Subjective Cash Flow and Discount Rate Expectations [June 2021] [ Journal of Finance] [Working paper version](with Sean Myers)  Data    

Why do stock prices vary? Using survey forecasts, we find that cash flow growth expectations explain most movements in the S&P 500 price-dividend and price-earnings ratios, accounting for at least 93% and 63% of their variation. These expectations comove strongly with price ratios, even when price ratios do not predict future cash flow growth. In comparison, return expectations have low volatility and small comovement with price ratios. Short-term, rather than long-term, expectations account for most price ratio variation. We propose an asset pricing model with beliefs about earnings growth reversal that accurately replicates these cash flow growth expectations and dynamics.

Survey expectations of dividend growth (blue) vary substantially over time and strongly comove with the S&P 500 price-dividend ratio (red). Survey expectations of returns (green) are relatively flat over time and have low comovement with the price-dividend ratio. 

Working papers

The Cross-Section of Subjective Expectations: Understanding Prices and Anomalies  [August 2023] (with Xiao Han and Sean Myers)

We propose a structural model of constant gain learning about future earnings growth that incorporates preferences for the timing of cash flows. As implied by the model, a cross-sectional decomposition using survey forecasts shows that high price-earnings ratios are accounted for by both low expected returns and overly high expected earnings growth. The model quantitatively matches a number of asset pricing moments, as learning about growth interacts strongly with the preference for the timing of cash flows, and provides insights on the roles of risk premia and mispricing in the cross-section of stocks. The magnitudes and timing of the comovement between prices, earnings growth surprises, and anomaly returns are all consistent with a gradual learning process rather than expectations being highly sensitive to the most recent realization. Large earnings growth surprises do not immediately translate into large one-period returns, but instead are gradually reflected in future returns over time. 

Stocks with higher P/E ratios are expected to have higher earnings growth and lower returns. These earnings growth expectations are overly high, which leads the realized returns on high P/E stocks to be even lower than expected. A model with constant gain learning about mean firm earnings growth and preferences for the timing of cash flows can match both the realized and expected dynamics of prices, returns, and earnings growth.

The Return of Return Dominance: Decomposing the Cross-Section of Prices: [June 2023] (with Xiao Han and Sean Myers)

2023 Jacobs Levy Center Research Paper Prize for Best Paper, 2023 Marshall Blume Prize in Financial Research 

What explains cross-sectional dispersion in stock valuation ratios? We find that 75% of cross-sectional dispersion in valuation ratios is reflected in differences in future returns, while only 25% is reflected in differences in future earnings growth. We show a similar dominance of predicted returns for explaining the dispersion in return surprises. The lack of earnings growth differences at long horizons provides new evidence in favor of long-run return predictability. We reconcile these conclusions with previous literature which has found a strong relation between prices and future profitability. Our results support models in which the cross-section of stock valuation ratios is driven mainly by discount rates or mispricing rather than future earnings growth. Evaluating five models of the value premium, we find that models based on risk premia struggle to match our results, whereas models based on mispricing perform better.

Cross-sectional differences in stock P/E ratios are mainly explained by expensive stocks having lower future returns and higher future P/E ratios rather than higher future earnings growth. As the horizon increases, the importance of the future P/E ratio declines and is largely replaced by a bigger role for future returns. 

Which Subjective Expectations Explain Asset Prices?  [July 2023] [Conditionally accepted at RFS] (with Sean Myers)

2023 Driehaus Center for Behavioral Finance Research Prize 

We present a method for determining whether errors in expectations explain asset pricing puzzles without imposing assumptions about the error mechanism. Using accounting identities and survey forecasts, we find that errors in expected long-term inflation explain price variation, return predictability, and the rejection of the expectations hypothesis for aggregate stock and bond markets. Errors in short-term (long-term) nominal earnings growth expectations explain (do not explain) stock price variation and return predictability. The relevant errors are consistent with mistakes about the persistence of forecasted variables and the response to surprises. A simple framework based on fundamental extrapolation successfully replicates these findings.

Survey expectations of long-term inflation are volatile, moving almost 1-1 with expectations of short-term inflation. In contrast, for survey expectations of S&P 500 nominal earning growth, almost of all of the movements occur in short-term expectations. 

The Effect of Buybacks on Capital Allocation [March 2022] 

This paper studies the macroeconomic effects of a 1982 SEC rule that made share buybacks a viable alternative to dividends for paying out funds to shareholders. I propose a quantitative model of heterogeneous firms with dividend adjustment costs and a manager-shareholder conflict, matched to micro data on US corporations’ cash flow statements. The flexibility of buybacks reduces capital misallocation. This is not only because investors can more easily shift resources to more productive firms, but also because stock prices become more responsive to productivity and thus help align incentives of managers and shareholders. This "stock price channel" allows the model to not only account for a decline in investment and increase in productivity, but also the increase in corporate cash holdings over the last decades.

Corporate capital and cash allocations before and after SEC rule 10b18, which spurred the use of buybacks. The horizontal axis shows firm productivity distribution. Buybacks reduce capital misallocation, reduce aggregate investment, and increase aggregate cash holdings.

Employment Dynamics and Monetary Policy for Emerging Economies under Informality  [October 2019] (with Stephen McKnight)

This paper investigates the role of labor informality in the propagation of transitory shocks and its implications for interest rate policy in preventing self-fulfilling inflation expectations. We develop a dynamic New Keynesian model where the size of the informal sector reacts to search and matching frictions in the formal sector, which can account for the observed behavior of formal and informal employment in Mexico. We show that informality reduces the volatility of aggregate consumption and employment, but investment volatility increases. While informality amplifies the propagation of demand shocks on inflation, it dampens the response of output, weakening the transmission mechanism of monetary policy to output. For interest-rate feedback rules that react to formal measures of inflation, we find that informality significantly restricts the ability of the Taylor principle to ensure determinacy. However, we show that determinacy can be restored when policy also responds to formal output.

Work in progress

Corporate Payouts and the Business Cycle