Abstract:This paper uses a Markov chain model to test the random walk hypothesis of stock prices. Given a time series of returns, a Markov chain is defined by letting one state represent high returns and the other represent low returns. The random walk hypothesis restricts the transition probabilities of the Markov chain to be equal irrespective of the prior years. Annual real returns are shown to exhibit significant nonrandom walk behavior in the sense that low (high) returns tend to follow runs of high (low) returns in the postwar period.

“Mean Reverting Stock Prices Revisited,” Journal of Financial and Quantitative Analysis Vol. 27, March 1992, pp. 1-18.

Abstract:This paper reexamines long-horizon stock returns and finds that previous work overstates the evidence of mean reversion. The overstatement is largely due to the implicit weighting of ordinary least-squares tests, which place more weight on the Depression and World War II observations, which have both large error variances and stronger mean-reverting tendencies. Additionally, the reliance on asymptotic statistics and the improper focus on only the most negative estimates of mean reversion contribute to the overstatement. Using generalized least-squares randomization tests on the 1926 to 1987 period, the random walk cannot be rejected for value- or equally-weighted real returns at any of 10 return horizons or by joint tests over all 10 horizons simultaneously. Additionally, the random walk cannot be rejected for the extended 1871 to 1987 period.

“Tests of the Nominal Contracting Hypothesis Using Stocks and Bonds of the Same Firms,” The Journal of Banking and Finance Vol. 16, June 1992, pp. 477-496, (with Eric Chang and J. Michael Pinegar).

Abstract:We test the nominal contracting hypothesis by examining the price responses of stocks and long-term bonds issued by the same firms to inflation surprises. We fail to find evidence that unexpected inflation transfers wealth to real from nominal contract holders, i.e., to stockholders from bondholders. An alternative interpretation of previous tests that seemingly support the nominal contracting hypothesis is proposed, based on firms’ asset rather than liability structures. Out test results and alternative interpretation suggest caution in ascribing to nominal contracts major intrafirm wealth redistribution due to unexpected inflation.

“Asymmetric Business Cycle Turning Points,” Journal of Monetary Economics Vol. 31, June 1993, pp. 341-362, (with Steven Thorley).

Abstract:This paper presents evidence that business cycles are characterized by ‘sharp’ troughs and ‘round’ peaks. Changes in growth rates surrounding NBER troughs are found to be larger than changes surrounding peaks, and the probability of a direct contraction to recovery transition is found to be higher than the probability of a direct recovery to contraction transition. These findings suggest caution in interpreting empirical tests of economic series that assume symmetry and motivate theoretic models in which additions to capacity, production, and employment at the end of a recession are not mirror images of the cutbacks at the end of an expansion.

“Stock Prices, News, and Business Cycles,” The Review of Financial Studies Vol. 6, No. 3, 1993, pp. 683-707, (with V. Vance Roley).

Abstract:Previous research finds that fundamental macroeconomic news has little effect on stock prices. We show that after allowing for different stages of the business cycle, a stronger relationship between stock prices and news is evident. In addition to stock prices, we examine the effect of real activity news on proxies for expected cash flows and equity discount rates. We find that when the economy is strong the stock market responds negatively to news about higher real economic activity. This negative relation is caused by the larger increase in discount rates relative to expected cash flows.

“Bubbles, Stock Returns, and Duration Dependence,” Journal of Financial and Quantitative Analysis Vol. 29, September 1994, pp. 379-401, (with Steven Thorley).

Abstract:A new testable implication is derived from the rational speculative bubbles model stating that the presence of bubbles implies positive duration dependence in runs of high returns. Specifically, the probability of observing an end to a run of high returns declines with the length of the run. Traditional duration dependence tests are adapted for use with discrete stock runs data and, consistent with the existence of bubbles, evidence of duration dependence in monthly real stock returns is found.

“REITs, Inflation, and Real Activity: Lessons from the Gold Market,” The Journal of Real Estate Finance and Economics Vol. 10, No. 3, 1995, pp. 285-297, (with Alan Larson).

