Zhi Da

Dividend Smoothing and Predictability

The relative predictability of returns and dividends is a central issue because it forms the paradigm to interpret asset price variation. A little studied question is how dividend smoothing, as a choice of corporate policy, affects predictability. We show that even if dividends are supposed to be predictable without smoothing, dividend smoothing can bury this predictability. Because aggregate dividends are dramatically more smoothed in the postwar period than before, the lack of dividend growth predictability in the postwar period does not necessarily mean that there is no cash flow news in stock price variations; rather, a more plausible interpretation is that dividends are smoothed. Using two alternative measures that are less subject to dividend smoothing---net payout and earnings---we reach the consistent conclusion that cash flow news plays a more important role than discount rate news in price variations in the postwar period. This paper was accepted by Wei Xiong, finance.

A Closer Look at the Short-Term Return Reversal

Stock returns unexplained by “fundamentals,” such as cash flow news, are more likely to reverse in the short run than those linked to fundamental news. Making novel use of analyst forecast revisions to measure cash flow news, a simple enhanced reversal strategy generates a risk-adjusted return four times the size of the standard reversal strategy. Importantly, isolating the component of past returns not driven by fundamentals provides a cleaner setting for testing existing theories of short-term reversals. Using this approach, we find that both liquidity shocks and investor sentiment contribute to the observed short-term reversal, but in different ways: Specifically, the reversal profit is attributable to liquidity shocks on the long side because fire sales more likely demand liquidity, and it is attributable to investor sentiment on the short side because short-sale constraints prevent the immediate elimination of overvaluation. This paper was accepted by Brad Barber, finance.

When the Bellwether Dances to Noise: Evidence from Exchange-Traded Funds

We provide novel empirical evidence that arbitrageurs transmit non-fundamental shocks from exchange-traded funds (ETFs) to the broad cross-section of stocks they hold, thus making these shocks systematic. Using a large sample of US equity ETFs from 2006 to 2012, we find a strong relation between measures of ETF activity and return comovement at both the fund level and the stock level, after controlling for time and stock fixed effects and a host of other controls including institutional trading. ETF trading activity increases a stock’s exposure to sentiment risk and makes its loading on lagged market return more negative, suggesting that at least some return comovement is excessive. The effect of ETF activity is stronger among small and illiquid stocks and during periods of turbulent markets. The link between ETF activity and return comovement weakens immediately following the recent flash crash as many high frequency traders who are natural ETF arbitrageurs chose to stay on the sidelines. ∗Mendoza College of Business, University of Notre Dame, Notre Dame, IN 46556. Tel. 574-631-8301. Fax. 574631-5544. Email zda@nd.edu or sshive1@nd.edu. Thanks to participants in the State of Indiana Finance Conference and seminar at University of Notre Dame, Malcom Baker, Robert Battalio, Martijn Cremers, Ben Golez, Robin Greenwood, Paul Schultz, Mao Ye, and Xiaoyan Zhang. Errors are ours.We provide novel evidence supporting the notion that arbitrageurs can contribute to return comovement via exchange trade funds (ETF) arbitrage. Using a large sample of US equity ETF holdings, we document the link between measures of ETF activity and return comovement at both the fund and the stock levels, after controlling for a host of variables and fixed effects and by exploiting the ‘discontinuity’ between stock indices. The effect is also stronger among small and illiquid stocks. An examination of ETF return autocorrelations and stock lagged beta provides evidence for price reversal, suggesting that some ETF†driven return comovement may be excessive.

Household Production and Asset Prices

We empirically examine the asset pricing implications of the Beckerian framework of household production, where utility is derived from both market consumption and home produced goods. We propose residential electricity usage as a real-time proxy for the service flow from household capital, because electricity is used in most modern-day household production activities and it cannot be easily stored. Using U.S. residential electricity usage from 1955 to 2012, our model based on household production explains the equity premium and the cross section of expected stock returns (including those of industry portfolios) with an R 2 of 71%. This paper was accepted by Jerome Detemple, finance.

Exchange Traded Funds and Asset Return Correlations

We provide novel evidence supporting the notion that arbitrageurs can contribute to return comovement via exchange trade funds (ETF) arbitrage. Using a large sample of US equity ETF holdings, we document the link between measures of ETF activity and return comovement at both the fund and the stock levels, after controlling for a host of variables and fixed effects and by exploiting the ‘discontinuity’ between stock indices. The effect is also stronger among small and illiquid stocks. An examination of ETF return autocorrelations and stock lagged beta provides evidence for price reversal, suggesting that some ETF‐driven return comovement may be excessive.

Industrial Electricity Usage and Stock Returns

The growth rate of industrial electricity usage predicts future stock returns up to 1 year with an R 2 of 9%. High industrial electricity usage today predicts low stock returns in the future, consistent with a countercyclical risk premium. Industrial electricity usage tracks the output of the most cyclical sectors. Our findings bridge a gap between the asset pricing literature and the business cycle literature, which uses industrial electricity usage to gauge production and output in real time. Industrial electricity growth compares favorably with traditional financial variables, and it outperforms Cooper and Priestley’s output gap measure in real time.

Building Castles in the Air: Evidence from Industry IPO Waves

We provide novel evidence supporting the view that stock prices of some firms in the early growth stage of their life cycle are set by optimistic investors fixated on sales growth. We identify these firms as those that went public during an industry IPO waves, had high sales growths but low gross margins in the first three years following the IPO. Consistent with overpricing, their stocks under-perform their peers by 0.92% per month during the subsequent four year period on a risk-adjusted basis, suggesting limits to arbitrage. This pattern is unrelated to the well documented long-run under-performance of IPOs.

What Drives Target Price Forecasts and Their Investment Value

This paper examines the informativeness of analysts’ target price forecasts by relating the investment value of target prices to their primary drivers. Decomposing target price forecasts into near-term earnings forecasts and price-to-earnings ratio forecasts, we show that target price revisions reflect information from both components. In addition, we also find that the relative importance of each component in target price revisions is related to firm characteristics. A portfolio based on target price implied expected returns delivers significant abnormal returns. More importantly, we find that the abnormal returns are associated with both earnings and price-to-earnings forecasts, which suggests that the informativeness of target price forecasts comes not only from analysts’ ability to forecast short-term earnings but also from their ability to assess risk and long-term growth prospect implied in price-to-earnings forecasts.

Arbitrage Trading: The Long and the Short of It

We examine net arbitrage trading (NAT) measured by the difference between quarterly abnormal hedge fund holdings and abnormal short interest. NAT strongly predicts stock returns in the cross-section. Across ten well-known stock anomalies, abnormal returns are realized only among stocks experiencing large NAT. Exploiting Regulation SHO, which facilitated short selling for a random group of stocks, we present causal evidence that NAT has stronger return predictability among stocks facing greater limits to arbitrage. We also find large returns for anomalies that arbitrageurs chose to exploit despite capital constraints during the 2007–09 financial crisis. We confirm our findings using daily data.Received September 1, 2016; editorial decision May 28, 2018 by Editor Andrew Karolyi. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Coordinated Noise Trading: Evidence from Pension Fund Reallocations

We document a novel channel through which coordinated noise trading exerts externalities on financial markets dominated by institutional investors. We exploit a unique set of events where Chilean pension fund investors followed an influential financial advisory firm that recommended frequent switches between equity and bond funds. The recommendations, which mostly followed short-term trends, generated large and coordinated fund flows. These flows resulted in substantial price pressure and increased volatility in financial markets. Pension funds increased cash holdings as a response. Our findings suggest that giving retirement savers unconstrained reallocation opportunities may exert negative externalities on financial markets.