The cross section of expected holding period returns and their dynamics: A present value approach

• Published in: Journal of financial economics Vol. 116; no. 3; pp. 505 - 525
• Main Authors: Lyle, Matthew R., Wang, Charles C.Y.
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.06.2015; Elsevier Sequoia S.A
• Subjects: Accounting data; Cross-sectional analysis; Discount rates; Economic forecasts; Economic models; Economic theory; Expected returns; Financial economics; Fundamental valuation; Holding period returns; Present value; Profitability; Regression analysis; Return on equity; Studies; Time series; Discount rates; Accounting data; G11; Expected returns; Holding period returns; G12; M41; Fundamental valuation; G17; Present value
• ISSN: 0304-405X; 1879-2774
• DOI: 10.1016/j.jfineco.2015.03.001

We provide a tractable model of firm-level expected holding period returns using two firm fundamentals—book-to-market ratio and return on equity—and study the cross-sectional properties of the model-implied expected returns. We find that firm-level expected returns and expected profitability are time-varying but highly persistent and that forecasts of holding period returns strongly predict the cross section of future returns up to three years ahead. We show a highly significant predictive pooled regression slope for future quarterly returns of 0.86. The popular factor-based expected return models have either an insignificant or a significantly negative association with future returns. In supplemental analyses, we show that these forecasts are also informative of the time series variation in aggregate conditions. For a representative firm, the slope of the conditional expected return curve is more positive in good times, when expected short-run returns are relatively low, and the model-implied forecaster of aggregate returns exhibits modest predictive ability. Collectively, we provide a simple, theoretically motivated, and practically useful approach to estimating multi-period-ahead expected returns.