Abstract:This study indirectly tests whether equity Real Estate Investment Trust (REITs) proxy for real estate when examining real estate’s inflation hedging ability. The hedging properties of gold, an underlying asset, are compared against those of gold stocks, a securitized form of the asset, and gold is shown to perform well as an inflation hedge, while gold stocks do not. This divergence between an asset and its securitized form suggests caution in drawing conclusions about real estate’s ability to hedge inflation from equity REIT studies.

“Geneva Steel: Initial Public Offering Case,” Journal of Financial Education Vol. 22, Spring 1996, pp. 82-100, (with Brent Wilson).

Abstract:The focus of this case is for the students to determine an offering price for the IPO of Geneva Steel. The company was created through a leveraged buyout of an operating facility of U.S. Steel. The case describes the history of the operating facilities and the buyout process. After over two years of successful operations, the owners want to issue shares to the public. The number of shares to be issued has been set, and only the offering price remains to be determined. The case includes information on the steel industry, operating and market data for other steel companies, and historic operating information for Geneva Steel. In addition to addressing the valuation, the case provides an opportunity to discuss the IPO underwriting process and terminology.

“Valuing Illiquid Real Property: The Pitfalls of Yield Capitulation,” Journal of Property Tax Management Vol. 6, Issue 4, Spring, 1995, pp. 43-56, (with Robert Crawford and Maxwell Miller).

Abstract:Yield capitalization is frequently used to value illiquid real assets. Among other assumptions, it assumes securities have liquidity and risk profiles similar to tangible real assets. This allows using the CAPM to determine capitalization rates. However, the CAPM method of estimating cap rates has numerous problems, even when dealing with liquid securities. However, when estimating the cap rates required for valuing illiquid and unsecuritized real property, additional adjustments are needed.

“Delayed Reaction to Good News and the Cross-Autocorrection of Portfolio Returns,” Journal of Finance Vol. 51, No. 3, July 1996, pp. 889-920, (with Michael Pinegar and Steven Thorley).

Abstract:We document a directional asymmetry in the small stock concurrent and lagged response to large stock movements. When returns on large stocks are negative, the concurrent beta for small stocks is high, but the lagged beta is insignificant. When returns on large stocks are positive, small stocks have small concurrent betas and very significant lagged betas. That is, the cross-autocorrelation puzzle documented by Lo and MacKinlay (1990a) is associated with a slow response by some small stocks to good, but not to bad, common news. Time series portfolio tests and cross-sectional tests of the delay for individual securities suggest that existing explanations of the cross-autocorrelation puzzle based on data measurement, minor market imperfections, or time-varying risk premiums fail to capture the directional asymmetry in the data.

“The Beta Debate: An Academic’s Perspective,” The Valuation Examiner, a newsletter to members of the National Association of Certified Valuation Analysis, Fourth Quarter, 1993, pp. 2-6.

Abstract:This article discusses the role of Beta and the Capital Asset Pricing Model in valuing businesses. Specifically the article reviews and comments on the Fama and French (1992) criticism of beta and the resulting plethora of journal articles written in support of and in opposition to beta. The style and level of the paper is intended to guide a practitioner reader through the maze of academic studies and to supply a list of key papers for anyone interested in delving deeper into the debate.

“Duration, Immunization, and Volatitlity for Taxable Debt Securities,” in Fixed Income Portfolio Strategies, edited by Frank Fabozzi, Probus Publishing Company, 1989, pp. 167-188, (with Ivan Call, and Roger Clarke).

Abstract:We develop a general closed-form expression for the after-tax duration of a bond with the possibility of an original issue discount, a market discount, an acquisition premium, and a premium. We use this expression to examine the determinants of a bond’s after-tax duration and volatility, to discuss the effects of recent and pending tax laws, and to explore after-tax immunization strategies.

“Spreadsheets,” in Introduction to Financial Management, fifth and sixth edition, McGraw-Hill Book Company, 1991, pp. 613-619.

Abstract:This section of the book first gives a history of computers and spreadsheets in business, second discusses how spreadsheets can help business managers, and third gives a detailed example of how to build a spreadsheet including cell-by-cell formulas.

