Profitability, asset investment, and aggregate stock returns

Using U.S. data from the CRSP/Compustat databases, the book-to-market ratio (B/M), profitability, and asset investment are found to exhibit robust joint predictive power for the equity premium, generating out-of-sample R²s of 7%, 20%, and 29%, respectively, in one-quarter-, one-year-, and two-year-ahead predictive regressions. Since profitability and investment are positively correlated with each other yet predict future returns in opposite directions, while B/M and profitability are negatively correlated with each other yet predict future returns in the same direction, the variables’ joint predictive power is much higher than the sum of their standalone counterparts. Just as Fama and French (2006, 2015, 2016) and Hou, Xue, and Zhang (2014, 2015, 2017) show that profitable firms who invest conservatively are associated with high future alphas in the cross section, we find that high aggregate profits and low asset growth precede high aggregate stock returns in the time series. In mid-2016, purely from a valuation standpoint, the stock market already appeared “expensive”—B/M was more than one standard deviation (s.d.) below its historical mean—with a one-year-ahead equity premium forecast of only 2.5%. Yet, since the low B/M was associated with high aggregate profitability (1.2 s.d. above its mean) generated from low aggregate investment (0.38 s.d. below its mean), the forecasted equity premium after incorporating these variables becomes 11.3%, which is much closer to the actual premium of 14.7%. We also find that short-term (long-term) asset growth predicts one-year-ahead (two-year-ahead) stock returns—consistent with firms’ investment decisions being more responsive to changes in discount rates that correspond to the investment’s time horizon. To explain this pattern from a behavioral perspective requires two types of sentiment—one that primarily influences short-term investment and another that affects long-term investment only.