The Value Spread: A Puzzle
The standard dynamic investment model fails to explain the value spread, which is the difference in the market equity-to-capital ratio between extreme book-to-market deciles. Even when the model manages to fit the valuation ratios across some testing assets, the implied expected return errors are large. In contrast to the model's superior in-sample fit of expected returns, recursive estimation reveals its poor out-of-sample performance. Time series instability and industry heterogeneity of the model parameters are the likely culprits. In all, we conclude that the dynamic investment framework is not yet useful for valuation and expected return estimation in practice.
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