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

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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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
Date of revision:
Handle: RePEc:edn:esedps:47
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  1. Bulkley, George & Harris, Richard, 1996. "Irrational Analysts' Expectations as a Cause of Excess Volatility in Stock Prices," Discussion Papers 9608, Exeter University, Department of Economics.
  2. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 15(2), pages 457-510.
  3. Christie, William G., 1990. "Dividend yield and expected returns *1: The zero-dividend puzzle," Journal of Financial Economics, Elsevier, vol. 28(1-2), pages 95-125.
  4. 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.
  5. Ball, Ray, 1978. "Anomalies in relationships between securities' yields and yield-surrogates," Journal of Financial Economics, Elsevier, vol. 6(2-3), pages 103-126.
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