McGraw-Hill

22 Seleaine securities
Pure returns also tend to be much less volatile than their
na’ive counterparts, because they capture more signal and less
noise. Consider a na’ive analysis of returns to book-to-price (BP)
ratios. As most utilities have high B/P ratios, a naive return to
high B/P will be affected by events such as oil price shocks,
which are relevant to the pricing of utility stocks, but not necessarily
to the pricing of other stocks with high B/Ps. By contrast, a
pure return to B/P controls for the static introduced by industryrelated
(and other) effects. By providing a clearer picture of the
precise relationships between stock price behavior, company
. fundamentals, and macroeconomic conditions, disentangling
improves return predictability.
In considering possible variables for inclusion in a model of
stock price behavior, it is important to recognize that pure stock returns
are driven by a combination of economic fundamentals and
investor psychology. That is, economic fundamentals, such as interest
rates, industrial production, and inflation, can explain only p
of the behavior of stock returns. Psychology, including investors’
tendency to overreact, their desire to seek safety in numbers, and
their selective memories, plays a substantial in security role pricing.
Signals by corporate management, including stock splits, earnings
preannouncements, changes in dividend policy, share repurchases
or secondary offerings, and insider trading activity, may also prov
productive.
It is also important to allow for the fact that price responses ma
be nonlinear. For instance, a stock might be expected to react twice as
favorably to a 2-cent positive earnings surprise as to a l-cent~surprise.
It is highly unlikely, however, that a 57-cent surprise wilelicit 57
times the response of a l-cent surprise. Investor enthusiasm tends to
taper off because of satiation, suspicion that such a large surprise
a
norwarring event, or fear that it reflects a data error.
Return-predictor relationships are likely to differ across different
types of stocks. Because the value sector includes more financial
stocks than the growth sector, for example, value stocks in general
tend to be more sensitive than growth stocks to changes in interest
rate default spreads. Eamings surprises and earnings estimate revisions,
by contrast, appear to be more important for growth than for
value stocks. Thus, Intel shares can take a nosedive when earnings
come in a penny under expectations, whereas Ford shares remain