Asset-Pricing Anomalies and Financial Distress

Abstract

This paper shows that financial distress is crucial in explaining the profitability of prominent market anomalies. In particular, price momentum, earnings momentum, credit risk, dispersion, and idiosyncratic volatility effects in the cross-section of stock returns arise in periods of deteriorating credit conditions and are nonexistent in stable or improving credit conditions. Essentially, these strategies target firms with substantially deteriorated credit conditions that keep on deteriorating over the holding period. In contrast, the accruals, size, and book-to-market anomalies are prominent in periods of improving or stable credit conditions. They disappear or are attenuated during deteriorating credit conditions. The size and book-to-market strategies also target firms whose credit conditions have deteriorated over the past but are profitable only if credit conditions improve over the holding period.

Keywords: asset-pricing anomalies, financial distress, credit rating, momentum, dispersion, accruals, size, book-to-market

JEL Classification: G12, G14