Style Drifter

Random Drift and Asset Allocation

Style Drifter

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).

This article contains the opinions of the author and those interviewed by the author but not necessarily Dimensional Fund Advisors Inc. or DFA Securities Inc., and does not represent a recommendation of any particular security, strategy or investment product. The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.


July 1999