“Do Investors Learn? Evidence from a Gold Market Anomaly,” The Financial Review, Vol. 32, No. 3, August 1997, pp. 501-526, (with Steven Thorley).

This study finds evidence that supports the investor learning hypothesis using data from the gold market. Consistent with conventional wisdom, the prior returns on an equally-weighted portfolio of gold producing stocks are found to predict gold returns. The predictive power is shown to have diminished since the first public discussion of the anomaly, a finding consistent with the investor hypothesis.

“Does the ‘Dow-10 Investment Strategy’ Beat the Dow Statistically and Economically?” Financial Analysts Journal, Vol. 53, No. 4, July/August, pp. 66-72, (with Kay Shields and Steven Thorley).

A comparison of returns from 1946 to 1995 on a portfolio of the 10 Dow Jones Industrial Average stocks with the highest dividend yields (the Dow-10) with those from a portfolio of all 30 stocks in the DJIA (the Dow-30) shows that the Dow-10 portfolio beats the Dow-30 statistically; that is, the Dow-10 has significantly higher average annual returns. After adjusting for the Dow-10 portfolio’s higher risk, extra transaction costs, and unfavorable tax treatment, however, the Dow-10 does not beat the Dow-30 economically. In some subperiods, Dow-10 performance is economically superior, but the question is how to interpret this information in light of the potential for data mining and investor learning.

“Bubbles and Duration Dependence in Asian Stock Markets,” Pacific-Basin Finance Journal, Vol. 6, No. 1-2, May 1998, (with Kalok Chan and Steven Thorley).

Six Asian stock markets (Hong Kong, Japan, Korea, Malaysia, Thailand, and Taiwan) and the U.S. stock market are evaluated for evidence of rational speculative bubbles using two types of tests. First, the duration dependence and conditional skewess tests of McQueen and Thorley (1994) are used on the complete time series of returns. Second, explosiveness tests are applied to specific episodes of apparent bubbles. In general, the Asian stock returns exhibit some unusual characteristics, but these characteristics do not conform to the predictions of the rational speculative bubbles model.

“Mining Fool's Gold,” Finincial Analysts Journal, Vol. 55, No. 2, March/April, 1999, pp. 61-72, (with Steven Thorley).

We investigate the popular Motley Fool Foolish Four portfolio as a case study in data mining—the practice of developing trading strategies by searching through databases for correlations and patterns. The performance of the Foolish Four portfolio is documented and used to illustrate the mistaken inferences that can plague any investment research project. Using the Foolish Four case study, we show that data mining can be detected by the complexity of the trading rule, the lack of a coherent story or theory, the performance of out-of-sample tests, and the adjustment of returns for risk, transaction costs, and taxes. Finally, we document that the Foolish Four and Dow Ten trading rules have become popular enough to influence selected stock prices at the turn of the year.

“Revisiting the Stock Price Impact of Quality Awards,” Omega, Vol. 27, No. 4, November/December, 1999, pp. 595-604, (with Greg Adams and Kristie Seawright).

In an event study, Hendricks and Singhal (1996) find evidence that firms that win quality awards are further rewarded with a stock price increase on the day of the award announcement. We extend their research and find three reasons why management, owners, and analysts should be cautious about expecting an abnormal return when a firm wins a quality award. First, in our sample of Baldrige Award winners, the evidence of a stock price response on the announcement day is only marginally significant. Second, in the most recent subperiod, 1992 to 1994, we find no evidence of positive abnormal returns. Third, the marginally significant group results are actually driven by just two companies (GM and Federal Express). A company-by-company microanalysis reveals that only 50 percent of the award winners experienced positive abnormal returns. The diminishing stock price response on event day does not necessarily imply a lack of stockholder rewards. Evidence from other studies suggests that the stockholders are rewarded for successful Total Quality Management (TQM) implementation, but the rewards can come long before and after the formal award is presented. From a shareholder value perspective, TQM still matters but the ceremonies may not.

