At McMaster University, students, researchers, faculty, and staff collaborate across disciplines to explore and expand their potential in a globally renowned, innovative education and research community, committed to advancing societal health and wellbeing. For the next several months, the DeGroote School of Business will be highlighting researchers that are contributing to this push for a brighter world.
It’s impossible to read the business section of a newspaper without coming across a story on the stock market. DeGroote Finance and Business Economics Professor Ronald Balvers has always been fascinated with the ups and downs of the market – especially the predictable components of stock prices.
But while standard explanations of stock market movements often start with investors, Balvers feels the expectations and circumstances of firms should be more prominent in the story. This area of research, which Balvers has been studying since the 1990s, is known as production-based asset pricing. It examines how firm productivity and profitability relate to stock returns.
“Traditional views – based on the circumstances of investors, and in particular their consumption prospects – perform very poorly in explaining and predicting what happens in the stock market,” explains Balvers, who is also the Michael Lee-Chin and Family Chair in Investment and Portfolio Management, and Director of the Michael Lee-Chin and Family Institute for Strategic Business Studies.
“Involving profitability, investment growth, and how the firm’s real assets are valued compared to the cost of ownership by buying shares leads to far better explanation. The implication is that financial investment decisions involve less uncertainty,” he continues.
“So, for instance, it becomes easier for folks planning their retirement to project what returns they can expect from their investment portfolio. Additionally, it becomes easier for individual investors to replicate the returns of hedge funds and other investment funds, but without paying substantial fees, by simply relating their portfolio choices to observable variables like firm profitability.”
With increased knowledge of what drives stock returns, says Balvers, it’s also easier for businesses to use returns as leading indicators to interpret stock price fluctuations, and to identify what they reveal about the business cycle.
“The business cycle is the fluctuation in economic activity that an economy experiences over a period of time,” explains Balvers. “So, businesses may, for example, use stock prices as a sort of advanced notice of a recession, which can help them to plan production better.”
One of Balvers’ current research projects examines how differences in stock returns across countries relate to differences in economic growth across countries. He has found that these differences explain “mean reversion” in stock prices between countries.
Mean revision is a theory that suggests stock prices have a tendency to move back toward an average trend, which can be the historical average of the return or another relevant average. This, he says, allows for more accurate predictions of which firms in which countries will have higher returns — allowing people to buy stocks in a more informed way.
“Countries lagging in technological sophistication generally have low past stock returns,” he says. “However, due to technological catch-up, leap-frogging, and the possibility of imitation, which is cheaper than invention, they are anticipated to have higher productivity growth, which leads to higher profitability for companies in these countries. Recent research by myself and others has found that higher profits relate to higher future stock returns.
“So, firms in lagging-technology countries, such as many African and Eastern European countries, are actually expected to generate higher future returns compared to those in leading-technology countries such as the United States,” he continues.
Balvers’ research extends beyond production-based asset pricing to examine what we can learn about society by observing stock returns. In these cases, rather than finding out how economic conditions affect stock prices, the formula can be turned around. Because demand for stocks is forward looking, it becomes possible to find out what current stock prices reveal about future economic conditions anticipated by market participants.
For instance, one of Balvers’ recent papers examines what the stock market implies about some of the perceived costs of global warming, while another addresses the impact that the boycotting by investors of “sin stocks” such as those of fossil fuels and cigarette producers have on stock returns.
Ronald Balvers is the Michael Lee-Chin and Family Chair in Investment and Portfolio Management, and Director of the Michael Lee-Chin and Family Institute for Strategic Business Studies, at the DeGroote School of Business. His research interests include production-based asset pricing, predictability of stock returns, and asset pricing with asymmetric information. He’s been a member of the editorial board of the International Journal of Financial Studies since 2012.