Asset Growth, Profitability, and Investment Opportunities

Abstract

We show that recent prominent equity factor models are to a large degreecompatible with the Intertemporal CAPM (ICAPM) framework. Factors associated withalternative profitability measures forecast the equity premium in a way that is consistentwith the ICAPM. Several factors based on firms’ asset growth predict a significant declinein stock market volatility, thus being consistent with their positive prices of risk. Theinvestment-based factors are also strong predictors of an improvement in future economicactivity. The time-series predictive ability of most equity state variables is not subsumedby traditional ICAPM state variables. Importantly, factors that earn larger risk prices tendto be associated with state variables that are more correlated with future investmentopportunities or economic activity. Moreover, these risk price estimates can be reconciledwith plausible risk-aversion parameter estimates. Overall, the ICAPM can be used as acommon theoretical background for recent multifactor models.