Asset Growth, Profitability, and Investment Opportunities
Management Science (Forthcoming)
49 Pages Posted: 25 Jan 2015 Last revised: 3 Jan 2018
Date Written: January 2, 2018
We show that recent prominent equity factor models are to a large degree compatible with the Merton's (1973) Intertemporal CAPM (ICAPM) framework. Factors associated with alternative profitability measures forecast the equity premium in a way that is consistent with the ICAPM. Several factors based on firms' asset growth predict a significant decline in stock market volatility, thus being consistent with their positive prices of risk. The investment-based factors are also strong predictors of an improvement in future economic activity. The time-series predictive ability of most equity state variables is not subsumed by traditional ICAPM state variables. Importantly, factors that earn larger risk prices tend to be associated with state variables that are more correlated with future investment opportunities or economic activity. Moreover, these risk price estimates can be reconciled with plausible risk aversion parameter estimates. Therefore, the ICAPM can be used as a common theoretical background for recent multi-factor models.
Keywords: Asset pricing models; Equity risk factors; Intertemporal CAPM; Predictability of stock returns; Cross-section of stock returns; stock market anomalies
JEL Classification: G10, G11, G12
Suggested Citation: Suggested Citation