Mispricing and the cross-section of stock returns

This paper employs the Campbell-Shiller (Rev Financ Stud 1:195–228, 1988) VAR model to derive a model-based mispricing measure that captures investor overreaction to growth. Using this mispricing measure, we find that stocks with low levels of mispricing outperform otherwise similar stocks. The long–short mispricing strategy generates statistically and economically significant returns over the sample period of July 1981 to June 2006. Moreover, this mispricing strategy outperforms the contrarian strategy using various accounting-fundamental-to-price ratios. Our results cast doubt on the risk story in explaining the abnormal returns of the mispricing strategy. Rather, our evidence suggests that asset prices reflect both covariance risk and mispricing.

Seasonality in the cross-section of stock returns

This paper presents a new pattern in the cross-section of expected stock returns. Stocks tend to have relatively high (or low) returns every year in the same calendar month. We recognize the annual cross-sectional autocorrelation pattern documented in Jegadeesh [1990. Evidence of predictable behavior of security returns. Journal of Finance 45, 881–898] at lags of 12, 24, and 36 months as part of a general pattern that lasts up to 20 annual lags, superimposed on the general momentum/reversal patterns. This pattern explains an economically and statistically significant magnitude of the cross-sectional variation in average stock returns. Volume and volatility exhibit similar seasonal patterns but they do not explain the seasonality in returns. The pattern is independent of size, industry, earnings announcements, dividends, and fiscal year. The results are consistent with the existence of a persistent seasonal effect in stock returns.     

Credit ratings and the cross-section of stock returns

Low credit risk firms realize higher returns than high credit risk firms. This is puzzling because investors seem to pay a premium for bearing credit risk. The credit risk effect manifests itself due to the poor performance of low-rated stocks (which account for 4.2% of total market capitalization) during periods of financial distress. Around rating downgrades, low-rated firms experience considerable negative returns amid strong institutional selling, whereas returns do not differ across credit risk groups in stable or improving credit conditions. The evidence for the credit risk effect points towards mispricing generated by retail investors and sustained by illiquidity and short sell constraints.     

Technology prospects and the cross-section of stock returns

In an economy with time-varying investment opportunities, the changes in technology prospects affect aggregate consumption and individual firm's future dividends, and lead to systematic technology risk. We construct a technology factor to track the changes in technology prospects measured by U.S. patent shocks, and find that this factor explains the growth of aggregate consumption, helps to price important stock portfolios, and carries significant risk premium. Our empirical results suggest the existence of technology risk in the cross-section of stock returns.     

Macroeconomic risk and the cross-section of stock returns

We develop a conditional version of the consumption capital asset pricing model (CCAPM) using the conditioning variable from the cointegrating relation among macroeconomic variables (dividend yield, term spread, default spread, and short-term interest rate). Our conditioning variable has a strong power to predict market excess returns in the presence of competing predictive variables. In addition, our conditional CCAPM performs approximately as well as Fama and French’s (1993) three-factor model in explaining the cross-section of the Fama and French 25 size and book-to-market sorted portfolios. Our specification shows that value stocks are riskier than growth stocks in bad times, supporting the risk-based story.     

Dispersion of beliefs,ambiguity, and the cross-section of stock returns

We examine whether ambiguity is priced in the cross-section of expected stock returns. Using the cross-sectional dispersion in real-time forecasts of real GDP growth as a measure for ambiguity, we find that high ambiguity beta stocks earn lower future returns relative to low ambiguity beta stocks. This negative predictive relation between the ambiguity beta and future returns is consistent with theory, which predicts the marginal utility of consumption to rise when ambiguity is high. We further show that the ambiguity premium remains significant after controlling for exposures to expected real GDP growth, VIX, and financial market dislocations index.     

Short sales,institutional investors and the cross-section of stock returns

Short-sale constraints are most likely to bind among stocks with low institutional ownership. Because of institutional constraints, most professional investors simply never sell short and hence cannot trade against overpricing of stocks they do not own. Furthermore, stock loan supply tends to be sparse and short selling more expensive when institutional ownership is low. Using institutional ownership as a proxy, I find that short-sale constraints help explain cross-sectional stock return anomalies. Specifically, holding size fixed, the under-performance of stocks with high market-to-book, analyst forecast dispersion, turnover, or volatility is most pronounced among stocks with low institutional ownership. Ownership by passive investors with large stock lending programs partly mitigates this under-performance, indicating some impact of stock loan supply. Prices of stocks with low institutional ownership also underreact to bad cash-flow news and overreact to good cash-flow news, consistent with the idea that short-sale constraints hold negative opinions off the market for these stocks.     

