump stock prices, pushing the bargains up and the bloated down.
What we're seeing in Figure 2 is not the delivery of a risk premium. There is nothing especially risky about the month of January. Instead, we're seeing the tracks of stocks being pushed back to equilibrium levels, stocks that had been overvalued or undervalued by the overreactive market.
The value premium is not a risk premium expected by a rational and efficient market.
It is a surprise.
See Table 2 in E. Fama and K. French "The Cross-section of Expected Stock Returns," The Journal of Finance, June 1992.
