Can quality ratings of the type provided by Standard & Poor’s predict the subsequent price behavior of common stocks? The author ranked all New York Stock Exchange stocks rated by Standard & Poor’s on the basis of the latter’s quality ratings and constructed portfolios based on these rankings. He then examined the degree of correspondence between the original quality rankings of the portfolios and their subsequent price risk, employing as his risk measures beta, which measures sensitivity to general market fluctuations, and the variance of monthly rates of return, which incorporates both market and non-market risk.
The author found perfect correspondence between quality ratings and subsequent beta, and nearly perfect correspondence between ratings and variance. Furthermore, the dispersion of returns on the individual stocks within each portfolio displayed nearly perfect correspondence with the portfolio’s average quality ranking.