Idiosyncratic risk and the cross-section of expected stock returns

Theories such as Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510] predict a positive relation between idiosyncratic risk and expected return when investors do not diversify their portfolio. Ang, Hodrick, Xing, and Zhang [2006. The cross-section of volatility and expected returns. Journal of Finance 61, 259–299], however, find that monthly stock returns are negatively related to the one-month lagged idiosyncratic volatilities. I show that idiosyncratic volatilities are time-varying and thus, their findings should not be used to imply the relation between idiosyncratic risk and expected return. Using the exponential GARCH models to estimate expected idiosyncratic volatilities, I find a significantly positive relation between the estimated conditional idiosyncratic volatilities and expected returns. Further evidence suggests that Ang et al.'s findings are largely explained by the return reversal of a subset of small stocks with high idiosyncratic volatilities.     

Sell-order liquidity and the cross-section of expected stock returns

We estimate buy- and sell-order illiquidity measures (lambdas) for a comprehensive sample of NYSE stocks. We show that sell-order liquidity is priced more strongly than buy-order liquidity in the cross-section of equity returns. Indeed, our analysis indicates that the liquidity premium in equities emanates predominantly from the sell-order side. We also find that the average difference between sell and buy lambdas is generally positive throughout our sample period. Both buy and sell lambdas are significantly positively correlated with measures of funding liquidity such as the TED spread as well option implied volatility.     

Idiosyncratic risk,costly arbitrage,and the cross-section of stock returns

We test a new cross-sectional relation between expected stock return and idiosyncratic risk implied by the theory of costly arbitrage. If arbitrageurs find it more difficult to correct the mispricing of stocks with high idiosyncratic risk, there should be a positive (negative) relation between expected return and idiosyncratic risk for undervalued (overvalued) stocks. We combine several well-known anomalies to measure stock mispricing and proxy stock idiosyncratic risk using an exponential GARCH model for stock returns. We confirm that average stock returns monotonically increase (decrease) with idiosyncratic risk for undervalued (overvalued) stocks. Overall, our results support the importance of idiosyncratic risk as an arbitrage cost.     

Time-dependent lottery preference and the cross-section of stock returns

Highlighting the importance of benchmark to identify lottery-like payoffs of stocks, this study proposes that investors’ lottery preference is formed toward tracking stocks’ performance over time. Accordingly, we develop a strategy based on time-dependent maximum daily return (denoted as TMAX) by buying (short selling) stocks with the most recent maximum daily returns (MAX) ranked in the bottom (top) decile of the historical distribution. The TMAX strategy generates significant premium that subsumes the profitability of Bali, Cakici, and Whitelaw’s (2011) MAX strategy, but not vice versa. A major advantage of the TMAX strategy is its time-invariant profitability across different periods and sentiment states. Further analyses show that the TMAX premium can be explained by shorting flow and behavioral theories, supporting the time-dependent feature of lottery preference.     

Foreign exchange risk and the cross-section of stock returns

We examine the relation between the cross-section of US stock returns and foreign exchange rates during the period from 1973 to 2002. We find that stocks most sensitive to foreign exchange risk (in absolute value) have lower returns than others. This implies a non-linear, negative premium for foreign exchange risk. Sensitivity to foreign exchange generates a cross-sectional spread in stock returns unexplained by existing asset-pricing models. Consequently, we form a zero-investment factor related to foreign exchange-sensitivity and show that it can reduce mean pricing errors for exchange-sensitive portfolios. One possible explanation for our findings includes Johnson's [2004. Forecast dispersion and the cross-section of expected returns. Journal of Finance, 59, 1957–1978] option-theoretic model in which expected returns are decreasing in idiosyncratic cashflow volatility.     

Endogenous technological progress and the cross-section of stock returns

I study the cross-sectional variation of stock returns and technological progress using a dynamic equilibrium model with production. Technological progress is endogenously driven by research and development (R&D) investment and is composed of two parts. One part is devoted to product innovation; the other, to increasing the productivity of physical investment. The latter is embodied in new tangible capital. The model breaks the symmetry assumed in standard models between tangible and intangible capital, in which the accumulation processes of tangible and intangible capital stock do not affect each other. Qualitatively and, in many cases, quantitatively, the model explains well-documented empirical regularities.     

