Essay on Stock Market Predictability

Essay on Stock Market Predictability

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I will now examine the effectiveness of the Book to Market ratio in predicting stock market returns. The Book to Market ratio is used to compare the book value and the market value of the firm. The book value is calculated by the firm’s accounting worth. The market value is determined by the market capitalization in the stock market. It is then found using the formula, Book Value of the firm / Market Value of the firm. Its purpose is to identify any securities that may be undervalued or overvalued. From the research of Fama and French (1992), we can see the cross sectional variation in stock returns can be shown by the book to market ratio of individual stocks. In Pontiff (1998), there were two measures of the book to market ratio that were used. One was the Dow Jones Industrial Average (DJIA) and the other was the Standard and Poor (S&P) Index. The DJIA book to market ratio’s ability of prediction is more precise for the years prior to 1960 while the S&P book to market ratio gives a predictive ability for the period after 1960. However, S&P’s relation is dramatically weaker than DJIA’s findings for the period before 1960 (Pontiff 1998, Page 141). A major reason for the book to market ratio’s ability to predict stock market returns is that book value acts as a proxy for future cash flows. We know that if we divide a cash flow proxy by the current market price, a variable is produced that can be correlated with future market returns. If better proxies are used, the correlation is even greater. Dividing the book value which is considered to be a future cash flow proxy by the price level or the market value gives us a proxy for the discount rate. If we take an aggregate measure of the book to market ratio, we can say that it predicts...

... middle of paper ... return predictability: is it there? Review of Financial Studies 20(3), 651−707.

Fama, E.F., French, K.R., 1988. Dividend yields and expected stock returns. Journal of Financial Economics 22(1), 3−25.

Fama, E.F., 1991. Efficient capital markets: II. Journal of Finance 46(5), 1575−1617.

Goyal, A., Welch, I., 2003. Predicting the equity premium with dividend ratios. Management Science 49(5), 639−654.

Goyal, A., Welch, I., 2008. A comprehensive look at the empirical performance of equity premium prediction. Review of Financial Studies 21(4), 1455–1508.

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Rapach, D. E., Wohar, M.E., 2006. In-sample vs. out-of-sample tests of stock return predictability in the context of data mining. Journal of Empirical Finance 13(2), 231–247.

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