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Forecasting Cross-Section Stock Returns using Theoretical Prices Estimated from an Econometric Model

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Author Info
George Buckley
Richard Holt ()

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Abstract

We contribute to the debate over whether forecastable stock returns reflect an unexploited profit opportunity or rationally reflect risk differentials. We test whether agents could earn excess returns by selecting stocks which have a low market price compared to an estimate of the fundamental value obtained from an econometric model. The criterion for stock picking is one which could actually have been implemented by agents operating in real time. We show that statistically significant, and quantitatively substantial excess returns are delivered by portfolios of stocks which are cheap relative to our estimate of fundamental value. There is no evidence that the underpriced stocks are relatively risky and hence the excess returns cannot easily be interpreted as an equilibrium compensation for risk.

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Publisher Info
Paper provided by Edinburgh School of Economics, University of Edinburgh in its series ESE Discussion Papers with number 47.

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Length: 26
Date of creation: Apr 2004
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Handle: RePEc:edn:esedps:47

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Related research
Keywords: Excess returns; Trading rule; Efficient markets; present value model; stock prices;

Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies

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  1. Elton, Edwin & Gruber, Martin & Rentzler, Joel, 1983. "A simple examination of the empirical relationship between dividend yields and deviations from the CAPM," Journal of Banking & Finance, Elsevier, vol. 7(1), pages 135-146, March. [Downloadable!] (restricted)
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    Other versions:
  3. Camerer, Colin, 1989. " Bubbles and Fads in Asset Prices," Journal of Economic Surveys, Blackwell Publishing, vol. 3(1), pages 3-41.
  4. Banz, Rolf W., 1981. "The relationship between return and market value of common stocks," Journal of Financial Economics, Elsevier, vol. 9(1), pages 3-18, March. [Downloadable!] (restricted)
  5. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June. [Downloadable!] (restricted)
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  9. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Cowles Foundation Discussion Papers 719R, Cowles Foundation, Yale University. [Downloadable!]
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  11. Bulkley, George & Harris, Richard D F, 1997. "Irrational Analysts' Expectations as a Cause of Excess Volatility in Stock Prices," Economic Journal, Royal Economic Society, vol. 107(441), pages 359-71, March. [Downloadable!] (restricted)
  12. Cochrane, John H., 1991. "Volatility tests and efficient markets : A review essay," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 463-485, June. [Downloadable!] (restricted)
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  13. Berk, Jonathan B, 1995. "A Critique of Size-Related Anomalies," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 8(2), pages 275-86. [Downloadable!] (restricted)
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