Working Paper: CEPR ID: DP4921
Authors: Martin Lettau; Jessica Wachter
Abstract: This paper proposes a dynamic risk-based model that captures the high expected returns on value stocks relative to growth stocks, and the failure of the capital asset pricing model to explain these expected returns. To model the difference between value and growth stocks, we introduce a cross-section of long-lived firms distinguished by the timing of their cash flows. Firms with cash flows weighted more to the future have high price ratios, while firms with cash flows weighted more to the present have low price ratios. We model how investors perceive the risks of these cash flows by specifying a stochastic discount factor for the economy. The stochastic discount factor implies that shocks to aggregate dividends are priced, but that shocks to the time-varying price of risk are not. As long-horizon equity, growth stocks co-vary more with this time-varying price of risk than value stocks, which co-vary more with shocks to cash flows. When the model is calibrated to explain aggregate stock market behaviour, we find that it can also account for the observed value premium, the high Sharpe ratios on value stocks relative to growth stocks, and the out-performance of value (and underperformance of growth) relative to the CAPM.
Keywords: duration; growth; habit formation; value
JEL Codes: G10; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| cash flow timing (D25) | expected returns (G17) |
| CAPM fails to account for value premium (G19) | expected returns on value stocks (G12) |
| shocks to near-term dividends (G35) | investor risk perception (G11) |
| investor risk perception (G11) | pricing of long-horizon equity (G12) |
| cash flows weighted towards the future (D25) | higher price ratios (P22) |
| cash flows weighted towards the present (G19) | lower price ratios (G19) |
| growth stocks covary more with time-varying price of risk (G17) | seen as riskier than value stocks (G11) |
| value stocks covary more with shocks to cash flows (G12) | seen as less risky than growth stocks (G12) |