*Article* **Size, Value and Business Cycle Variables. The Three-Factor Model and Future EconomicGrowth: Evidence from an Emerging Market**

#### **Fahad Ali 1,\*, RongRong He 2 and YueXiang Jiang 1**


Received: 1 November 2017; Accepted: 14 February 2018; Published: 28 February 2018

**Abstract:** The paper empirically investigates three different methods to construct factors and identifies some pitfalls that arise in the application of Fama-French's three-factor model to the Pakistani stock returns. We find that the special features in Pakistan significantly affect size and value factors and also influence the explanatory power of the three-factor model. Additionally, the paper examines the ability of the three factors to predict the future growth of Pakistan's economy. Using monthly data of both financial and non-financial companies between 2002 and 2016, the article empirically investigates and finds that: (1) size and book-to-market factors exist in the Pakistani stock market, two mimic portfolios SMB and HML generate a return of 9.15% and 12.27% per annum, respectively; (2) adding SMB and HML factors into the model meaningfully increases the explanatory power of the model; and (3) the model's factors, except for value factor, predict future gross domestic product (GDP) growth of Pakistan and remain robust. Our results are robust across sub-periods, risk regimes, and under three different methods of constructing the factors.

**Keywords:** emerging markets; KSE Pakistan; three-factor model; size and value premiums; future economic growth

**JEL Classification:** G11; G12; O10
