Market Segmentation and Stock Price Behaviour

We employ Campbell and Shiller’s (1989) VAR methodology to examine the relative performance of the CAPM and the consumption‐CAPM. We find that although neither provides a complete description of stock price behaviour, the former clearly dominates the latter. We then consider the implications for sub‐sectors of the market. According to the CAPM, sub‐sector returns depend on the covariance of sub‐sector returns with market returns. However, if analysts are more skilled at eliminating mis‐pricing in sub‐sectors of the market than in the market as a whole, the required return on a sectoral portfolio may depend only on the expected return variance within that sub‐sector. Using quarterly UK data for five industry‐based portfolios, we find little support for the covariance model at the sectoral level, whereas the own‐variance model fares better. It seems therefore that moving from return variances to covariances produces little if any improvement in the performance of the CAPM.