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Operating Leverage, Stock Market Cyclicality, and the Cross-Section of Returns

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  • Francois Gourio

Abstract

I use a putty-clay technology to explain several asset market facts. The key mechanism is as follows: a one percent increase in revenues leads to a more-than-one percent increase in profits, since labor costs don’t move one-for-one. This amplification is greater for plants with low productivity for which the average profit margin (revenue minus costs) is small. This “operating leverage” effect implies that low productivity plants benefit disproportionately from business cycle booms. These plants have thus higher systematic risk and higher average returns. This model can help explain the empirical findings of Fama and French (1992), and more generally the sources of differences in market betas across firms. I obtain supporting evidence for the mechanism using firm- and industry-level data. The aggregate effect follows from trend growth: low-productivity plants outnumber high-productivity plants, making the aggregate stock market procyclical. I examine these aggregate implications and find that this model generates a volatile stock market return that predicts the business cycle.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2005 Meeting Papers with number 66.

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Date of creation: 2005
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Handle: RePEc:red:sed005:66

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Keywords: Fama and French ; Operating Leverage; Tobin's q;

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Cited by:
  1. Lu Zhang, 2005. "Anomalies," NBER Working Papers 11322, National Bureau of Economic Research, Inc.
  2. Cochrane, John H., 2005. "Financial Markets and the Real Economy," Foundations and Trends(R) in Finance, now publishers, vol. 1(1), pages 1-101, July.
  3. Motohiro Yogo & Leonid Kogan & Joao Gomes, 2007. "Durability of Output and Expected Stock Returns," 2007 Meeting Papers 432, Society for Economic Dynamics.

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