Predictability and the Cross-Section of Expected Returns: A Challenge for Asset Pricing Models

51 Pages Posted: 2 Jun 2016 Last revised: 11 Sep 2020

See all articles by Christian Schlag

Christian Schlag

Goethe University Frankfurt; Leibniz Institute for Financial Research SAFE

Michael Semenischev

University of Muenster - Finance Center Muenster

Julian Thimme

Karlsruhe Institute of Technology

Date Written: November 15, 2019

Abstract

Many modern macro finance models imply that excess returns on arbitrary assets are predictable via the price-dividend ratio and the variance risk premium of the aggregate stock market. We propose a simple empirical test for the ability of such a model to explain the cross-section of expected returns by sorting stocks based on the sensitivity of expected returns to these quantities. Models with only one uncertainty-related state variable, like the habit model or the long-run risks model, cannot pass this test. However, even extensions with more state variables mostly fail. We derive criteria models have to satisfy to produce expected return patterns in line with the data and discuss various examples.

Keywords: Asset pricing, cross-section of stock returns, predictability

JEL Classification: G12, E44, D81

Suggested Citation

Schlag, Christian and Semenischev, Michael and Thimme, Julian, Predictability and the Cross-Section of Expected Returns: A Challenge for Asset Pricing Models (November 15, 2019). SAFE Working Paper No. 289, Available at SSRN: https://ssrn.com/abstract=2788117 or http://dx.doi.org/10.2139/ssrn.2788117

Christian Schlag

Goethe University Frankfurt ( email )

Faculty of Economics and Business
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, Hessen 60323
Germany

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany
+49 69 798 33699 (Phone)

Michael Semenischev

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 22854 (Phone)
+49 251 83 22690 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=2986

Julian Thimme (Contact Author)

Karlsruhe Institute of Technology ( email )

Kaiserstra├če 12
Karlsruhe, Baden W├╝rttemberg 76131
Germany

HOME PAGE: http://julianthimme.de

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