Expected Returns and the Cross-Sectional Skewness of Book-to-Market Ratios

The skewness of the cross-sectional distribution of book-to-market ratios is shown to be an important state variable. It varies through time in correlation with the business cycle and with indicators of investor sentiment. When times are ‘good’ a tail of low book-to-market stocks causes a left skew in the distribution. In ‘bad’ times high book-to-market stocks make the distribution more symmetric. The variable is valuable for forming conditional expectations for returns on various long-short strategies. These include ones based on firm characteristics such as size, age, volatility, profitability and dividend payment, and ones based on book-to-market and momentum. It is also instrumental in predicting the excess return on the equal-weighted market portfolio. Significant predictive ability remains even when controlling for other proxies for investor sentiment and for macroeconomic conditions. August 13, 2008 *** JOB MARKET PAPER *** † University of California at Los Angeles, Anderson School of Management. [email protected]. I am grateful to Shlomo Benartzi, Avanidhar Subrahmanyam, Richard Roll, Mark Grinblatt, Alessio Saretto, Itzhak Ben-David and Nicholas Barberis for their excellent comments. I also thank the participants of the UCLA and UC Irvine finance seminars, and my colleagues, Yuzhao Zhang and Albert Sheen for great discussions. USC FBE FINANCE SEMINAR presented by Ehud Peleg FRIDAY, Sept. 12, 2008 10:30 am – 12:00 pm, Room: JKP-202