The Cross-Section of Expected Stock Returns 44l The relation between average return and E/P has a familiar U Jaffe, Keim, and Westerfield (1989 )for U.S. data, and chan Lakonishok (1991)for Japan). Average returns decline from month for the negative E/P portfolio to 0. 93% for the firms in portfolio 1B that have low but positive E/P. Average returns then increase monotone cally, reaching 1. 72% per month for the highest E/P portfolio The more striking evidence in Table Iv is the strong positive relation between average return and book-to-market equity. Average returns rise from 0.30%for the lowest BE/ME portfolio to 1.88% for the highes difference of 1.53% per month. This spread is twice as large as the difference of 0.74% between the average monthly returns on the smallest and largest ize portfolios in Table Il. note also that the strong relation between book-to market equity and average return is unlikely to be a B effect in disguises Table Iv shows that post-ranking market Bs vary little across portfolios formed on ranked values of BE/ mE On average only about 50(out of 2317)firms per year have negative book quity, Be. The negative BE firms are mostly concentrated in the last 14 years of the sample, 1976-1989, and we do not include them in the tests. We an report, however, that average returns for negative BE firms are high like the average returns of high BE /ME firms. Negative BE(which results from persistently negative earnings)and high BE /ME (which typically means that stock prices have fallen) are both signals of poor earning prospects. The imilar average returns of negative and high BE/ME firms are thus consist ent with the hypothesis that book-to-market equity captures cross-sectional variation in average returns that is related to relative distress B. Fama-MacBeth Regression B.I. BE/ME The FM regressions in Table III confirm the importance of book-to- market quity in explaining the cross-section of average stock returns. The slope from the monthly regressions of returns on In(BE/ME) alone is 0. 50% with a t-statistic of 5.71. This book-to-market relation is stronger than the size effect, which produces a t-statistic of-2.58 in the regressions of returns on In(ME)alone. But book-to-market equity does not replace size in explain ing average returns. when both In(ME)and in(Be/ME)are included in the regressions, the average size slope is still-199 standard errors from 0; the book-to-market slope is an impressive 4. 44 standard errors from o B.2.L The FM regressions that explain returns with leverage variables provide interesting insight into the relation between bookto-market equity and average return. We use two leverage variables, the ratio of book assets to market equity, A/ME, and the ratio of book assets to book equity, A/BE.We interpret A/ ME as a measure of market leverage, while a/BE is a measure