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

What explains cross-sectional dispersion in stock valuation ratios? We find that over 70% of dispersion in valuation ratios is reflected in differences in future returns, while less than 30% is reflected in differences in future earnings growth. We show a similar dominance of future returns for explaining the dispersion in return surprises. Existing models based on risk premia struggle to match these results, whereas models based on mispricing perform better. We reconcile these conclusions with previous literature showing that prices strongly predict profitability. The lack of earnings growth differences at long horizons provides new evidence in favor of return predictability.

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?  [February 2023] [R&R at RFS] (with Sean Myers)

We present a method for determining whether errors in expectations explain asset pricing puzzles without imposing assumptions about the mechanism of the error. Using accounting identities and survey forecasts, we find that errors in expected long-term inflation and short-term nominal earnings growth explain price variation, return predictability, and the rejection of the expectations hypothesis for aggregate stock and bond markets. Errors in expected short-term inflation and long-term nominal earnings growth play no role. The relevant errors are consistent with mistakes about both the persistence of forecasted variables and the response to surprises. A fundamental extrapolation model 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 Cross-Section of Subjective Expectations: Understanding Prices and Anomalies  [December 2022] (with Xiao Han and Sean Myers)

Using survey forecasts, we find that subjective expectations of earnings growth and price growth account for over 90% of cross-sectional variation in stock price-earnings ratios. This is largely due to expected earnings growth, which is more volatile and more correlated with P/E ratios than expected price growth. Due to forecasters consistently overestimating the earnings growth of high P/E firms, errors in expected earnings growth account for 36-43% of all cross-sectional variation in P/E ratios. In contrast to previous findings for the aggregate market, in the cross-section forecasters correctly expect lower price growth for high P/E stocks but understate the magnitude of the relationship. Using 22 anomaly characteristics, we decompose realized price growth on anomaly portfolios and find that expected price growth plays only a minor role. Instead, realized price growth for anomaly portfolios is largely explained by errors in expected earnings growth.

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