Some background on Bond duration: Duration measures bond’s price sensitivity to interest rates changes. It’s estimated based on the discounted expectations of the bond future cash flows and expressed in the number of years. The longer the duration, the higher the bond interest rate risk. (read more: Bond Performance when Interest Rates Spike)
Dechow, Sloan, and Soliman (2004) employs this duration techniques to evaluate equity risks. Following the traditional Macaulay duration, they construct a discounted cash flow forecasting model for stocks as well. Contrary to bonds, stocks do not have a well-defined finite maturity and cash flows are not that predictable. So their formula is built with a finite forecasting period and an infinite terminal value. Their study finds that similar to bonds, stocks with higher cash-flow duration are associated with high return volatilities and betas (i.e., higher risks.)
This recent research by Dr. Weber re-examines the term structure of equity returns. With the primary question being:
At the end of June each year t from 1963 to 2013, Weber sorts stocks into 10 portfolios based on cash-flow duration and rebalances the equal-weighted portfolio on an annual basis.
So now that we’ve recognized that there is variation between low duration and high duration returns we should explore the second main question of this paper, WHY?
Upon further tests, the authors prove that existing risk factors cannot sufficiently explain this low-duration premium. What’s more, the premiums are stronger following periods of high investor sentiment, which indicates that human behavioral might be an explanation.
Weber hypothesizes that analysts tend to extrapolate from past earnings growth into the future. 5 words can explain this premium: Temporary Overpricing of High-duration Stocks.
To test his hypothesis, Weber studies the analyst’s earnings expectations of each of the 10 groups. The table below shows the evolution of the average portfolio long-term earnings growth (LTG) forecast from year 1 to year 5.
- The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.Key points: it’s about “Extrapolation Bias”…
2. All the results show that analysts have overly optimistic earnings expectations for high-duration stocks, but they adjust downwards over time.
Duration has been a key characteristic in the analysis of the bond market for a long time, maybe forever, but it’s a tool that has not been traditionally used by equity investors. This paper has pointed out that although it may be challenging to implement this to realize profits that doesn’t mean that being aware of cash flow durations in equities is a useless metric. 1
The term structure of equity returns is downward-sloping: stocks with high cash flow duration earn 1.10% per month lower returns than short-duration stocks in the cross section. I create a measure of cash flow duration at the firm level using balance sheet data to show this novel fact. Factor models can explain only 50% of the return differential, and the difference in returns is three times larger after periods of high investor sentiment. Analysts extrapolate from past earnings growth into the future and predict high returns for high-duration stocks following high-sentiment periods, contrary to ex-post realizations. I use institutional ownership as a proxy for short-sale constraints, and find the negative cross-sectional relationship between cash flow duration and returns is only contained within short-sale constrained stocks.
Notes:
Short-Duration Stock Anomaly: Risk or Mispricing was originally published at Alpha Architect. Please read the Alpha Architect disclosures at your convenience.