Finance Canaries: The Price of Leading
SOME INDUSTRIES' CASH FLOW FLUCTUATIONS ARE AHEAD OF THE BUSINESS CYCLE, ACCORDING TO RESEARCH BY MAX CROCE. THIS MAKES THEM RISKIER THAN THE REST AND FORCES THEM TO PAY A 3.6% PREMIUM TO INVESTORSOld-time miners would have never ventured into the tunnels without canaries. The birds, more sensitive than men to noxious gases, would die before them in case of a dangerous leak, providing the miners with enough time to run for their lives.
Max Croce (Bocconi Department of Finance) has developed a method to single out stock exchange canaries (i.e. industries that are ahead of the business cycle) in a forthcoming paper with Tatyana Marchuk (BI Norwegian Business School) and Christian Schlag (Goethe University Frankfurt).
“Finance practitioners are familiar with leading and lagging variables,” Professor Croce said. “Leading variables respond promptly to exogenous shocks, whereas lagging variables adjust with a delay. In our paper, we extend the concept to leading and lagging industries.”
Even though leading industries are very similar to lagging industries across many aspects, their cash flow helps predict the cash flow of lagging industries, whereas their price-dividends ratio has forecasting power on future industrial production and unemployment above and beyond that of other common forecasting factors.
“The timing of information about leading industries provides valuable early resolution of uncertainty for industries that go through aggregate economic fluctuations with a delay,” Prof. Croce adds. “Hence, lagging firms are safer than leading firms.”
Being riskier, US listed firms in leading industries pay an average annualized return 3.6% higher than that of firms in lagging industries. Part of this premium is due to the fact that leading industries are per se riskier, and the authors estimate that the premium paid for the pure information timing is about 1.5%.
Leading industries, though, are not so easy to detect. In the US data analyzed by the authors, no industry is systematically leading the cycle or lagging behind it. The IT sector, for example, was leading the cycle in the late 1990s, whereas real estate and banks were leading in the mid-2000s. Croce and his colleagues developed a methodology to single out them, as soon as financial data are provided, and to design an investment strategy based on this information.
“We’ve observed that investors care about the timing of information,” Prof. Croce concluded, “meaning that they have utility functions more sophisticated than commonly thought. This opens avenues of collaboration with the colleagues in the Department of Decision Sciences who work on these topics.”
Max Croce, Tatyana Marchuk, Christian Schlag, “The Leading Premium,” forthcoming in Review of Financial Studies. DOI: https://doi.org/10.1093/rfs/hhad009.
by Fabio Todesco