“Don't Fall Into the Data Mine,” Investors Relations Quarterly, Vol. 3, No. 2, Fall, 1999, pp. 18-23, (with Steven Thorley).

We update our "Mining Fool's Gold" (FAJ) paper adding several years of data, tests of the newer version of the Foolish Four (called Foolish 4.1 and 4.2), and fun examples of non-financial data.

“Cross-autocorrelation in Asian Stock Markets,” Pacific-Basin Finance Journal, Vol. 7, No. 5, December, 1999, pp. 471-494, (with Eric Chang and Michael Pinegar).

We evaluate six Asian stock markets (Hong Kong, Japan, Singapore, South Korea, Taiwan, and Thailand) and the U.S. stock market for evidence of cross-autocorrelation. We find some evidence of Lo and MacKinlay's (1990a) cross-autocorrelation in all six of the Asian markets. Specifically, within each country, monthly returns on a portfolio of small stock are correlated with the lagged returns on a portfolio of large stocks. Cross-autocorrelation is strongest in the U.S. and weakest in Singapore and Taiwan, where the lagged response is evident only after conditioning on the direction (up or down) of the market.

After documenting the international evidence of cross-autocorrelation, we report the results of five additional tests designed to shed light on existing explanations of the cross-autocorrelation puzzle and give direction for further research. First, we show that cross-autocorrelation exists after controlling for non-synchronous trading. Second, we do not find much evidence of across-ocean or inter-Asian cross-autocorrelation; monthly returns on portfolios of Asian stocks are generally not correlated with the lagged return on a portfolio of large U.S. stocks or with large stocks in other Asian countries. Third, we confirm McQueen, Pinegar, and Thorley's (1996) finding of directional asymmetry in the U.S., with small stocks responding to lagged good, but not bad, news. However, the directional asymmetry is not universal and is significant only in the U.S. and Taiwan. Fourth, we show that large stocks retain their predictive power in some, but not all, of the markets after correcting for small stock autocorrelation. Fifth, we find that the degree of cross-autocorrelation in monthly returns has not weakened since the market correction of 1987.

“Stock Strategy Performance Claims: Don't Fall Into the Data Mine,” AAII Journal, Vol. 22, No. 2, pp. 2-7, (with Steven Thorley).

This article reprints our "Don't Fall Into the Data Mine," (IRQ) paper adding a discussion of meta-generational mining.

"Some Loans are More Equal than Others: Third-Party Originations and Defaults in the Subprime Mortgage Industry," Real Estate Economics, Vol. 30, No 4, Winter 2002, pp 667-697.

We show how agency problems between lenders (principals) and third-party originators (TPO; agents) imply that TPO-originated loans are more likely to default than similar retail-originated loans. The nature of the agency problem is that TPO's are compensated for writing loans, but are not completely held accountable for the subsequent performance of those loans. Using a hazard model with jointly estimated competing risks and unobserved heterogeneity, we find empirical support for the TPO/default prediction using individual fixed-rate subprime loans with first liens secured by residential real estate originated between January 1, 1996, and December 31, 1998. We find that apparently equal loans (similar ability to pay, option incentives and term) can have unequal default probabilities. We also find that, initially, the agency-cost risk was not priced. At first, the market did not recognize the higher channel risk, since TPO and retail loans received similar interest rates even thought the TPO loans were more likely to default. We also show that this inefficiency was short-lived. As the difference in default rates became apparent, interest rates on TPO loans rose about 50 basis points above otherwise similar retail loans.

"The Effects of Inflation News on High Frequency Stock Returns", forthcoming in the Journal of Business (with Greg Adams, and Bob Wood).

Previous research using daily returns finds conflicting evidence about the relationship between unanticipated inflation (news) and stock returns. We explore the relationship by looking at the response (in minutes and trades) of size-based stock portfolios to unexpected changes in the regularly scheduled Producer Price Index (PPI) and Consumer Price Index (CPI) announcements. In particular, we answer the following three questions: 1) Do stocks respond to inflation news? 2) What is the speed and path of the response? and 3) Is the response stable or does it vary with the economy, the directions of the news, or time?