The Anatomy of Fluctuations in Book/Market Ratios

The Anatomy of Fluctuations in Book/Market Ratios We analyze trading activity accompanying equities' year-to-year switches from " growth " (low book-to-market ratios) to " value " (high book-to-market ratios), and vice versa. We find that a large book/market ratio increase, i.e., a shift from growth to value, is accompanied by a strongly negative small-trade order imbalance. Large-trade imbalance exhibits weaker patterns across stocks that experience large changes in book/market. The evidence indicates that growth-to-value shifts are more strongly related to small traders than large ones. The interaction of book/market ratios with order flows plays a crucial role in return predictability. Specifically, the predictive ability of book/market ratios for future returns is significantly enhanced for those stocks that have experienced book/market increases as well as high levels of net selling by way of small orders. 2 1 Introduction The notion that the cross-section of stock returns can be driven by behavioral considerations has taken increased impetus in recent years. While early empirical studies by Black, Jensen, and Scholes (1972) and Fama and MacBeth (1973) suggest a significant positive cross-sectional relation between security betas and expected returns, supporting the capital asset pricing model find that the relation between return and market beta is insignificant. 1 This calls into question the empirical importance of rational links between risk and expected returns. On the importance of characteristics other than those directly related to risk-return models, the evidence is much more compelling. The landmark study by Fama and French (1992) finds that size and the book/market ratio strongly predict future returns (returns are negatively related to size and positively to book/market). Fama and French (1993) provide evidence that a three-factor model based on factors formed on the size and book-market characteristics explains average returns, and argue that the characteristics compensate for " distress risk. " But Daniel and Titman (1997) argue that, after controlling for size and book/market ratios, returns are not strongly related to betas calculated based on the Fama and French (1993) factors (see, however, 1 Internationally, Rouwenhorst (1999) finds no significant relation between average return and beta with respect to the local market index. Tests of the consumption-based capital asset pricing model (Breeden (1979)) have also led to inconclusive results; see, for example, Hansen and Singleton (1983). Jagannathan and Wang (1996) find a modest positive relation between conditional beta and expected returns when the market is expanded to include human capital. 3 …