On the following page is an excerpt of a table replicated from The cross-section of expected stock returns (Journal of Finance, Fama and French(1992)). Interpret the relevant section in the table and explain the manifestation of why Fama and French suggest that the CAPM should be augmented with Book-to-Market to describe stock returns in the cross-section.

 

Transcribed Image Text:

Table IV Properties of Portfolios Formed on Book-to-Market Equity (BE/ME) and Earnings-Price Ratio (E/P): July 1963 to December 1990 at the end of each year t-1, 12 portfolios are formed on the basis of ranked values of BE/ME or E/P. Portfolios 2-9 cover deciles of the ranking ariables. The bottom and top 2 portfolios (LA, 1B, 10A, and 10B) split the bottom and top deciles in half. For E/P, there are 13 portfolios; portfolio 0 s stocks with negative E/P. Since BE/ME and E/P are not strongly related to exchange listing, their portfolio breakpoints are determined on the asis of the ranked values of the variables for all stocks that satisfy the CRSP-COMPUSTAT data requirements. BE is the book value of common quity plus balance-sheet deferred taxes, A is total book assets, and E is earnings (income before extraordinary items, plus income-statement eferred taxes, minus preferred dividends). BE, A, and E are for each firm's latest fiscal year ending in calendar year t-1. The accounting ratios re measured using market equity ME in December of year - 1. Firm size In(ME) is measured in June of year t, with ME denominated in millions f dollars. We calculate each portfolio's monthly equal-weighted return for July of year t to June of year t + 1, and then reform the portfolios at the nd of year t. Return is the time-series average of the monthly equal-weighted portfolio returns (in percent). In(ME), In(BE/ME). In(A/ME), In(A/BE), E(+)/P, and E/P dummy are the time-series averages of the monthly average values of these variables in each portfolio Since the E/P dummy is 0 when arnings are positive, and 1 when earnings are negative, E/P dummy gives the average proportion of stocks with negative earnings in each ortfolio. 8 is the time-series average of the monthly portfolio 3s. Stocks are assigned the post-ranking 3 of the size-8 portfolio they are in at the end of June year (Table 1). These individual-firm ßs are averaged to compute the monthly as for each portfolio for July of year t to June of year t + 1. Firms is the average number of stocks in the portfolio each month. Portfolio 0 1A Return B In(ME) In(BE/ME) In(A/ME) In(A/BE) E/P dummy E(+)/P Firms 0.30 1.36 4.53 -2.22 - 1.24 0.94 0.29 0.03 89 1B 0.67 1.34 4.67 -1.51 -1.09 -0.79 <<-0.40 0.71 0.15 0.04 2 3 Panel A: Stocks Sorted on Book-to-Market Equity (BE/ME) 0.87 0.97 1.30 1.44 1.50 1.27 1.27 1.32 1.30 1.27 4.69 4.56 -0.75 <-0.14 4.23 4.06 3.85 0.03 0.21 0.56 0.71 0.91 -0.05 0.70 0.68 0.70 0.09 0.09 0.11 0.11 0.12 235 239 98 0.68 0.10 0.06 209 0.70 0.08 0.08 222 4 1.04 1.28 4.47 -0.51 0.20 0.71 0.08 0.09 226 5 1.17 1.27 4.38 -0 32 0.40 0.71 0.08 0.10 230 6 7 0.11 237 9 1.59 1.29 3.51 0.42 1.12 0.70 0.15 0.12 239 10A 1.92 1.33 3.06 0.66 1.35 0.70 0.22 0.11 120 10B 1.83 1.35 2.65 1.02 1.75 0.73 0.36 0.10 117 Table IV Properties of Portfolios Formed on Book-to-Market Equity (BE/ME) and Earnings-Price Ratio (E/P): July 1963 to December 1990 at the end of each year t-1, 12 portfolios are formed on the basis of ranked values of BE/ME or E/P. Portfolios 2-9 cover deciles of the ranking ariables. The bottom and top 2 portfolios (LA, 1B, 10A, and 10B) split the bottom and top deciles in half. For E/P, there are 13 portfolios; portfolio 0 s stocks with negative E/P. Since BE/ME and E/P are not strongly related to exchange listing, their portfolio breakpoints are determined on the asis of the ranked values of the variables for all stocks that satisfy the CRSP-COMPUSTAT data requirements. BE is the book value of common quity plus balance-sheet deferred taxes, A is total book assets, and E is earnings (income before extraordinary items, plus income-statement eferred taxes, minus preferred dividends). BE, A, and E are for each firm's latest fiscal year ending in calendar year t-1. The accounting ratios re measured using market equity ME in December of year - 1. Firm size In(ME) is measured in June of year t, with ME denominated in millions f dollars. We calculate each portfolio's monthly equal-weighted return for July of year t to June of year t + 1, and then reform the portfolios at the nd of year t. Return is the time-series average of the monthly equal-weighted portfolio returns (in percent). In(ME), In(BE/ME). In(A/ME), In(A/BE), E(+)/P, and E/P dummy are the time-series averages of the monthly average values of these variables in each portfolio Since the E/P dummy is 0 when arnings are positive, and 1 when earnings are negative, E/P dummy gives the average proportion of stocks with negative earnings in each ortfolio. 8 is the time-series average of the monthly portfolio 3s. Stocks are assigned the post-ranking 3 of the size-8 portfolio they are in at the end of June year (Table 1). These individual-firm ßs are averaged to compute the monthly as for each portfolio for July of year t to June of year t + 1. Firms is the average number of stocks in the portfolio each month. Portfolio 0 1A Return B In(ME) In(BE/ME) In(A/ME) In(A/BE) E/P dummy E(+)/P Firms 0.30 1.36 4.53 -2.22 - 1.24 0.94 0.29 0.03 89 1B 0.67 1.34 4.67 -1.51 -1.09 -0.79 <<-0.40 0.71 0.15 0.04 2 3 Panel A: Stocks Sorted on Book-to-Market Equity (BE/ME) 0.87 0.97 1.30 1.44 1.50 1.27 1.27 1.32 1.30 1.27 4.69 4.56 -0.75 <-0.14 4.23 4.06 3.85 0.03 0.21 0.56 0.71 0.91 -0.05 0.70 0.68 0.70 0.09 0.09 0.11 0.11 0.12 235 239 98 0.68 0.10 0.06 209 0.70 0.08 0.08 222 4 1.04 1.28 4.47 -0.51 0.20 0.71 0.08 0.09 226 5 1.17 1.27 4.38 -0 32 0.40 0.71 0.08 0.10 230 6 7 0.11 237 9 1.59 1.29 3.51 0.42 1.12 0.70 0.15 0.12 239 10A 1.92 1.33 3.06 0.66 1.35 0.70 0.22 0.11 120 10B 1.83 1.35 2.65 1.02 1.75 0.73 0.36 0.10 117

Answer rating: 100% (QA)

The table shows the average returns of portfolios formed on size and booktomarket equity The returns ... View the full answer