Monday, June 04, 2012

CAPM Never Confirmed?

I was looking at a 2004 JEP paper from Fama and French on the history of the CAPM.  Interestingly, they mention all the papers that showed the slope on CAPM betas was too low, and it included just about every important empirical paper on this subject.  It got me thinking: was there ever a paper that didn't estimate the security market line was 'too low?'

Recall that, in cross-section regressions, the Sharpe–Lintner model predicts that the intercept is the riskfree rate and the coefficient on beta is the expected market return in excess of the risk-free rate, E(RM) - Rf. The regressions consistently find that the intercept is greater than the average risk-free rate (typically proxied as the return on a one-month Treasury bill), and the coefficient on beta is less than the average excess market return (proxied as the average return on a portfolio of U.S. common stocks minus the Treasury bill rate). This is true in the early tests, such as Douglas (1968), Black, Jensen and Scholes (1972), Miller and Scholes (1972), Blume and Friend (1973), and Fama and MacBeth (1973), as well as in more recent cross-section regression tests, like Fama and French (1992).

The evidence that the relation between beta and average return is too flat is confirmed in time series tests, such as Friend and Blume (1970), Black, Jensen, and Scholes (1972), and Stambaugh (1982). The intercepts in time series regressions of excess asset returns on the excess market return are positive for assets with low betas and negative for assets with high betas.

When I was in grad school, this was not conventional wisdom, though with hindsight it supposedly was.  Rather, we emphasized that you could not reject the CAPM if you threw the kitchen sink of uncertainties and refinements in there. This kind of historical revisionism, common among stock prognosticators and consultants, is really misleading because it makes it seem that a bunch of really smart experts are never really wrong about something right in the middle of their bailiwick.  


paul b said...

This is from Fischer Black’s 1993 JPM article “Beta and Return” after sighting numerous studies finding a flatter than predicted beta line.
“Moreover, if the line is really flat, that implies dramatic investment opportunities for those who use beta. A person who normally holds both stocks and bonds or stocks and cash can shift to a portfolio of similar total risk but higher expected return by emphasizing low-beta stocks.
Beta is a valuable investment tool if the line is as steep as the CAPM predicts. It is even more valuable if the line is flat. No matter how steep the line is, beta is alive and well.”

It was not a question of “rejecting” CAPM based on empirical studies. It’s always been, “what is a good theory of value?” And CAPM is a pretty good theory.

Eric Falkenstein said...

I lost the citation, but I think Stephen Ross said that the CAPM is even more important if it is wrong around that time. I'm not so sure, it depends why it's wrong. if it's wrong because risk is not really measured by beta, it isn't clear maximizing a Sharpe ratio is optimal. Now, I think maximizing a Sharpe ratio seems like a good idea, but I'm not sure that this is obviously a good objective.

Eric Falkenstein said...

Also, the CAPM presumably was useful for estimating returns and the cost of capital. There is no empirical support for that assertion. It is merely a good normative guide given E(ret) is uncorrelated (at best) with beta/volatility.