Working Paper: NBER ID: w11144
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 covary more with this time-varying price of risk than value stocks, which covary more with shocks to cash flows. When the model is calibrated to explain aggregate stock market behavior, 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 outperformance of value (and underperformance of growth) relative to the CAPM.
Keywords: Value Premium; Growth Stocks; Risk-Based Model; Stochastic Discount Factor
JEL Codes: G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| lower sensitivity to time-varying price risks (G19) | high expected returns on value stocks (G12) |
| greater betas with respect to shocks to near-term dividends (C46) | value stocks (G12) |
| greater betas with respect to changes in expected dividend growth (C46) | growth stocks (G31) |
| risk premium for long-horizon equity < risk premium for short-horizon equity (G12) | observed value premium (G19) |
| differential correlations of value and growth portfolios with underlying economic shocks (G19) | observed value premium (G19) |