A recent paper, What Factors Drive Global Stock Returns?, by Kewei Hou, G. Andrew Karolyi and Bong Chan Kho of Ohio State University and Seoul National University, narrows down the reasons for divergent performance. After sifting through monthly returns of 26,000 individual stocks from 49 countries (including India) over the 1981 to 2003 period, the authors conclude that these factors are cash flow-to-price and momentum, taken together with a global market risk factor. The emphasis on cash flow-to-price is a bit different from the usual price-to-earnings or price-to-book measures, especially the latter, when valuations are being considered. The authors point out that “there has been some recent research suggesting that the value relevance of accruals — and, thus, earnings — may be greatly weakened in less transparent accounting systems, so that cash flow measures may be more useful predictors”.
What’s interesting, however, is the weight given to momentum. This is a factor that every investor knows is extremely important in the market (it is usually referred to as ‘sentiment’), but, for some reason, it has been short-changed in the academic literature. Hopefully, this study will make amends.
Hedge Funds risks
For a long time now, economists have been predicting (and expecting) that global economic growth would fall victim to a crash in the US dollar triggered by America’s yawning current account deficit. Another crisis that has, similarly, been predicted ad nauseam but has not materialised is that of the bankruptcy of a few large hedge funds.
The doomsayers say that the highly sophisticated trading models used by such funds (mainly investment vehicles for the rich) and their propensity to trade in highly illiquid and opaque markets means that sooner or later at least some of these highly-leveraged funds might go under. Worse, they could take a few large banks with them since the latter have made a big business out of lending to the former. Recently, Raghuram Rajan, chief economist, International Monetary Fund, pointed to the fact that hedge fund managers face strong incentives to take big risks.
However, Norbert Walter, chief economist at Deutsche Bank, which itself is a big player in the hedge fund lending business, begs to differ. While in Mumbai last week, he said that the number of hedge funds had increased enormously over the last few years. The idea that all of them will take the same bet on a particular market isn’t likely. The range and diversity of their trading strategies means that even if some of them get hit if, say, the market for options on Ecuadorean electricity utility bonds collapses, there are more than enough funds who have taken the opposite set of bets. This means that some funds will go under, while others will make a killing. There is little risk of a ‘systemic’ collapse.
I buy expensive suits. They just look cheap on me. – Warren Buffett :))