The cross-section of stock returns in an early stock market

Using a new dataset which contains monthly data on 1015 stocks traded on the London Stock Exchange between 1825 and 1870, we investigate the cross section of stock returns in this early capital market. Unique features of this market allow us to evaluate the veracity of several popular explanations of asset pricing behavior. Using portfolio analysis and Fama–MacBeth regressions, we find that stock characteristics such as beta, illiquidity, dividend yield, and past-year return performance are all positively correlated with stock returns. However, market capitalization and past-three-year return performance have no significant correlation with stock returns.     

Social media effect,investor recognition and the cross-section of stock returns

Investor recognition affects cross-sectional stock returns. In informationally incomplete markets, investors have limited recognition of all securities, and their holding of stocks with low recognition requires compensation for being imperfectly diversified. Using the number of posts on the Chinese social media platform Guba to measure investor recognition of stocks, this paper provides a direct test of Merton's investor recognition hypothesis. We find a significant social media premium in the Chinese stock market. We further find that including a social media factor based on this premium significantly improves the explanatory power of Fama-French factor models of cross-sectional stock returns, and these results are robust when we control for the mass media effect and liquidity effect. Finally, we find that investment strategies based on the social media factor earn sizable risk-adjusted returns, which signifies the importance of the social media premium in portfolio management.     

Cashflow risk,systematic earnings revisions,and the cross-section of stock returns

The returns of stocks are partially driven by changes in their expected cashflow. Using revisions in analyst earnings forecasts, we construct an analyst earnings beta that measures the covariance between the cashflow innovations of an asset and those of the market. A higher analyst earnings beta implies greater sensitivity to marketwide revisions in expected cashflow, and therefore higher systematic risk. Our analyst earnings beta captures exposure to macroeconomic fluctuations and has a positive risk premium that provides a partial explanation for the value premium, size premium, and long-term return reversals. From 1984 to 2005, 55.1% of the return variation across book-to-market, size, and long-term return reversal portfolios is captured by their analyst earnings betas.     

Composition of wealth,conditioning information,and the cross-section of stock returns

Value stocks covary with aggregate consumption more than growth stocks during periods when financial wealth is low relative to consumption. However, the conditional value premium does not exhibit such countercyclical behavior. Consequently, a one-factor conditional consumption-based asset pricing model can be rejected without making any arbitrary assumptions on the dynamics of the price of risk or the conditional moments. Empirical evidence is somewhat more consistent with a consumption-based model augmented with an aggregate wealth growth factor, which can be motivated by either recursive preferences or relative wealth concerns.     

Limited investor attention,relative fundamental strength,and the cross-section of stock returns

We explore the underlying reasons for the apparent mispricing of firms based on fundamental information. We document that a relative fundamental strength strategy that buys (sells) firms with strong (weak) fundamentals is highly profitable for up to three years. The results cannot be explained by either price or earnings momentum, are robust to risk adjustments based on standard asset pricing models, and survive a battery of robustness tests. The strategy also works better among small firms, as well as firms with low analyst coverage and a high probability of informed trading. Our empirical findings support the hypotheses of limited investor attention and informed trading.     

The cross-section and time series of stock and bond returns

Bond factors which predict future U.S. economic activity at business cycle horizons are priced in the cross-section of U.S. stock returns. High book-to-market stocks have larger exposures to these bond factors than low book-to-market stocks, because their cash flows are more sensitive to the business cycle. Because of this new nexus between stock and bond markets, a parsimonious three-factor dynamic no-arbitrage model can be used to jointly price book-to-market-sorted portfolios of stocks and maturity-sorted bond portfolios, while reproducing the time-series variation in expected bond returns. The business cycle itself is a priced state variable in stock and bond markets.     

The relationship between asset growth and the cross-section of stock returns

There is a large body of literature examining the association between stock characteristics and the cross-section of stock returns in international markets. Recently, Cooper et al. (2008) reported a strong association between total asset growth and stock returns in the US. In this paper, we show that an asset-growth effect also exists in the Australian equity market. Of particular interest, it is present amongst the largest Australian stocks. Over the 1983-2007 period, an equally-weighted portfolio of low-growth Big stocks outperforms a portfolio of high-growth Big stocks by an average 1% per month, equating to nearly 13% per annum. At an individual stock level of analysis, the asset-growth effect remains even after controlling for other variables whose association with the cross-section of returns is well known. Finally, we explicitly test whether asset growth is a priced risk factor using the common two-stage cross-sectional regression methodology. We find no evidence to support a risk-based explanation, thereby lending credence to Cooper et al.’s (2008) suggestion that the asset-growth effect is attributable to mispricing.