David Booth

Random Drift and Asset Allocation

A doubling of the price-earnings ratio occurs when r-g is cut in half. If r-g is 6%, then the P/E ratio for a stock or index is 16.7. If r-g is 3%, then the P/E ratio is 33.3.

Since current forecasts call for a modest growth in corporate earnings, the drop in r-g for large cap stocks appears to be due to a reduction in the cost of capital rather than an increase in the growth rate of earnings. A sharp drop in the average cost of capital produces a large increase in stock prices.

In summary, all three of the Fama/French factor returns have long runs in performance. Over the last thirty-five years, the drift in factor returns is about what is to be expected from random walks.

The last four years has been a period of unusually good returns for large cap stocks, while being a normal period for small cap stocks. The strong relative performance is due in large part to a reduction in the average cost of capital for large cap stocks. Based on the current valuation ratios, small cap stocks have a "normal" expected return and large cap stocks have a "below normal" expected return. The expected premium return for small cap stocks is unusually high.

Fama, Eugene F. and Kenneth R. French. "The Cross-Section of Expected Stock Returns." Journal of Finance 47 (1992).

Fama, Eugene F. and Kenneth R. French. "Size and Book-to-Market Factors in Earnings and Returns." Journal of Finance 50 (1995).

July 1999